The Conceptual Framework provides the foundation for Standards and Accounting Guidelines that:
- contribute to transparency by enhancing the comparability and quality of financial information, enabling investors and other market participants to make informed economic decisions.
- strengthen accountability by reducing the information gap between the providers of capital and the people to whom they have entrusted their money. Standards and Accounting Guidelines based on the Conceptual Framework provide information needed to hold management to account. As a source of comparable information, those Standards and Accounting Guidelines are also of vital importance to regulators.
- contribute to economic efficiency by helping investors to identify opportunities and risks, thus improving capital allocation. For businesses, the use of a single, trusted accounting language derived from Standards and Accounting Guidelines based on the Conceptual Framework lowers the cost of capital and reduces reporting costs.
The following is intended to further explore what good information and its qualities are.
I have written two pieces about this from an IFRS point of view, I refer to What is useful information? and More details to present Useful Financial Information.
The core requirements to provide good information
Information that serves public policy objectives has to be useful, and if requirements for information are to change, it should be because the new information will be more cost-effective than the old.
Ideally information should always be fit for purpose and cost-effective. In deciding whether information meets these tests, regard should be had to nine key attributes of good information. The list is based partly on similar lists that appear in studies whose scope goes well beyond financial reporting, such as works on information systems and on research methods, and partly on briefer lists of desirable characteristics of financial reporting information developed in the conceptual frameworks of the leading financial reporting standard-setters.
It is suggested that information should be:
- Relevant Assessing information quality for measurement
- Accurate Assessing information quality for measurement
- Fairly presented, and should
- Avoid perverse effects.
Some are the same as used in the Conceptual Framework but a few are quite different but still in my believe rather important for preparers of Financial Statements whether under IFRS or any local GAAP.
These attributes are considered in turn below, with particular reference to how far they are relevant to financial reporting measurement information.
Relevant Assessing information quality for measurement
The principle that financial reporting measurements should provide relevant information seems to be indisputable. Two points are worth noting:
Relevance is subjective. What is relevant to one user of information is not necessarily relevant to another. Even groups of users that are often referred to as though they have identical interests, such as shareholders, are likely in practice to have diverse preferences as to what they regard as relevant.
Relevance frequently conflicts in practice with the achievement of other objectives, such as accuracy and reliability. For example, current values may be more relevant than historical costs, but may be less reliable. Forecasts of future cash flows may be even more relevant and even less reliable. Behavioral factors also tend to make information less reliable the more relevant it is (see ‘Avoid perverse effects‘).
Accurate Assessing information quality for measurement
The principle that financial reporting measurements should be accurate also seems to be indisputable, though because such measurements are often subjective or matters of convention, accountants are sometimes reluctant to use words like accuracy in case they give a misleading impression of certainty or objective reality. Some commentators regard accuracy as merely an aspect of reliability rather than a desirable characteristic in its own right; this point is discussed next.
While everybody agrees that financial reporting measurements should provide reliable information, there is no consensus as to what exactly reliability means. For example, views differ as to whether verifiability is an essential component of reliability. In measurement generally (as opposed to financial reporting specifically), repeatability is usually regarded as a key aspect of reliability. A measurement of a physical attribute is reliable if different people making the same measurement would all arrive at the same answer.
Financial reporting measurements do not concern physical attributes, but the principle of repeatability could still be applied to them, though with greater difficulty. 100 people estimating the recoverable amount of a portfolio of debts, for example, might reasonably come up with 100 different answers. While this may seem an unpromising result, it should at least establish the range and popularity of possible measurements of the recoverable amount.
Reliability implies not only that information is accurate, but that there is some reason why users should rely on it. This might be because the information has been verified by a third party or because it comes from a reliable source or for some other reason. Reliable and useful information should therefore be both accurate and have some additional characteristic that allows the user to place reliance on it. Perhaps trustworthiness would be an appropriate term for this characteristic. On this analysis, accuracy and reliability are distinct qualities.
A further important point about reliability is that, like relevance, it is subjective. Information that one person will accept as reliable will be rejected by another. It also depends heavily on context. Sources that would be accepted as reliable in one context would be rejected in another.
One interpretation of the reliability test is that financial reporting information should reflect only independently verifiable data. However, it can be argued that no basis of measurement meets the reliability test expressed in quite this way.
It is possible, indeed, that the importance of reliability in financial reporting is sometimes overstated and that, although in principle all measurements have to pass a reliability test before they are allowed in accounts, this principle is sometimes honored more in the breach than in the observance.
Ernst & Young, for example, cites real cases of charges for share-based payments where the possible range of reasonable calculations for the charge is extraordinarily wide (in one case, extending from £47m to £479m). But charges for share-based payments nonetheless appear in accounts. How can measurements relating to pension liabilities decades into the future be regarded as reliable in any ordinary sense of the word? But would it be sensible for accounts to ignore such liabilities on the grounds that they cannot be reliably measured? Some considerations on the other side of the argument appear at ‘Avoid perverse effects’ below.
Here measurements are treated as reliable if they are objective. The more objective a measurement is, the more likely it is that other persons making the same measurement on the same measurement basis would arrive at the same answer and the more likely it is to be verifiable.
Verifiability is a stronger test than auditability. Even subjective measurements can be audited. But where financial reporting information is to be audited, the more verifiable it is, the greater the potential reliance that can be placed on the assurance process.
