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The Financial Accounting Standards Board Concepts Statement 2 and the International Accounting Standards Board framework is responsible for the regulations, accounting standards and different procedures that will occur in the preparation of the financial statements as well as providing the right information to make correct economic decisions. The framework is made of the four principal qualitative characteristics which are basically the key concepts of helping users of financial statements to absorb the correct information that they need in order to provide the financial statements. These are understandability, relevance, reliability, and comparability. Relevance has a subheading of materiality and reliability of faithful representation, substance over form, neutrality, prudence and completeness.
This assignment will be separated into three sections. In the first section there will be a brief discussion about the different definitions of materiality and about the misunderstanding of its meaning to the users and the auditors. Moreover there will be a brief discussion on why materiality can be described as a threshold quality according to ASB and an underlying quality of relevance in the IASB. In the second section there will be a definition and explanation of what prudence and neutrality are as well as explaining how prudence affects neutrality. In the third section, definitions and explanations will cover the conflicting targets of principal qualitative characteristics of relevance and reliability. Also a discussion about the trade-off of relevance and reliability will be mentioned as well as why reliability is less important in managerial accounting and in relevance more important.
According to IASB's framework "Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful" (Gordeeva M.(2011:42)). According to FASB and US GAAP, materiality can be defined as "The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgement of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement"(Gordeeva M.(2011:41)).
Materiality can be defined in various ways, but the problem is that users of financial reporting often misunderstand the concept of materiality to specific situations leading into a collapse. A striking example would be the one with Enron Company between the years 2001 and 2002, where the stock of market and other stakeholders where misled due to errors of materiality. Such errors might be the variety of definitions of materiality, user-orientation, practical approach and proof of sufficiency. In the case of user-orientation is when the users are excluded of making materiality decisions and the decisions are made by the preparers of financial statements and the auditors, leaving the judgement of users which is central to the definition of reality out. The problem with practical approach is that accountants often have difficulties in understanding materiality to put it into practise and proof of sufficiency is the difficulties that the accountant has in order to prove that his/her decisions of materiality will be forcible in the future. (Gordeeva, M. (2011))
Moreover materiality is an important part of the qualitative characteristics, since it is a role by which a decision will have to be made in order to disclose an item or not and to correct certain misstatements in the financial statements from a given entity-information. For example, the misclassification of an asset, such as equipment to plant will be immaterial since it does not affect the statement of financial position. But the misclassification of plant and equipment to inventory would be considered as material. According to ASB (1999) an item that will be considered material will have to influence the economic decision of users of financial statements together with the calculations of management's stewardship. This can sometimes influence the opinion of the audit whether items are material or immaterial. Auditors consider materiality as a professional judgment that will be proceeded by the information given to the users of financial statements and are more concerned on the omissions and misstatements that could affect the economic decisions of users. Thus the auditor determines what is material to users and often uses a percentage benchmark that will determine the level of materiality of financial statements. (Gordeeva, M. (2011)) (FASB (2010)) (IASB (2006)) (ASB (1999)) (Weetman P (2011)) (Weygandt,Kieso,Kimmel(2003)) (Wood F, Sangster A (2008))
What is more, according to ASB (1999) materiality asks by the information content whether to include or exclude the information from the financial statements so that the usefulness of financial information will be maximised. For this reason it can be described as a threshold quality through the information of the financial statements. "The IASB framework includes materiality as a component of relevance" (IASB (2006:65)), but not as a qualitative characteristic of information. Thus "materiality provides a threshold or cut-off point for deciding what information to report" (IASB (2006:65)). In other words we cannot determine whether information is material or not in particular situations. (Gordeeva, M. (2011)) (FASB (2010)) (IASB (2006)) (ASB (1999)) (Weetman P (2011)) (Weygandt,Kieso,Kimmel(2003))
Furthermore neutrality, as has been previously noted, is a subheading of relevance and it states that in order for the information to be reliable in the financial statements, it should always be neutral and thus "free from deliberate or systematic bias" (ASB (1999:38)). According to ASB(1999) if the financial information is selected or presented so that a decision or judgement, that would have to be made, is determined for a result or outcome, it will not be considered as neutral information. Thus the IASB concluded that neutrality is "the absence of bias intended to attain a predetermined result or to induce a particular behaviour-play an essential role in decision-useful information" (IASB (2006:67)). (FASB (2010)) (IASB (2006)) (ASB (1999)) (Weetman P (2011))
