CONCEPTUAL FRAMWORK -Qualitative characteristics

Qualitative characteristics of financial statements.

Qualitative characteristics are the qualities or attributes that make financial

accounting information useful to the users.

In deciding which information should be included in financial statements, the

objective is to ensure that the information is useful to the users in making
economic decisions.

Qualitative characteristics are classified into:

a. Fundamental qualitative characteristics
b. Enhancing qualitative characteristics

Fundamental qualitative characteristics.

The fundamental qualitative characteristics relate to the content or substance of

financial information.

The fundamental qualitative characteristics are relevance and faithful

representation.

Information must be both relevant and faithfully represented if it is to be useful.

Enhancing qualitative characteristics.

The enhancing qualitative characteristics are intended to increase the usefulness

of the financial information that is relevant and faithfully represented,

The enhancing qualitative characteristics relate to the presentation or form of

financial information.

The enhancing qualitative characteristics are:

a. Understandability
b. Comparability
c. Verifiability
d. Timeliness

Qualitative characteristic of relevance.

Relevance means "the capacity of information to make a difference in a decision

made by users."
Relevance is the capacity of the information to influence a decision.

Relevance requires that the financial information should be related or pertinent

to the economic decision.

Information that does not bear on an economic decision is useless.

To be useful, the information must be relevant to the decision-making needs of

users.

Broadly, the statement of financial position is relevant in determining financial

position and the income statement is relevant in determining financial
performance.

Specifically, the earnings per share information is more relevant than book value
per share in determining the attractiveness of an investment.

Major ingredients of relevant information.

The ingredients of relevance are predictive value and confirmatory value.

Information has predictive value when it can help Users increase the
likelihood of correctly predicting or forecasting outcome of events.

For example, information about financial position and financial performance

is frequently used in predicting dividend and wage payments and the ability
of the entity to meet maturing commitments.

The net cash provided by operating activities is valuable in predicting loan

payment or default.

Financial information has confirmatory value if it provides feedback about

previous evaluations.

In other words, financial information has confirmatory value when it enables users
confirm or correct earlier expectations.

For example, a net income measure has confirmatory value if it can help
shareholders confirm or revise their expectation about an entity's ability to
generate earnings.

Often, information has both predictive and confirmatory value.

The predictive and confirmatory roles of information are interrelated.

An example is an interim income statement which provides feedback about
income to date and serves as a basis Tor predicting the annual income.

If the interim income statement for the first quarter is P2,000,000 (confirmatory
value), and this trend continues for the entire year, it is logical to assume that the
net income after four quarters or one year would be (predictive value).

Materiality an relation to relevance,

Materiality is a practical rule in accounting which dictates that strict adherence

to GAAP is not required when the items are not significant enough to affect the
evaluation, decision and fairness of the financial statements. Materiality is also
known as the doctrine of convenience.

Materiality is really a "quantitative threshold" linked very closely to the qualitative

characteristic of relevance.

The relevance o/ information is affected by its nature and materiality.

In other words, materiality is a "subquality" of relevance based on nature and

magnitude of the item to which the information relates.

Materiality is a relativity. Materiality of an item depends on relative size rather than

absolute size. What is material for one entity may be immaterial for another.

An error of P 100,000 in the financial statements of a multinational entity may not

be important but may be so critical for a small entity.

When is an item material?

The Conceptual Framework does not specify a uniform quantitative threshold for
materiality.

Very often, materiality is dependent on good judgment, professional expertise

and common sense.

However, a general guide may be given, to wit:

"An item is material if knowledge of it would affect or influence the decision of

the informed users of the financial statements".

Information is material if the omission or misstatement could influence the

economic decision that the users make on the basis of the financial information
about the entity.
Faithful representation

Under the Conceptual Framework for Financial Reporting, the term faithful
representation is used instead of the term reliability.

Faithful representation means that financial reports represent economic

phenomena or transactions in words and numbers.

Stated differently, the descriptions and figures match what really existed or
happened.

Simply worded, faithful representation means that the actual effects of the
transactions shall be properly accounted for and reported in the financial
statements.

