Concepts Statement 2 examines the qualitative characteristics that make accounting information useful, and the FASB has gone to considerable effort to lay out what usefulness means. Usefulness for making investment, credit, and similar decisions is the most important quality in its “Hierarchy of Accounting Qualities” [the hierarchy graph is represented later in this post].
Usefulness is a high-level abstraction. To serve as a meaningful criterion or standard against which to judge the results of financial accounting, usefulness needs to be made more concrete and specific by analyzing it into its components at lower levels of abstraction. The two primary components of usefulness are relevance and reliability.
While those concepts are more concrete than usefulness, they are still quite abstract. That is why Concepts Statement 2 focuses at a still more concrete level, where the concepts of predictive value and feedback value, timeliness, representational faithfulness, verifiability, neutrality, and comparability together serve as criteria for determining information’s usefulness.
For accounting standards setting, usefulness cannot be interpreted to mean whatever a particular individual interprets it to mean. A judgment that a piece of information is useful must be the result of a careful analysis that confirms first that the information possesses the qualities at the most concrete level of the hierarchy:
- Is it timely and does it have predictive or feedback value or both?
- Is it representationally faithful, verifiable, and neutral?
If it has those characteristics, it is relevant and reliable. Only then, if information has survived that kind of examination, can it be deemed useful.
Through this post, I discuss each element of the hierarchy of accounting qualities presented below. Enjoy!
[Source: Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 2, par. 32].
The exhibit shows two constraints, primarily quantitative rather than qualitative in nature.
- The pervasive constraint is that the benefits of information should exceed its cost. Information that would be useful for a decision may be just too expensive to justify providing it.
- The second constraint is a materiality threshold, meaning that “the requirement that information be reliable can still be met even though it may contain immaterial errors, for errors that are not material will not perceptibly diminish its usefulness” (Con 2, Par 33).
The hierarchy distinguishes between user-specific and decision-specific qualities because whether a piece of information is useful to a particular decision by a particular decision maker depends in part on the decision maker. Usefulness depends on a decision maker’s degree of prior knowledge of the information as well as on his or her ability to understand it.
The better informed decision makers are, the less likely it is that any new information can add materially to what they already know. That may make the new information less useful, but it does not make it less relevant to the situation.
If an item of information reaches a user and then, a little later, the user receives the same item from another source, it is not less relevant the second time, though it will have less value. For that reason, relevance has been defined in this Statement (paragraphs 46 and 47) in terms of the capacity of information to make a difference (to someone who does not already have it) rather than in terms of the difference it actually does make.
Financial information is a tool and, like most tools, cannot be of much direct help to those who are unable or unwilling to use it or who misuse it. Its use can be learned, however, and financial reporting should provide information that can be used by all—nonprofessionals as well as professionals—who are willing to learn to use it properly.
Efforts may be needed to increase the understandability of financial information. Cost-benefit considerations may indicate that information understood or used by only a few should not be provided. Conversely, financial reporting should not exclude relevant information merely because it is difficult for some to understand or because some investors or creditors choose not to use it.
The two primary decision-specific qualities that make accounting information useful for decision making are “relevance” and “reliability” which will be discussed in more detail on the next section. If either is missing completely from a piece of financial statement, the financial statement will not be useful.
In choosing between accounting alternatives, one should strive to produce information that is both as relevant and as reliable as possible, but at times it may be necessary to sacrifice some degree of one quality for a gain in the other.
“To be relevant to investors, creditors, and others for investment, credit, and similar decisions, accounting information must be capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations” (Concepts Statement 2, paragraph 47).
That definition of relevance is more explicit than the dictionary meaning of relevance as bearing on or relating to the matter in hand. As alluded to earlier, prior knowledge of information may diminish its value but not its relevance and, hence, its usefulness, for it is information’s ability to “make a difference” that makes it relevant to a decision.
Statements about relevance of financial statement information must answer the question “relevant to whom for what purpose?”
For information to be judged relevant, an object to which it is relevant must always be understood:
(a) Predictive Value And Feedback Value – To be relevant, information must have predictive value or feedback value or both. Information can make a difference to decisions by improving decision makers’ capacities to predict or by confirming or correcting their earlier expectations. Usually, information does both at once, because knowledge about the outcome of actions already taken will generally improve decision makers’ abilities to predict the results of similar future actions. Without a knowledge of the past, the basis for a prediction will usually be lacking. Without an interest in the future, knowledge of the past is sterile. To say that accounting information has predictive value is not to say that in itself it constitutes a prediction. “Predictive value means value as an input into a predictive process, not value directly as a prediction. It is the quality of information that helps users to increase the likelihood of correctly forecasting the outcome of past or present events.” (Concepts Statement 2, glossary).
