Chapter1: Environment and Theoretical Structure of Financial Accounting
Qualitative Characteristics of Financial Reporting Information
Fundamental Qualitative Characteristics
RELEVANCE. Obviously, to make a difference in the decision process, information must be relevant to the decision. Relevance in the context of financial reporting means that the information must possess predictive valueconfirmation of investor expectations about future cash-generating ability. and/or confirmatory value,confirmation of investor expectations about future cash-generating ability. typically both. For example, if net income and its components confirm investor expectations about a company's future cash-generating ability, then net income has confirmatory value for investors. This confirmation also can be useful in predicting the company's future cash-generating ability as expectations are revised.
This predictive ability is central to the concept of “earnings quality,” the ability of reported earnings (income) to predict a company's future earnings. This is a concept we revisit frequently throughout this textbook in order to explore the impact on earnings quality of various topics under discussion. For instance, in Chapter 4 we discuss the contents of the income statement and certain classifications used in the statement from the perspective of helping analysts separate a company's transitory earnings from its permanent earnings. This separation is critical to a meaningful prediction of future earnings. In later chapters, we look at how various financial reporting decisions affect earnings quality.
Faithful representation also assumes the information being relied on is free from bias. Financial information should not influence decision making to achieve a predetermined result. In that regard, neutrality neutral with respect to parties potentially affected. is highly related to the establishment of accounting standards. You learned earlier that changes in accounting standards can lead to adverse economic consequences for certain companies, their investors and creditors, and other interest groups. Accounting standards should be established with overall societal goals and specific objectives in mind and should try not to achieve particular social outcomes or favor particular groups or companies.
The FASB faces a difficult task in balancing neutrality and the consideration of economic consequences. A new accounting standard may favor one group of companies over others, but the FASB must convince the financial community that this is a consequence of the standard and not an objective used to set the standard.
Uncertainty is a fact of life when we measure many items of financial information included in financial statements. Estimates are common. We would not expect all measurements to be error-free. However, the information should be free from material error if it is to be useful.
Enhancing Qualitative Characteristics
Verifiability implies a consensus among different measurers. implies a consensus among different measurers. For example, the historical cost of a piece of land to be reported in a company's balance sheet usually is highly verifiable. The cost can be traced to an exchange transaction, the purchase of the land. However, the fair value of that land is much more difficult to verify. Appraisers could differ in their assessment of fair value. The term objectivity often is linked to verifiability. The historical cost of the land is objective and easy to verify, but the land's fair value is subjective, influenced by the measurer's past experience and prejudices. A measurement that is subjective is difficult to verify, which makes it less reliable to users.
Understandability users must understand the information within the context of the decision being made. means that users must understand the information within the context of the decision being made. This is a user-specific quality because users will differ in their ability to comprehend any set of information. The overriding objective of financial reporting is to provide comprehensible information to those who have a reasonable understanding of business and economic activities and are willing to study the information.
31Ibid., par. QC9.
32Companies occasionally do change their accounting practices, which makes it difficult for users to make comparisons among different reporting periods. Chapter 4 and Chapter 20 describe the disclosures that a company makes in this situation to restore consistency among periods.