How does relevance and faithful representation enhance usefulness of financial accounting?

The fundamental (primary) and enhancing (secondary) qualitative characteristics

What are the Qualitative Characteristics of Accounting Information?

The demand for accounting information by investors, lenders, creditors, etc., creates fundamental qualitative characteristics that are desirable in accounting information. There are six qualitative characteristics of accounting information. Two of the six qualitative characteristics are fundamental (must have), while the remaining four qualitative characteristics are enhancing (nice to have).

Fundamental (Primary) Qualitative Characteristics

Qualitative characteristics of accounting information that must be present for information to be useful in making decisions:

1. Relevance
2. Representational faithfulness

Enhancing (Secondary) Qualitative Characteristics

Qualitative characteristics of accounting information that impact how useful the information is:

1. Verifiability
2. Timeliness
3. Understandability
4. Comparability

We will look at each qualitative characteristic in more detail below.

Relevance

Relevance refers to how helpful the information is for financial decision-making processes. For accounting information to be relevant, it must possess:

1. Confirmatory value – Provides information about past events
2. Predictive value – Provides predictive power regarding possible future events

Therefore, accounting information is relevant if it can provide helpful information about past events and help in predicting future events or in taking action to deal with possible future events. For example, a company experiencing a strong quarter and presenting these improved results to creditors is relevant to the creditors’ decision-making process to extend or enlarge credit available to the company.

Representational Faithfulness

Representational faithfulness, also known as reliability, is the extent to which information accurately reflects a company’s resources, obligatory claims, transactions, etc. To help, think of a pictorial depiction of something in real life – how accurately does the picture represent what you see in real life? For accounting information to possess representational faithfulness, it must be:

1. Complete – Financial statements should not exclude any transaction.
2. Neutral – The degree to which information is free from bias. Note that there are subjectivity and estimation involved in financial statements, therefore information cannot be truly “neutral.” However, if a company polled 1,000 accountants and took the average of their answers, that would be considered neutral and free from bias.
3. Free from error – The degree to which information is free from errors.

Verifiability

Verifiability is the extent to which information is reproducible given the same data and assumptions. For example, if a company owns equipment worth $1,000 and told an accountant the purchase cost, salvage value, depreciation method, and useful life, the accountant should be able to reproduce the same result. If they cannot, the information is considered not verifiable.

Timeliness

Timeliness is how quickly information is available to users of accounting information. The less timely (thus resulting in older information), the less useful information is for decision-making. Timeliness matters for accounting information because it competes with other information. For example, if a company issues its financial statements a year after its accounting period, users of financial statements would find it difficult to determine how well the company is doing in the present.

Understandability

Understandability is the degree to which information is easily understood. In today’s society, corporate annual reports are in excess of 100 pages, with significant qualitative information. Information that is understandable to the average user of financial statements is highly desirable. It is common for poorly performing companies to use a lot of jargon and difficult phrasing in its annual report in an attempt to disguise the underperformance.

Comparability

Comparability is the degree to which accounting standards and policies are consistently applied from one period to another. Financial statements that are comparable, with consistent accounting standards and policies applied throughout each accounting period, enable users to draw insightful conclusions about the trends and performance of the company over time. In addition, comparability also refers to the ability to easily compare a company’s financial statements with those of other companies.

The qualitative characteristics of accounting information are important because they make it easier for both company management and investors to utilize a company’s financial statements to make well-informed decisions.

More Resources

Thank you for reading CFI’s guide on Qualitative Characteristics of Accounting Information. To keep learning and advancing your career, the following resources will be helpful:

• Audit Materiality
• Audited Financial Statements
• Public Company Filings
• Financial Accounting Theory