Lecture 9 (Ensuring the quality of financial statements)

Question 1

RELEVANCE

Answer 1

Relevant financial information is capable of making a difference in the decisions made by users.

Question 2

FAITHFUL REPRESENTATION

Answer 2

Financial reports represents economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. To be perfectly faithful representation, a depiction would have three characteristics. It would be COMPLETE, NEUTRAL AND FREE FROM ERROR.

Question 3

PREDICTIVE VALUE

Answer 3

Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. The information could be a forecast provided by the user. Alternatively it could be information that others, such as investors or financial analysts, use as input data for their own predictions.

Question 4

CONFIRMATORY VALUE

Answer 4

Financial information has confirmatory value if it provides feedback (confirms or changes) about previous evaluations.

Question 5

COMPLETE

Answer 5

A complete depiction includes all information necessary for a user to understand what is being reported. This includes the words used to describe the item, and any notes of explanation that help the reader to understand.

Question 6

NEUTRAL

Answer 6

Financial information that is neutral has no bias in the selection or presentation of that information.

Question 7

FREE FROM ERROR

Answer 7

Means there are no errors or omissions in the description of the phenomenon, and the prices used to produce the reported information has been selected and applied with no errors in the process. Does not mean they are completely accurate.

Question 8

MATERIALITY

Answer 8

Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial formation about a specific reporting entity.

Question 9

ENHANCING QUALITATIVE CHARACTERISTICS

Answer 9

They are: comparability; verifiability; time and understandability.

Question 10

COMPARABILITY

Answer 10

Enables users to identify and understand similarities in, and differences among, items. Refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities.

Question 11

VERIFIABILTY

Answer 11

Means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Direct verification is usually carried out by auditors on behalf of investors.

Question 12

UNDERSTANDABILITY

Answer 12

Financial information is understandable if it is presented clearly and concisely, using recognisable classification and descriptions.

Question 13

GOING CONCERN

Answer 13

The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists the financial statements may have to be prepared in a different basis and, if so, the basis used is disclosed.

Question 14

ACCRUALS

Answer 14

Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period. This is important because information about a reporting entity’s economic resources and claims and changes in its economic resources and claims during the period provides a better basis for assessing the entity’s past and future performance than information solely about cash receipts and payments in that period.

Question 15

CONSISTENCY

Answer 15

An aspect of comparability. The UK Companies Act requires that accounting policies shall be applied consistently within the same accounts and from one period to the next.

Question 16

PRUDENCE

Answer 16

Prudence is the inclusion of a degree of caution in the exercise of judgements needed in making the estimates required under conditions of uncertainty, such that gains and assets are not overstated and losses and liabilities are not understated.

Companies Act requires that the amount of any item shall be determined on a prudent basis, and in particular:

a) only profits realised at the sate of the financial year-end shall be included in the profit and loss account; and
b) all liabilities and losses which have arisen or are likely to arise in respect of the financial year shall be taken into account, including those which only become apparent between the date of the financial year end and the date on which signed by the board of directors.

Question 17

RELIABILITY

Answer 17

Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent.

Question 18

SUBSTANCE OVER FORM

Answer 18

The IASB framework (1989) made clear that if information is to meet the test of faithfully representation, then the method of accounting must reflect the substance of the economic reality of the transaction and not merely its legal form.

Question 19

Arguments for regulation

Answer 19

Accounting information is a public good- market failure; investor protection; increased comparability and transparency lowers the cost of capital provided there is confidence- need for independent audit to confirm “true and fair view”.

Question 20

Arguments against regualtion

Answer 20

There are economic incentives to disclose credibly, arising from agency theory- no information viewed as bad news; costs may exceed benefits.

Question 21

COMPANIES ACT 2006

Answer 21

There are many rules protecting those investing in a company and to guide those operating companies.
For companies who do not follow IAS regulation, the companies act prescribes formats of presentation of statement of financial position and profit and loss account.
The UK legislation places strong emphasis on the requirement to present a true and fair view in financial statements.
Requires a statement to be inserted in directors’ report confirming that there are no relevant information that have not been disclosed to auditors.

Question 22

IASB

Answer 22

harmonised accounting standards.
IAS REGULATION:
• Overrides company law
• Requires all listed group to prepare financial statements using international financial reporting standards (IFRS).
Purpose is to harmonise financial information presented by public listed companies in order to ensure a high degree of transparency and comparability.

Question 23

UK REGULATORY FRAMEWORK (FRC)

Answer 23

FRC: set standards for corporate reporting, audit and actuarial practice and monitor and enforce accounting and auditing standards.