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The Conceptual Framework for Financial Accounting and Reporting was set by FASB since its inception in 1973. The Framework is intended to set forth a system of interrelated objectives and underlying concepts that will serve as the basis for evaluating existing standards of financial accounting and reporting. Under this project, the FASB has established a series of pronouncements, including the Statement of Financial Accounting Concepts (SFAC) , and intended to provide the board with a common foundation and the basic reasons for considering the merits of various alternative accounting principles.
In May 1980, the framework project issued a concept statement of Qualitative Characteristics of Accounting Information (SFAC No. 2). (See Exhibit 1-1) It examines the characteristics that make accounting information useful for investing, credit, and similar decisions. Those characteristics of accounting information can be viewed as a hierarchy of qualities, among which understandability and usefulness are the most essential and important ones for decision making.
Exhibit 1-1 The Qualitative Characteristics of Accounting Information
The primary decision-specific qualities that make accounting information useful are relevance and reliability, which are both critical. No matter how reliable, if the information is irrelevant to decision-making, it is useless. Similarly, relevant information will be of little value if it cannot be relied on.Next，we will learn more about these two characteristics, including their components that make them desirable. Here we also will discuss two secondary qualities, comparability and consistency.
Accounting information to be valuable, it should be related to decision-making. To be relevant, the information shall have predictive value, feedback value , and be presented on a timely basis .
To make a difference in the decision-making process, accounting information must have predictive value and feedback value. Generally, useful accounting information possesses both of these two qualities.For example, if the confirmation of net income and its components could help the investors to forecast the firm’s future cash-generating ability, then the net income information has predictive value for investors.This confirmation can also be useful in predicting future cash-generating ability as expectations are revised,then the net income information has feedback value for investors.
Timely requires that accounting information is available to users early enough to allow its use in the decision-making process. Also, it is an important component of relevance. The need for timely information requires that firms provide information to external users on a periodic basis. The SEC requires its registrants to submit financial statement information not only on an annual basis, but also quarterly for the first three quarters of each fiscal year.
Reliability is the extent to which information is with verifiability, representational faithfulness , and neutrality.
Verifiability means the accounting information can be verified to be true. It implies a consensus among different measures. For example, the historical cost of a piece of land reported in the balance sheet of a company is usually highly verifiable, because the cost can be traced to a transaction, such as the purchase of the land. However, the market value of that land is much more difficult to verify. Appraisers could differ in their assessment of market value. The term verifiability is often linked to objectivity. The historical cost of the land is objective, but the land’s market value is subjective, influenced by the appraiser’s previous experience and prejudices. A measurement that is subjective is difficult to verify, which makes it more difficult for users to rely on.
Representational faithfulness means information should match what really existed. Faithfulness exists when there is an agreement between a measure or description and the phenomenon it purports to represent.For example, assuming that the term inventory in a balance sheet of a retail company is understood by external users to be merchandise kept for sale. Then if inventory includes goods produced by the company itself, then the account of inventory of this company lacks representational faithfulness.
Neutrality means cannot select information for favor one over another. Reliability assumes the information being relied on is neutral with respect to parties potentially affected. In this regard, neutrality is highly related to the establishment of accounting standards. Accounting standards should be established with overall social goals and specific objectives in mind and should try not to 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. The FASB must convince the financial community that this is an implementation consequence of the standard but not an objective used to set the standard.
The quality of relevance and reliability are often conflict with each other. For example, the forecasted net income provided by management of a company may possess a high degree of relevance to investors and creditors trying to predict future cash flows. However, a forecast necessarily contains subjectivity in the estimation of future events. GAAP presently do not require companies to provide forecasts of any financial variables.
In order to clarify the trend of business performance, the user must be able to compare the financial statements of companies in different periods. In order to evaluate different business performance, the user must also be able to compare the financial statements of different entities. Therefore, for the different periods of the same entity or different entities, the approach of measurement and reporting for similar transactions or other matters must be consistent. Comparability is the ability to help users distinguish similarities and differences between events and conditions.
Consistency requires an entity to give the same treatment to comparable transactions from period to period. For example, if fixed assets were determined by history cost, and in the next period they should be determined by the same basis. Consistency can increase the usefulness of the reports and facilitate the detection of trends.
In order to adapt to changing environments, sometimes entities need to change particular accounting method. Consistency allows a company to change accounting methods, but it must firstly demonstrate that the newly adopted method is preferable to the old, and the entity must justify the use of an alternative accounting method can cope with new changes in the environment.
The accountant must consider many concepts and principles when determining how to handle a particular item. However, it will be costly and time-consuming if accounting uses all of the proper concepts and principles. The materiality concept involves the relative size and importance of an item to a firm.
For users of accounting information, the information for decision-making has important influence and is most important. If accounting information misplaced priorities, it would mislead decision-making and lead users to make wrong decisions.
It’s important to note that an item material to one entity may not be so material to another. The determination of materiality is largely depending on the professional judgment of accountants. For example,an item costing $100 might be material to a small entity and might not be material to a big entity. When determining whether its material for the entity, accountants should consider not only the size of the amount,but also the nature of the transaction, the impact on business, etc..