Financial Accounting Standards Board ( FASB )

Facts about FASB

Since 1973, the Financial Accounting Standards Board (FASB) has been the designated organization in the private sector for establishing standards of financial accounting that govern the preparation of financial reports by nongovernmental entities. Those standards are officially recognized as authoritative by the Securities and Exchange Commission (SEC) (Financial Reporting Release No. 1, Section 101, and reaffirmed in its April 2003 Policy Statement) and the American Institute of Certified Public Accountants (Rule 203, Rules of Professional Conduct, as amended May 1973 and May 1979). Such standards are important to the efficient functioning of the economy because decisions about the allocation of resources rely heavily on credible, concise, and understandable financial information.

The SEC has statutory authority to establish financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. Throughout its history, however, the Commission’s policy has been to rely on the private sector for this function to the extent that the private sector demonstrates ability to fulfill the responsibility in the public interest.

The Mission of the Financial Accounting Standards Board

The mission of the FASB is to establish and improve standards of financial accounting and reporting that foster financial reporting by nongovernmental entities that provides decision-useful information to investors and other users of financial reports. That mission is accomplished through a comprehensive and independent process that encourages broad participation, objectively considers all stakeholder views, and is subject to oversight by the Financial Accounting Foundation’s Board of Trustees.

Our Independent Structure

The FASB is part of a structure that is independent of all other business and professional organizations. That structure includes the Financial Accounting Foundation (Foundation), the FASB, the Financial Accounting Standards Advisory Council (FASAC), the Governmental Accounting Standards Board (GASB), and the Governmental Accounting Standards Advisory Council (GASAC).

Financial Accounting Foundation (FAF)

The Foundation is the independent, private sector organization that is responsible for the oversight, administration, and finances of the FASB, the GASB, and their advisory councils FASAC and GASAC. The Foundation’s primary duties include protecting the independence and integrity of the standards-setting process and appointing members of the FASB, GASB, FASAC, and GASAC. The Foundation's website includes a complete description of the Foundation, provides a list of and background information about members of the Board of Trustees, and provides other useful information.

Financial Accounting Standard Board

In 1973, the Foundation established the FASB to establish and improve standards of financial accounting and reporting for nongovernmental entities. Consistent with that mission, the FASB maintains the FASB Accounting Standards CodificationTM (Accounting Standards Codification) which represents the source of authoritative standards of accounting and reporting, other than those issued by the SEC, recognized by the FASB to be applied by nongovernmental entities.

Financial Accounting Standards Advisory Council (FASAC)

The primary function of FASAC is to advise the FASB on technical issues on the Board’s agenda, possible new agenda items, project priorities, procedural matters that may require the attention of the FASB, and other matters as may be requested by the FASB or its chairman. At present, the Council has more than 30 members who represent a broad cross section of the FASB’s constituency.

Governmental Accounting Standards Board

In 1984, the Foundation established the GASB to set standards of financial accounting and reporting for state and local governmental units. As with the FASB, the Foundation is responsible for selecting its members, ensuring adequate funding, and exercising general oversight.

Governmental Accounting Standards Advisory Council (GASAC)

The GASAC has responsibility for advising the GASB on technical issues on the Board’s agenda, project priorities, matters likely to require the attention of the GASB, and such other matters as may be requested by the GASB or its chairman.

Our People

The five, full-time members of the FASB are appointed by the Foundation’s Board of Trustees and may serve up to two five-year terms. A 60+ person staff supports the Board.

Board members and staff each have a concern for investors, other users, and the public interest in matters of financial accounting and reporting and collectively have knowledge and experience in investing, accounting, finance, business, accounting education, and research. To ensure the independence of Board members and staff, the Foundation has implemented policies about personal investments and other personal activities that are designed to prevent potential conflicts of interest.

Members of the FASB

FASB Staff

Our Standards-Setting Process

The FASB accomplishes its mission through a comprehensive and independent process that encourages broad participation, objectively considers all stakeholder views, and is subject to oversight by the Financial Accounting Foundation’s Board of Trustees.

The Rules of Procedure describe the FASB’s operating procedures, including the due process activities that are to be open to public participation or observation to provide transparency into the standards-setting process. In particular, the Rules of Procedure describe:

The FASB mission, how the mission is accomplished, and related principles that guide the Board’s standards-setting activities

The organization in which the FASB operates

The operating procedures of the FASB, including the responsibilities of the Chairman, the composition of the FASB technical staff, the role of advisory groups including the Emerging Issues Task Force, and the role of public forums in our due process

Our various forms of communications, including the form and content of Accounting Standards Updates, Exposure Drafts, and Concepts Statements

Protocols for meetings of the FASB and voting requirements

Rules governing public announcements and the kinds of information made broadly available to the public.

