Accounting: The Language of Business - Vol. 2 (Intermediate: Part 8)

While expanding market access for American industry, financial markets and farmers is critical, I believe it needs to be done responsibly, accounting for the treatment and protection of workers and the environment.

Mark Udall

Financial Reporting Theory (Part B)

by

Charles Lamson

Conceptual Framework: International Financial Reporting Standards (IFRS)

The International Accounting Standards Board's (IASB's) objective and qualitative characteristics are identical to Generally Accepted Accounting Principles [GAAP or US GAAP (the accounting standard adopted by the U.S. Securities and Exchange Commission) ( Wikipedia)]. However, they differ in the descriptions of elements of financial reporting and principles of recognition and measurement in financial reporting. The IASB, like the Financial Accounting Standards Board [FASB (a private standard-setting body whose primary purpose is to establish and improve Generally Accepted Accounting Principles within the United States in the public's interest) (fasb.org)], from part 7 , is also currently revising its framework.

The Objective of Financial Reporting

According to the conceptual framework, [The Conceptual Framework (or “Concepts Statements”) is a body of interrelated objectives and fundamentals. The objectives identify the goals and purposes of financial reporting and the fundamentals are the underlying concepts that help achieve those objectives.] also discussed in part 7, the objective of financial reporting is:

To provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit (From the FASB's Concepts Statement No. 8, Paragraph OB2, and the IASB's Conceptual Framework for Financial Reporting, Paragraph OB2.

The conceptual framework indicates that the primary users of financial information are the investors, lenders, and other creditors who cannot demand information from the entity. [If the objective were to provide information to a different group (e.g. regulators), then the boards would arrive at different reporting requirements.]. For instance, if Bank of America extends credit to Johnson & Johnson, the bank can demand any information needed to approve the loan. However, an individual investor in Johnson & Johnson's publicly traded debt usually cannot obtain additional information from the entity to help assess the amount, timing, and uncertainty of future cash flows. Investors also will require financial information to form an opinion about a company's future cash flows and earnings---and many of the standard-setting board's decisions are based on this need.

The Qualitative Characteristics of Financial Information

The objective of financial reporting is to provide useful information for decision-making by investors, lenders, and other creditors. What characteristics make financial information useful? The conceptual framework divides the qualitative characteristics in two fundamental characteristics and enhancing characteristics, and discusses the cost constraint on providing information.

Fundamental Characteristics

Fundamental characteristics are those basic characteristics that distinguish useful financial information from information that is not useful. The FASB identifies the two fundamental characteristics as relevance and faithful representation. This post discusses relavance, and part 9 of this volume will cover faithful representation.

Relevance. Financial information is relevant if it is capable of making a difference in decision making by exhibiting the following attributes:

• Predictive value

• Confirmatory value

• Materiality

Information has predictive value if decision makers can use it as an input into processes that help forecast future outcomes. For example, companies report sales revenue each year. Financial statement users may use the prior year's revenues to predict future revenues. Both BMW and Porsche, German automobile manufacturers, reported sales increases in their earnings announcements for fiscal 2015. By highlighting the increase in sales, the companies implicitly benchmarked the current sales against past sales. The sales from prior years can then be useful to investors in forecasting future revenues in periods beyond 2015.

Information has confirmatory value if it provides feedback about prior evaluations. For example, financial statement users will often compare reported net income to prior earnings forecasts. Consider Johnson & Johnson, which beat or exceeded analysts' forecasted earnings per share in the fourth quarter of 2016 by reporting earnings per share of $1.58.

The concept of materiality also determines the relevance of the information. Information is material if reporting it inaccurately or omitting it would affect financial statement users' decisions. The materiality of an item can depend on its size or nature. The conceptual framework does not specify a quantitative threshold for the materiality of an item nor does it identify the specific nature of items that would be considered material. Rather, whether an item is material depends on the company and its financial reporting. Preparers and auditors must use professional judgment to determine the materiality of an item.

As an example of materiality varying with size, consider a $5,000 loss incurred when a computer is damaged. For a small startup consulting firm, the loss could be material---that is, it could affect the financial statement user's decisions such as extending credit to the firm. For a large, profitable consulting firm, a $5,000 loss would likely be immaterial. The planned disposition of a major operating segment is an example of an item that is material by its nature. Even though there is no quantifiable amount that would be reported in the financial statements, not informing financial statement users of the planned disposition could affect their assessment of the company's future performance and their decisions about investing in or extending credit to the company. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 27-28*

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