Conceptual Framework — Joint Project of the IASB and FASB

Conceptual Framework — Joint Project of the IASB and FASB

WHY WE NEED A CONCEPTUAL FRAMEWORK?

A common goal of the FASB and IASB, shared by their constituents, is for their standards to be “principles-based.” To be principles-based, standards cannot be a collection of conventions but rather must be rooted in fundamental concepts. For standards on various issues to result in coherent financial accounting and reporting, the fundamental concepts need to constitute a framework that is sound, comprehensive, and internally consistent.

·        The goals of the new project are to build on the two Boards’ existing frameworks by refining, updating, completing, and converging them into a common framework that both Boards can use in developing new and revised accounting standards.

·        Without the guidance provided by an agreed-upon framework, standard setting ends up being based on the individual concepts developed by each member of the standard-setting body.

This Preliminary Views is the first in a series of publications being developed jointly by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (the Boards) as part of a joint project to develop a common Conceptual Framework for Financial Reporting. The Boards expect to issue other discussion papers that will seek comments on parts of what ultimately will be an improved conceptual framework for financial reporting that both will adopt to replace their separate frameworks.

WHY THE BOARDS ARE RECONSIDERING THEIR FRAMEWORKS

A common goal of the Boards—a goal shared by their constituents—is for their standards to be clearly based on consistent principles. To be consistent, principles must be rooted in fundamental concepts rather than being a collection of conventions. For the body of standards taken as a whole to result in coherent financial reporting, the fundamental concepts need to constitute a framework that is sound, comprehensive, and internally consistent.

Another common goal of the Boards is to bring their standards into convergence. The Boards are aligning their agendas more closely to achieve convergence in future standards, but they will encounter difficulties in doing that if they base their decisions on different frameworks.

To provide the best foundation for developing principles-based and converged standards, the Boards undertook a joint project to develop a common and improved conceptual framework. The goals for the project include updating and refining the existing concepts to reflect changes in markets, business practices, and the economic environment in the two or more decades since the concepts were developed. The Boards also intend to improve some parts of the existing frameworks, such as recognition and measurement, as well as to fill some gaps in the frameworks. For example, neither framework includes a robust concept of a reporting entity. The FASB’s Concepts Statements include no definition of a reporting entity or discussion of how to identify one. Paragraph 8 of the IASB’s Framework defines a reporting entity as “an entity for which there are users who rely on the financial statements as their major source of financial information about the entity.” But the Framework does not include a discussion of either why that definition is appropriate or how it should be applied.

Because the qualitative characteristics distinguish more useful information from less useful information, they are the qualities to be sought in making decisions about financial reporting.

Relevance

Whether relevance is a desirable qualitative characteristic that belongs in the conceptual framework is not at issue. Both the FASB’s and the IASB’s existing frameworks discuss relevance as a qualitative characteristic of financial reporting information, as do all other frameworks that the Boards reviewed. However, the two frameworks define relevance and identify its components somewhat differently, and the Boards determined that the meaning of predictive value needed attention.

Capable of Making a Difference in Decisions

 

The FASB’s and the IASB’s definitions of relevance are similar, with one potentially significant exception. The IASB Framework (paragraph 26) says that information is relevant “when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations.” FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, paragraph 47, says that, to be relevant, “. . . accounting information must be capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations.” Thus, the definitions differ in whether information must actually make a difference in a decision or be capable of making a difference in a decision.

The Boards concluded that information must be capable of making a difference in a decision to be relevant. 

The other qualitative characteristics and the pervasive constraints on financial reporting help to determine how much of the information that may be capable of making a difference can and should be provided in financial reports.

Whether or not it is possible to demonstrate conclusively that a particular item of information will affect (or has affected) users’ decisions, standard setters can and should take steps to understand how investors and creditors use financial reporting information and how financial reports might better serve their needs.

What Are the Components of Relevance?

The Boards identified no significant issues that relate to identifying the components of relevance. Therefore, they made only minor changes in that area, one of which affects terminology. The IASB Framework identifies predictive value and confirmatory value as components of relevance, and the FASB’s Concepts Statement 2 refers to predictive value and feedback value.