A high-level overview of the standards setting process as established by the Rules of Procedure follows. The nature and extent of the Boards’ specific research and outreach activities will vary from project to project, depending on the nature and scope of the reporting issues involved.

The Board identifies a financial reporting issues based on requests/recommendations from stakeholders or through other means.

The FASB Chairman decides whether to add a project to the technical agenda, after consultation with FASB Members and others as appropriate, and subject to oversight by the Foundation's Board of Trustees.

The Board deliberates at one or more public meetings the various reporting issues identified and analyzed by the staff.

The Board issues an Exposure Draft to solicit broad stakeholder input. (In some projects, the Board may issue a Discussion Paper to obtain input in the early stages of a project)

The Board holds a public roundtable meeting on the Exposure Draft, if necessary.

The staff analyzes comment letters, public roundtable discussion, and any other information obtained through due process activities. The Board redeliberates the proposed provisions, carefully considering the stakeholder input received, at one or more public meetings.

The Board issues an Accounting Standards Update describing amendments to the Accounting Standards Codification.

Additional Information

General Information

For further information about the FASB, including Board meeting schedules, access the FASB website at www.fasb.org, call or write Financial Accounting Standards Board, 401 Merritt 7, PO Box 5116, Norwalk, CT 06856-5116, telephone (203) 847-0700 or e-mail questions to director@fasb.org.

To Order Publications

Documents published by the FASB may be obtained by placing an order on the FASB website at www.fasb.org or by contacting the FASB Order Department at 1-800-748-0659, weekdays 8:30 a.m. to 5:00 p.m. eastern time.

Public Roundtable Meetings and Comment Letters

For information about submitting written comments on documents or about public roundtable meetings, access the FASB website at www.fasb.org or contact the FASB Project Administration Department at (203) 956-5389.

CONSTRAINTS ON FINANCIAL REPORTING

CONSTRAINTS ON FINANCIAL REPORTING

QC48. In addition to the qualitative characteristics of relevance, faithful representation, comparability, and understandability, decision-useful financial reporting is subject to two pervasive constraints: materiality and benefits that justify costs. The two constraints are linked because each concerns why some information is included in financial reports and other information, or the same type of information in different circumstances, is not.

Materiality

QC49. Information is material if its omission or misstatement could influence the resource allocation decisions that users make on the basis of an entity’s financial report. Materiality depends on the nature and amount of the item judged in the particular circumstances of its omission or misstatement. A financial report should include all information that is material in relation to a particular entity—information that is not material may, and probably should, be omitted. To clutter a financial report with immaterial information risks obscuring more important information, thus making the report less decision useful.

QC50. Materiality is considered in the context of the other qualitative characteristics, especially relevance and faithful representation. For example, whether information faithfully represents what it purports to represent should take into account the materiality of any potential misstatement. Thus, materiality is a pervasive constraint on the information to be included in an entity’s financial report rather than a qualitative characteristic of decision-useful financial reporting information. Materiality also differs from both the qualitative characteristics and the constraint of benefits that justify costs in that materiality is not a matter to be considered by standard setters.

QC51. It is not feasible to specify a uniform quantitative threshold at which a particular type of information becomes material. Materiality judgments are made in the context of the nature and the amount of an item, as well as the entity’s situation. For example:

a. Disclosure of the effects of an accounting change in circumstances that put an entity in danger of being in breach of covenant regarding its financial condition, or that help to avoid such a breach of covenant, may justify a lower materiality threshold than if the entity’s position were stronger.

b. A misclassification of an asset as equipment that should have been classified as plant may not be material because it does not affect classification on the statement of financial position; the line item “plant and equipment” is the same regardless of the misclassification. However, a misclassification of the same amount might be material if it changed the classification of an asset from plant or equipment to inventory.

c. An error of 10,000 in the amount of uncollectible receivables is more likely to be material if the total amount of receivables is 100,000 than if it is 1,000,000. Similarly, the materiality of such an error also may depend on the significance of receivables to an entity’s total assets and of uncollectible receivables to an entity’s reported financial performance.

d. Amounts too small to warrant disclosure or correction in normal circumstances may be considered material if they arise from abnormal or unusual transactions or events or if they involve related parties. Similarly, the amount of a misstatement that would be immaterial if it results from an unintentional error might be considered material if it results from an intentional misstatement.

QC52. In addition, the amount of deviation that is considered immaterial may increase as the attainable degree of precision decreases. For example, the amount of accounts payable usually can be determined from supplier invoices more accurately than can liabilities arising from litigation that must be estimated, and a deviation considered material for the first item may be immaterial for the second.

