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Exposure Draft Conceptual Framework for Financial Reporting: The objective of financial reporting and qualitative characteristics and constraints of decision-useful financial reporting information.
Presented by: (Thursday 8-10am)
Loke Siew Fong CEA080077
Tang Chung Sin CEA080172
Ting Chiu Hsia CEA080177
Ting Eng Eng CEA080178
Tnay Syn Siang CEA080180
Generally, this paper is an Exposure Draft issued and published by Financial Accounting Standards Board (FASB) as well as International Accounting Standards Board (IASB) for public comment. It is a product of the Boards' considerations of the issues and feedbacks received on the Discussion Paper, which is being addressed in the first phase of the project to develop a common conceptual framework for financial reporting to replace their existing frameworks.
There are quite some reasons why Boards are reconsidering their frameworks.
A common goal of the Boards to set their standards clearly based on consistent principles.
Both of the IASB's Framework and FASB's Concept Statement explained concepts that continuously being an adequate foundation for consistent standards.
The goal of Boards to converge their standard.
There are a total of two chapters discussed in the Exposure Draft. Basically, Chapter 1 describes the objectives of financial reporting, the primary user group to which financial reporting is directed, types of decision made by the group as well as financial information that are useful to that group in making those decisions. On the other hand, Chapter 2 describes the qualitative characteristics that make financial information useful. Besides, it also discuss on two pervasive constraints in providing financial reporting information which is materiality and cost.
Chapter 1: The Objective of Financial Reporting
In this chapter, it establishes the objective of general purpose financial reporting by business entities in private sector, which is also the foundation of the frameworks.
Objective of General Purpose Financial Reporting
The main purpose of general purpose financial reporting is to provide financial information for present and potential capital providers as well as non capital providers in which are useful in making decision related to reporting entity.
General Purpose Financial Reporting
The general purpose financial reporting focuses on the needs of a wide range of users rather than only to the needs of single group. It stems from the information need of users who lack in ability to prescribe all the financial information they need from the reporting entity, in which they rely partly on information provided in financial reports.
Capital Providers and the Entity Perspective
Financial reports should reflect on the perspective of the entity rather than the perspective of the entity's equity investors as it focuses on the need of all capital provider rather than the needs of particular group. However, additional information that aimed for the need of specific entity's equity investors is also allowable. Capital providers (equity investors, lenders, and other creditors) provide economic resources to entity in exchange for claims to those resources. Therefore, capital providers have the most critical and immediate need for general purpose financial information about the economic resources of an entity.
Financial reporting is important because it provides information that is useful in making decisions especially for capital providers.
Usefulness of Financial Reporting in Assessing Cash Flow Prospects
Financial reports provide information about cash flows in an entity, the amount, timing and uncertainty from various resources. However, future predictions of cash flows depend on entity's present cash resources and its ability to generate enough cash. The ability of entity's to generate cash also affects the values of debt and equity interests.
Usefulness of Financial Reporting in Assessing Stewardship
Management's performance in discharging responsibilities, also known as stewardship responsibilities, affects greatly on entity's ability to generate net cash inflows. Therefore, it helps existing equity investors to make decision in their capacity as owners about whether to replace or reappoint managements, how to compensate management, and how to vote on shareholders proposals about management's policies and other matters. Potential investors may also use the information in deciding whether to provide economic resources to entity.
Limitations of General Purpose Financial Reporting
Financial reporting provides only one sources of information needed. Thus, users of financial reports also have to consider information from other sources such as political events in order to make good decision. Besides, the information provided are also based on estimates, judgment and models that had happened and exist rather than exact depictions of the effect. Although standards did establish concepts underlying the estimates, judgment and models of financial effect, it is unlikely that ideal financial reporting can be produced due to constraint such as cost.
Information about an Entity's Resources, Claims to Those Resources, and Changes in Resources and Claims
Financial reporting should provide information about the economic resources of the entity (its assets) and the claims to those resources (its liabilities and equity) as well as the effects of transactions or other events that changes them.
Economic Resources and Claims to Them
Information on economic resource and claims to them help capital providers to identify entity's financial strengths and weaknesses as well as assessing entity's liquidity and solvency. Besides, it also indicates the cash flow potential of some economic resources and cash needed to satisfy claims of lenders and other creditors. Furthermore, users may also assess the effectiveness of management discharging their stewardship responsibilities by comparing actual results with expectations. In conclusion, information on these resources and claim are important for users to predict how future cash flows will be distributed to claims to economic resources besides considering the needs of additional financing and how likely it'll be successful in obtaining financing.
Changes in Economic Resources and Claims to Them
Information about effects of transactions and other events as well as circumstances that changes in economic resource and claims to them help user of the entity's financial reports to assess the amount, timing, and uncertainty of its future cash flows. This information includes quantitative measures and other information about changes in economic resources and claims that are a result of the entity's financial performance, which are reflected by accrual accounting and cash flows during a period, and changes that are not a result of the entity's financial performance.
