CHAPTER 3 More specifically, the earnings per share information is more

relevant than book value per share in determining the attractiveness

CONCEPTUAL FRAMEWORK of an investment.
Qualitative characteristics
Ingredients of relevance
TECHNICAL KNOWLEDGE
To identify the qualitative characteristics of accounting Financial information is capable of making a difference in a decision
information if it has predictive value and confirmatory value.
To identify the fundamental qualitative characteristics.
To identify the enhancing qualitative characteristics. Financial information has predictive value if it can be used as an
To understand the cost constraint on useful information. input to processes employed by users to predict future outcome.

QUALITATIVE CHARACTERISTICS In other words, financial information has predictive value when it
can help users increase the likelihood of correctly or accurately
Qualitative characteristics are the qualities or attributes that make predicting or forecasting outcome of events.
financial accounting information useful to the users.
For example, information about financial position and past
In deciding which information to include in financial statements, the performance is frequently used in predicting dividend and wage
objective is to ensure that the information is useful to the users in payments and the ability of the entity to meet maturing commitments.
making economic decisions.
The net cash provided by operating activities is valuable in predicting
Under the Conceptual Framework for Financial Reporting, loan payment or default.
qualitative characteristics are classified into fundamental qualitative
characteristics and enhancing qualitative characteristics. Financial information has confirmatory value if it provides feedback
about previous evaluations.
Fundamental qualitative characteristics
In other words, financial information has confirmatory value when it
The fundamental qualitative characteristics relate to the content or enables users confirm or correct earlier expectations.
substance of financial information.
For example, a net income measure has confirmatory value if it can
The fundamental qualitative characteristics are relevance and help shareholders confirm or revise their expectation about an entity's
faithful representation. ability to generate earnings.

Information must be both relevant and faithfully represented if it is Often, information has both predictive and confirmatory value. The
to be useful. predictive and confirmatory roles of information are interrelated.

Neither a faithful representation of an irrelevant phenomenon nor an An example is an interim income statement which provides feedback
unfaithful representation of a relevant phenomenon helps users make about income to date and serves as a basis for predicting the annual
good decisions. income.

Application of qualitative characteristics The interim income statement for the first quarter shows net income
of P2,000,000. This information is the confirmatory value.
The most efficient and effective process of applying the fundamental
qualitative characteristics would usually be: If this trend continues for the entire year, it is logical to assume that
the net income after four quarters or one year would be P8,000,000.
First, identify an economic phenomenon or transaction that has the This information is the predictive value.
potential to be useful.
Materiality
Second, identify the type of information about the phenomenon or
transaction that would be most relevant and can be faithfully Materiality is a practical rule in accounting which dictates that strict
represented. adherence to GAAP is not required when the items are not significant
enough to affect the evaluation, decision and fairness of the financial
Third, determine whether the information is available. statements.

Relevance The materiality concept is also known as the doctrine of convenience.

In the simplest terms, relevance is the capacity of the information to Materiality is really a quantitative threshold linked very closely to
influence a decision. the qualitative characteristic of relevance.

To be relevant, the financial information must be capable of making The relevance of information is affected by its nature and materiality.
a difference in the decisions made by users.
In other words, materiality is a subquality of relevance based on the
In other words, relevance requires that the financial information nature or magnitude or both of the items to which the information
should be related or pertinent to the economic decision. relates.

Information that does not bear on an economic decision is useless. The Conceptual Framework does not specify a uniform quantitative
threshold for materiality or predetermine what could be material in a
To be useful, information must be relevant to the decision making particular situation.
needs of users. Materiality is a relativity

For example, broadly, the statement of financial position is relevant Materiality of an item depends on relative size rather than absolute
in determining financial position, and the income statement is size. What is material for one entity may be immaterial for another.
relevant in determining performance.
An error of P500,000 in the financial statements of a multinational The new definition of materiality narrows the definition to primary
entity may not be important but may be so critical for a small entity. users who are primarily affected by general purpose financial
statements.
When is an item material?
The primary users include the existing and potential investors,
There is no strict or uniform rule for determining whether an item is lenders and other creditors.
material or not.
The new definition specified that only primary users of The nal
Very often, this is dependent on good judgment, professional statements are considered because these groups are the users to
expertise and common sense. whom general purpose financial statements are primarily directed.