Benefits and Costs

QC53. The benefits of financial reporting information should justify the costs of providing and using it. The benefits of financial reporting information include better investment, credit, and similar resource allocation decisions, which in turn result in more efficient functioning of the capital markets and lower costs of capital for the economy as a whole. However, financial reporting and financial reporting standards impose direct and indirect costs on both preparers and users of financial reports, as well as on others such as auditors or regulators. Thus, standard setters seek information from preparers, users, and other constituents about what they expect the nature and quantity of the benefits and costs of proposed standards to be and consider in their deliberations the information they obtain.

QC54. The economy and society as a whole are the ultimate beneficiaries of financial reporting that exhibits the qualitative characteristics to the maximum extent feasible. The benefits of financial reporting information include more efficient functioning of the capital markets, which may result in better availability and pricing for consumers, and in better opportunities and compensation for employees and other suppliers of services or goods. Preparers of decision-useful financial reporting information enjoy other benefits also, including improved access to capital markets, favorable impact on public relations, and perhaps lower costs of capital. The benefits may also include better management decisions because financial information used internally is often based at least partly on information prepared for external reporting purposes.

QC55. The direct costs of providing information include costs of collecting and processing the information, costs of having others verify it, and costs of disseminating it. Direct costs necessitated by changes in financial reporting include revising collection and processing systems and educating preparers, managers, and investors and creditors. Indirect costs may arise from litigation or from revealing secrets to trade competitors or labor unions (with a consequent effect on wage demands).

QC56. The costs that users incur directly are mainly the costs of analysis and interpretation, including revision of analytical tools necessitated by changes in financial reporting requirements. Users’ costs may also include costs of separating decision-useful information from other information that is less useful or redundant. However, not requiring decision-useful information also imposes costs, including the costs that users incur to obtain or attempt to estimate needed information using incomplete data in the financial report or data available elsewhere.

QC57. Preparers incur the direct (and most of the indirect) costs of providing financial information, but investors and, to a lesser extent, other providers of capital ultimately bear those costs in the form of reduced returns to them. Preparers may also be able to pass some of those costs along to customers. Initially at least, the benefits of new financial reporting information may be enjoyed by parties other than those who bear most of the costs. Ultimately, however, both the costs and the benefits of financial information are diffused widely throughout the economy.

QC58. In assessing whether the benefits of a proposed standard are likely to justify the costs it imposes, standard setters generally consider the practicability of implementing it and whether some degree of precision might be sacrificed for greater simplicity and lower cost, in addition to other factors. Standard setters’ assessment of whether the benefits of providing information justify the related costs usually will be more qualitative than quantitative. Even the qualitative information that standard setters can obtain about benefits, in particular, and costs often will be incomplete. Nevertheless, standard setters should do what they can to assure that benefits and costs are appropriately balanced.

QC59. Constituents sometimes express concern that the availability of newly required financial reporting information will lead to economic consequences that are adverse to them or to others. Whether the perceived economic consequences of improved financial reporting information may be detrimental (or beneficial) to particular entities or groups of entities are not costs (or benefits) that standard setters can appropriately consider. To do so would result in information that fails the test of neutrality (paragraphs QC27–QC31). Such consequences, if they occur, result from the availability of financial reporting information that is more useful for making resource allocation decisions than the information previously available.

How the Qualitative Characteristics Relate to the Objective of Financial Reporting and to Each Other

How the Qualitative Characteristics Relate to the Objective of Financial Reporting and to Each Other

QC42. The objective of financial reporting is to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions. Each qualitative characteristic discussed in this chapter makes its own distinct contribution to the decision usefulness of financial reporting information. The discussion in paragraphs QC43–QC47 considers both the contributions of, and the relationships among, the qualitative characteristics of financial reporting information. The discussion takes as its starting point that investors, creditors, and other users of financial reports wish to understand economic phenomena that are pertinent to their decisions.

QC43. The qualitative characteristic of relevance is concerned with the connection of economic phenomena to the decisions of investors, creditors, and other users of financial reporting information—the pertinence of the phenomena to those decisions. Application of the qualitative characteristic of relevance will identify which economic phenomena should be depicted in financial reports, with the intent of providing decision-useful information about those phenomena. Economic phenomena about which information is useful for making those decisions are relevant, and phenomena about which information is not useful are irrelevant. Logically, then, relevance must be considered before the other qualitative characteristics because relevance determines which economic phenomena should be depicted in financial reports.

