Accounting Qualitative Characteristics of Financial Statements There

Accounting

Qualitative Characteristics of Financial Statements

There are four principal qualitative characteristics that make the information provided in financial statements useful to users. These are understandability, relevance, reliability and comparability. The first section of this paper will be dedicated to explaining each of these concepts and how they relate to making financial statements more valuable for the audience.

The first principal qualitative characteristic is understandability. This relates not only to the information but to the way it is presented. There are three factors in understandability -- the users' abilities, aggregation and classification of information. There are a number of different stakeholders for financial accounting data, including shareholders, potential shareholders, creditors, regulators and internal stakeholders. While some of these groups, such as regulators and creditors, are expert in deciphering financial information, shareholders might not be (and often aren't). The information contained in financial statements is valuable to shareholders only if they can make sense of it. Given that many shareholders are not particularly well-trained in deciphering financial information, there needs to be a relatively simple and easy-to-understand methods of presenting financial data.

This brings us to aggregation as the next major issue in understandability. The financial statements and forms like the annual report are compilations of thousands if not millions of individual transactions that have been recorded by the company. The choice of which aggregate line items to present is important. The formats agreed to under GAAP or IFRS has specific mandatory line items, and others that are commonplace. Even the dimmest shareholder can understand "revenue," "cost of goods sold" and "net income." Thus, presenting simple aggregate data, rather than each individual account, provides all stakeholders with an easy-to-understand summary of the firm's financial condition. The notes to the financial statements contribute to breaking down the aggregated information into its component parts, should the stakeholder want to learn about the item in more detail.

The final issue in understandability is the classification of information. There are four main statements that are presented -- the income statement, the balance sheet, the statement of cash flows and the statement of changes in owners' equity. Each of these presents a specific set of information relating to the financial condition of the company. In addition, the manner in which different items are classified has to be consistent as well. For example, the company must always classify the same type of asset in the same way (either as short-term or long-term, for example). Not only are these rules prescribed under GAAP or IFRS, but for any company they should be followed so that the statements are easier to understand.

The second principal qualitative characteristic that makes the information in financial statements useful to users is relevance. The data needs to be relevant along the lines of having both predictive value and confirmatory value. For example, all financial statements cover the immediate time period, which is the confirmatory value. The statements look into the past and confirm the performance and financial condition of the firm. Most annual reports in particular also feature the past two or three years' worth of statements as well. This allows a user to examine the trends that the company is facing, helping to lend to the financial statements. This is merely a matter of presentation, but it does lend the statements some additional predictive value that they otherwise would not have if a different method of presentation was used.

The third principal qualitative characteristic that makes the information in financial statements useful to users is reliability. All major economies have laws that prescribe how the statements must be compiled, and there are also governing bodies with enforcement powers to ensure such compliance for public companies. In Britain, the U.S., and Canada there are Generally Accepted Accounting Practice (or Principles) that guide the methods by which the statements are compiled and presented; in many other countries International Financial Reporting Standards are used. By having such consistent standards, and enforcement of those standards, stakeholders can more readily understand trust the statements, and can rely that the information contained in the statements is accurate. Additionally, the regulators can find irregularities more easily as the result of using specific sets of standards to produce financial accounting statements.

The fourth principal qualitative characteristic that makes the information in financial statements useful to users is comparability. This is particularly important when users are making use of the statements to aid in investment decisions. If all statements are produced according to the same standards, and they are presented in the same manner, then the user can easily compare the performance of one company vs. another, or the performance of the same company over two or more different time periods.

Each of these principles contributes in its own way to making financial statements more useful to end users. The use of standards such as GAAP ensures that financial statements meet all of these qualitative criteria, thereby enhancing the usefulness and trustworthiness of financial statements. Overall, when statements meet these four qualitative principals, the financial system as a whole benefits because the integrity of the financial statements themselves is less open to question, and the users can focus on interpreting the figures and data presented for their own purposes, rather than to try and decipher whether the statement can be trusted or not. Additionally, once users have a little bit of knowledge about how to read statements, they can proceed with using them to make financial decisions, thereby reducing the risk of investing and bringing more money into the equity market in particular.

Framework for the Preparation and Presentation of Financial Statements

When preparing financial statements, income is the earnings of the company for all of its activities, net of costs. There are three forms of income, generally speaking, the gross income, operating income and net income. Revenue is the total earnings generated by the company's activities, net of allowance for credit default. Income takes this figure and subtracts from it the firm's expenses. For the gross income, only the cost of goods sold is deducted. For the operating income, fixed costs are also deducted. For the net income, all costs including taxes and interest expense are deducted. The term "income" without further qualification is typically understood to be the net income. This is the increase in wealth of the company based on its activities for the previous period. It can be distributed to shareholders, and any remaining will go to the balance sheet as an increase in the book value of the company.

There is sometimes some confusion between the terms "income" and "revenue." Revenue is for the most part a gross figure that compiles all of the earnings of the company before considering the costs. Income is figure net of costs. It is important to understand this distinction so that the terms are not misunderstood. In addition, the term "income" should ideally be qualified to know what type (level) of income is being discussed. Again, this will reduce confusion to the audience when they are trying to determine what income in particular is being discussed.