What are the two characteristics for qualitative financial information?

SFAC No. 2 outlines the are two primary qualitative characteristics and their components. You are expected to understand the fundamental qualitative characteristics and the enhancing characteristics. Both characteristics should be present in order for financial information to be useful to readers. The two fundamental characteristics to remember come exam day are relevance and faithful representation.

Relevance: Key Components

Financial information is relevant and influences financial statement readers decision making process. Financial information is considered relevant if it has predictive value, confirmatory value, and materiality.

1) Predictive value – Financial information that has predictive value can be applied to predict future information.

2) Confirmatory value – Financial information that has confirmatory value can be applied to provide information that confirms or changes previous determinations.

3) Materiality – Financial information is considered material such that if absent or omitted, it would cause a potential influence on existing or potential decisions.

Faithful Representation: Key Components

Financial information is faithfully represented if it is considered reliable to financial statement readers and alleviates doubt in their decision-making process. Financial information is considered faithfully represented if it has completeness, neutrality, and has a freedom from error. 

1) Completeness – Financial statements are considered complete if it allows the user to have all information that is pertinent and necessary to coming to an appreciate decision.

2) Neutrality – Financial statements are considered neutral if they are reported without bias in the selection or the presentation of the financial information.

3) Freedom from error – Financial information is considered to be free from error when no omissions or errors have been applied when selecting reporting processes.

The purpose of financial statements is to give financial statements information about the change in financial position, financial performance and financial position of the organization. These can provide data use in decision making such as investment, credit and economic decision making which are useful for various users. There are seven main groups of users which are public, investors, lenders, employees, customers, supplies, government and other agencies and the needs of information is different for each group, for instance, employee will interest on the profitability, retirement benefits and employment opportunities and so on.

The qualitative characteristics can be categorized as fundamental (relevance and faithful representation) or enhancing (comparability, verifiability, timeliness and understandability) based on how they influence the usefulness of financial information. However, it can limited by two pervasive constraints which is cost and materiality in providing useful financial information.

Fundamental Qualitative Characteristics of Financial Information

1. Relevance: Relevant financial reporting information means the ability of users (shareholder) to make a difference in their decision. Information regarding to economic phenomenon will help the users make a difference decision if it included predictive value and confirmatory value.
   • Predictive Value: Information has predictive value if the value can be useful to the shareholder in predicting certain things that is related to future. Information which is highly predictable does not necessary has predictive value. For instance, depreciation of plant and equipment by using straight line method can be highly predictable every year, but it cannot assist in evaluating the net cash flows.
   • Confirmatory value: Information has confirmatory value if it confirms the validity of prior expectation or correcting them according to the prior evaluations. The outcomes will be same as past expected if the information has confirmed past expectation while the outcome can be changed if correcting in past expectations occurred.
2. Faithful Representation: Useful financial information needs not only be a relevant but also be a faithful representation. Financial reporting information included the characteristics of complete, neutral, and free from material error is supposed to be faithful representation of an economic phenomenon. A single description in financial reports may correspond to multiple economic phenomena. For instance, the plant and equipment presents in the balance sheet may stand for all the plant and equipment that owned by entity.
   • Complete: Complete financial reporting information must have all the necessary information which is useful for decision making and should not be missing a material fact or consideration that would cause the financial reporting information misleading.
   • Neutrality: Neutrality in financial reporting information must be free from bias which the information provided does not favor to the particular group over other interested person. In order to have neutral information, information must report in faithful and trustworthiness condition without changing anything that need to be conveyed for the purpose of inducing someones behavior.
   • Free from error: A set of financial reporting information is said to be true if the information is free from error. However, due to some constraint and uncertainty in economy phenomena, financial reporting information does not provide absolutely value which is totally free from error. Therefore, a various type of judgments and estimation based on appropriate input are used by the management in assessing the financial reporting.

