Qualitative characteristics of financial statements

This chapter explains the qualitative characteristics that make financial information relevant, faithfully represented, 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 fall into two groups:

• Fundamental qualitative characteristics
• 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

Relevant financial information is capable of making a difference in the decisions users make, even if some users choose not to use it (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

Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions that users make on the basis of the financial statements.

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) requires judgement, so it’s subjective. Many entities treat any item above 5% of profit before 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.

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

The information is selected and presented without bias, supported by the exercise of prudence. Prudence means exercising caution when making judgements under uncertainty, so that assets and income are not overstated and liabilities and expenses are not understated. It does not allow assets or income to be deliberately understated, or liabilities or expenses overstated, because that would itself be bias.

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

Faithful representation depicts the substance of a transaction, not just its legal form. This is the principle of substance over form: transactions are reported according to their economic reality rather than their legal form. For example, if a company “sells” goods to a bank but agrees to buy them back later at a higher price, the substance is a secured loan. The goods stay in the company’s inventory, and the cash received is shown as a liability, not as revenue.

Enhancing qualitative characteristics

The enhancing qualitative characteristics are:

• Comparability
• Timeliness
• Verifiability
• Understandability

Definitions

Comparability

Enables users to identify and understand similarities in, and differences among, items (IASB Conceptual Framework).

Timeliness

Having information available to decision-makers in time to be capable of influencing their decisions (IASB Conceptual Framework).

Verifiability

Helps assure users that the information faithfully represents the economic phenomena it purports to represent (IASB Conceptual Framework).

Understandability

Classifying, characterising, and presenting information clearly and concisely (IASB Conceptual Framework), assuming users have a reasonable knowledge of business and economic activities.

Comparability allows 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.

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 means that different knowledgeable and independent observers could reach a similar or the same consensus that a particular depiction is a faithful representation. It can be direct or indirect:

• Direct verifiability means confirming an amount by direct observation. For example, counting cash in hand.
• Indirect verifiability means 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 doesn’t mean leaving things out. Excluding complex phenomena to make the statements easier to understand would make them incomplete, and therefore possibly misleading (a failure of faithful representation).

Balance between the qualitative characteristics

The qualitative characteristics work together, and you sometimes need to balance one against another to meet the objectives of financial reporting.

For example, trying to include every bit of information to achieve relevance may delay publication and render the statements untimely - the relative importance of each characteristic in a given situation is a matter of professional judgement.