CHAPTER 3 — . - CONCEPTUAL FRAMEWORK Qualitative characteristics TECHNICAL KNOWLEDGE To identify the qualitative characteristics of accounting information. To identify the fundamental qualitative characteristics. To identify the enhancing qualitative characteristics. ry To understand the cost constraint on useful inforniation. Thi 46ting QUALITATIVE CHARACTERISTICS Qualitative characteristics are the qualities or attributes that make financial accounting information useful to the users. In deciding which information to include in financial statements, the objective is to ensure that the information is useful to the users in making economic decisions. Under the Conceptual Framework for Financial Reporting, qualitative characteristics are classified into fundamental qualitative characteristics and 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. Neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions. Application of qualitative characteristics The most efficient and effective process of applying the fundamental qualitative characteristics would usually be: First, identify an economic phenomenon or transaction that has the potential to be useful. Second, identify, the type of information about the phenomenon or transaction that would be most relevant and can be faithfully represented. Third, determine whether the information is available. 47 ce rteRelevance | In the simplest terms, relevance is the capacity of the information to influence a decision. To be relevant, the financial information must be capable of making a difference in the decisions made by users. In other words, relevance requires that the finangig information should be related or pertinent to the economic decision. 5 Information that does not bear on an economic decision jg useless. To be useful, information must be relevant to the decision making needs of users. For example, broadly, the statement of financial position is relevant in determining financial position, and the income statement is relevant in determining performance. More specifically, the earnings per share information is more relevant than book value per share in determining the attractiveness of an investment. Ingredients of relevance Financial information is capable of making a difference in a decision if it has predictive value and confirmatory value. Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcome. In other words, financial information has predictive value when it can help users increase the likelihood of correctly of accurately predicting or forecasting outcome of events. For example, information about financial position and past 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 i predicting loan payment or default. 48 Fir fee In wh Fo. it ¢ abe oft Th int An fed pre inemn is re 1e ed re ue ast ng in 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 jt 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 for predicting the annual income. The interim income statement for the first quarter shows net income of P2,000,000. This information is the confirmatory value. If this trend continues for the entire year, it is logical to assume that the net income after four quarters or one year would be P8,000,000. This information is the predictive value. Materiality 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. The materiality concept 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 of information is affected by its nature and materiality. In other words, materiality is a subquality of relevance based on the nature or magnitude or both of the items to which the information relates. The Conceptual Framework does not specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation. 49Materiality is a relativity iversi sould Materiality of an item depends on relative size rather than Cou absolute size. What is material for one entity may be immaterial for another. An error of P500,000 in the financial statements of a multinational entity may not be important but may be is ra critical for a small entity. By When is an item material? be There is no strict or uniform rule for determining whether re an item is material or not. Very often, this is dependent on good judgment, professional ay F expertise and common sense. As a general guide, an item is material if knowledge of it could Coe reasonably affect or influence the economic decision of the 0 primary users of the financial statements. New definition of materiality I The IASB provided the following new definition of materiality. Information is material if omitting, could reasonably be expected to decisions that primary users of ge statements make on the basis of those financial information about a speci misstating or obscuring it oe influence the economic neral purpose financial statements which provide fic reporting entity. Exaniy In other words, an information is mate! misstatement and obscuring of the reasonably affect the econome decision - aa a vial if the omission, information could of primary users. The revised definition of materiality highlights three important aspects: a. Could reasonably be expected to influence b. Obscuring information c. Primary users 50Could reasonably be expected to influence The could reasonably be expected to influence threshold adds an element of reasonability of financial information on which economic decision is based. By including the term could reasonably be expected to influence in the new definition, material information shall be limited to the economic decision of primary users rather than to all users which is too broad in scope. Moreover, the could reasonably be expected to influence threshold insures that information capable of influencing economic decision of the primary users shall be included in the financial statements. Obscuring information Obscuring information is a new concept added to the new definition of materiality. Information is obscured if presenting or communicating it would have a similar effect as omitting or misstating the information. Obscuring information means the presentation of financial information not readily understood or not clearly expressed. Obscuring information may be characterized by deliberate vagueness, ambiguity and abstruseness. Examples of obscured material information are: a. The language is vague or unclear. b. The information is scattered throughout the financial statements. c. Dissimilar items are aggregated inappropriately. d. Similar items are disaggregated inappropirately. 