Comparable Assessing information quality for measurement
Comparability in financial reporting measurements has at least four aspects.
- Consistency in the treatment of different items and different transactions.
- Comparability of information across different reporting entities.
- Consistency across reporting entities in the measurement of similar items and similar transactions.
- Comparability over time.
The third item on the list may appear to be implied by the second. But at present, while different entities’ reported numbers may well be comparable in the sense that they use the same measurement basis, they may nonetheless measure similar items at different amounts – because the items have different historical costs, for example.
Comparability is not an overriding objective. There is often a trade-off between comparability and other desirable qualities of financial reporting information. For example, it is often sensible for accounting requirements to change, which reduces comparability over time. And information that is cost-effective for one company may not be for another.
Concise Assessing information quality for measurement
Other things being equal, where information is concerned, the shorter the better.
The relevance of this to financial reporting is that some measurement information may need to be accompanied by significant explanatory material if it is to be properly understood. Financial reporting information has diverse purposes and diverse users, and the importance that different users attach to conciseness will vary depending on their capacity and willingness to spend time assimilating disclosures and explanations.
Timely Assessing information quality for measurement
There is no point in preparing information that arrives too late to be useful. Some types of measurement information may be quicker to prepare than others, or take less time to check. There may also be trade-offs with accuracy to the extent that information can be improved with the benefit of hindsight, and with reliability if independent checks would delay the information.
The principle that information should be understandable if it is to be useful is indisputable, but there is often disagreement as to who needs to understand it. One argument sometimes put forward in relation to financial reporting information is that it only needs to be understood by financial reporting experts. The contrary view, which is adopted here, is that users of financial reporting information should understand what it means and how to use it; this does not mean that they necessarily understand the details of how it is compiled.
This is consistent with the diverse purposes and users of financial reporting, which is not used exclusively by financial reporting experts.
Users of financial reporting rely on information from a variety of sources, and if financial reporting becomes too difficult to understand (or less useful for any other reason), the result is likely to be that users will place relatively greater reliance on other sources. Some people believe that increased interest in narrative reporting is partly attributable to such causes.
Fairly presented Assessing information quality for measurement
It is possible to provide accurate financial reporting information, but to give a misleading impression. Fair presentation may be a question of putting information in context, or of telling not just the truth but the whole truth, or of avoiding misleading arrangements or emphases in the way the information is presented. This is an issue that can be especially important where information is inherently uncertain – for example, because it is based on forecasts of business performance.
Decisions on what constitutes fair presentation in any particular case are often subjective, so achieving this goal may conflict with meeting other criteria such as reliability and comparability.
Avoid perverse effects Assessing information quality for measurement
In assessing the probable and actual effects of measurement information:
- it is its impact on behavior that counts; and Assessing information quality for measurement
- how people use information and respond to it are therefore critical issues. Assessing information quality for measurement
It cannot be assumed that those who use financial reporting information are perfectly rational in how they respond to it. Certain biases in the way that people typically process information are well-attested; some of these are intellectual short-cuts that people use to make it easier to handle information, others are emotional biases. These biases may well affect how people deal with financial reporting information.
For example, there is some evidence that investors tend to disregard the effects of changes in the value of money. As much financial reporting information includes data that covers long periods of time, this could have a distorting effect on how people interpret it.
How, if at all, financial reporting should respond to such biases is far from clear. The point being made here is simply that they are relevant to how information is used, and are therefore at least potentially relevant to deciding measurement questions in financial reporting.
Much information is relevant because it measures performance on which organisations and individuals are judged. But if people are judged on the basis of a particular measure, this can have perverse effects: ‘when a measure becomes a target, it ceases to be a good measure.’ There are three key problems here:
- Desirable activities whose results are not reflected in the measurement will tend to be neglected. For example, some argue that concentration on annual profit measurement leads to the long-term and non-financial effects of actions being disregarded by managers. Assessing information quality for measurement
- There will be a tendency to redefine what is or is not included in the measurement, so as to achieve a favorable result.
- Those whose performance is being judged in the light of the measurement have a motive to bias it.
All of these are behavioral issues with which financial reporting (and business reporting in general) constantly has to grapple. Other things being equal, information that does not have perverse effects is obviously preferable to information that does.
The implications of such behavioral issues for financial reporting are profound, as they suggest a need for it to be constantly evolving to keep ahead of the behavioral techniques that will inevitably develop to ensure that reported measures are as favorable as possible, regardless of whether they reflect underlying reality. This gives the development of measurement practices dynamic and iterative qualities, illustrated below:
There are also behavioral issues affecting the links between management reporting and financial reporting, and whether particular measurement practices lend themselves to fraud.
- As the standard-setting process has developed a life of its own, prescribed measurement practices have moved further and further away from the practices that businesses adopt to meet the information needs of their owners and managers. While this may be regarded as a progressive development, it also carries a risk that standardised measurement practices will become divorced from what owners and managers regard as useful. There also has to be a question as to how far it is sensible for those working within a business to judge their performance on one basis while reporting to the outside world on another. Assessing information quality for measurement
- The issue of fraud has been raised frequently the argument being raised that ‘If accounting standard-setters force accountants to include unverifiable value changes in income, … frauds will increase. This is a question of the behavioral impact of information requirements.