QC44. In logical order, the next qualitative characteristic to be applied is faithful representation. Once relevance is applied to determine which economic phenomena are pertinent to the decisions to be made, faithful representation is applied to determine which depictions of those phenomena provide the best correspondence of relevant phenomena with their representations. (Considering faithful representation after relevance does not mean that faithful representation is secondary to relevance. Rather, relevance is considered first because it would be illogical to consider how to faithfully represent a phenomenon that is not pertinent—information about it is not relevant—to the decisions of users of financial reports.) Application of the faithful representation characteristic determines whether a proposed depiction in words and numbers is faithful (or unfaithful) to the economic phenomena being depicted. Faithful depictions of relevant phenomena can be decision useful; unfaithful depictions will be either useless for making decisions or misleading.

QC45. The qualitative characteristics of relevance and representational faithfulness contribute to decision usefulness in different ways. Thus, they work in concert with one another. Both relevance and faithful representation are necessary because a depiction is decision useful only if it faithfully represents an economic phenomenon that is relevant to investment and credit decisions. A depiction that is a faithful representation of an irrelevant phenomenon is not decision useful, just as a depiction that is an unfaithful representation of a relevant phenomenon is not decision useful. Thus, either irrelevance (the economic phenomenon is not connected to the decision to be made) or unfaithful representation (the depiction is not connected to the phenomena) results in information that is not decision useful. Together, relevance and faithful representation make financial reporting information decision useful.

QC46. The next qualitative characteristics in logical order after faithful representation are comparability and understandability. They enhance the decision usefulness of financial reporting information that is relevant and representationally faithful. For example, comparability can enhance the decision usefulness of information because comparable information helps users to detect similarities and differences in the underlying economic phenomena. Understandability can enhance the decision usefulness of information because it helps users to better comprehend the meaning of that information. However, comparability and understandability cannot, either individually or in concert with each other, make information decision useful if it is irrelevant or not faithfully represented.

QC47. The qualitative characteristics are complementary concepts in achieving decision-useful financial reporting information; their application, in concert, should maximize the usefulness of financial reports. However, standard setters sometimes may need to compromise on one or more of those characteristics because of cost-benefit considerations or technical feasibility issues. Cost-benefit considerations may, for example, cause standard setters to adopt a less relevant or less representationally faithful depiction to reduce the costs of preparing financial reporting information. (See paragraphs QC53–QC59.) Nevertheless, the purpose of the qualitative characteristics (and the rest of the conceptual framework) is to identify the ideals toward which to strive.

THE QUALITATIVE CHARACTERISTICS part 3

THE QUALITATIVE CHARACTERISTICS part 3

Neutrality

QC27. Neutrality is the absence of bias intended to attain a predetermined result or to induce a particular behavior. Neutrality is an essential aspect of faithful representation because biased financial reporting information cannot faithfully represent economic phenomena.

QC28. Neutrality is incompatible with conservatism, which implies a bias in financial reporting information. Neutral information does not color the image it communicates to influence behavior in a particular direction. For example, automobiles might be produced with speedometers that indicate a higher speed than the automobile actually is traveling at to influence drivers to obey the speed limit. But those “conservative” speedometers would be unacceptable to drivers who expect them to faithfully represent the speed of the automobile. Conservative or otherwise biased financial reporting information is equally unacceptable.

QC29. However, to say that financial reporting information should be neutral does not mean that it should be without purpose or that it should not influence behavior. On the contrary, relevant financial reporting information, by definition, is capable of influencing users’ decisions. Financial reporting information influences behavior, as do the results of elections, school examinations, and lotteries. Elections, examinations, and lotteries are not unfair—do not lack neutrality—merely because some people win and others lose. So it is with neutrality in financial reporting.

QC30. For example, some constituents told standard setters that requiring recognition of the cost of all employee share options would have a greater effect on some entities than on others. Therefore, some entities might win while others lose in terms of the effect on their relative cost of capital. Others said that a requirement to recognize the cost of all employee share options would cause some entities either to cease granting share options or to change the nature of the options they grant. None of those potential effects imply that the information resulting from recognizing the cost of employee share options would lack neutrality. On the contrary, the information would lack neutrality if standard setters had designed the requirements to eliminate the potential effect on particular types of entities, to encourage entities to award particular types of options, or otherwise to favor—in effect, to grant an accounting subsidy to—particular entities or particular types of compensation.

QC31. The consequences of a new financial reporting standard may indeed be bad for some interests in either the short or long term. But the dissemination of unreliable and potentially misleading information is, in the long run, bad for all interests. The responsibility of standard setters is to the integrity of the financial reporting system—a responsibility that could not be fulfilled if a standard setter changed direction with every change in the political wind. Politically motivated standards would quickly lose their credibility. They would also cast doubt on the credibility of all standards, including those that provide decision-useful financial reporting information as judged by the qualitative characteristics.

Completeness

QC32. Completeness means including in financial reporting all information that is necessary for faithful representation of the economic phenomena that the information purports to represent. Therefore, completeness, within the bounds of what is material and feasible, considering the cost, is an essential component of faithful representation.

