Which qualitative characteristics of accounting information is reflected when accounting information is free from errors?

Qualitative characteristics or qualities necessary for information serve a major supporting role in the decision usefulness, decision model approach to accounting theory. Qualitative characteristics are the tributes that make the information provided in financial statements useful to users.

Accounting information that is reported to facilitate economic decisions should possess certain characteristics or normative standards. The informational qualities, which has been accepted by FASB (USA) in its Concept No. 2 “Qualitative Characteristics of Accounting Information” is displayed in Table 1.

International Accounting Standards Board (1ASB) has recognized the four principal qualitative characteristics of accounting information:

1. Understandability

2. Relevance

3. Reliability

4. Comparability.

The other qualities suggested by IASB are materiality, faithful representation, substance over form, neutrality, prudence, completeness, timeliness.

The qualitative characteristics that have been found possessing wider acceptance and recognition in accounting literature are as follows:

1. Relevance:

Relevance is closely and directly related to the concept of useful information Relevance implies that all those items of information should be reported that may aid the users in making decisions and/or predictions. In general, information that is given greater weight in decision-making is more relevant.

Specially, it is information’s capacity to make a difference that identifies it as relevant to a decision. American Accounting Association’s Committee to Prepare a Statement of Basic Accounting Theory defines relevance as “the primary standard and requires that information must bear upon or be usefully associated with actions it is designed to facilitate or results desired to be produced”.

Financial Accounting Standards Board in its Concept No. 1 comments:

“Relevant Accounting information must be capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present and future events or to confirm or correct expectations.”

2. Reliability:

Reliability is described as one of the two primary qualities (relevance and reliability) that make accounting information useful for decision-making. Reliable information is required to form judgments about the earning potential and financial position of a business firm. Reliability differs from item to item.

Some items of information presented in an annual report may be more reliable than others. For example, information regarding plant and machinery may be less reliable than certain information about current assets because of differences in uncertainty of realization. Reliability is that quality which permits users of data to depend upon it with confidence as representative of what it purport to represent.

FASB Concept No. 2 concludes:

“The reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user that it has that representational quality. To be useful information must be reliable as well as relevant. Degrees of reliability must be recognized. It is hardly ever a question of black or white, but rather of more reliability or less. Reliability rests upon the extent to which the accounting description or measurement is verifiable and representationally faithful. Neutrality of information also interacts with those two components of reliability to affect the usefulness of the information.”

3. Understandability:

Understandability is the quality of information that enables users to perceive its significance. The benefits of information may be increased by making it more understandable and hence useful to a wider circle of users.

Presenting information which can be understood only by sophisticated users and not by others, creates a bias which is inconsistent with the standard of adequate disclosure. Presentation of information should not only facilitate understanding but also avoid wrong interpretation of financial statements. Thus, understandable financial accounting information presents data that can be understood by users of the information and is expressed in a form and with terminology adapted to the user’s range of understanding.

4. Comparability:

Economic decision requires making choice among possible courses of actions. In making decisions, the decision-maker will make comparisons among alternatives, which is facilitated by financial information. Comparability implies to have like things reported in a similar fashion and unlike things reported differently.

FASB (USA) Concept No. 2 defines comparability, “… as the quality or state of having certain characteristics in common, and comparison is normally a quantitative assessment of the common characteristics. Clearly, valid comparison is possible only if the measurements used- the quantities or ratios-reliably represent the characteristic that is the subject of comparison”.

Comparable financial accounting information presents similarities and differences that arise from basic similarities and differences in the enterprise or enterprises and their transactions, and not merely from difference in financial accounting treatment.

Information, if comparable, will assist the decision-maker to determine relative financial strengths and weaknesses and prospects for the future, between two or more firms or between periods in a single firm.

5. Consistency:

Consistency of method over a period of time is a valuable quality that makes accounting numbers more useful. Consistent use of accounting principles from one accounting period to another enhances the utility of financial statements to users by facilitating analysis and understanding of comparative accounting data.

