Karlstad Business School

Karlstad Business School Paper On Conceptual framework: objective and Qualitative characteristics Presented to Berndt Andersson Dept. of Business Administration Prepared By: Mohammed Toufiq Rizwan 830105 T911 In Partial Fulfillment of the Requirements of FEAD 10 Karlstad University October 22, 2009 1

Abstract In October 2004, the FASB and IASB added to their agendas a joint project to develop an improved, common conceptual framework that builds on their existing frameworks, that is, the IASB s Framework for the Preparation and Presentation of Financial Statements and the FASB s Statements of Financial Accounting Concepts. (FASB, 2009). Accounting conceptual framework can be defined as a coherent system of inter-related objectives and fundamentals that should lead to consistent standards that prescribe the nature, function and limits of financial accounting and financial statements (Lynch, 1998). The conceptual framework project of IASB consist of 8 phases and this paper is prepared based on the phase A, which is objectives and qualitative characteristics of financial reporting. The purpose of this paper is to provide basic information about the conceptual framework, and mostly about the objectives and qualitative characteristics of financial reporting. Besides this, I have tried to find out the importance of qualitative characteristics in user groups. For doing so, several pre studies are reviewed to find out the consideration qualitative characteristics by the user group in judging financial information to be useful or not. The outcome, however, somewhat similar even though the studies selected for this paper were based on different countries and user groups. 2

Table of Content Abstract 1.1 Introduction 4 1.1.1 Conceptual Framework 4 1.1.2 Phase A: Objectives and Qualitative Characteristics 5 1.2 Purpose of the Study 9 1.3 Methodology 9 2. literature Review 10 3. Analysis and Findings 13 4. Conclusion 14 Reference 3

1. 1 Introduction In October 2004, the FASB and IASB added to their agendas a joint project to develop an improved, common conceptual framework that builds on their existing frameworks, that is, the IASB s Framework for the Preparation and Presentation of Financial Statements and the FASB s Statements of Financial Accounting Concepts. (FASB, 2009). And the board has decided to conduct this conceptual framework project in 8 phases. These phases includes, Objectives and qualitative characteristics Definitions of elements, recognition and derecognition Measurement Reporting entity concept Boundaries of financial reporting, and presentation and disclosure Purpose and status of the framework Application of the framework to not-for-profit entities Remaining issues (if any) Out of this eight phases, first four of them are currently active. This paper has been prepared by focusing on the Phase A (Objectives and Qualitative Characteristics). And later on the objective of the conceptual framework project and importance of qualitative characteristics of accounting information has discussed in details. The reason of chosing phase A is because other following phases somewhat depends on this phase (Moehrle et. el., 2008). 1.1.1 Conceptual Framework According to Lynch (1998), accounting conceptual framework can be defined as a coherent system of inter-related objectives and fundamentals that should lead to consistent standards that prescribe the nature, function and limits of financial accounting and financial statements. And so the conceptual framework project seeks to provide a comprehensive and coherent definition of the nature and function of accounting principle (Kripke, 1989). So it can be said that conceptual framework projects sets to be guideline 4

for executing accounting standards to make financial reporting more understanding and useful for users. The conceptual framework project's overall objective is to create a sound foundation for future accounting standards that are principles-based, internally consistent and internationally converged. (IASB, 2004). So it carries an prime objective to set a base to provide information that are useful for decision making, helps predicting cash flows, and delivers information about economic resources, and claims and changes in claims. The main reasons for developing an agreed conceptual framework are that it provides: a framework for setting accounting standards; a basis for resolving accounting disputes; fundamental principles, which then do not have to be repeated in accounting standards. (Becker, 2004) 1.1.2 Phase A: Objectives and Qualitative Characteristics The aim of the Objectives and Qualitative Characteristics phase of Financial Reporting, is to consider: The objective of financial reporting The qualitative characteristics of financial reporting information The trade-offs among qualitative characteristics and how they relate to the concepts of materiality and cost-benefit relationships. (FASB, 2009) The above mentioned aims were considered for this phase is because, conceptual framework is said to be the guideline for setting standards in order to make financial reporting more useful. And to do so it had to be informative. Some specific qualitative characteristics make the financial statements and their elements more informative and useful. The graphic below gives a detail picture of qualitative characteristics 5