51 a aPrimary users The new definition of materiality narrows the definition to primary users who are primarily affected by general Purpose financial statements. The primary users include the existing and potential investors, lenders and other creditors. The new definition specified that only primary users of financial statements are considered because these groups are the users to whom general purpose financial statements are primarily directed. Such primary users cannot require reporting entities to provide information directly to them and therefore must rely on general purpose financial reports for how much financial information is needed. The other users include the employees, customers, government agencies and the public in general. Factors of materiality Materiality depends on the magnitude and nature of the financial information. In the exercise of judgment in determining materiality, the relative size and nature of an item are considered. The size of the item in relation to the total of the group to which the item belongs is taken into account. For example, the amount of advertising in relation to total selling expenses, the amount of office salaries to total administrative expenses, the amount of prepaid expenses t0 total current assets and the amount of leasehold improvements to total property, plant and equipment. ‘The nature of the item may be inherently material because bY its very nature it affects economic decision. For example, the discovery of a P20,000 bribe is a material event even for a very large entity. 52 Faithf Faithful econom Stated ¢ what re Simply ' effects 0 reportec For ex when th not be f To reco erroneou A compl a user tc depicted, Actually, accompa: The pur disclosy Standarcof re re to ly ial to tal tal old , bY rial Faithful representation Faithful representation means that. financial reports represent economic phenomena or transactions in words and numbers. Stated differently, the descriptions and figures must 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. 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 Completeness requires that relevant information should be presented in a way that facilitates understanding and avoids erroneous implication. A complete depiction includes all information necessary for a user to understand the phenomenon or transaction being depicted, including all necessary description and explanation. 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. 53Standard of adequate disclosure Completeness is the result of, the standard of adequate disclosure or principle of full disclosure. The standard of adequate disclosure means that all significan, and relevant information leading to the preparation of financial statements shail 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 buy disclosure of which is necessary in order that the financial statements would not be misleading. The standard of adequate disclosure is best described by disclosure of any financial facts significant enough to influence the judgment of informed users. Neutrality A neutral depiction is without bias in the preparation or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, de-emphasized or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users. In other words, to be neutral, the information contained in the financial statements must be free from bias. ‘The financial information should not favor one party to the detriment of another party. The information is directed to the common needs of many uses and not to the particular needs of specific users, Neutrality is synonymous with the all-e ing principle of fairness. mrcompassing 7 To be neutral is to be fair. 54 prudence the Revis concept of Prudence with the u ts or U are not un Neutrality Conservé Conservatt Conserva! allernative In the sim record any For e and net re Continge probabi Expre, “Anticipate Oss.” “In the mat. Position the Capturing jh the hand.” Don't coun;Int of nce or ed, the ved j in the Prudence The Revised Conceptual Framework has reintroducéd the concept of prudence. , Prudence is the exercise of care and caution when dealing with the uncertainties in the measurement process such that vasets or income are not overstated and liabilities or expenses are not understated. Neutrality ‘is supported by the exercise of prudence. Conservatism Conservatism is synonymous with prudence. Conservatism means that when alternatives exist, the alternative which has the least effect on equity should be chosen. In the simplest words, 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. It is to be emphasized that conservatism is not a license to deliberately understate net income and net assets. For example, if an entity has a cash of P500,000 and reports only P 100,000, this is not conservatism but fraud or inaccurate reporting. Expressions of conservatism (nsepate no profit and provide for probable and measurable loss.” “In the matter of income recognition, the accountant takes the Position that no matter how sure the businessman might be in Te nnng ihe bird in the bush, he, the accountant; must see it in “Don't count your chicks until the eggs hatch”. 55Free from error Free from error means there are no errors or omissio i ms in description of the phenomenon or transaction, the Moreover, the process used to produce the re information has been selected and applied with no ¢ the process. Porteg TLOrS in In this context, free from error does not mean Perfeg ¢ tly 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 it 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 selecting and applying an appropriate process for developing the estimate. Measurement uncertainty Measurement uncertainty arises when monetary amounts in financial reports cannot be observed directly and must instead be estimated. Measurement uncertainty can affect faithful representation if the level of uncertainty in providing an estimate is high. However, the use of reasonable estimate is an essential part of providing financial information and does not undermin® the usefulness of the financial information. As long as the estimate is clearly and accurately describe! and explained, even a high level of measurement uncertain! does not affect the usefulness of the financial informatio" 56 Subst: if infor! other &" transac their su The ec usually legal fo Substar of faith! Faithfu of an ec represe? Repre subst transac The ter owners term Tn forr But in | Provisio, is an ing lessor Accordir use The per represenveloping yunts it d must ntatiot high. al pat ermil scribll tai” tio” Substance over form If information is to represent faithfully the transactions and other events it purports to represent, it is necessary that the iransactions and events are accounted in accordance with their substance and not merely their 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 the legal form. Representing a legal form that differs from the economic substance of the underlying economic phenomenon or transaction could not result in a faithful representation. Example of substance over form An example is when the lessee leased property frora the lessor. The terms of the lease provide that the lease transfers ownership of the asset to the lessee by the end of the lease term. In form, the contract is a lease as popularly understood. But in substance, in reality, if the "transfer of ownership provision" is to be considered, the real intent of the parties is an installment purchase of an asset by the lessee from the lessor. Accordingly, the lessee shall record an acquisition of right of use asset and set up a liability to the lessor. The periodic rental is conceived as an installment payment representing interest and principal. 