The importance of relevance and faithful representation in financial reporting

1. Describe what you understand by the above statement and explain briefly the qualitative characteristics.
2. Discuss and describe two IASB / AASB accounting standards and the utilisation of the qualitative characteristics to promote decision useful information.
3. Select a company from the Australian Securities Exchange (except banks) website and download the most recent annual report. With regard to your chosen standards, and in the context of your company annual report, comment on the effect the qualitative characteristics have had on the financial statements.

The financial information presented in the Balance sheet is useful but it should also possess the qualities that assist in the fundamental decision making qualities of relevance and representation in a faithful manner. Both the aspects are very critical. However, even if the information is relevant but does not faithfully represent the economic phenomena then it is useless. Difficulty is faced by the FASB in balancing the neutrality and the various economic consequences. In order to make a difference in the process of decision making by using the information from the financial statements, the information must be relevant to the decision. Relevance of information means that the information must have a predictive value and the information must also have a confirmatory value. For example, the net income and the components of net income confirm the expectations of the investors about the future cash generating ability of the company. The net income serves as an important tool for effective investment decision making. There is existence of faithful representation when there is agreement between the measure or the description and the phenomenon that is represented (ey.com, 2015). For example, in the balance sheet, the term inventory in the balance sheet of a retail company represents the items that are intended to be sold in the course of the business. But if the inventory says that the machines that has been used to produce inventory then it lacks faithful representation.

The prime objective of financial reporting is to provide financial information about the reporting entity that is useful for the investors, lenders and the other creditors for the purpose of decision making. The conceptual framework of the financial statement is prepared to for the primary users of the financial statements like the investors , lenders and the creditors and it is also addresses the employees , suppliers , customers , government bodies and the general public (Vitez, 2015).

The revised framework of the financial statements attempts to create a conceptual framework based on the fundamental economic concept that is useful for the purpose of decision making (Mukherjee & Hanif, 2015). The financial information presented in the balance sheet does not limit itself to the presentation of the entity’s financial position, performance and the changes in the financial position to assess the ability of the entity to generate the cash flows (ifrs.org, 2014). But the financial information is presented in a broader aspect. It reports the entity’s economic resources, claims and changes. In the revised framework, the qualitative characteristics represented by the financial statements are divided into the fundamental qualitative characteristics and the enhancing qualitative characteristics (Porter & Norton, 2009). The fundamental qualitative characteristics comprises of relevance and faithful representation and the enhancing qualitative characteristics includes comparability, timeliness, verifiability and the ability to understand (Fasb.org, 2015).

Conceptual framework of financial statements

The investors can make a difference in the decision making by using relevant information from the financial statements. The financial information presented in the balance sheet must have a predictive value and confirmatory value (Fasb.org, 2015). The financial information must have a faithful representation. It has replaced the previously used term “reliability” that was used to describe the financial statements (Ifrs.org, 2015). A faithful financial information represents the economic phenomena that has three major features.

• Completeness
• Neutrality
• Free of error

Qualitative features of the financial statements such as comparability, verifiability, timeliness and understandability will increase the relevance and the faithfulness of the financial information (Iasplus.com, 2015). The qualitative characteristics of the financial statements assist in financial decision making in the following ways –

• Comparability helps the user to identify the similarity and the variances among the various items. The similarity and the difference can be identified between the different periods within the set of the financial statements and the across the reporting entities. The methods are applied consistently during the preparation of the financial statements in the achievement of comparability.
• The framework of the financial statement has introduced new term “verifiability”. The financial information presented in the financial statements is verifiable which enable the users to reach to a particular consensus that the depiction of a particular event or a transaction is a faithful representation.
• In the new framework, timelessness of the financial information is also considered as a qualitative characteristic. While providing the information in the financial statements it is stressed that there is balance between the reporting technique and the information has to be reliable. Timelessness will influence the decision makers (kpmg.com, 2010).
• Understandability of the financial statement is a key qualitative characteristic. The information presented in the financial statements must be clear and presented in a concise manner which is understandable (Aasb.gov.au, 2015); (Iasplus.com, 2015).

AASB 129 – Financial Reporting in the Hyperinflationary Economy

According to AASB 129, the financial reporting in the Hyperinflationary economies has been discussed.  The standard is applicable to the individual financial statements including the consolidated financial statements of any organization whose functional currency is the currency of a hyper inflationary economy (Comlaw.gov.au, 2015). The calculation of the operating costs and the financial position in the local currency without any kind of restatement is not useful. The money loses the power to purchase at the rate of the local currency that comparison of the amounts from the transactions and the from other events has occurred at different times even if the accounting period is same can be misleading.  It is important for the restatement of the financial statements according to the Standard in order to avoid any kind of error. Hyperinflation is an indication of the characteristics of the economy of a country. The entities that report in the currency of the same hyperinflationary economy must apply this standard in the same date (aasb.gov.au, 2015). The standard is applicable for the entity at the beginning of the reporting period in which the existence of hyperinflation in an economy has been identified in whose currency the reporting is being done (Australian Master Accountants Guide, 2015).

