Which of the following is the best description of faithful representation in relation to information in financial statement?

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Chapter 3 - Conceptual Framework (Qualitative Characteristics)

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Chapter 3- Conceptual Framework (Qualitative Characteristics)

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Financial information has several qualities that make it useful. These qualities are outlined in Chapter 3 of the Conceptual Framework for Financial Reporting, approved by the International Accounting Standards Board (IASB).

Fundamental Qualitative Characteristics

1. Relevance

Relevant information is capable of making a difference in the decisions made by users. Relevance requires financial information to be related to an economic decision. Otherwise, the information is useless.

Financial information is useful if it has predictive value and confirmatory value. Predictive value helps users in predicting or anticipating future outcomes. Confirmatory value enables users to check and confirm earlier predictions or evaluations.

Materiality is an aspect of relevance which is entity-specific. It means that what is material to one entity may not be material to another. It is relative. Information is material if it is significant enough to influence the decision of users. Materiality is affected by the nature and magnitude (or size) of the item.

2. Faithful Representation

The financial information in the financial reports should represent what it purports to represent. Meaning, it should reflect what really happened, with the correct financial values.

There are three characteristics of faithful representation: 1. Completeness (adequate or full disclosure of all necessary information), 2. Neutrality (fairness and freedom from bias), and 3. Free from error (no inaccuracies and omissions).

Enhancing Qualitative Characteristics

1. Comparability

Comparable information enables comparisons within the entity and across entities. When comparisons are made within the entity, information is compared from one accounting period to another. For example: income is compared for the years 2019, 2020, and 2021. Comparability of information across entities enables analysis of similarities and differences between different companies.

2. Verifiability

Verifiability helps to assure users that information represents faithfully what it purports to represent. Financial information is supported by evidence and independent individuals can check them to see whether such information is faithfully represented. In other words, information is verifiable if it can be audited.

3. Timeliness

Timeliness means providing information to decision-makers in time to be capable of influencing their decisions. It shouldn't be significantly delayed or else it will be of little or no value.

4. Understandability

Understandability requires financial information to be understandable or comprehensible to users with reasonable knowledge of business and economic activities. To be understandable, information should be presented clearly and concisely. However, it is improper to exclude complex items just to make the reports simple and understandable.

Key Takeaways

Fundamentally, financial statement information needs to be 1) relevant and 2) faithfully represented. Faithful representation means that information is complete, neutral, and free from bias.

The quality of financial statements is enhanced by comparability, verifiability, timeliness, and understandability.

Web link

APA format

Qualitative characteristics of financial information (2022). Accountingverse.
https://www.accountingverse.com/financial-accounting/introduction/qualitative-characteristics.html

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Chapter Outline

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This article relates to the outcome of the FA2 syllabus ‘Explain generally accepted accounting principles and concepts’ and has been written to complement the FA2 article titled ‘A matter of principle’ (see 'Related links'). The focus for this article is on qualitative accounting characteristics rather than principles of accounting.

What are the qualitative characteristics?

The Conceptual Framework for Financial Reporting (the Conceptual Framework) identifies two fundamental qualitative characteristics and four enhancing qualitative characteristics relating to useful financial information:

Fundamental qualitative characteristics

• Relevance
• Faithful representation

Enhancing qualitative characteristics

• Comparability
• Verifiability
• Timeliness
• Understandability

Financial reports include financial information and, when preparing these reports, consideration should be given to the type of information that is likely to be most useful to existing and potential investors, lenders and other creditors for making decisions about the reporting entity.

If financial information is to be useful then it must be relevant and must also faithfully represent what is being reported. The usefulness of this information is enhanced if it is comparable, verifiable, timely and understandable.

Each of these qualitative characteristics will be considered below.

Fundamental qualitative characteristics

Relevance
Financial information is relevant if it is capable of making a difference in the decisions made by users of that information. Such information can make a difference if it has:

• predictive value
• confirmatory value, or
• both.

Predictive value means that the information can be used to predict future outcomes. The financial information itself does not need to be a prediction or a forecast, but can be interpreted by users to allow them to make their own predictions. For example, current year revenue information could be used as the basis to predict revenue in future years.

Confirmatory value means that the information provides feedback on previous evaluations (ie it allows users to confirm or change their opinion on such evaluations). For example, the same current year revenue information indicated above could be compared with revenue predictions which had been made in prior years to correct or improve processes that were used to make those previous predictions.

As you can see, the predictive value and confirmatory value of financial information are interrelated.

Determining whether financial information is relevant involves considering materiality. More information on materiality can be found in the article ‘A matter of principle’.

Faithful representation
The Conceptual Framework uses the term ‘economic phenomena’ to refer to information about an entity’s economic resources, claims against the entity and the effects of transactions and other events and conditions that change those resources and claims.

An entity’s financial report represents such economic phenomena in words and numbers. As well as being relevant, the substance of these phenomena must be faithfully represented.

The Conceptual Framework identifies that to be a perfectly faithful representation, a depiction of any economic phenomena would need to be:

• complete
• neutral, and
• free from error.

Although such perfection is rarely (if ever) achievable, faithful representation requires that the above qualities should be maximised to the extent possible.

For information to be complete it must include all information necessary for a user to understand it.

Neutrality means that there is no bias in the selection or presentation of financial information.

Being ‘free from error’ does not mean that the information needs to be perfectly accurate. Rather, that there are no errors or omissions in the depiction of any phenomena and that the processes used to produce the reported information have been selected and applied with no errors in the process. For example, in some circumstances an estimate could be used in determining financial information. Although it may not be 100% accurate, such an estimate might still be faithfully represented as long as the amount is described clearly and accurately as being an estimate, the limitations of the estimating process are explained, and no errors were made in selecting and applying an appropriate process used for developing the estimate.

Enhancing qualitative characteristics

Comparability
Users of financial information make decisions between alternative courses of action. For example, whether to sell or hold an investment in the shares of a company. Therefore, financial information is more useful if it can be compared with similar information about other entities and with similar information about the same entity for another period or date.

Verifiability
When information can be verified, it gives assurance that the information faithfully represents the economic phenomena being represented. For information to be verifiable, it means that different knowledgeable and independent parties could reach consensus (although not necessarily complete agreement) that a particular depiction is a faithful representation.

Timeliness
In general, the sooner information is available, the more useful it is. Although some information may continue to be timely for a long time (for example, information used to identify and assess trends), newer information is usually more useful than older information.

Understandability
Classifying, characterising and presenting information clearly and concisely makes it understandable. Some information required for financial reports is inherently complex and, although leaving such information out may make financial reports seem easier to understand, it would also make them incomplete. This ultimately does not aid understandability. Financial reports are intended for use by users with a reasonable knowledge and the Conceptual Framework accepts that even knowledgeable users may need to seek advice to aid their understanding of more complex issues.

Summary

Candidates must have knowledge of the fundamental and enhancing qualitative characteristics. Further, by ensuring that the key points of each of these qualitative characteristics are understood, candidates should be better prepared to answer questions that might arise in the exam. 

Written by a member of the FA2 examining team

What is faithful representation in financial accounting?

Which of the following is the best description of reliability in relation to information in financial statements?

What does the concept of faithful representation include?

Which of the following is a characteristic of faithful representation?