Changes in Resources and Claims Resulting from Financial Performance
An entity's financial performance provides information about the return it has produced on its economic resources. The variability of that return is important, especially in assessing the uncertainty of future cash flows. Besides, entity's past financial performance are also helpful in predicting the entity's future returns on its resources, and also in assessing management's ability to discharge its stewardship responsibilities to its capital providers.
Financial Performance Reflected by Accrual Accounting
Accrual accounting shows the financial effects of transactions and other events and circumstances that have cash or other consequences for an entity's resources and the claims to them in the periods in which those transactions, events, or circumstances occur. Without accrual accounting, important economic resources and claims to resources would be excluded from financial statements which may makes it difficult to assess entity's past performance and future prospects. Other than changes resulting from transactions, information about an entity's financial performance during a period reflected by changes in its resources and the claims to those resources are useful in assessing entity's past and future ability to generate net cash inflows. Besides, it may also indicate the extent to which events such as changes in market prices influence entity's economic resources and the claims to those resources. This in turn affects the entity's ability to generate net cash inflows
Financial Performance Reflected by Cash Flow Accounting
Information about an entity's cash flow during a period helps users to assess the entity's ability to generate future net cash inflows. Besides, it also indicated how entity obtains and spends cash which may affect the entity's liquidity and solvency.
Changes in Resources and Claims Not Resulting from Financial Performance
This information provided in financial reports helps capital providers to distinguish between changes that are the result of financial performance or not. It is useful in assessing to what extent the total change in economic resources and claims to those resources caused by management's ability to protect and enhance the entity's economic resources which may form expectations about its future financial performance.
Since management understand more about the operations and ongoing activities of the entity than external users, management's explanation and other information should be disclosed in financial reporting to help users understand the information provided. Furthermore, information provided in financial reporting depends on, or affected by, management's estimates and judgments. Therefore, disclosing management's explanation on underlying assumptions or methods used, including those significant uncertainties in the principal applied helps capital providers in better evaluation of financial information.
Appendix: Basis for Conclusions
This appendix summarizes considerations that Board members thought significant in reaching the conclusions in this chapter of the proposed conceptual framework. It includes reasons for accepting some alternatives and rejecting others.
Objective of Financial Reporting
General Purpose Financial Reporting
Objectives should focus on financial reporting as a whole and not just presenting financial statements.
Common Needs of Users
Information needed by users other than capital providers which did not overlap with common needs of capital providers are beyond the scope of general purpose financial reporting.
One Set of General Purpose Financial Reports
For now, information conveyed in general purpose financial reports still considered the best to serve the needs of users. This is because of common interest of users in evaluating entity's ability to generate net cash inflows and management's ability to enhance and safeguard the investment by capital providers.
In modern business environment, most of the companies tend to grow larger and need for capital increases and new business forms evolved whereby there is a separate legal entity between entity, management and capital providers. Therefore, reporting based on entity's perspective is more consistent.
Primary User Group
Boards concluded that primary users of financial reporting information would be present and potential capital providers as they have the most direct and immediate interest in entity's ability to generate net cash inflows and management's ability to enhance and protect the investment by capital providers.
Usefulness for Making Decisions
Evaluating Past Performance and Predicting Future Cash Flows
Information to assess how management has fulfilled its stewardship responsibility should stay as a part of overall objective to provide useful information in making resources allocation decisions. It is unnecessary to eliminate any discussion of stewardship; even with explanation as it may mistakenly understood that Boards do not think it's important. Besides, adding a separate objective for stewardship is also not necessary because it might imply that financial reporting attempt to separate the effects of management's performance from the effects of events and circumstances that are beyond management's control. Thus, a modification to objective of general purpose financial reporting had been done which includes decisions made to protect and enhance an investment.
Decision Usefulness for Different Types of Entities
The objective of general purpose financial reporting should be the same for all entities that issue such reports so. Although objective is the same for all entities, cost constraints sometimes may lead standard setters to permit or require differences in reporting for some types of entities. However, such differences are a result of variations in the perceived costs and benefits of the information when applied to different entity types, not different objectives.
Financial Reporting and Management's Information Needs
Basically, general purpose financial reporting focused on the common need of capital providers. While management's needs of information are differ from capital providers. Since managements can get access to entity's financial information easily to meet its unique needs, general purpose financial reporting is should not focus on needs of management.
The Significance of Information about Financial Performance
Information on entity's financial performance measured by accrual accounting is needed by users to assess entity's ability to generate net cash inflows or to assess management discharge of its stewardship responsibility. Therefore, entity's economic resources and changes in resources and claims as reflected by various measurement attributes within accrual accounting are essential.