Understandability is the quality of information that enables users who have a reasonable knowledge of business and economic activities and financial reporting, and who study the information with reasonable diligence, to comprehend its meaning. (FASB, 2008) According to FASB (2008) the quality of understandability is defined in relation to users who satisfy those expectations. Understandability is enhanced when information is classified, characterized, and presented clearly and concisely. Comparability also enhances understandability (Later discussed). The primary qualities that make accounting information useful for decision making are relevance and reliability. Both of this qualities are important and can be defined based on their components. Relevance. To be relevant information must possess predictive value and feedback value. It means financial information should confirm investors expectation about future cash flow (feedback value) and this confirmation can also be useful in predicting the future cash flow of an entity. For example, if net income and its components confirm investor expectations about future cash-generating ability, then net income has feedback value for investors. This confirmation can also be useful in predicting future cash-generating 6

ability as expectations are revised (McGraw Hill, 2007). In determining what is relevant, considerations would include: current trends in the market place; transparency; and clarity (AICPA, 2000). Besides feedback and predictive value timeliness also is an important component of relevance. Users of the information requires information for making their future financial decision, and so they must require the information early enough to be useful. Timeliness refers to the information being disclosed early enough for the decision makers. The SECs in most of the countries requires its registrants to submit financial statement information not only on an annual basis, but also quarterly for each fiscal year so that the information can be available to the users when it is necessary. Reliability. Information is said to be reliable if it is verifiable, representationally faithful, and free of bias. Verifiability implies a consensus among different measurers. implies a consensus among different measurers. For example, the historical cost of a piece of land to be reported in the balance sheet of a company is usually highly verifiable (McGraw Hill, 2007). In this case the cost of the land can be followed even though the market value of the land can be much more difficult to verify. The term objectivity often is linked to verifiability. The historical cost of the land is objective but the land s market value is subjective, influenced by the measurer s past experience and prejudices. A measurement that is subjective is difficult to verify, which makes it more difficult for users to rely on. (McGraw Hill, 2007). According to FASB (2008), To be useful in financial reporting, information must be a faithful representation of the economic phenomena that it purports to represent. Faithful representation is attained when the depiction of an economic phenomenon is complete, neutral, and free from material error. Financial information that faithfully represents an economic phenomenon depicts the economic substance of the underlying transaction, event, or circumstance, which is not always the same as its legal form. Neutrality refers to the absence of bias. Biased that can lead to a predetermined result or to a particular behavior. Neutral information does not color the image it communicates to influence behavior in a particular direction. Financial reports are not neutral if, by the selection or presentation of financial information, they influence the making of a decision or judgment in order to achieve a predetermined result or outcome. However, to say that 7

financial reporting information should be neutral does not mean that it should be without purpose or that it should not influence behavior. On the contrary, relevant financial reporting information, by definition, is capable of influencing users decisions (FASB, 2008). In considering the importance of other qualitative characteristics, secondary qualities are also important. These qualities are, Comparability, and Consistency Comparability. FASB defines comparability as the quality of information that enables users to identify similarities in and differences between two sets of economic phenomena. Consistency, on the other hand, is the use of the same accounting policies and procedures, either from period-to period within an entity or in a single period across entities (FASB, 2008). It can be said that comparability is the goal, whereas consistency works as a mean to reach to that goal. The essence of decision making is choosing between alternatives. Thus, information about an entity is more useful if it can be compared with similar information about other entities and with similar information about the same entity for some other period or some other point in time. Comparability is not a quality of an individual item of information but, rather, a quality of the relationship between two or more items of information. Comparability should not be confused with uniformity (FASB, 2008). For information should be comparable within the financial report of same entity among different period and for doing so it has to be consistent in using the standards and formats. Even though these qualities seems to be important, they still considered as the secondary qualities. FASB (2008), in their Exposure Draft, stated comparability, verifiability, timeliness, and understandability as the enhancing qualitative characteristics. These enhancing qualitative characteristics are complementary to the fundamental qualitative characteristics. Enhancing qualitative characteristics distinguish more-useful information from less-useful information. 8