As a general guide, an item is material if knowledge of it could Such primary users cannot require reporting entities to provide
reasonably affect or influence the economic decision of the primary information directly to them and therefore must rely on general
users of the financial statements. purpose financial reports for how much financial information is
needed.
New definition of materiality
The other users include the employees, customers, government
The IASB provided the following new definition of materiality. agencies and the public in general.

Information is material if omitting, misstating or obscuring it could Factors of materiality

reasonably be expected to influence the economic decisions that
primary users of general purpose financial statements make on the Materiality depends on the magnitude and nature of the financial
basis of those statements which provide financial information about information.
a specific reporting entity.
In the exercise of judgment in determining materiality, the relative
In other words, an information is material if the omission, size and nature of an item are considered.
misstatement and obscuring of the information could reasonably
affect the econome décision of primary users. The size of the item in relation to the total of the group to which the
item belongs is taken into account.
The revised definition of materiality highlights three important
aspects: For example, the amount of advertising in relation to total selling
a. Could reasonably be expected to influence expenses, the amount of office salaries to total administrative
b. Obscuring information expenses, the amount of prepaid expenses to total current assets and
c. Primary users the amount of leasehold improvements to total property, plant and
equipment.
Could reasonably be expected to influence
The nature of the item may be inherently material because by its very
The could reasonably be expected to influence threshold adds an of nature it affects economic decision.
element reasonability of financial information on which economic
decision is based. For example, the discovery of a P20,000 bribe is a material event
even for a very large entity.
By including the term could reasonably be expected to influence in
the new definition, material information shall be limited to the Faithful representation
economic decision of primary users rather than to all users which is
too broad in scope. Faithful representation means that financial reports represent
economic phenomena or transactions in words any numbers.
Moreover, the could reasonably be expected to influence threshold
insures that information capable of influencing economic decision of Stated differently, the descriptions and figures must match what
the primary users shall be included in the financial statements. really existed or happened.

Obscuring information Simply worded, faithful representation means that the actual effects
of the transactions shall be properly accounted for and reported in
Obscuring information is a new concept added to the new definition the financial statements.
of materiality.
For example, if the entity reports purchases of P5,000,000 when the
Information is obscured if presenting or communicating it would actual amount is P8,000,000, the information would not be faithfully
have a similar effect as omitting or misstating the information. represented.

Obscuring information means the presentation of financial To record a sale of merchandise as miscellaneous income would not
information not readily understood or not clearly expressed. also be a faithful representation of the sale transaction.

Obscuring information may be characterized by deliberate vagueness,

ambiguity and abstruseness. Ingredients of faithful representation

To be a perfectly faithful representation, a depiction should have

Examples of obscured material information are: three characteristics, namely:
a. The language is vague or unclear. a. Completeness
b. The information is scattered throughout the financial statements. b. Neutrality
c. Dissimilar items are aggregated inappropriately. c. Free from error
d. Similar items are disaggregated inappropirately.
Completeness
Primary users
Completeness requires that relevant information should be presented
in a way that facilitates understanding and avoids erroneous Conservatism means that when alternatives exist, the alternative
implication. which has the least effect on equity should be chosen.

A complete depiction includes all information necessary for a user to In the simplest words, conservatism means "in case of doubt, record
understand the phenomenon or transaction being depicted, including any loss and do not record any gain."
all necessary description and explanation.
For example, if there is a choice between two acceptable asset values,
Actually, to be complete, the financial statements shall be the lower figure is selected.
accompanied by notes to financial statements.
Accordingly, inventories are measured at the lower of cost and net
The purpose of the notes is to provide the necessary disclosures realizable value.
required by Philippine Financial Reporting Standards.
Contingent loss is recognized as a "provision" if the loss is probable
Standard of adequate disclosure and the amount can be reliably measured.