Financial Position and Solvency
Since preparing a statements of financial positions towards the need of particular group of user are inconsistent with the main objectives of serving common needs of capital providers as primary user group, Boards rejected the suggestions on main purpose of preparing statement of financial position to assess entity's solvency.
Chapter 2: Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information
This chapter describes the qualitative characteristics of useful financial information. The qualitative characteristics can be categorized as fundamental (relevance and faithful representation) or enhancing (comparability, verifiability, timeliness and understandability) based on how they influence the usefulness of financial information. However, it can limited by two pervasive constraints which is cost and materiality.
Fundamental qualitative characteristics
Relevant financial reporting information means the ability of users (shareholder) to make a difference in their decision. Information regarding to economic phenomenon will help the users to make a difference decision if it included predictive value and confirmatory value.
Information has predictive value if the value can be useful to the shareholder in predicting certain things that is related to future. Information which is highly predictable does not necessary has predictive value.
Information has confirmatory value if it confirms the validity of prior expectation or correcting them according to the prior evaluations. The outcomes will be same as past expected if the information has confirmed past expectation while the outcome can be changed if correcting in past expectations occurred.
Useful financial information needs not only be a relevant but also be a faithful representation. Financial reporting information which included the characteristics of complete, neutral, and free from material error is supposed to be faithful representation of an economic phenomenon.
Complete financial reporting information must have all the necessary information which is useful for decision making and should not be missing a material fact or consideration that would cause the financial reporting information misleading.
Neutrality in financial reporting information must be free from bias which the information provided does not favor to the particular group over other interested person. In order to have neutral information, information must report in faithful and trustworthiness condition without changing anything that need to be conveyed for the purpose of inducing someone's behavior.
Free from error
A set of financial reporting information is said to be true if the information is free from error. However, due to some constraint and uncertainty in economy phenomena, financial reporting information does not provide absolutely value which is totally free from error. Therefore, a various type of judgments and estimation based on appropriate input are used by the management in assessing the financial reporting.
Application of the Fundamental Qualitative Characteristics
Relevance is the fundamental qualitative characteristic which connected to the economic phenomena and must be considered first before the other qualitative characteristics. Once the relevance is applied to distinguish which economic phenomena should be presented, faithful representation is going to determine which characteristics are best to correspond to the relevant phenomena
Enhancing Qualitative Characteristics
Enhancing qualitative characteristics are additional benefit added to the fundamental to enhance the decision usefulness of financial information.
Comparability refers to the ability of the users to distinguish similarities and differences between two economic phenomena. Comparability between entities and consistency in the application of methods or procedures over time period will enhance the informational value in relative economic performance.
Verifiability refers to the capable of the users to ensure that the information faithfully represents what it purports to represent and to ensure the selected technique of measurement had been used is without bias and error. The information is verified when the different evaluators or observers who are knowledgeable confirmed and come up with the same result.
Timeliness means that the information must be received by the users at the right time before it loses its ability to affect the decision. Information should be provided with sufficient timeliness to give a clear and meaningful picture for the shareholders. Information that is not available when it is needed by the decision makers will be useless and the information may lose its potential value.
Understandability means the users could be able to identify or discover the meaning of the message that trying to be shown in the quality financial information. Users of financial statements are assumed to have sufficient knowledge to study the information properly. If the information is classified, clearly represent and concise, it will help to enhance understandability. Sometimes, the information is complicated and hard to understand, the users may seek an advisor to explain to them.
Application of the Enhancing Qualitative Characteristics
Enhancing qualitative characteristics provide additional benefit and usefulness in the financial reporting information. Therefore, the four important characteristics which are comparability, verifiability, timeliness and understandability should be extent widely. However, the enhancing qualitative characteristics will be useless if the financial information is irrelevant or not faithfully represented in fundamental step.
The application of the enhancing qualitative characteristics is redundant process that does not follow priority and prescribed order. Sometimes, one or some of the enhancing qualitative characteristics will be given up to maximize the usefulness of another qualitative characteristic. If such situation happened, appropriate information or evidence should be disclosed.
Constraints on Financial Reporting
Materiality can be explained as the level of an omission or misstatement of financial reporting information which could influence the decision of users. Materiality depends on the size and nature of the item judged in the light of the surrounding circumstances. It is hard to determine a consistent quantitative at which a specific information become material. In order to provide a faithful representation and relevant financial information, materiality level should be establish so as to detect material misstatement to avoid incomplete, biased, or not free from error in financial reporting information.
Cost is one of the pervasive constraints in providing useful financial reporting. The benefit of financial reporting imposes costs. Cost of producing information such as cost of collecting, classifying, processing, verifying and disseminating should be determined clearly. Besides, cost of omission and error in decision making also need to be included. Shareholders and individual entities use financial reporting information to make decision and enjoy those benefits will lower the cost of capital.