 The restatement of the financial statements will depend in the change in the prices of the goods as a result of the various political, economic and social forces that are acting in the economy that will affect the purchasing power of money. In a hyperinflationary economy, the property, plant and equipment must be measured at fair value.  However in some cases, the financial statements are based on the current cost approach that reflects the changes in the prices of the assets that has been held. In case of a hyper inflationary economy, the standard is applicable for the representation of the primary financial statements of the entities in the currency of the hyper inflationary economy (Horngren, 2013).

In case of a hyperinflationary economy, the accounting standards presented by AASB will make the information reliable and authentic. The gain or loss in the monetary position of the entity in case of a hyperinflationary economy can be derived by the resulting difference between the restatement of the non- monetary assets, owner’s equity and the items represented in the comprehensive income and the adjustment of the index that is linked with the assets and the liabilities. This will make the information presented in the balance sheet more reliable. The qualitative characteristics that are that are presented by the balance sheet are the relevance and faithfulness of the financial information. In case of a hyper inflationary economy, the financial information that is presented in the balance sheet will increase the faithfulness of the information to the investors. In a hyperinflationary economy, the purchasing power of the investors declines. Thus the financial information presented in the balance sheet will reflect the change in the purchasing power of money. This will be helpful in taking the economic decisions (Henderson et al., 2015).

Revised framework of financial statements and qualitative characteristics

AASB 2 – Share based Payment

 The Standard specifies the financial reporting in case of share based payments. The profit and loss of the entity is reflected after the share based transactions has been made. It also reflects the expenses that are associated with the transaction in which the option of the share is granted to the employees. The Standard is applicable for all share based transactions. It includes equity settled share based payment transactions and cash settled share based payment transactions. In a share based payment transaction, the entity will recognize the goods and services that has been received or acquired (aasb.gov.au, 2006). The entity will also have to recognize the increase in the equity if the goods and services were received in equity settled transaction or the liability of the goods and services were acquired in case of cash settled share based payment transaction (Charteredaccountants.com.au, 2015).

The increase in equity when the goods and services have been received will be measured at fair value of the goods and services (Comlaw.gov.au, 2015). The fair value has to be estimated in a reliable manner. If it is not possible to estimate the value of the goods and services at the fair value then the entity will measure the value and the increase in equity in reference to the fair value of the equipments that has been granted (aasb.gov.au, 2015).

Qualitative characteristics of the financial information that is relevance and faithfulness will be reflected in the calculation of the share based payment transaction.  This will make the information available to the investors more reliable and authentic. The trust of the investors will increase if there is clarity in the transactions made by the organization. The main qualitative characteristics of financial information are its comparability, verifiability, timelessness and understandability. Since the share based payments for the equity transactions are made at fair value, the information reflected in the financial statements are reliable and relevant. They can be used for taking the major economic decisions. The information in the financial statements can be used for the major investment decisions (Australian Master Accountants Guide, 2015).

The financial statement of Wools worth presents a comprehensive statement of the financial performance of the company. The standard AASB -2, Share based payment has been noted in the financial statements. The fair value of the changes in the equity transactions has been noted. For the year 2014, the movement in the fair value of the investments in equity securities has been seen in the balance sheet of Wools worth. The changes in the equity have been presented in the financial statement. The financial statement presents consolidated information related to the changes in equity transactions and the transaction regarding the share based payments. This will make the information more reliable to the investors and will assist them in sound decision making (Woolworthslimited.com.au, 2015).

Since, Australia does not operate in a hyperinflationary economy; the Accounting standard of AASB 129 is not applicable in case of the organization (Asx.com.au, 2015).

Conclusion

Qualitative characteristics of the financial statements assist in the process of decision making. The qualitative characteristics help in economic decision making. It makes the information presented in the balance sheet more reliable and faithful. The financial information must be relevant and faithful. It should be able to assist in sound decision making. The qualitative features of the financial statements that assist in sound decision making are comparability, verifiability, timelessness and understandability. In the present report the qualitative characteristics of the accounting standards AASB 129 and AASB – 2 has been analyzed. AASB -129 represents the financial reporting in a hyper inflationary economy. The changes in the value of the assets have to be noted in a hyperinflationary economy. The value of the assets will be measured at fair value. This makes the information reliable and authentic. In AASB – 2 , the standards for share based payment transactions has been discussed. The share based payment transactions of the equity shares are done at fair value. Wools worth has been chosen as the organization where the standards are applicable. Since the organization operates in Australia, it operates in an economy with inflation rate stability. Thus the standard for hyper inflation will not be applicable for Wools worth. But the financial statement of Wools worth has shown the transactions related to the share based payments. This will help the investors in sound decision making and make the information faithful and relevant.

References

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