Qualitative Characteristics of Useful Financial Information Flashcards
What is the main criterion for judging accounting choices?
The main criterion for judging accounting choices is decision usefulness.
What are two FUNDAMENTAL QUALITATIVE CHARACTERISTICS of useful information?
Relevance and Faithful Representation.
RELEVANCE:
What is relevance in accounting information?
Accounting info has relevance if it makes a differences in a decision. Relevant information has either predictive value or confirmatory value, or both. Predictive value helps users forecast future events. For example, the sales and profit reported by Reitmans in its comparative financial statements may be used along with other information to help predict future sales and profit. Confirmatory value confirms or corrects prior expectations. The sales and profit reported by Reitmans can also be used to confirm or correct previous predictions made by users.
RELEVANCE:
Materiality is an important component of relevance. Describe it. How do you determine the materiality of an amount?
An item is material when it is likely to influence the decision of a reasonably careful investor or creditor. It is immaterial if including it or leaving it out has no impact on a decision maker. Materiality and relevance are both defined in terms of making a difference to a decision maker. A decision to not disclose certain information may be made because the users do not need that kind of information (it is not relevant) or because the amounts involved are too small to make a difference (they are immaterial). To determine the materiality of an amount, the accountant usually compares it with such items as total assets, total liabilities, gross revenues, cash and profit.
RELEVANCE:
Why are wastepaper baskets expensed immediately in terms of materiality?
Materiality is also related to the cost constraint. Assume that Yanik Co. purchases several inexpensive pieces of office equipment, such as wastepaper baskets. Although it is correct to capitalize these wastepaper baskets and depreciate them over their useful lives, they are usually expensed immediately instead. Immediate expensing is the easiest, and thus the least costly, method of accounting for these items and is justified because these costs are immaterial. Making depreciation schedules for these assets is costly and time-consuming. Expensing the wastepaper baskets will not make a material difference to total assets and profit.
In short, if the item does not make a difference, in a decision-making, GAAP does not have to be followed.
FAITHFUL REPRESENTATION:
Once it is determined which info is relevant to financial statement users, then how the info is reported must be determined. To be useful, information must be a faithful representation of the economic reality of the events that it is reporting and not just the legal form. Give an example.
To be useful, information must be a faithful representation of the economic reality of the events that it is reporting and not just the legal form. For example, a company may sign a lease agreement that requires periodic rental payments to be made over the life of the lease. If a company follows the legal form of the transaction, the periodic rental payments will be recorded as ret expense. However, for certain leases, the economic reality is that an asset is purchased and the periodic payments are loan payments. For these leases, it is necessary to record an asset and a liability to show the economic reality.
FAITHFUL REPRESENTATION:
How is faithful representation achieved and explain.
Faithful representation is achieved when the information is 1) complete, 2) neutral and 3) free from material error.
1) Accounting information is “complete” if it includes all information necessary to show the economic reality of the underlying transactions and events. If information is omitted, users will not be able to make appropriate resource allocation decisions. If Reitman did not disclose when payments are due on its long-term debt, users would not have the necessary information to predict future cash flows.
2) Accounting information is “neutral” if it is free from bias that is intended to attain a predetermined result or to encourage a particular behaviour. For example, accounting information would be biased if the income statement was prepared so that it resulted in a high enough level of profit that the management team received their bonuses.
3) If an error in accounting information could have an impact on an investor’s or creditor’s decision, then the error is a “material error.” There will always be some errors in accounting information because estimates, such as estimated useful life, are used. If accounting information is to be free from material error, estimates must be based on the best available information and be reasonably accurate. Accountants must use professional judgement and caution when using estimates in financial reporting.
What are the 5 ENHANCING QUALITATIVE CHARACTERISTICS?
They are comparability, verifiability, timeliness and understandability.
COMPARABILITY:
What is comparability? How is it reduced?
Accounting information about a company is most useful when it can be compared with accounting information about other companies. There is “comparability” when companies with similar circumstances use the same accounting principles. Comparability enables users to identify the similarities and differences between companies.
Comparability is reduced when companies use different methods of accounting for specific items. For example, there are different methods of determining the cost of inventory, which can result in different amounts of profit. But if each company states which cost determination method it uses, the external user can determine whether the financial information for two companies is comparable.
COMPARABILITY:
Comparability is easier when accounting policies are used consistently. Consistency means? Can a company change its accounting policies?
Consistency means that a company uses the same accounting principles and methods from year to year. For example, if a company selects FIFO as its inventory cost formula in the first year of operations, it is expected to use FIFO in subsequent years. When financial information has been reported consistently, the financial statements make it possible to do a meaningful analysis of company trends.
This does not mean, however, that a company can never change its accounting policies. Sometimes changes in accounting policies are required by standard setters. For example, when Canadian companies adopted either ASPE or IFRS in 2011, they were required to change some accounting policies. At other times, management may decide that it would be better to change to a new accounting policy. To do this, management must prove that the new policy will result in more relevant information in the statements.
In the year of a change in an accounting policy, the change and its impact must be disclosed in the notes to the financial statements. This disclosure makes users of the financial statements aware of the lack of consistency. In addition, the financial statements for past years must be restated as if the new accounting policy had been used in those years.
VERIFIABILITY:
Describe verifiability.
Verifiability helps assure users that the financial information shows the economic reality of the transaction. Information is verifiable if two knowledgeable and independent people would generally agree that it is faithfully represented. For example, the balance in a bank account can be directly verified by obtaining confirmation of the amount from the bank. Other types of information can be verified by checking inputs to a formula and recalculating the outputs. Information must be verifiable for external professional accountants to audit financial statements and to provide an opinion that the financial statements are presented fairly.
TIMELINESS:
Describe timeliness.
Timeliness means that accounting information is provided when it is still highly useful for decision-making. In other words, it must be available to decision makers before it loses its ability to influence decisions. Many people believe that by the time annual financial statements are issued- sometimes up to six months after a company’s year-end- the information has limited usefulness for decision-making. Timely interim financial reporting is essential to decision-making.
UNDERSTANDABILITY:
Describe understandability. Understandability is greater when the information is?
For the information in financial statements to be useful, users must be able to understand it. Understandability enables reasonably informed users to interpret and comprehend the meaning of the information provided in the financial statements. Users are expected to have a reasonable knowledge of business, economic, and financial activities, and of financial reporting. Users who do not have this level of understanding are expected to rely on professionals who do have an appropriate level of expertise. One of the benefits to Canadian public companies of using IFRS is that their financial statements will not be better understood by global users.
Understandability is greater when the information is classified, characterized, and presented clearly and concisely. In making decisions, users should review and analyze the information carefully.
What is full disclosure?
The accounting concept that recognizes that financial statement information must be complete and requires the disclosure of circumstances and events that make a difference to financial statement users. It is important that investors be made aware of events that can affect a company’s financial health.
Full disclosure is respected through two elements in the financial statements: the data they contain and the accompanying notes. For example, one of the notes in the statements summarizes the company’s significant accounting policies. The summary includes the methods used by the company when there are alternatives in acceptable accounting principles.
The information that is disclosed in the notes to the financial statements generally falls into the three additional categories. The information can:
- Give supplementary detail or explanation (for example, a schedule of property, plant, and equipment
- Explain unrecorded transactions (for example, contingencies, commitments, and subsequent events)
- Supply new information (for example, information about related party transactions)
Deciding how much disclosure is enough can be difficult. Accountants must use professional judgement in determining what information is relevant and material to users. Accountants must also consider the cost of providing the information versus the benefits.
