Qualitative characteristics of financial statements

This chapter explains the qualitative characteristics that make financial information relevant, reliable, and useful. These characteristics matter because financial statements serve many different users, and those users rely on high-quality information to make economic decisions.

Learning objectives

By the end of this lesson, you should be able to:

• Define and apply the qualitative characteristics of useful financial information.

Qualitative characteristics of financial statements

Qualitative characteristics are the attributes that make the information in financial statements useful to users.

These attributes are classified into two (2), namely:

1. Fundamental qualitative characteristics
2. Enhancing qualitative characteristics

The distinction matters:

• Fundamental characteristics are essential. Without them, financial information isn’t useful.
• Enhancing characteristics increase usefulness when the fundamental characteristics are already present.

Fundamental qualitative characteristics

The fundamental qualitative characteristics of the financial statements are:

• Relevance
• Faithful representation.

Relevance

Relevance means financial information makes a difference in the decisions users make (IASB Conceptual Framework).

Information is relevant if it can be used for predictive and/or confirmatory purposes:

• It has predictive value if it helps users predict what might happen in the future.
• It has confirmatory value if it helps users confirm (or revise) assessments and predictions they made in the past.

For example, a company’s revenue trend over the past three years can help investors forecast future earnings (predictive value). It can also help them check whether earlier expectations about growth were accurate (confirmatory value).

The relevance of financial information is affected by its materiality.

Materiality

Definitions

Materiality

An accounting principle that states that items or information are considered material if their omission or misstatement could influence the economic decisions of users taken financial statements. Information is material if it could reasonably be expected to affect users’ decisions.

Materiality is an entity-specific aspect of relevance based on the nature or magnitude (or both) of the items to which the information relates in the context of an individual entity’s financial report.

For example, a $100,000 error may be material for a small business but immaterial for a large corporation.

Deciding what is material (i.e., significant) is requires judgment, so it’s subjective. Many entities treat any item above 5% of profit after tax as material. That guideline is quantitative, but some items may be smaller in value and still be material because of qualitative factors.

A classic example is a bribe paid by a director, which may be small in monetary value but is qualitatively material due to its legal and reputational implications for the company.

Materiality acts like a threshold. You consider materiality first; if an item is not material, you generally don’t need to evaluate it further for the other qualitative characteristics. In practice, whether an item is material affects how it is treated in the accounts.

Faithful representation

Financial information must faithfully represent the substance of what it represents. Information is faithfully represented if it is:

1. Complete
2. Neutral
3. Free from error

Definitions

Complete

Financial statements should include all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations.

Neutral

Where depiction is without bias in the selection or presentation of financial information and therefore supported by the exercise of prudence.

Free from Error

There are no misstatements or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process

Substance over form is implied in faithful representation.

Enhancing qualitative characteristics

The enhancing qualitative characteristics of the fundamentals are:

• Comparability
• Timeliness
• Verifiability
• Understandability

Definitions

Comparability

This enables users to identify and understand similarities in, and differences among, items (IASB Conceptual Framework). Comparability enables both intra (year-on-year) and inter (between entities) comparisons of financial information. Consistency is related to comparability but is not the same. It helps to achieve the goal of comparability. Consistency does not override the need for a change in accounting policies or presentation where the need arises. When a company changes an accounting policy, it is required to restate prior period figures where practicable, so that users can still make meaningful comparisons across periods.

Timeliness

It means having information available to decision-makers in time to be capable of influencing their decisions (IASB Conceptual Framework). Financial information is less useful the longer it takes to report it. For instance, a company’s annual financial statements published 18 months after the reporting period end would be of limited value to investors making current investment decisions, as the company’s financial position may have changed significantly.

Verifiability

It helps assure users that the information faithfully represents the economic phenomena it purports to represent (IASB Conceptual Framework). It therefore means that different knowledgeable and independent observers could reach a similar or the same consensus that a particular depiction is a faithful representation. Verifiability can either be direct or indirect. Direct verifiability involves confirming an amount by direct observation. For example, counting cash in hand. Indirect verifiability involves checking the inputs to a model and recalculating the outputs using the same methodology. For example, verifying inventory valuations by checking unit costs and quantities.

Understandability

Involves classifying, characterising, and presenting information clearly and concisely (IASB Conceptual Framework). Users are assumed to have a reasonable knowledge of business and economic activities. However, well-informed and diligent users may sometimes need to seek the aid of an adviser to understand information about complex economic phenomena. Nevertheless, it is not a justification to exclude complex phenomena from the statements to ensure understandability, as this might render the information incomplete, and therefore irrelevant for decision making.

Balance between the qualitative characteristics

The qualitative characteristics work together to make information useful. Sometimes you need to balance (or trade off) one characteristic against another to meet the objectives of financial reporting.

For example, trying to include every bit of information to achieve relevance may delay the publication of the statements and render them untimely. The relative importance of the qualitative characteristics in each situation is a matter of professional judgment. The aim is to achieve an appropriate balance among the characteristics to meet the objectives of financial reporting.