For example, if the entity reports purchases of P5,000,000 when the actual
amount is P8,000,000, the information would not be faithfully represented.

To record a sale of merchandise as miscellaneous income would not also be a

faithful representation of the sale transaction.

When ending inventory is misstated, either understated or overstated, the

presentation or reporting lacks faithful representation.

The recognition of an impairment loss on property, plant and equipment is an

application of faithful representation.

Ingredients of faithful representation?

To be a perfectly faithful representation, a depiction should have three

characteristics, namely:
a. Completeness
b. Neutrality
c. Free from error

Completeness of financial statements and the related standard of adequate

disclosure.

Completeness requires that relevant information should be presented in a that

facilitates understanding and avoids erroneous implication.

Completeness is the result of the adequate disclosure standard or the principle of

full disclosure.
The standard of adequate disclosure means that all significant and relevant
information leading to the preparation of financial statements shall be clearly
reported.

Adequate disclosure however does not mean disclosure of just any data.

The accountant shall disclose a material fact known to him which is not disclosed
in the financial statements but disclosure of which is necessary in order that the
statements would not be misleading.

In other words, the standard of adequate disclosure is best described by

disclosure of any financial facts significant enough to influence the judgment of
informed users.

Actually, to be complete, the financial statements shall be accompanied by

"notes to financial statements".

The purpose of the notes is to provide the necessary disclosures required by

Philippine Financial Reporting Standards,

Notes to financial statements provide narrative description or disaggregation of

the items presented in the financial statements and information about items that
do not qualify for recognition.

Neutrality of financial statements,

Neutrality means that the financial statements should not be prepared so as

to favor one party to the detriment of another party.

To be neutral, the information contained in the financial statements must be free

from bias.

A neutral depiction is "without bias" in the selection or presentation of financial

information.

Neutrality is synonymous with the all-encompassing "principle of fairness". To be

neutral is to be fair.

The information is directed to the common needs of many users and not to the
particular needs of specific users.

Characteristic of "free from error".

Free front error means there are no errors 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.

In this context, free from error does not mean perfectly accurate in all respects.

For example, an estimate of an unobservable price or value cannot be

determined to be accurate or inaccurate.

However, a representation of that estimate can be faithful if the amount is

described clearly and accurately as an estimate.

Moreover, the nature and limitations of the estimating process are explained, and
no errors have been made in applying an appropriate process for developing the
estimate.

Concept of substance over form.

If information is to represent faithfully the transactions it purports to represent, it is

necessary that the transactions are accounted for in accordance with their
economic substance and reality and not merely their legal form.

In other words, if there is a conflict between substance and form, the economic
substance of the transaction shall prevail over the legal form.

The economic substance of transactions and events are usually emphasized

when economic substance differs from legal form.

Substance over form is not considered a separate component of faithful

representation because it would be redundant.

Faithful representation inherently represents the substance of an economic

phenomenon or transaction rather than merely representing its legal form.

Conservatism

There is no discussion of conservatism or prudence in the Conceptual Framework

for Financial Reporting.

The Conceptual Framework did not include conservatism or prudence as an

aspect of faithful representation because to do so would be inconsistent with
neutrality.
Most often, a conservative or prudent approach is subjective and may contain
an element of bias.

Concept of conservatism.

Under conservatism, when alternatives exist, the alternative which has the least
effect on equity shall be chosen.

Stated differently, managers, investors and accountants have generally preferred

that possible errors in measurement be in the direction of understatement rather
than overstatement of net income and net assets.

In the simplest terms, conservatism means "in case of doubt, record any loss and
do not record any gain."

For example, if there is a choice between two acceptable asset values, the lower
figure is selected.

Accordingly, inventories are measured at the lower of cost and net realizable
value.

Contingent loss is recognized as a "provision" if the loss is probable and the

amount can be reliably measured.

Contingent gain is not recognized but disclosed only.

Conservatism is not a license to deliberately understate net income and net

assets.

Prudence.

Conservatism is synonymous with prudence.

Prudence is the desire to exercise care and caution when dealing with the
uncertainties in the measurement process such that assets and income are not
overstated or liabilities and expenses are not understated.

Qualitative characteristic of understandability.