Completeness is the result of the standard of adequate disclosure or Contingent gain is not recognized but disclosed only.
principle of full disclosure.
It is to be emphasized that conservatism is not a license to
The standard of adequate disclosure means that all significant and deliberately understate net income and net assets.
relevant information leading to the preparation of financial
statements shall be clearly reported. For example, if an entity has a cash of P500,000 and reports only
P100,000, this is not conservatism but fraud or inaccurate reporting.
Adequate disclosure however does not mean disclosure of just any
data. Expressions of conservatism

The accountant shall disclose a material fact known to him which is "Anticipate no profit and provide for probable and measurable loss."
not disclosed in the financial statements but disclosure of which is
necessary in order that the financial statements would not be "In the matter of income recognition, the accountant takes the
misleading. position that no matter how sure the businessman might be in
capturing the bird in the bush, he, the accountant, must see it in the
The standard of adequate disclosure is best described by disclosure hand."
of any financial facts significant enough to influence the judgment of
informed users. "Don't count your chicks until the eggs hatch".

Neutrality Free from error

A neutral depiction is without bias in the preparation or presentation Free from error means there are no errors or omissions in the
of financial information. description of the phenomenon or transaction.

A neutral depiction is not slanted, weighted, emphasized, de- Moreover, the process used to produce the reported information has
emphasized or otherwise manipulated to increase the probability that been selected and applied with no errors in the process.
financial information will be received favorably or unfavorably by
users. In this context, free from accurate in all respects. error does not mean
perfectly
In other words, to be neutral, the information contained in the
financial statements must be free from bias. For example, an estimate of an unobservable price or value cannot
be determined to be accurate or inaccurate.
The financial information should not favor one party to the detriment
of another party. However, a representation of that estimate can be faithful if the
amount is described clearly and accurately as an estimate.
The information is directed to the common needs of many users and
not to the particular needs of specific users. Moreover, the nature and limitations of the estimating process are
explained, and no errors have been made in selecting and applying an
Neutrality is synonymous with the all-encompassing principle of appropriate process for developing the estimate.
fairness.
Measurement uncertainty
To be neutral is to be fair.
Measurement uncertainty arises when monetary amounts in financial
reports cannot be observed directly and must instead be estimated.
Prudence
Measurement uncertainty can affect faithful representation if the
The Revised Conceptual Framework has reintroduced the concept of level of uncertainty in providing an estimate is high.
prudence.
However, the use of reasonable estimate is an essential part of
Prudence is the exercise of care and caution when dealing with the providing financial information and does not undermine the
uncertainties in the measurement process such that assets or income usefulness of the financial information.
are not overstated and liabilities or expenses are not understated.
As long as the estimate is clearly and accurately described and
Neutrality is supported by the exercise of prudence. explained, even a high level of measurement uncertainty does not
affect the usefulness of the financial information.
Conservatism
Substance over form
Conservatism is synonymous with prudence.
If information is to represent faithfully the transactions and other Comparability between and across entities is the quality of
events it purports to represent, it is necessary that the transactions information that allows comparisons between two or more entities
and events are accounted in accordance with their substance and not engaged in the same industry.
merely their legal form.
Comparability across entities is also known as intercomparability or
The economic substance of transactions and events are usually dimensional comparability.
emphasized when economic substance differs from legal form.
For information to be comparable, like things must look alike and
Substance over form is not considered a separate component of different things must look different.
faithful representation because it would be redundant.
Comparability is not enhanced by making unlike things look alike or
Faithful representation inherently represents the substance of an making like things look different.
economic phenomenon or transaction rather than merely
representing the legal form. Consistency

Representing a legal form that differs from the economic substance Implicit in the qualitative characteristic of comparability is the
of the underlying economic phenomenon or transaction could not principle of consistency.
result in a faithful representation.
Consistency is not the same as comparability.
Example of substance over form
In a broad sense, consistency refers to the use of the same method for
An example is when the lessee leased property from the lessor. the same item, either from period to period within an entity or in a
single period accross entities.
The terms of the lease provide that the lease transfers ownership of
the asset to the lessee by the end of the lease term. Comparability is the goal and consistency helps to achieve that goal.

In form, the contract is a lease as popularly understood. In a limited sense, consistency is the uniform application of
accounting method from period to period within an entity.
But in substance, in reality, if the "transfer of ownership provision"
is to be considered, the real intent of the parties is an installment On the other hand, comparability is the uniform application of
purchase of an asset by the lessee from the lessor. accounting method between and across entities in the same industry.

Accordingly, the lessee shall record an acquisition of right of use An entity cannot use the FIFO method of inventory valuation in one
asset and set up a liability to the lessor. year, the average method method in the next year, again the FIFO
method in succeeding year and so on.
The periodic rental is conceived as an installment payment
representing interest and principal. If the FIFO method is adopted in one year, such method is followed
from year to year. Consistency is desirable and essential to achieve
Enhancing qualitative characteristics comparability of financial statements.

