THE QUALITATIVE CHARACTERISTICS part2

THE QUALITATIVE CHARACTERISTICS part2

QC7. The qualities of decision-useful financial reporting information are relevance, faithful representation, comparability, and understandability. The qualities are subject to two pervasive constraints: materiality and benefits that justify costs.

Relevance

QC8. To be useful in making investment, credit, and similar resource allocation decisions, information must be relevant to those decisions. Relevant information is capable of making a difference in the decisions of users by helping them to evaluate the potential effects of past, present, or future transactions or other events on future cash flows (predictive value) or to confirm or correct their previous evaluations (confirmatory value). Timeliness—making information available to decision makers before it loses its capacity to influence decisions—is another aspect of relevance.

QC9. The phrase capable of making a difference is important. In the past, some participants in the standard-setting process have claimed that information lacks relevance if it is not possible to demonstrate either that it has been or will be used or that it has affected or will affect a particular decision. But information may be capable of making a difference in a decision—and thus be relevant—even if some users choose not to take advantage of it or are already aware of it. Different users may use different types of information or may use the same information differently. Also, many users may incorporate the available financial reporting information into their decision processes and may not be aware of other pertinent information that financial reports could include. Those users may not be able to determine how, or even whether, such additional information would affect their decisions until the information becomes available and they have had the opportunity to incorporate it into their decision-making processes. Also, some users may have easier access to sources of information outside general purpose financial reports than do others. Accordingly, standard setters cannot rely entirely on users to request or identify all of the information that is capable of making a difference in a decision.

Predictive Value and Confirmatory Value

QC10. To say that an item of financial reporting information has predictive value means that it has value as an input to a predictive process. It does not mean that the information itself is a prediction or forecast. Investors, creditors, and others often use information about the past to help in forming their own expectations about the future. Without knowledge of the past, users generally will have no basis for a prediction. For example, information about past or current financial position and performance, generally considered in conjunction with other information, is often used in predicting future financial position and performance and other matters, such as future dividend, interest, or wage payments and the entity’s ability to meet its commitments as they become due.

QC11. The focus on predictive value as one aspect of relevance does not mean that relevant information is, in effect, designed to predict itself. Information that has predictive value need not be—and usually is not—part of a series in which the next number in the series can be accurately predicted on the basis of the previous numbers in the series. For example, investors and other users of financial reporting information often wish to predict revenue for the next reporting period. Reported revenue for the most recent reporting period is likely to have value as an input to whatever process a particular user employs to predict future revenue. But current revenue does not, by itself, predict future revenue. (Some types of predictions may be necessary to estimate financial reporting amounts, for example, the predicted useful life of a long-lived asset is used in determining depreciation amounts, and the expected return on a financial instrument is used in estimating its fair value. Those types of predictions necessary to make estimates are not what the framework means by predictive value.)

QC12. In addition, financial information may be highly predictable without being relevant to users’ assessments of the amounts, timing, and uncertainty of an entity’s future cash flows. An example is straight-line depreciation of the original (historical) cost of a piece of equipment. Reported depreciation expense for one year exactly predicts depreciation expense for the next year in the life of the equipment. Historical-cost depreciation reflects the using up or consumption of an asset, which is a real-world economic phenomenon. (See paragraph QC18.) But the amounts allocated to each year and the resulting carrying amount may not faithfully represent the decline in the asset’s value or its current condition in financial terms unless the value of the asset declines ratably over its estimated useful life. In such circumstances, historical cost depreciation may not be very helpful in assessing an entity’s ability to generate net cash inflows.

QC13. Information that has confirmatory value may confirm past (or present) expectations based on previous evaluations or it may change (correct) them. Information that confirms past expectations decreases the uncertainty (increases the likelihood) that the results will be as previously expected. If the information changes expectations, it changes the perceived probabilities of the range of possible outcomes or their amounts. In other words, the information changes the degree of confidence in past expectations. Either way, it is capable of making a difference in users’ decisions.

QC14. The predictive and confirmatory roles of information are interrelated; information that has predictive value usually also has confirmatory value. For example, information about the current level and structure of assets and liabilities helps users to predict an entity’s ability to take advantage of opportunities and to react to adverse situations. The same information helps to confirm or correct users’ past predictions about that ability.