If we look at the enhancing qualitative characteristics, we will see that timeliness and verifiability has been separated as enhancing qualities. And reliability has been stated as only faithful representation of information. Consideration of these qualities by different users and there fulfillment of the objective of financial reporting is the main issue of this paper. 1.2 Purpose of the study The purpose of this study is to provide an overview on the phase A of the conceptual framework of financial reporting, that is the Objective of this project and the qualitative characteristics of financial reporting. As a part of this paper the secondary purpose is to find out the ways users consider the qualitative characteristics of financial information. 1.3 Methodology In order to fulfill the purpose of this paper, content analysis method has been used. I have gone through several relevant articles, books, and other electronic sources along with the information sources of various bodies such as IASB, FASB etc. My primary objective was to find out as much information (relevant and reliable) as I can from these secondary sources. A literature review has included in this paper as a part of the source of the data required to analyze the important of qualitative characteristics to various users, mainly to investors, students, and auditors. Studies related to representing developing countries (Iran), and developed countries (UK, Australia, France) has been chosen to find out the outcome. 9

2. Literature review Financial reporting information is directed to meeting the needs of a wide range of users, with present and potential investors and creditors being the primary users. Those users, especially investors, may have widely differing degrees of knowledge about the business and economic environment, business activities, securities markets, and related matters (FASB, 2006). According to the preliminary view of FASB in developing financial reporting standards, standard setters presume that those who use the resulting information will have a reasonable knowledge of business and economic activities and be able to read a financial report. Standard setters also presume that users of financial reporting information will review and analyze the information with reasonable diligence. Both the FASB s and the IASB s existing frameworks identify a particular group of primary users. Information that satisfies the needs of that particular group of users is likely to meet most of the needs of other users (FASB, 2008). The IASB Framework, paragraph 10, says: As investors are providers of risk capital to the entity, the provision of financial statements that meet their needs will also meet most of the needs of other users that financial statements can satisfy. The present and potential investors, lenders, and other creditors are the primary users of financial information. Corporate reporting is generally directed at providing information, which will assist the user in decision making. Timeliness of reports is recognized by the accounting profession, the users of accounting information, and the regulatory and professional agencies as an important characteristic of financial accounting information (Soltani, 2002). The issue of timeliness of financial reporting, an important qualitative characteristic of accounting information, has received much attention from regulatory and professional bodies in France in recent years (Soltani, 2002). The increasing presence of international investors, particularly from the US, on the Paris Stock Exchange adds to the importance of this issue. The timeliness of corporate and audit reports in the French context is analyzed by examining the trend in reporting delay of companies, the effect that qualified reports have on the timeliness of corporate reporting, and the relationship between reporting behavior and types of audit reports over a 10-year period. In his study Soltani 10