In addition prudence or conservatism is "the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that gains and assets are not overstated and losses and liabilities are not understated" (ASB (1999:39)). Accountants might misuse prudence by understating the value of the assets and thus understate earnings, "anticipate no profit and provide for all possible losses" (Pizzey A(1994:21)). Prudence and neutrality are incompatible with each other, since "neutral information does not colour the image it communicates to influence behaviour in a particular direction" (IASB (2006:52)). For example they might set speedometers to cars, which they indicate a higher speed than the actual in order for the drivers not to drive fast. The same goes with financial reporting, which they might use biased information that according to neutrality is unacceptable. Consequently whilst neutrality tries to avoid systematic bias, prudence is a "biased concept" and tries to ensure that assets and profits are not overstated and liabilities and losses not understated. Thus neutrality and prudence settle by finding a balance that the understatement of profit and assets and overstatements of losses and liabilities do not occur, so "to understate is as bad as to overstate, and accountants must not lose sight of the need for correct, reliable figures" (Pizzey A(1994:21)). (IASB (2006)) (Weetman P (2011)) (ASB (1999)) (Weygandt, Kieso,Kimmel(2003)) (Wood F, Sangster A (2008))
Furthermore according to ASB (1999) in order to decide which information to include in the financial statements a choice needs to be made, if it will be relevant or reliable. If a choice is mutually exclusive between relevance and reliability, then the chosen one will have to be "in the relevance of the information provided being maximised" (ASB (1999:32)).Information will be considered relevant "if it has the ability to influence the economic decisions of users and is provided in time to influence those decisions" (ASB (1999:35)). Relevance also states that in order to make better assessments using the information it will have to have a good presentation of the financial statements. Relevant information has predictive value and confirmatory value. The predictive value is when the information helps the users to calculate past, present and future events, without exact forecasts. Confirmatory value is when it helps the users of the accounts to confirm or correct the different calculations that occurred in the past. There might also be a situation where information may include both predictive and confirmatory value. Predictive and confirmatory values have a connection between them, since predictive value information will usually have confirmatory value. For example the information of the current level and structure of assets and liabilities will help the users to predict the ability of an entity so that they will take caution and advantage of the opportunities or adverse situations. (ASB (1999)) (IASB (2006)) (IASB (2008)) (IASB (1989))
On the other hand accounting information will be considered reliable if it is free of material error and bias and will depend upon the users to represent the financial statements faithfully of what are expected to represent, to be "factual, verifiable and neutral"(Weygandt,Kieso,Kimmel(2003:286)). (Weetman P (2011))
Relevance and reliability are two conflicting targets that often bring tension when it comes to decide the best way of presenting the accounting information. For these reason there is trade-off between relevance and reliability due to the timely manner that the information should be delivered in time. According to IASB timeliness, as the timely manner mentioned previously, is an aspect of relevance since users will have to be given their information before it loses its capacity and therefore influence decisions. In addition some information has to be timely longer than other information, because there might be some aspects in the information that users have to consider before making their decisions. For example users will have to calculate the trends of different items that will be included in the financial statements, such as credit payment decisions or investments. Moreover another reason that there is a trade-off between relevance and reliability is "whether the costs of producing further information exceed the benefits" (Weetman P (2011:79)). This is because the benefits that are contained through the information should be greater than the cost that we have to provide. Standard-setters have to consider that benefits and costs act as a total, not separately. (Weetman P (2011)) (ASB (1999)) (IASB (2006)) (IASB (2008)) (IASB (1989)) (Weygandt, Kieso,Kimmel(2003)) (Smith M. (1996))
In conclusion we saw that materiality can cause confusion to users of financial statements, is often misunderstood on how accountants and auditors see materiality and thus various errors are provided. In addition we saw how the ASB describes it as a threshold quality and IASB as an underlying quality of relevance. Moreover we explained what is prudence as well as neutrality and how it conflicted with neutrality. Furthermore we have specified that relevance and reliability bring tension between them so as to create a trade-off between them which is formed through aspects such as timeliness, benefits and costs. Finally what we can see is that financial information provides information for the users in order for them to calculate the amount, timing and uncertainty of future cash flows of an entity. In addition qualitative characteristics distinguish between more and less useful information in order for the users to make correct decision in the financial reports.
Weetman P (2011:79)