Understandability requires that financial information must be comprehensible or

intelligible if it is to be useful.

Accordingly, the information should be presented in a form and expressed in

terminology that a user understands.
Classifying, characterizing and presenting information "clearly and concisely"
makes it understandable.

An essential quality of the information provided in financial statements is that it is

readily understandable by users.

But the complex economic activities make it impossible to reduce the financial
information to the simplest terms.

Accordingly, the users should have an understanding of the complex economic

activities, the financial accounting process and the terminology in the financial
statements.

Financial statements cannot realistically be understandable to everyone.

Financial reports are prepared for users who have a reasonable knowledge of
business and economic activities and who review and analyze the information
diligently.

Qualitative characteristic of comparability

Comparability means the Ability to bring together for the purpose of noting points
of likeness and difference,

Comparability is the enhancing qualitative characteristic that enables users to

identify and understand similarities and dissimilarities among items.

Comparability may be made within an entity or between and across entities.

Two kinds of comparability?

The two kinds of comparability are comparability within an entity and

comparability across entities.

Comparability within an entity is the quality of information that allows comparisons

within a single entity through time or from one accounting period to the next.

Comparability within an entity is also known as horizontal comparability or

intracomparability.

Comparability across entities is the quality of information that allows comparisons

between two or more entities engaged in the same industry.
This comparability is also known as intercomparability or dimensional
comparability

The financial statements of different entities are compared in order to evaluate

their relative financial position, financial performance and cash flows.

Users' decisions involve choosing between alternatives.

Consequently, relevant and faithfully represented information is most useful if it

can be compared with similar information about the same entity for the previous
period and with similar information reported by other entities.

Principle of consistency,

Implicit in the qualitative characteristic of comparability is the principle of

consistency.

The principle of consistency requires that the accounting methods and practices
should be applied on a uniform basis from period to period.

Consistency is not the same as comparability.

Comparability is the goal and consistency help to achieve that goal.

Consistency is desirable and essential to achieve comparability of financial

statements.

Technically, consistency is the uniform application of accounting method from

period to period within an entity.

On the other hand, comparability is the uniform application of accounting

method between and across entities in the same industry.

An entity cannot use the FIFO method of inventory valuation in one year, the
average method in the next year, another method in succeeding year and so on.

If the FIFO method is adopted in one year, such method is followed from year to
year.

However, consistency does not mean that no change in accounting method can
be made.

If the change will result to more useful and meaningful information, then such
change should be made.
But there should be full disclosure of the change and the peso effect thereof.

It is inappropriate to leave accounting policies unchanged when better and

acceptable alternatives exist.

Verifiability.

Verifiability means that different knowledgeable and independent observers

could reach consensus that a particular depiction is n faithful representation.

In other words, verifiability implies consensus.

The information is verifiable in the sense that it is supported by evidence so that

an accountant that would look into the same evidence would arrive at the
game decision or conclusion.

Verifiable financial information provides results that would be substantially

duplicated by measurers using the game measurement method

Enhancing quality of timeliness.

Timeliness means having information available to decision makers in time to

influence their decisions.

In other words, timeliness requires that financial information must be available or

communicated early enough when a decision is to be made.

Relevant and faithfully represented financial information furnished after a

decision is made is useless or of no value.

Relevant information may lose relevance if there is undue delay in the reporting.

Timeliness enhances the truism that "without knowledge of the past, the basis for
prediction will usually be lacking and without interest in the future, knowledge of
the past is sterile."

What happened in the past would become the basis of what would happen in
the future.

Cost constraint on useful information.

Cost is a pervasive constraint on the information that can be provided by financial

reporting.
Reporting financial information imposes cost and it is important that such cost is
justified by the benefit derived from the financial information.

In other words, the cost constraint is a consideration of the cost incurred in

generating financial information against the benefit to be obtained from having
the information.

The benefit derived from the information should exceed the cost incurred in
obtaining the information.

Otherwise, the financial accounting information may not be reported.

However, the evaluation of the cost constraint is a judgmental process.

Assessing whether the cost of reporting outweighs or falls short of the benefit is
difficult to measure and becomes a matter of professional judgment.