It is relatively unimportant to the investor what precise rules or conventions are adopted by a company in reporting its earnings, if he knows what method is being followed and is assured that it is followed consistently from year to year. Lack of consistency produces lack of comparability. The value of inter-company comparisons is substantially reduced when material differences in income are caused by variations in accounting practices.

6. Neutrality:

Neutrality is also known as the quality of ‘freedom from bias’ or objectivity. Neutrality means that, in formulating or implementing standards, the primary concern should be the relevance and reliability of the information that results, not the effect that the new rule may have on a particular interest or user(s).

A neutral choice between accounting alternatives is free from bias towards a predetermined result. The objectives of (general purpose) financial reporting serve many different information users who have diverse interests, and no one predetermined result is likely to suit all users’ interests and purposes.

Therefore, accounting facts and accounting practices should be impartially determined and reported with no objective of purposeful bias toward any user or user group. If there is no bias in selection of accounting information reported, it cannot be said to favour one set of interests over another. It may, in fact, favour certain interests, but only because the information points that way.

7. Materiality:

The concept of materiality permeates the entire field of accounting and auditing. The materiality concept implies that not all financial information need or should be communicated in accounting reports-only material information should be reported. Immaterial information may and probably should be omitted. Information should be disclosed in the annual report which is likely to influence economic decisions of the users. Information that meets this requirement is material.

8. Timeliness:

Timeliness means having information available to decision-makers before it loses its capacity to influence decisions, Timeliness is an ancillary aspect of relevance, If information is either not available when it is needed or becomes available long after the reported events that it has no value for future action, it lacks relevance and is of little or no use, Timeliness alone cannot make information relevant, but a lack of timeliness can rob information of relevance it might otherwise have had.

Clearly, there are degrees of timeliness, some reports need to be prepared quickly, say in case of takeover bid or strike. In some other contexts, such as routine reports by a business firm of its annual results, a longer delay in reporting information may materially affect the relevance and, therefore, the usefulness of information. But in order to have gain in relevance that comes with increased timeliness, it may involve sacrifices of other desirable characteristics of information, and as a result there may be an overall gain or loss in usefulness.

For example, it may sometimes be desirable to sacrifice precision for timeliness, for an approximation produced quickly is often more useful than precise information that is reported after a longer delay.

9. Verifiability:

The quality of verifiability contributes to the usefulness of accounting information because the purpose of verification is to provide a significant degree of assurance that accounting measures represent, what they purport to represent.

Verification does not guarantee the suitability of method used, much less the correctness of the resulting measure. It does convey some assurance that the measurement rule used, whatever it was, was applied carefully and without personal bias on the part of the measurer.

According to FASB, “Verifiability means no more than that several measures are likely to obtain the same measure. It is primarily a means to attempting to cope with measurement problems stemming from the uncertainty that surrounds accounting measures and is more successful in coping with some measurement problems than others. Verification of accounting information does not guarantee that the information has a high degree of representational faithfulness and a measure with a high degree of verifiability is not necessarily relevant to the decision for which it is intended to be useful.”

10. Conservatism:

There is a place for a convention, such as conservatism – meaning prudence in financial accounting and reporting, because business and economic activities are surrounded by uncertainty, but it needs to be applied with care.

Conservatism in financial reporting should no longer connote deliberate consistent, understatement of net assets and profits. Conservatism is a prudent reaction to uncertainty to try to ensure that uncertainties and risks inherent in business situations are adequately considered.

Thus, if two estimates of amounts to be received or paid in the future are about equally likely, conservatism dictates using the less optimistic estimates. However, if two amounts are not equally likely, conservatism does not necessarily dictate using the more pessimistic amount rather than the more likely one.

Conservatism no longer requires deferring recognition of income beyond the time that adequate evidence of its existence becomes available, or justifies recognizing losses before there is adequate evidence that they have been incurred.