The Boards concluded that confirmatory value and feedback value have the same meaning. In the interest of convergence of terminology, the Boards decided to use confirmatory value in the broad sense of either confirming the accuracy of prior predictions or correcting them.

The Boards concluded that timeliness pertains only to relevance. In contrast, materiality is pertinent to faithful representation.

What Does Predictive Value Mean?

The Boards identified the meaning of predictive value as an issue needing attention, more specifically, whether the framework should define predictive value in statistical terms. That is an issue largely because it is easy to confuse predictive value as used in financial reporting concepts with predictability and related terms used in statistics.

The Boards concluded that adopting statistical notions and terminology in the framework would be inappropriate. To do so would imply that relevant financial reporting information must, in itself, predict the future. Although financial reporting might include forward-looking information, the Boards noted that information need not be forward-looking to have predictive value. In other words, financial reports supply the information; investors, creditors, and other users make the predictions Standard setters cannot, and do not try to, dictate how an individual user makes those predictions.

Should Additional Qualitative Characteristics Be Added?

The Boards considered whether additional qualitative characteristics should be added. They evaluated potential candidates in the context of the purpose of the qualitative characteristics, which is to help ensure that financial reporting information achieves its objective to the maximum extent feasible by distinguishing more useful information from less useful information.

1.    Transparency

Regardless of exactly what it is that accountants or others think should be transparent, they seem to use the term to mean clear, candid, or easily seen through, which is consistent with the term’s meaning in general use.

The Boards concluded that transparency should not be added as a qualitative characteristic of decision-useful financial reporting information because to do so would be redundant because the framework already, including faithful representation which mean the same thing.

2.    True and Fair View

Some discussions of accounting concepts or principles refer to a true and fair view or fair presentation.

The Boards concluded that true and fair view or present fairly is not a qualitative characteristic. Instead, a true and fair view should result from applying the qualitative characteristics. Or to present a true and fair view is much the same as for a financial report to faithfully represent, which already is a qualitative characteristic.

3.    High Quality

Qualitative characteristics should lead to high-quality accounting standards, which in turn should lead to high-quality financial reporting information that is useful for making decisions. That is, quality is defined by the objectives and qualitative characteristics.

The Boards concluded that high quality is achieved by adherence to the objectives and qualitative characteristics. High-quality information is the goal to which financial reporting and standard setters aspire. Therefore, the Boards did not add high quality as a qualitative characteristic.

4.    Credibility

5.    Internal Consistency

Constituents have sometimes suggested other criteria for standard-setting decisions, and the Boards have at times cited some of those criteria as part of the rationale for some decisions. Those criteria include: a. Simplicity

b. Preciseness

c. Operationality

d. Practicability or practicality

e. Acceptability.

The Elements of Financial Statements

The Elements of Financial Statements

1. Financial statements portray the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics. These broad classes are termed the elements of financial statements. The elements directly related to the measurement of financial position in the balance sheet are assets, liabilities and equity. The elements directly related to the measurement of performance in the income statement are income and expenses. The cash flow statement usually reflects income statement elements and changes in balance sheet elements; accordingly, this Framework identifies no elements that are unique to this statement.

2. The presentation of these elements in the balance sheet and the income statement involves a process of sub-classification. For example, assets and liabilities may be classified by their nature or function in the business of the entity in order to display information in the manner most useful to users for purposes of making economic decisions.

Financial Position

3. The elements directly related to the measurement of financial position are assets, liabilities and equity. These are defined as follows:

(a) An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

(b) A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

(c) Equity is the residual interest in the assets of the entity after deducting all its liabilities.

Aus49.1 In respect of not-for-profit entities in the public or private sector, in pursuing their objectives, goods and services are provided that have the capacity to satisfy human wants and needs. Assets provide a means for entities to achieve their objectives. Future economic benefits or service potential is the essence of assets.

Future economic benefits is synonymous with the notion of service potential, and is used in this Framework as a reference also to service potential. Future economic benefits can be described as the scarce capacity to provide benefits to the entities that use them, and is common to all assets irrespective of their physical or other form.