Timeliness

QC15. Timeliness, which is an ancillary aspect of relevance, means having information available to decision makers before it loses its capacity to influence decisions. If information becomes available only after the time that a decision must be made, it has no capacity to influence that decision and thus lacks relevance. Timeliness alone cannot make information relevant. But having relevant information available sooner can enhance its capacity to influence decisions, and a lack of timeliness can rob information of relevance it might otherwise have had. To sacrifice some degree of precision for increased timeliness sometimes may be desirable because an approximation produced quickly may be more useful than precise information that takes longer to produce. However, some information may continue to be timely long after the end of a reporting period because some users may continue to need to consider that information in making decisions. For example, users may need to assess trends in various items of financial reporting information in making investment or credit decisions.

Faithful Representation

QC16. To be useful in making investment, credit, and similar resource allocation decisions, information must be a faithful representation of the real-world economic phenomena that it purports to represent. The phenomena represented in financial reports are economic resources and obligations and the transactions and other events and circumstances that change them. To be a faithful representation of those economic phenomena, information must be verifiable, neutral, and complete.

QC17. Information cannot be a faithful representation of an economic phenomenon unless it depicts the economic substance of the underlying transaction or other event, which is often, but not always, the same as its legal form. Thus, to include what has often been termed substance over form as a separate qualitative characteristic is unnecessary because faithful representation is incompatible with information that subordinates substance to form.

QC18. The phrase real-world economic phenomena deserves emphasis because its implications have often been overlooked. The phenomena depicted in financial reports are real world because they exist now or have already occurred. For example, a stamping machine exists in the real world. In contrast, an accounting construct such as a “deferred charge” (that is not an economic resource) or a “deferred credit” (that is not an economic obligation) is a creation of accountants. Because such deferred charges and deferred credits do not exist in the real world outside financial reporting, they cannot be faithfully represented as the term is used in the framework. The phenomena to be represented in financial reports are economic because they are “relating to the production and distribution of material wealth.”2 The machine qualifies as an economic phenomenon, and a photograph may be one way to faithfully represent it. However, a photograph is not sufficient for financial reporting. Inclusion of information about the machine in an entity’s financial reports, especially in its financial statements, requires that the machine be depicted in words and numbers. Determining how best to depict in financial terms the machine as it currently exists in the real world is the role of faithful representation. The machine’s original cost is a real-world economic phenomenon, and reporting that amount would be one way to faithfully represent the machine. However, if the machine is three years old, reporting it at original cost would not be a faithful representation of the machine as it now exists. In that situation, reporting the machine at an amount based on allocating its original cost over its useful life (amortized or depreciated cost) rather than at its original cost would better represent the machine as it currently exists. Another method, such as reporting the machine at an amount based on what it would cost to replace it in its current condition (replacement cost) might provide an even better representation of the machine as it now exists in the real world. Another method of representing the machine in its current condition would be to report the amount that would be received for the machine in a current exchange between a willing buyer and willing seller (fair value). Whether one of those methods would provide both a more relevant and more representationally faithful depiction of the machine is an issue for standard setters to resolve.

QC19. The meaning of the phrase what it purports to represent has also sometimes been misunderstood. For example, the number 1,000 is the result of multiplying 100 by 10. If the result of that calculation is all that the information purports to represent, 1,000 might be said to be a faithful representation. But faithful representation applies only to real-world economic phenomena (paragraph QC18). Multiplying 100 by 10 might be part of faithfully representing a real-world economic phenomenon, such as the total cost of 100 items acquired for 10 each. But the result of the calculation, by itself, is not a real-world economic phenomenon. Therefore, the cost of 100 items, not the result of the underlying calculation, would be what the information purports to represent as the framework uses that term.

Certainty, Precision, and Faithful Representation

QC20. An entity’s financial report, especially its financial statements, can be thought of as a financial model of the entity—a model that represents the entity’s economic resources and obligations and changes in them, including the financial flows into, out of, and within the entity. Like all models, it must abstract from much that goes on in the real world. No model can show everything that happens within a complex entity—to do so, the model would virtually have to reproduce the original. However, the mere fact that a model works—that when it receives inputs it produces outputs—gives no assurance that it faithfully represents the original. Just as an inexpensive sound system may fail to reproduce faithfully the sounds that went into the microphone, so a poor financial model fails to represent faithfully the real-world economic phenomena that it models. The question that standard setters must face continually is how much precision is necessary and feasible in the financial reporting model. A perfect sound reproduction system would be too expensive for most people, and the cost of a perfect financial reporting model, even if technically feasible, would make it equally impractical.

