Explaining “qualitative characteristics” from the IFRS Conceptual Framework for Financial Reporting
Helping students to understand, rather than just memorise, IFRS principles. This article is also relevant to FASB’s Statement of Financial Accounting Concepts No. 8: Conceptual Framework for Financial Reporting.
The IFRS Conceptual Framework underpins what international financial reporting standards say and why they identify a particular accounting treatment.
Students must understand this if they are to understand wider IFRS principles.
An important aspect of the Conceptual Framework is an attempt to define “high quality” information, or in other words, what makes financial information useful.
Primary qualitative characteristics
According to the Conceptual Framework, useful information has the qualitative characteristics of being relevant, and faithfully represents the underlying event. The words and numbers on the page (or the screen) communicates the underlying economic reality.
Now I think of these primary characteristics as cats – just because it helps me to imagine how they work. So we have two cats – Relevance and Faithful representation – and they are the primary qualitative characteristics of useful financial information.
Relevance means that information has predictive or confirmatory value. That is, it helps users to predict future outcomes, for example future profits, or it can confirm or refute previous predictions.
Faithful representation means a depiction which is complete, neutral and free from error.
- Completeness means that all the information that a user needs to understand the economic phenomena is included;
- Neutrality means that the representation is unbiased, it’s neither overly optimistic nor overly pessimistic.
- Freedom from error means that there are no errors in the depiction which would make a difference to the economic decision – the information does not have to be completely accurate but it has to be good enough for decision-making purposes.
Enhancing qualitative characteristics
Then there are four secondary characteristics known as enhancing qualitative characteristics which also contribute to high-quality information. And I think of these as kittens.
The kittens are:
Comparability: good quality information allows users to compare the financial results of a business over time or with other businesses.
Verifiability: different observers are able to agree on what the information means.
Understandability: information should be understandable to users with a reasonable level of knowledge.
Timeliness: information tends to be more useful if it is more current.
These secondary characteristics are kittens because they are enhancing rather than overriding. If there is a conflict between the primary characteristics and the secondary characteristics then the primary characteristic prevails.
For example, you cannot oversimplify information to the extent that it is no longer a faithful representation just to make it more understandable – because faithful representation is a cat (a primary characteristic) and understandability is a kitten (a secondary characteristic).
If the underlying economic phenomenon is complex, and therefore inherently difficult to understand, then its representation will be complex.
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Now one final point about Qualitative characteristics of the conceptual framework. – in any business decision there is an overriding cost quality trade-off and this is formalised in the Conceptual Framework as the cost constraint.
The costs of reporting better quality financial information need to be justified by the extra benefits of that better quality financial information.
So we must strike a balance between maximising the qualitative characteristics of financial information and producing that information at an acceptable cost.
I think of the cost constraint as a big angry dog, Fido, because, well, how else do you keep cats and kittens in line?
This is part of the Concepts series of articles.