selected the data from more than 5000 annual reports of French publicly held companies for the years 1986 1995. These bear witness to an improvement in timeliness of corporate and audit reports. This improvement is greater for reports from consolidated accounts of groups than those from annual accounts of companies (Soltani, 2002). Mirshekary and Saudagaran (2005), in their study draws its sample of financial statement users from bank loan officers and bank investment officers as being representative of a market economy, auditors from the Audit Organization to represent the governmentestablished and -managed audit organization, Tax Officers to respond to accounting measurements from a tax perspective, stock brokers and institutional investors who have emerged to service the country s movement into a market-based economy promoting the stock exchange, and academics responsible for accounting education geared towards meeting the country s need for professional accountants (Mirshekary and Saudagaran, 2005). As a part of their study Mirshekary and Saudagaran found, all user-groups believe a delay in published annual reports (timeliness), lack of trust in information (reliability), and lack of adequate information (relevance) are factors restricting the effective use of annual reports. Smith (1996), on the other hand, selected two groups for his study. To explore the potential of his research approach two groups of respondents were identified: A group of users. Forty MBA Finance students at a UK university business school skilled in financial statement analysis and already familiar with those properties deemed desirable in accounting communications. A group of auditors. Eighteen practicising accountants from the London office of a Big 6 accounting firm, comprising three partners, five managers, three assistant managers, four supervisors and three seniors (Smith, 1996). The empirical findings for both MBA Finance students and accounting practitioners demonstrate preferences which suggest that these users are prepared to sacrifice completeness, comparability, timeliness and understandability in disclosures in return for reliability, objectivity and relevance. This preference for reliability and relevance is consistent with the proposals of accounting standard setters worldwide, and may be attributable to a correspondence of the user groups concerned with the sophisticated target user designated by the accounting standard-setters. (Smith, 1996) 11

In Australia, qualitative characteristics are implicit in a number of financial reporting reforms recommended by the ASCPA/ICAA [10, para. 3026] as a consequence of this debate, which would improve relevance and comparability and highlight the need for timely information, future oriented information, consistency of accounting policies and a preference for substance over form (Smith, 1996). Sims and Cullis (1995), in their study, used mailed questionnaire that they have sent to various institutional user groups in order to find out their consideration about the primary qualitative characteristics set by AASB. The most responded groups were corporate accountants, government department accountants, and academics. A good representation of the population also came from the public practitioner. Their study revealed a significant issues within factors effect for both of these characteristics, and it found the significance of the two primary qualitative characteristics of useful financial information, relevance and reliability. 12

3. Analysis and Findings The literature review shows the outcome of various studies conducted on financial information users and financial reporting in order to find out the significance of the qualitative characteristics in fulfilling the objective of conceptual framework project. Most of the reviewed studies were conducted on users and practitioners. Some of them selected MBA students as a representative of educated user of information (Smith, 1996), some of them used practitioner, such as auditors, accountants (Smith, 1996; Sims and Cullis, 1995). Other users such as various types of bankers were also part of the study (Mirshekary and Saudagaran, 2005). Soltani (2002), on the other hand, used annual report of companies from various periods in order to find out their intention of adopting timeliness, to prove the importance of this qualitative characteristics on financial reporting. Outcome of the studies, however, brought out almost the similar outcome. The role of relevance and reliability on financial reporting seems to have similar importance to almost all user, which justifies their being the primary qualities of financial reporting (Sims and Cullis, 1995; Smith, 1996; Mirshekary and Saudagaran, 2005). Timeliness, a component of relevance, came out to be a significant characteristics users and professional give importance to (Mirshekary and Saudagaran, 2005; Soltani, 2002). Soltani s study showed that annual reports of the publicly traded companies have increased their timeliness as the investment in French stock exchange increased. The reason behind is the attitude of the practitioner towards adopting the timeliness in a significant basis. Mirshekary and Saudagaran (2005), found that all user-groups in their study believe a delay in published annual reports (lack of timeliness), plays a role in restricting the effective use of annual reports. 13

4. Conclusion Relevancy and reliability, as two primary qualitative characteristics, gets their importance from the user in considering financial information as useful. But if the users can not compare reliable and relevant information, then the useful information might fail as useful for decision making. Studies followed in this paper, mostly dealt with the primary qualities and didn t show any significant results of users preference on other qualitative characteristics or their elements. It concluding this paper, it can be said that users and practitioner of financial information consider the reliability and relevancy of information to be useful, but without comparability and consistency information can not be useful for making future financial decision. 14

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