Application of the Constraints on Financial Reporting
Materiality is said to be one of the pervasive constraint on financial reporting because it attribute to all the qualitative characteristics. For example, materiality need to be measured when determine the sufficiency of relevant information and sufficiency of complete, neutral, and free from error to faithfully represent in financial reporting. Application of the cost constraint in financial reporting included evaluate whether the benefits of reporting information will be able to impose the costs. It is necessary to reflect on whether one or some qualitative characteristics one or some of the enhancing qualitative characteristics will be given up to reduce the cost.
Basis for Conclusions
Basis for conclusions is the thoughts of the Boards members in reaching the conclusion of the planned framework after revising 179 comment letters. It included the reasons of accepting or rejecting options. The Boards firstly concluded on the fundamental qualitative characteristics. The framework stated that two fundamental qualitative characteristics include relevance and faithful representation.
However, there is puzzlement in whether the information should be able to make a difference to the financial reporting or the information itself should actually make a difference in order to be relevance. The Boards members determined that the information should be able to make a differentiation in order to be relevance. This is because the information that itself could make a difference is often hard to be found. In determining which information should be relevant, the Boards had taken steps to identify with how the users use the financial statements.
Predictive value and confirmatory value are also a component of relevance. The Board determined that confirmatory value is same with feedback value. However, they chose to use confirmatory value as a general term. There is also an issue of choosing the term of predictive value or predictability. Predictive value means the value that can assist in predicting future while predictability is used by statisticians to describe the accuracy of the predicted value. In the end, the Board chose to use predictive value as they think that there should not have statistical term been used in financial reporting and the information itself only need to be able to assist in predicting in order to be relevance.
Besides relevance, faithful representation is also a fundamental qualitative characteristic. There is argument about the definition of reliability. Different entities that had remarked on the exposure draft had differently defined reliability. Hence, the Board had determined a new term to clarify the real definition, which is faithful representation.
From the conclusion of the Boards member, substance over form is not included in as an element of faithful representation. This is because the principle of substance over form could not help in reaching faithful representation. The Boards also included neutrality as an element but do not included prudence as one of the element. A warning to be prudence may guide to unfairness in financial reporting, and this will cause contrast with the element of neutrality which require a financial report to be out of bias.
Furthermore, there is another concern on whether the faithful representation can be measured empirically. There are interests to measure faithful representation empirically. However, there is still lack of method to put it into action. Moreover, the statistical definition of reliability is different with presented framework and there are also different usage of term between statistic and financial framework.
Next is for enhancing qualitative characteristics. The Boards determined comparability as a crucial enhancing characteristic. When the information can be able to weigh against, it will increase its usefulness to the financial report's users.
The Boards decided verifiability as an enhancing characteristic rather than an element of faithful representation. This is because determine verifiability as faithful representation may cause certain information to be expelled from financial statement as many information could not be verified. Any information that could be verified could make the information more helpful to decision makers.
The Boards also further decide that timeliness is one of the enhancing traits as the information that could be reported in a set time could improve the quality of the relevance and faithful representation. Understandability also is an enhancing characteristic. The more the understandability of information will help increase the effectiveness of information to users.
Besides, the Boards also had measured whether other qualitative features should be included. The other features included transparency, true and fair view, credibility, internal consistency, high quality and other decision criteria.
For transparency, the Boards consider that adding it as a qualitative characteristic will be unnecessary, because its elements had already enclosed in faithful presentation and understandability. While for the true and fair view, in the point view of Boards, it should not be a qualitative characteristic but should be the result of a financial statement after adheres with framework.
Credibility is also not accepted as a qualitative feature. The credibility of the information can only be examined by the users themselves based on their on perceptions of the financial report. Same as the internal consistency, it is not accepted as qualitative feature as by applying this attribute, the financial reporting might not be able to develop fast. High quality is also not included as qualitative characteristic. The high quality of financial information should be the target after following the financial framework.
The other decision criteria include simplicity, preciseness, operationality, practicability, and acceptability. According to Boards, these criteria generally are part of the overall weighing of benefits and costs of providing financial information.
In the basis of conclusion, the Boards had also discussed how they relate the qualitative attribute to the objective of financial reporting. Due to the puzzlement of their relations among the respondents, the Boards classified the qualitative features to fundamental and enhancing features. Their relations are depended on their usefulness. The fundamental characteristics should be measured first and the enhancing should be measured next to make the information judgment helpful.
Materiality and cost are the constraints that limit the information for financial reporting. Material is a constraint in which the Boards concluded that materiality is a concern for individual body and their auditors, not standard setters, because whether something is material can be evaluated only with respect to a particular reporting entity's circumstances.
For cost, the Boards think that unable to perform cost-benefit analyses effectively bring the largest effect. It is hard for the standard setters to reveal that the benefits of a planned framework would justify the related costs.