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.

These secondary characteristics are kittens because they enhance the primary characteristics but can never override them. If a conflict occurs between a primary characteristic and a secondary characteristic, 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 inherently difficult to understand, then its representation will be complex.

Now one final point about the qualitative characteristics of the Conceptual Framework. In any business decision, there is an overriding trade-off between cost and quality. This is formalised in the Conceptual Framework as the cost constraint.

The costs of reporting better quality financial information must be justified by the extra benefits of that better quality financial information.

So, we must strike a balance between maximising financial information’s qualitative characteristics and producing it 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.

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