Application of the Fundamental Qualitative Characteristics of Financial Information

Relevance is the fundamental qualitative characteristic which connected to the economic phenomena and must be considered first before the other qualitative characteristics. Once the relevance is applied to distinguish which economic phenomena should be presented, faithful representation is going to determine which characteristics are best to correspond to the relevant phenomena. Therefore, relevance and faithful representation must work in a line to provide useful financial information to the users.

Enhancing Qualitative Characteristics of Financial Information

Enhancing qualitative characteristics are additional benefit added to the fundamental to enhance the decision usefulness of financial information.

1. Comparability: Comparability refers to the ability of the users to distinguish similarities and differences between two economic phenomena. Comparability between entities and consistency in the application of methods or procedures over time period will enhance the informational value in relative economic performance. In order to maximize the fundamental qualitative characteristics, some degree of comparability should be included in relevant and faithful representation.
2. Verifiability: Verifiability refers to the capable of the users to ensure that the information faithfully represents what it purports to represent and to ensure the selected technique of measurement had been used is without bias and error. The information is verified when the different evaluators or observers who are knowledgeable confirmed and come up with the same result. Verification can be distinguished as direct or indirect. Direct verification can be verified through an amount or other representation while indirect verification refer to the amount or other representation which is verified by examining the inputs and recount the outputs by adopting same accounting convention.
3. Timeliness: Timeliness means that the information must be received by the users at the right time before it loses its ability to affect the decision. Information should be provided with sufficient timeliness to give a clear and meaningful picture for the shareholders. Information that is not available when it is needed by the decision makers will be useless and the information may lose its potential value.
4. Understandability: Understandability means that the quality of financial information that the users could be able to identify or discover the meaning of the message that trying to be shown. Users of financial statements are assumed to have sufficient knowledge to study the information properly. If the information is classified, clearly represent and concise, it will help to enhance understandability. Sometimes, the information is complicated and hard to understand, the users may seek an adviser to explain to them.

Application of the Enhancing Qualitative Characteristics of Financial Information

Enhancing qualitative characteristics provide additional benefit and usefulness in the financial reporting information. Therefore, the four important characteristics which are comparability, verifiability, timeliness and understandability should be extent widely. However, the enhancing qualitative characteristics will be useless if the financial information is irrelevant or not faithfully represented in fundamental step. The application of the enhancing qualitative characteristics is redundant process that does not follow priority and prescribed order. Sometimes, one or some of the enhancing qualitative characteristics will be given up to maximize the usefulness of another qualitative characteristic. If such situation happened, appropriate information or evidence should be disclosed.

Constraints on Financial Reporting

1. Materiality: Materiality can be explained as the level of an omission or misstatement of financial reporting information which could influence the decision of users. Materiality depends on the size and nature of the item judged in the light of the surrounding circumstances. It is hard to determine a consistent quantitative at which a specific information become material. In order to provide a faithful representation and relevant financial information, materiality level should be establish so as to detect material misstatement to avoid incomplete, biased, or not free from error in financial reporting information.
2. Cost: Cost is one of the pervasive constraints in providing useful financial reporting. The benefit of financial reporting imposes costs. Normally, management will tend to use more qualitative rather than quantitative when evaluating and justify those costs in the benefit of financial reporting information. However, it is often incomplete and imperfect if using qualitative technique to analysis cost and benefit of financial reporting. Cost of producing information such as cost of collecting, classifying, processing, verifying and disseminating should be determined clearly. Besides, cost of omission and error in decision making also need to be included. Shareholders and individual entities use financial reporting information to make decision and enjoy those benefits will lower the cost of capital.

Application of the Constraints on Financial Reporting

Materiality is said to be one of the pervasive constraint on financial reporting because it attribute to all the qualitative characteristics. For example, materiality need to be measured when determine the sufficiency of relevant information and sufficiency of complete, neutral, and free from error to faithfully represent in financial reporting. Application of the cost constraint in financial reporting included evaluate whether the benefits of reporting information will be able to impose the costs. It is necessary to reflect on whether one or some qualitative characteristics one or some of the enhancing qualitative characteristics will be given up to reduce the cost.

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