QC33. The importance of completeness is clear in the context of a line item on a financial statement. For example, to omit some revenues during the period from the item revenues on a statement of income (or profit or loss) would faithfully represent neither that item nor subsequent subtotals and totals. Completeness is also important in developing estimates of economic phenomena, such as in estimating fair value using a valuation technique. For example, estimating the fair value of a financial instrument using a pricing model must take into account all of the economic factors that are valid inputs to the model used. Thus, to omit dividends expected to be paid on the underlying shares over the term of a call or put option on those shares would not faithfully represent the fair value of the option.

QC34. Ideally, an entity’s financial report should include everything about the entity that is necessary to understand the effects of all economic phenomena that are pertinent to users’ investment, credit, and similar resource allocation decisions. Completeness, however, is relative because financial reports cannot show everything. To try to include in financial reports everything that any potential user might want would not be cost beneficial (paragraphs QC53–QC59) and might conflict with other desirable characteristics, such as understandability (paragraphs QC39–QC41). In addition, as discussed in paragraph OB14, those who use financial reports in making resource allocation decisions must also take into account information from other sources, for example, industry information about general supply and demand factors for an entity’s products and potential technological innovations.

Comparability (Including Consistency)

QC35. Comparability, including consistency, enhances the usefulness of financial reporting information in making investment, credit, and similar resource allocation decisions. Comparability is the quality of information that enables users to identify similarities in and differences between two sets of economic phenomena. Consistency refers to use of the same accounting policies and procedures, either from period to period within an entity or in a single period across entities. Comparability is the goal; consistency is a means to an end that helps in achieving that goal.

QC36. The essence of investment, credit, and similar resource allocation decisions is choosing between alternatives, such as whether to buy shares in Entity A or in Entity B. Thus, information about an entity gains greatly in usefulness if it can be compared with similar information about other entities and with similar information about the same entity for some other period or some other point in time. Comparability is not a quality of an individual item of information, but rather a quality of the relationship between two or more items of information.

QC37. Comparability sometimes has been confused with uniformity. For information to be comparable, like things must look alike and different things must look different. An overemphasis on uniformity, for example, requiring all entities to use the same assumptions on economic factors such as the expected future dividend rate on their shares as inputs to a valuation model, may reduce comparability by making unlike things look alike. Comparability of financial reporting information is not enhanced by making unlike things look alike any more than it is by making like things look different.

QC38. Permitting alternative accounting methods for the same transactions or other events (real-world economic phenomena) is undesirable because to do so diminishes comparability and may diminish other desirable qualities as well, for example, faithful representation and understandability. Regardless of its importance, however, comparability alone cannot make information useful for decision making. Standard setters may conclude that a temporary reduction in comparability is worthwhile to improve relevance or faithful representation (or both) in the longer term. For example, a temporary reduction in period-to-period consistency, and thus in comparability, occurs when a new financial reporting standard requires a change to a method that improves relevance or faithful representation. Such a change in reporting effectively trades a temporary reduction in period-to-period consistency for greater comparability in the future. In that situation, appropriate disclosures can help to compensate for the temporary reduction in comparability.

Understandability

QC39. Understandability is the quality of information that enables users who have a reasonable knowledge of business and economic activities and financial reporting, and who study the information with reasonable diligence, to comprehend its meaning. (Paragraphs QC3 and QC4 discuss standard setters’ expectations of users of financial reporting information. The quality of understandability is defined in relation to users who satisfy those expectations.) Relevant information should not be excluded solely because it may be too complex or difficult for some users to understand. Understandability is enhanced when information is classified, characterized, and presented clearly and concisely. Comparability also enhances understandability.

QC40. Information cannot influence a particular user’s decision unless it is presented in a manner that the user can understand. However, information may be relevant to a situation even though some people who confront the situation cannot understand it—at least not without help. For example, a traveler in a foreign country may have trouble ordering from a menu printed in an unfamiliar language. The listing of items on the menu is relevant to the decision, but the traveler may not be able to use that information unless it is translated into a language that the traveler understands. Thus, information may not be useful to a particular user even though it is relevant to the situation the user faces.

QC41. Similar situations arise frequently in financial reporting. For example, investors or creditors unfamiliar with actions an entity might take to hedge its exposure to financial risks might have difficulty understanding a note to the financial statements that explains its hedging activities and how those activities are reflected in its financial report. That information, however, is relevant to decisions about the entity and should be understandable to users who have a reasonable knowledge of hedging activities and who read and consider the information with reasonable diligence. The understandability of information about hedging activities and related hedge accounting might be improved by a standard setter requiring, or an entity voluntarily providing, tabular or graphic formats (or both), as well as narrative explanations. However, conciseness is essential because to overwhelm users with unnecessarily lengthy narratives or unnecessary information can rob even relevant and representationally faithful information of its decision usefulness. Standard setters, together with those who prepare financial reports, should take whatever steps are necessary and feasible to improve the clarity and conciseness of financial reporting information so that the intended users (paragraph QC4) can understand it.