(b) Timeliness – To be relevant, information also must be timely. Timeliness means “having information available to a decision maker before it loses its capacity to influence decisions” (Concepts Statement 2, glossary). Information that is not available when it is needed or becomes available only long after it has value for future action is useless.
“Reliability is the quality of information that allows those who use it to depend on it with confidence. The reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user, which comes through verification, that it has that representational quality” (Concepts Statement 2, paragraph 59).
The hierarchy of qualities decomposes reliability into two components, representational faithfulness and verifiability, with neutrality shown to interact with them:
(a) Representational Faithfulness – Representational faithfulness is “correspondence or agreement between a measure or description and the phenomenon it purports to represent. In accounting, the phenomena to be represented are economic resources and obligations and the transactions and events that change those resources and obligations” (Concepts Statement 2, paragraph 63). The FASB’s conceptual framework emphasizes that accounting is a representational discipline. It represents things in the financial statements that exist in the real world. Therefore, the correspondence between the accounting representation and the thing being represented is critical. Concepts Statement 2 uses an analogy with mapmaking to illustrate what it means by representational faithfulness:
A map represents the geographical features of the mapped area by using symbols bearing no resemblance to the actual countryside, yet they communicate a great deal of information about it. The captions and numbers in financial statements present a “picture” of a business enterprise and many of its external and internal relationships more rigorously—more informatively, in fact—than a simple description of it.
Just as the lines and shapes on a road map represent roads, rivers, and geographical boundaries, so also descriptions and amounts in financial statements represent cash, property, sales, and a host of things owned or owed by an entity as well as transactions and other events and circumstances that affect them or their values. The items in financial statements have a higher degree of reliability as quantitative representations of economic things and events in the real world—and therefore more usefulness to investors and other parties interested in an entity’s activities—if they faithfully represent what they purport to represent. Since the benefit of the information is representational and not aesthetic, to take “artistic license” with the data decreases rather than increases its benefit.
Just as a cartographer cannot add roads, bridges, and lakes where none exist, an accountant cannot add imaginary items to financial statements without spoiling the representational faithfulness, and ultimately the usefulness, of the information. Striving for representational faithfulness does not comprehend creating an exact replica of the activities of an enterprise. Perfect information is as beyond the reach of accountants as it is of non-accountants.
(b) Completeness – Completeness of information is an important aspect of representational faithfulness, and thus of reliability, because if financial statements are to faithfully represent an enterprise’s financial position and changes in financial position, none of the significant financial functions of the enterprise or its relationships can be lost or distorted. Completeness is defined as “the inclusion in reported information of everything material that is necessary for faithful representation of the relevant phenomena” (Concepts Statement 2, glossary). Financial statements are incomplete, and therefore not representationally faithful, if, for example, an enterprise owns an office structure but reports no “building” or similar asset on its balance sheet. Although completeness implies showing what is material and feasible, it must always be relative. Financial statements cannot show everything or they would be prohibitively expensive to provide.
(c) Verifiability – Verifiability is “the ability through consensus among measurers to ensure that information represents what it purports to represent or that the chosen method of measurement has been used without error or bias” (Concepts Statement 2, glossary). Verifiability is an essential component of reliability—to be reliable, accounting information must be both representationally faithful and verifiable.