QC21. Economic activities take place under conditions of uncertainty, and most financial reporting measures involve estimates of various types, some of which incorporate management judgment. With the possible exception of the amount of cash that an entity controls, it rarely is possible to develop a measure of an economic phenomenon that does not involve some degree of uncertainty. For instance, an entity’s receivables could be represented as the sum of the legal claims embodied in the receivables. However, a more relevant representation would be the estimated amount of cash inflows that will result from the receivable, which requires reflecting the effects of uncertainty about whether the receivables are collectible. An estimate of receivables that are collectible at a point in time may be a faithful representation even though the amount that is eventually collected differs from the previous estimate. To faithfully represent an economic phenomenon, an estimate must be based on the appropriate inputs, and each input must reflect the best available information. Accuracy of estimates is desirable, of course, and some minimum level of accuracy (precision) is necessary for an estimate to be a faithful representation of an economic phenomenon. However, faithful representation implies neither absolute precision in the estimate nor certainty about the outcome. To imply a degree of precision or certainty of information that it does not possess would diminish the extent to which the information faithfully represents the economic phenomena that it purports to represent.

QC22. Some financial reporting measures that are often thought of as precise, or at least more precise than the alternatives, prove to be not necessarily so precise upon closer inspection. For example, measures based on original cost have long been regarded as highly precise representations of economic phenomena, and it is true that the cost of acquiring assets can often be determined unambiguously. However, if a collection of assets is bought for a specified amount, the cost of each individual item may be impossible to ascertain. The problem of determining cost becomes more difficult if assets are fungible. If an entity has made several purchases at different prices and a number of disposals at different dates, only by the adoption of some convention (such as first-in, first out [FIFO]) can a cost be allocated to the assets on hand at a particular date. The result is that what is shown as the assets’ cost is only one of several alternatives, and it is difficult to verify that the chosen amount faithfully represents the economic phenomenon in question, that is, the purchase price of the assets.

Components of Faithful Representation

Verifiability

QC23. To assure users that information faithfully represents the economic phenomena that it purports to represent, the information must be verifiable. Verifiability implies that different knowledgeable and independent observers would reach general consensus, although not necessarily complete agreement, either: a. That the information represents the economic phenomena that it purports to represent without material error or bias (by direct verification); or

b. That the chosen recognition or measurement method has been applied without material error or bias (by indirect verification).

To be verifiable, information need not be a single point estimate. A range of possible amounts and the related probabilities can also be verified.

QC24. Financial reporting information may not faithfully represent economic phenomena because of errors of either method or application or both. Errors of method result from using a recognition or measurement method that is unlikely to produce a result that faithfully represents the economic phenomena that it purports to represent. For example, the method may consistently omit, misdescribe, or misstate the amount of particular economic phenomena, such as a method that consistently produces results that understate the item in question (an example of bias). Errors of application result from misapplying a recognition or measurement method. Application errors may be either unintentional (for example, because of lack of skill) or intentional (for example, because of lack of integrity). Intentional errors, whether by use of an inappropriate method or by inappropriate application of a method, are likely to lead to bias which in turn results in information that is not neutral (paragraphs QC27–QC31).

QC25. Verification may be either direct or indirect. With direct verification, an amount or other representation itself is verified, such as by counting cash or observing marketable securities and the quoted prices for them. With indirect verification, the amount or other representation is verified by checking the inputs and recalculating the outputs, using the same accounting convention or methodology. An example is verifying the carrying amount of inventory by checking the inputs (quantities and costs) and recalculating the ending inventory using the same cost flow assumption (for example, average cost or FIFO).

QC26. Direct verification is more helpful in assuring that information faithfully represents the economic phenomena that it purports to represent because direct verification tends to minimize both error and bias in method and application. In contrast, indirect verification tends to minimize only application bias. Indirect verification is generally based on the same method used to produce the amount being verified. Thus, even though different verifiers reach consensus, an indirectly verified amount may not faithfully represent the economic phenomena that it purports to represent because the method used may give rise to material error. Even though indirect verification does not guarantee the appropriateness of the method used, it does carry some assurance that the method used, whatever it was, was applied carefully and without error or personal bias on the part of the one applying it. In many situations, knowledgeable and independent observers may need to apply both direct and indirect verification.