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.

Qualitative Characteristics of Decision-Useful Financial Reporting Information part 1

2: Qualitative Characteristics of Decision-Useful Financial Reporting Information part 1

INTRODUCTION

QC1. The objective of financial reporting is to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions (paragraph OB2). To achieve that objective, financial reporting should provide information to help those users in assessing the amounts, timing, and uncertainty of an entity’s future cash flows (paragraph OB3). Because the qualitative characteristics discussed in this chapter distinguish more useful information from less useful information, they are the qualities to be sought in making decisions about financial reporting.

QC2. The qualitative characteristics of decision-useful financial reporting information, together with two constraints on providing that information, are discussed in paragraphs QC7–QC59, following a discussion of standard setters’ expectations of users and preparers of that information.

USERS AND PREPARERS OF FINANCIAL INFORMATION

QC3. Financial reporting information is directed to meeting the needs of a wide range of users, with present and potential investors and creditors being the primary users. Those users, especially investors, may have widely differing degrees of knowledge about the business and economic environment, business activities, securities markets, and related matters.

QC4. In developing financial reporting standards, standard setters presume that those who use the resulting information will have a reasonable knowledge of business and economic activities and be able to read a financial report. Standard setters also presume that users of financial reporting information will review and analyze the information with reasonable diligence. Financial reporting is a means of communicating information and, like most other types of information, cannot be of much direct help to those who are unable or unwilling to use it or who misuse it. One does not need to be a cartographer to use a map to get to an unfamiliar location. But it is necessary to know how to read a map, including understanding the concepts and symbols used in preparing it, and one must study the map carefully to get to the desired location. Likewise, one does not need to be an accountant or a professional investor to use financial reporting information, but it is necessary to learn how to read a financial report. And users need to study the information with the degree of care consistent with both the underlying transactions and other events and the related financial reporting to make a well-informed investment or credit decision. (Paragraphs QC39–QC41 discuss the qualitative characteristic of understandability.)

QC5. Standard setters also presume that preparers of financial reports will exercise due care in implementing a financial reporting requirement. Exercising due care includes

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comprehending the reporting requirements for a transaction or other event and applying them properly, as well as presenting the resulting information clearly and concisely.

QC6. Standard setters, of course, also bear responsibilities to exercise due care in developing financial reporting standards, including communicating requirements in a manner that preparers can be expected to comprehend and implement without undue effort. However, the qualitative characteristics (and the framework as a whole) pertain to the information that results from the process of establishing standards and implementing them—not to the characteristics of the standards themselves.

The Objective of Financial Reporting 2

1: The Objective of Financial Reporting 2

11. The objective of financial reporting stems from the information needs of external users who lack the ability to prescribe all the financial information they need from an entity and therefore must rely, at least partly, on the information provided in financial reports. Information needed to satisfy the specialized needs of management and other potential users, such as tax authorities or other governmental agencies that are able to prescribe the information they need from an entity is beyond the scope of the framework.

12. Investors and creditors (and their advisors) are the most prominent external groups who use the information provided by financial reporting and who generally lack the ability to prescribe all of the information they need. Investors’ and creditors’ decisions and their uses of information have been studied and described to a greater extent, and thus are better understood, than those of other external groups. In addition, information that meets the needs of investors and creditors is also likely to be useful to members of other groups who are interested in an entity’s ability to generate net cash inflows. Thus, the primary users of general purpose financial reports are present and potential investors and creditors (and their advisors). (Throughout the framework, the term investors and creditors refers to investors and creditors and their advisors.)

13. Present and potential investors and creditors have a common interest in the ability of an entity to generate net cash inflows. Accordingly, information about that ability is the primary focus of financial reporting because it helps satisfy the needs of investors and creditors. Other potential users of financial reports discussed in paragraph OB6 also have either a direct interest or an indirect interest in an entity’s ability to generate net cash inflows. For example, although an entity is not a direct source of cash flows to its customers, an entity can continue to provide goods or services to customers only by generating sufficient cash to pay for the resources it uses and to satisfy its other obligations. Thus, information that meets the needs of investors and creditors is also likely to be useful to members of other groups who are interested in an entity’s ability to generate net cash inflows. By focusing primarily on the needs of present and potential investors and creditors, the objective of financial reporting encompasses the needs of a wide range of users.