The enhancing qualitative characteristics relate to the presentation However, consistency does not mean that no change in accounting
or form of the financial information. method can be made.

The enhancing qualitative characteristics are intended to increase the If the change would result to more useful and meaningful
usefulness of the financial information that is relevant and faithfully information, then such change shall be made.
represented.
But there shall be full disclosure of the change and the peso effect
The enhancing qualitative characteristics are comparability, thereof.
understandability, verifiability and timeliness.
It is inappropriate for an entity to leave accounting policies
Relevant and faithfully represented financial information is useful unchanged when better and acceptable alternatives exist.
but the information would be most useful if it is comparable,
understandable, verifiable and timely. Understandability

Comparability Understandability requires that financial information must be

comprehensible or intelligible if it is to be most useful.
Comparability means the ability to bring together for the purpose of
noting points of likeness and difference. Accordingly, the information should be presented in a form and
expressed in terminology that a user understands.
Comparability is the enhancing qualitative characteristic that enables
users to identify and understand similarities and dissimilarities Classifying, characterizing and presenting information "clearly and
among items. concisely" makes it understandable.

Comparability may be made within an entity or between and across An essential quality of the information provided in financial
entities. statements is that it is readily understandable by users.

Comparability within an entity is the quality of information that But the complex economic activities make it impossible to reduce the
allows comparisons within a single entity through time or from one financial information to the simplest terms.
accounting period to the next.
Accordingly, the users shall have an understanding of the complex
Comparability within an entity is also known as horizontal economic activities, the financial accounting process and the
comparability or intracomparability. terminology in the financial statements.
Financial statements cannot realistically be understandable to What happened in the past would become the basis of what would
everyone. happen in the future.

Financial reports are prepared for users who have a reasonable Cost constraint on useful information
knowledge of business and economic activities and who review and
analyze the information diligently. Cost is a pervasive constraint on the information that can be
provided by financial reporting.
At times, even well-informed and diligent users may need to seek the
aid of an adviser to understand information about complex Reporting financial information imposes cost and it is important that
phenomena or transactions. such cost is justified by the benefit derived from the financial
information.
Understandability is very essential because a relevant and
faithfully represented information may prove useless if it is not In other words, the cost constraint is a consideration of the cost
understood by users. incurred in generating financial information against the benefit to be
obtained from having the information.
Verifiability
The benefit derived from the information should exceed the cost
Verifiability means that different knowledgeable and independent incurred in obtaining the information.
observers could reach consensus, although not necessarily complete
agreement, that a particular depiction is a faithful representation. However, the evaluation of the cost constraint is substantially a
judgmental process.
In other words, verifiability implies consensus.
Assessing whether the cost of reporting outweighs or falls short of
The financial information is verifiable in the sense that it is supported the benefit is difficult to measure and becomes a matter of
by evidence so that an accountant that would look into the same professional judgment.
evidence would arrive at the same economic decision or conclusion.

Verifiable financial information provides results that would be

substantially duplicated by measurers using the same measurement
method.

Accordingly, verifiability helps assure users that information

represents the economic phenomenon or transaction it purports to
represent.

Verifiability is synonymous with objectivity.

Types of verification

Verification can be direct or indirect.

Direct verification means verifying an amount or other representation

through direct observation, for example, by counting cash.

Indirect verification means checking the inputs to a model, formula

or other technique and recalculating the inputs using the same
methodology.

An example is verifying the carrying amount of inventory by

checking the inputs in quantities and costs, and recalculating the
ending inventory using the same cost flow assumption, such as first-
in, first-out.

Timeliness

Timeliness means that financial information must be available or

communicated early enough when a decision is to be made.

Relevant and faithfully represented financial information furnished

after a decision is made is useless or of no value."

For example, the most important attribute of quarterly or interim

financial information is its timeliness.

Generally, the older the information, the less useful.

However, some information may continue to be timely long after the

end of reporting period because some users may need to identify and
assess trends.

Timeliness enhances the truism that without knowledge of the past,

the basis for prediction will usually be lacking and without interest in
the future, knowledge of the past is sterile.