Or more formally: Qualitative Characteristics of Useful Financial Information
What types of information are useful to users for making decisions about the reporting entity using the general purpose financial report compiled by the reporting entity. And equally important what are the cost constraints on the reporting entity’s ability to provide useful financial information.
Some information will be more important than other information and some more important information will be easily maintained, collected and reported and other more important information will be expensive to maintain, collect and report, the question being when it is too expensive to maintain, collect and report.
The first two fundamental qualitative characteristics…..
Financial information is considered to be useful if it is relevant and it faithfully represents what it purports to represent. So relevance and faithful representation are considered to be the fundamental qualitative characteristics
From Merriam-Webster a nice definition: A definition of relevance is the ability (as of an information retrieval system) to retrieve material that satisfies the needs of the users. https://www.merriam-webster.com/dictionary/relevance
Relevant financial information is capable of making a difference in decisions made by users if it has predictive value, confirmatory value or both.
Predictive value – the financial information is useful because it can be used as an input to processes employed by users to predict future outcomes, in making users’ own predictions.
Confirmatory value – the financial information is useful if it provides feedback about previous evaluations (confirms or changes a previous understanding).
A definition of faithful representation falls in to two pieces:
- a definition of faithful is being true to the facts, to a standard or to an original https://www.merriam-webster.com/dictionary/faithful,
- a definition of representation is one that represents: an incidental or collateral statement of fact on the faith of which a contract is entered into https://www.merriam-webster.com/dictionary/representation.
Financial Statements are a relative simple model to represent as accurate as possible in words and numbers the financial outcome of transactions in a business model operated by the reporting entity’s management and governing board.
To be useful the financial statements must not only represent the financial outcome of transactions in a business model in words and numbers, but it must also faithfully represent the substance of the financial outcome of transactions in a business model that it intends to represent. Many times the substance of the financial outcome of transactions in a business model and its legal form are the same. However, if they are not the same, only presenting the legal form of the transaction(s) would be no faithful representation of the transaction(s).
The following three characteristics are providing a prefect faithful representation in words (and numbers) of the substance of the financial outcome of transactions in a business model that it intends to represent: 1) complete, 2) neutral, and 3) free from error. However this is aiming high, perfection is seldom achieved, also keeping in mind the cost constraint. Let’s discuss the three characteristics in more detail:
- a complete representation in words (descriptions and explanations) and numbers includes all information useful to a user to understand the substance of the financial outcome of the transactions it intends to represent.
A complete representation in words and numbers of a group of assets would include, at a minimum, a description of the nature of the assets in the group, a numerical depiction of all of the assets in the group, and a description of what the numerical representation represents (for example, historical cost or fair value).
For some items, a complete representation in words and numbers may also entail explanations of significant facts about the quality and nature of the items, factors and circumstances that might affect their quality and nature, and the process used to determine the numerical representation.
- A neutral representation in words (descriptions and explanations) and numbers is without bias (without personal and sometimes unreasoned judgment) in the selection or presentation of financial information. Neutral information is not useless, it is also not information with no purpose or no influence on behavior, NO it is, as defined before capable of making a difference in decisions by users.
Exercising prudence supports neutrality to a great extend. The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated. Equally, the exercise of prudence does not allow for the understatement of assets or income or the overstatement of liabilities or expenses. However, exercising prudence should not be imbalanced, there is no need for more convincing evidence to support the recognition of assets or income than for the recognition of liabilities or expenses.
3. Free from error in faithful representation does not mean accurate in all respects. It means accurate within the context of the representation in words (descriptions and explanations) and numbers. An estimated provision for doubtful debtors is accurate within the nature of being an estimate.
A representation of this estimate can be faithful if the amount is described clearly and accurately as being an estimate, 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.
Even a high level of measurement uncertainty does not necessarily prevent such an estimate from providing useful information. Using the wording ‘estimate’ in the presentation of the the substance of the financial outcome of transactions in a business model, gives rise to measurement uncertainty. But the use of reasonable estimates is a common process in the preparation of useful financial statements.
Again loosely based on Merriam-Webster, material is having real importance or great consequences and then materiality is the quality or state of being material.
So information is material if it is of real importance or having great consequences. Omitting material information or misstating material information in general purpose financial reports leads to a situation that primary users of general purpose financial reports potentially make different decisions as a result of the omission and/or misstatement.
Hence materiality is an entity-specific aspect, part of the relevance characteristic based on the nature and/or magnitude of the reporting item(s) to which the information relates in the context of the financial report of the relevant reporting entity.