Limitations and Evolution of General Purpose External Financial Reporting

14. Financial reporting is but one source of information needed by those who make investment, credit, and similar resource allocation decisions. Users of financial reports also need to consider pertinent information from other sources, for example, information about general economic conditions or expectations, political events and political climate, or industry outlook.

15. Users of financial reports also need to be aware of the characteristics and limitations of the information in them. To a significant extent, financial reporting information is based on estimates, rather than exact measures, of the financial effects on entities of transactions and other events and circumstances that have already happened or that already exist. The framework establishes the concepts that underlie those estimates and other aspects of financial reports. The concepts are the goal or ideal toward which standard setters and preparers of financial reports should strive. Like most goals, the framework’s vision of the ideal financial reporting is unlikely to be achieved in full, at least not in the short term, because of considerations of technical feasibility and cost. In some areas, users of financial reports (and standard setters) may need to continue to accept estimates based more on accounting conventions than on the concepts in the framework. Nevertheless, establishing a goal toward which to strive is essential if financial reporting is to evolve in a common direction that improves the information provided to investors, creditors, and others for use in making resource allocation decisions.

Financial Statements and Financial Reporting

16. Financial statements, including the accompanying notes, are a central feature of financial reporting. However, the objective pertains to all of financial reporting, not just financial statements, because some types of both financial and nonfinancial information may best be communicated by means other than traditional financial statements. Corporate annual reports, prospectuses, and annual reports filed with governmental agencies in some jurisdictions are common examples of reports that include financial statements, other financial information, and nonfinancial information. News releases, management’s forecasts or other descriptions of its plans or expectations, and descriptions of an entity’s social or environmental impact are examples of reports giving financial information other than financial statements or giving only nonfinancial information.

17. Paragraphs OB18–OB26 describe the financial reporting information that has long been considered useful in assessing an entity’s ability to generate net cash inflows and why the information is useful for that purpose. Discussion of that information does not imply that other information might not also be useful in achieving the objective of financial reporting.

INFORMATION ABOUT AN ENTITY’S RESOURCES, CLAIMS TO THOSE RESOURCES, AND CHANGES IN RESOURCES AND CLAIMS

18. To help present and potential investors and creditors and others in assessing an entity’s ability to generate net cash inflows, financial reporting should provide information about the economic resources of the entity (its assets) and the claims to those resources (its liabilities and equity). Information about the effects of transactions and other events and circumstances that change resources and claims to them is also essential.

19. Most of the information provided in financial statements about resources and claims and the changes in them results from the application of accrual accounting, although information about cash flows during a period is also important (paragraph OB24). Accrual accounting attempts to reflect the financial effects of transactions and other events and circumstances that have cash (or other) consequences for an entity’s resources and the claims to them in the periods in which they occur or arise. The buying, producing, selling, and other operations of an entity during a period, as well as other events that affect its economic resources and the claims to them, often do not coincide with the cash receipts and payments of the period. The accrual accounting information in financial reports about an entity’s resources and claims and changes in resources and claims generally provides a better basis for assessing cash flow prospects than information solely about the entity’s current cash receipts and payments. Without accrual accounting, important economic resources and claims to resources would be excluded from financial statements.

Economic Resources and Claims to Them

20. Information about an entity’s economic resources and the claims to them—its financial position—can provide a user of the entity’s financial reports with much insight into the amounts, timing, and uncertainty of its future cash flows. That information helps investors, creditors, and others to identify the entity’s financial strengths and weaknesses and to assess its liquidity and solvency. Moreover, it indicates the cash flow potentials of some economic resources and the cash needed to satisfy most claims of creditors. Some of an entity’s economic resources, such as accounts receivable or investments in debt instruments, are direct sources of future cash inflows. In addition, many creditors’ claims, such as accounts payable or outstanding debt instruments, are direct causes of future cash outflows. However, many of the cash flows generated by an entity’s operations result from combining several of its economic resources to produce or provide and market goods or services. Although those cash flows cannot be identified with individual economic resources (or claims), investors and creditors need to know the nature and quantity of the resources available for use in an entity’s operations, which is provided by information about its financial position. That information is also likely to help those who wish to estimate the value of the entity, but financial reports are not designed to show the value of an entity. Estimating the value of an entity would require taking into account information in addition to that provided in financial reports, for example, general economic conditions in the industry in which the entity operates.

21. Information about an entity’s financial structure, as reflected in its financial position, helps users to assess its needs for additional borrowing or other financing and how successful it is likely to be in obtaining that financing. It also helps users to predict how future cash flows will be distributed among those with a claim on the entity’s economic resources.