4. The definitions of an asset and a liability identify their essential features but do not attempt to specify the criteria that need to be met before they are recognized in the balance sheet. Thus, the definitions embrace items that are not recognized as assets or liabilities in the balance sheet because they do not satisfy the criteria for recognition discussed in paragraphs 82 to 98. In particular, the expectation that future economic benefits will flow to or from an entity must be sufficiently certain to meet the probability criterion in before an asset or liability is recognized.

5. In assessing whether an item meets the definition of an asset, liability or equity, attention needs to be given to its underlying substance and economic reality and not merely its legal form. Thus, for example, in the case of finance leases, the substance and economic reality are that the lessee acquires the economic benefits of the use of the leased asset for the major part of its useful life in return for entering into an obligation to pay for that right an amount approximating to the fair value of the asset and the related finance charge. Hence, the finance lease gives rise to items that satisfy the definition of an asset and a liability and are recognized as such in the lessee’s balance sheet.

6. Balance sheets drawn up in accordance with current Australian Accounting Standards may include items that do not satisfy the definitions of an asset or liability and are not shown as part of equity.

The definitions set out in paragraph 49 will, however, underlie future reviews of existing Australian Accounting Standards and the formulation of further Standards.

Assets

7. The future economic benefit embodied in an asset is the potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. The potential may be a productive one that is part of the operating activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce cash outflows, such as when an alternative manufacturing process lowers the costs of production.

8. An entity usually employs its assets to produce goods or services capable of satisfying the wants or needs of customers; because these goods or services can satisfy these wants or needs, customers are prepared to pay for them and hence contribute to the cash flow of the entity. Cash itself renders a service to the entity because of its command over other resources.

Aus54.1 In respect of not-for-profit entities, whether in the public or private sector, the future economic benefits are also used to provide goods and services in accordance with the entities’ objectives. However, since the entities do not have the generation of profit as a principal objective, the provision of goods and services may not result in net cash inflows to the entities as the recipients of the goods and services may not transfer cash or other benefits to the entities in exchange.

Aus54.2 In respect of not-for-profit entities, the fact that they do not charge, or do not charge fully, their beneficiaries or customers for the goods and services they provide does not deprive those outputs of utility or value; nor does it preclude the entities from benefiting from the assets used to provide the goods and services. For example, assets such as monuments, museums, cathedrals and historical treasures provide needed or desired services to beneficiaries, typically at little or no direct cost to the beneficiaries. These assets benefit the entities by enabling them to meet their objectives of providing needed services to beneficiaries.

9. The future economic benefits embodied in an asset may flow to the entity in a number of ways. For example, an asset may be:

(a) used singly or in combination with other assets in the production of goods or services to be sold by the entity;

(b) exchanged for other assets;

(c) used to settle a liability; or

(d) distributed to the owners of the entity.

10. Many assets, for example, property, plant and equipment, have a physical form. However, physical form is not essential to the existence of an asset; hence patents and copyrights, for example, are assets if future economic benefits are expected to flow from them to the entity and if they are controlled by the entity.

11. Many assets, for example, receivables and property, are associated with legal rights, including the right of ownership. In determining the existence of an asset, the right of ownership is not essential; thus, for example, property held on a lease is an asset if the entity controls the benefits which are expected to flow from the property. Although the capacity of an entity to control benefits is usually the result of legal rights, an item may nonetheless satisfy the definition of an asset even when there is no legal control. For example, know-how obtained from a development activity may meet the definition of an asset when, by keeping that know-how secret, an entity controls the benefits that are expected to flow from it.

12. The assets of an entity result from past transactions or other past events. Entities normally obtain assets by purchasing or producing them, but other transactions or events may generate assets. Examples include property received by an entity from government as part of a program to encourage economic growth in an area, and the discovery of mineral deposits. Transactions or events expected to occur in the future do not, in themselves, give rise to assets. Hence, for example,

an intention to purchase inventory does not, of itself, meet the definition of an asset.