57Enhancing qualitative.characteristics The enhancing qualitative characteristics relate to Presentation or form of the financial information the The enhancing qualitative characteristics are intendeq increase the usefulness of the financial information that relevant and faithfully represented. ? The enhancing qualitative characteristics are comparability understandability, verifiability and timeliness. , Relevant and faithfully represented financial information ig useful but the information would be most useful if it ig comparable, understandable, verifiable and timely. 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. 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 between and across entities is the quality of information that allows comparisons between two or more entities engaged in the same industry. Comparability across entities is also known @ intercomparability or dimensional comparability. For information to be comparable, like things must look alike and different things must look different. Comparability is not enhanced by making unlike things look alike or making like things look different. 58 en Consiste! Impheit i the princif Hansistenc In broad hod to Hl information But there s ctlect ther 1 is inappy unchangednd jon me tal of ore as ike ook Consistency Implicit in the qualitative characteristic of comparability is the principle of. consistency. Consistency is not the same as comparability. In a-broad sense, consistency refers to the use of the same method for the same item, either from period to period within an entity or in a single period accross entities. Comparability is the goal and consistency helps to achieve that goal. In a limited sense, 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 method in the next year, again the FIFO method in succeeding year and so on. If the FIFO method is adopted in one year, such method is followed from year to year. Consistency is desirable and essential to achieve comparability of financial statements. However, consistency does not mean that no change in accounting method can be made. If the change would result to more useful and meaningful information, then such change shall be made. But there shall be full disclosure of the change and the peso effect thereof. It is inappropriate for an entity to leave accounting policies unchanged when better and acceptable alternatives exist. 59Understandability Understandability requires that financial information, m, be comprehensible or intelligible if it is to be most usefuy). Accordingly, the information should be presented in a for and expressed in terminology that a user understands, s 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 shall 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. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex phenomena or transactions. Understandability is very essential because a relevant and faithfully represented information may prove useless it is not understood by users. 60 ae verifi verifia bil indepen der nece 5 aril js a faith fe abil In other ‘The financi supported | nto the a decision 0! Verifiable be substan mest According repres purpor Verifiat Types « Verifi Direci repre counting Indirect formula or, the same y An exampl checking th the ending such as finon, he SS to put ant 5 if Verifiability Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. In other words, verifiability implies consensus. The financial 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 same economic decision or conclusion. Verifiable financial information provides results that would be substantially duplicated by measurers using the same measurement method. Accordingly, verifiability helps assure users that information represents the economic phenomenon or transaction it purports to represent. Verifiability is synonymous with objectivity. Types of verification Verification can be direct or indirect. Direct verification means verifying an amount or other representation through direct observation, for example, by counting cash. Indirect verification means checking the inputs to a model, formula or other technique and recalculating the inputs using the same methodology. An example is verifying the carrying amount of inventory by checking the inputs in quantities and costs, and recalculating the ending inventory using the same cost flow assumption, such as first-in, first-out. , 61Timeliness Timeliness means that financial information must be avails or communicated early enough when a decision is to be mad, Relevant and faithfully represented financial informatin | furnished after a decision is made is useless 0 value." important attribute of quarterl: the most i vt = pogeran hy ‘ion is its timeliness. interim financial informa’ Generally, the older the information, the less useful. Yor However, some information may continue to be timely long after the end of reporting period because some users may need to identify and assess trends. sm that without knowiedge of the ion will usually be lacking and knowledge of the past is sterile, Timeliness enhances the trw past, the basis for predi without interest in the futur 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 tiformation 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 efit to be obtained from having the information. q The benefit derived from the information should ¢ f ed the cost incurred in obtaining the information However, the evaluation of the cost co ) paint is substantially a judgmental process, ‘ Assessing whether the cost of reporting outweighs or fall short of the benefit is difficult to measure and becomes & matter of professional judgment, 62 QUEST! 4, What i financi 2. What @ 3, What a 4, Explai applyit 5. Explai 6. What | 7. Explai 8, Explai 9. When 10. Expla 11. What detert 12. Exple faith 13. What 14. Exple 15. What 16. Expl, comp 17. Expl