Changes in Economic Resources and Claims to Them

22. Information about effects of transactions, other events, and circumstances that change an entity’s economic resources and the claims to them also helps a user of the entity’s financial reports to assess the amounts, timing, and uncertainty of its future cash flows. That information includes quantitative measures (and other information) about an entity’s financial performance measured by accrual accounting, its cash flows during a period, and changes in economic resources and claims that do not directly affect cash.

Financial Performance Measured by Accrual Accounting

23. Information about an entity’s financial performance during a period measured by changes in its resources and the claims to them other than claims resulting from transactions with owners as owners, as well as the components of the total change, is critical in assessing the entity’s ability to generate net cash inflows. Therefore, information about financial performance measured by accrual accounting rather than only by the entity’s cash transactions during the period is essential to users of financial reports (paragraph OB19). That information indicates the extent to which the entity has increased its available economic resources, and thus its capacity for generating net cash inflows, through its operations rather than by obtaining additional financing from investors or creditors. An entity’s financial performance provides information about the return it has produced on the economic resources it controls. In the long run, an entity must produce a positive return on its economic resources if it is to generate net cash inflows and thus provide a return to its investors and creditors. The variability of that return is also important, especially in assessing the uncertainty of future cash flows, as is information about the components of that return. Investors and creditors usually find information about an entity’s past financial performance helpful in predicting the entity’s future returns on its resources, which will be its future financial performance.

Financial Performance Measured by Cash Flows during a Period

24. Information about an entity’s cash flows during a period is another aspect of its financial performance that helps users to assess the entity’s ability to generate future net cash inflows. Information about an entity’s cash flows during a period indicates how it obtains and spends cash, including information about its borrowing and repayment of borrowing, its capital transactions, including cash dividends or other distributions to owners, and other factors that may affect the entity’s liquidity or solvency. Investors, creditors, and others use information about cash flows to help them understand an entity’s business model and operations, evaluate its financing and investing activities, assess its liquidity or solvency, or interpret information provided about financial performance. Cash flow information provides a perspective on the entity’s economic activities that is different from the one provided by accrual accounting—a perspective that is largely free from the measurement and related issues inherent in accrual accounting.

Changes in Resources and Claims That Do Not Affect Cash

25. Financial reporting should also provide information about changes in an entity’s economic resources and claims to them that do not affect cash. Examples include acquiring economic resources in exchange for creditors’ claims, settling creditors’ claims by transfers of noncash resources, and converting creditors’ claims into ownership claims. Investors, creditors, and others need that information to understand fully information about an entity’s financial position and financial performance. It also helps users understand the information provided about cash flows during a period.

Management’s Explanations

26. Financial reporting should include management’s explanations and other information needed to enable users to understand the information provided. The usefulness of financial reports to investors, creditors, and others in forming expectations about an entity is enhanced by management’s explanations of the information in them. Management knows more about the entity and its affairs than external users do and can often increase the usefulness of financial reports by identifying particular transactions and other events and circumstances that have affected the entity or may affect it in the future and by explaining their financial effects on the entity. In addition, financial reporting often provides information that depends on, or is affected by, management’s estimates and judgments. Investors, creditors, and others are aided in evaluating estimates and judgmental information by explanations of underlying assumptions or methods used, including disclosure of significant uncertainties about principal underlying assumptions or estimates.

THE OBJECTIVE OF FINANCIAL REPORTING AND ASSESSING MANAGEMENT’S STEWARDSHIP

27. Management of an entity is accountable to owners (shareholders) for the custody and safekeeping of the entity’s economic resources and for their efficient and profitable use. Management’s stewardship responsibilities include protecting the entity’s economic resources, to the extent possible, from unfavorable economic effects of factors in the economy such as inflation or deflation and technological and social changes. Management is also accountable for ensuring that the entity complies with applicable laws, regulations, and contractual provisions. Because management’s performance in discharging its stewardship responsibilities significantly affects an entity’s ability to generate net cash inflows, management’s stewardship is of significant interest to users of financial reports who are interested in making resource allocation decisions.

28. Users of financial reports who wish to assess how well management has discharged its stewardship responsibilities generally are interested in making resource allocation decisions, which include, but are not limited to, whether to buy, sell, or hold the entity’s securities or whether to lend money to the entity. Decisions about whether to replace or reappoint management, how to compensate management, and how to vote on shareholder proposals about management’s policies and other matters are also potential considerations in making resource allocation decisions in the broad sense in which that term is used in the framework. Thus, the objective of financial reporting stated in paragraph OB2 encompasses providing information useful in assessing management’s stewardship. In addition, the information discussed in paragraphs OB18–OB26 is useful in assessing how well management has discharged its stewardship responsibilities because management is responsible for the entity’s resources and related claims and changes in resources and claims.