13. There is a close association between incurring expenditure and generating assets but the two do not necessarily coincide. Hence, when an entity incurs expenditure, this may provide evidence that future economic benefits were sought but is not conclusive proof that an item satisfying the definition of an asset has been obtained. Similarly the absence of a related expenditure does not preclude an item from satisfying the definition of an asset and thus becoming a candidate for recognition in the balance sheet. For example, items that have been donated to the entity may satisfy the definition of an asset.

Liabilities

14. An essential characteristic of a liability is that the entity has a present obligation. An obligation is a duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. This is normally the case, for example, with amounts payable for goods and services received. Obligations also arise, however, from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. If, for example, an entity decides as a matter of policy to rectify faults in its products even when these become apparent after the warranty period has expired, the amounts that are expected to be expended in respect of goods already sold are liabilities.

15. A distinction needs to be drawn between a present obligation and a future commitment. A decision by the management of an entity to acquire assets in the future does not, of itself, give rise to a present obligation. An obligation normally arises only when the asset is delivered or the entity enters into an irrevocable agreement to acquire the asset. In the latter case, the irrevocable nature of the agreement means that the economic consequences of failing to honour the obligation, for example, because of the existence of a substantial penalty, leave the entity with little, if any, discretion to avoid the outflow of resources to another party.

16. The settlement of a present obligation usually involves the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party. Settlement of a present obligation may occur in a number of ways, for example, by:

(a) payment of cash;

(b) transfer of other assets;

(c) provision of services;

(d) replacement of that obligation with another obligation; or

(e) conversion of the obligation to equity.

An obligation may also be extinguished by other means, such as a

creditor waiving or forfeiting its rights.

17. Liabilities result from past transactions or other past events. Thus, for example, the acquisition of goods and the use of services give rise to trade payable (unless paid for in advance or on delivery), and the receipt of a bank loan results in an obligation to repay the loan. An entity may also recognize future rebates based on annual purchases by customers as liabilities; in this case, the sale of the goods in the past is the transaction that gives rise to the liability.

18. Some liabilities can be measured only by using a substantial degree of estimation. Some entities describe these liabilities as provisions. In some countries, such provisions are not regarded as liabilities because the concept of a liability is defined narrowly so as to include only amounts that can be established without the need to make estimates.

The definition of a liability in paragraph 49 follows a broader approach. Thus, when a provision involves a present obligation and satisfies the rest of the definition, it is a liability even if the amount has to be estimated. Examples include provisions for payments to be made under existing warranties and provisions to cover pension obligations.

Equity

19. Although equity is defined in paragraph 49 as a residual, it may be sub classified in the balance sheet. For example, in a corporate entity, funds contributed by shareholders, retained earnings, reserves representing appropriations of retained earnings and reserves representing capital maintenance adjustments may be shown separately. Such classifications can be relevant to the decision-making needs of the users of financial reports when they indicate legal or other restrictions on the ability of the entity to distribute or otherwise apply its equity. They may also reflect the fact that parties with ownership interests in an entity have differing rights in relation to the receipt of dividends or the repayment of contributed equity.

20. The creation of reserves is sometimes required by statute or other law in order to give the entity and its creditors an added measure of protection from the effects of losses. Other reserves may be established if national tax law grants exemptions from, or reductions in, taxation liabilities when transfers to such reserves are made. The existence and size of these legal, statutory and tax reserves is information that can be relevant to the decision-making needs of users.

Transfers to such reserves are appropriations of retained earnings rather than expenses.

21. The amount at which equity is shown in the balance sheet is dependent on the measurement of assets and liabilities. Normally, the aggregate amount of equity only by coincidence corresponds with the aggregate market value of the shares of the entity or the sum that could be raised by disposing of either the net assets on a piecemeal basis or the entity as a whole on a going concern basis.

22. Commercial, industrial and business activities are often undertaken by means of entities such as sole proprietorship, partnerships, trusts and various types of government business undertakings. The legal and regulatory framework for such entities is often different from that applying to corporate entities. For example, there may be few, if any, restrictions on the distribution to owners or other beneficiaries of amounts included in equity. Nevertheless, the definition of equity and the other aspects of this Framework that deal with equity are appropriate for such entities.

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.