In summary, verifiability means no more than that several measurers are likely to obtain the same measure. It is primarily a means of attempting to cope with measurement problems stemming from the uncertainty that surrounds accounting measures and is more successful in coping with some measurement problems than others.” … A measure with a high degree of verifiability is not necessarily relevant to the decision for which it is intended to be useful.” [Concepts Statement 2, paragraph 89]
Three ideas are the focus of the discussion in Concepts Statement 2 of verifiability and its relation to reliability:
. Accounting information is verifiable if accounting measures obtained by one measurer can be confirmed or substantiated by having other measurers measure the same phenomenon with essentially the same results. Some accounting measurements are more easily verified than others. Alternative measures of cash will be closely clustered together, with a consequently high level of verifiability. There will be less unanimity about receivables (especially their net value), still less about inventories, and least about depreciable assets. … [Concepts Statement 2, paragraphs 84 and 85]
. The purpose of verification is to confirm the representational faithfulness of accounting information—to provide a significant degree of assurance to a user that accounting measures essentially agree with or correspond to the economic things and events that they represent (Concepts Statement 2, paragraphs 59, 81, and 86). Accounting information may not be representationally faithful because measurer bias or measurement bias (or both) gives a measure the tendency to be consistently too high or too low instead of being equally likely to fall above and below what it represents. Representational faithfulness is adversely affected if information is intentionally biased to attain a predetermined result or induce a particular mode of behavior, a possibility that is discussed in the next section on neutrality.
. The extent to which verifiability adds reliability to accounting information depends on whether an accounting measure itself has been verified or only … the procedures used to obtain the measure have been verified. For example, the price paid to acquire a block of marketable securities or a piece of land is normally directly verifiable, while the amount of depreciation for a period is normally only indirectly verifiable by verifying the depreciation method, calculations used, and consistency of application. … [Concepts Statement 2, paragraph 87]
In present practice, for example, the result of measuring the quantity of an inventory is directly verifiable, while the result of measuring the carrying amount or book value of the inventory is only indirectly verifiable—the auditing process checks on the accuracy or verity of the inputs and recalculates the outputs but does not verify them.
For quantities there is a well-defined formal system (perpetual inventory system) which specifies the relevant empirical inputs (receipts and issues) and the output provides an expectation or prediction of the quantity on hand. The physical count is a separate [or direct] verification of that output.
“For book values there is disagreement about the formal system (LIFO or FIFO the relevant inputs (which costs are to be attached [to inventory] and which are to be expensed). The output [book value of the inventory on hand] … is not separately verifiable” [Robert R. Sterling, “On Theory Construction and Verification,” The Accounting Review, July 1970,p. 450, footnote 16].
Measures of the quantity of the inventory resulting from the perpetual inventory system and the physical count verify each other if they essentially agree. Independent measures of a phenomenon need not use the same measurement process. In the absence of a perpetual inventory system, however, verifying the quantity of the inventory requires at least two independent physical counts or a third way to measure the quantity of the inventory.
It makes a difference to the reliability of accounting information whether an accounting measure itself is verified or only the procedures used to obtain the measure are verified because even if disagreements about choice of method and relevant inputs are ignored or resolved, merely rechecking the mechanics does not verify the representational faithfulness of the measure, leaving its reliability in doubt.
Since the point is likely to be misunderstood, it should explicitly be noted that the inability to verify the representational faithfulness of an accounting measure does not necessarily mean that the measure does not represent what it purports to represent. It generally means only that no one can know the extent to which the measure has or does not have that representational quality. Since the extent to which it represents faithfully the economic phenomenon it purports to represent is unknown, however, the measure cannot accurately be described as reliable.
Considerable confusion about reliability of accounting information results from the propensity of accountants and others to use reliable, objective, and verifiable interchangeably even though the three terms are not synonyms if used precisely. Reliable is a broader term than verifiable, comprising not only verifiability but also representational faithfulness. Objective is a narrower term than verifiable. It means being independent of the observer, implying that objective accounting information is free of measurer bias—not affected by the hopes, fears, and other thoughts and feelings of the measurer—but saying little or nothing about measurement bias.
Neutrality is concerned with bias and thus is a factor in reliability of accounting information. It is the “absence in reported information of bias intended to attain a predetermined result or to induce a particular mode of behavior” (Concepts Statement 2, glossary).
Accounting information is neutral if it “report[s] economic activity as faithfully as possible, without coloring the image it communicates for the purpose of influencing behavior in some particular direction” (paragraph 100).
A common perception and misconception is that displaying neutrality means treating everyone alike in all respects. It would not necessarily show a lack of neutrality to require less disclosure of a small company than of a large one if it were shown that an equal disclosure requirement placed an undue economic burden on the small company. Solomons says that neutrality “does not imply that no one gets hurt”.
Neutrality requires that information should be free from bias toward a predetermined result, but that is not to say that standards setters or those who provide information according to promulgated standards should not have a purpose in mind for financial reporting. Accounting should not be without influence on human behavior, but it should not slant information to influence behavior in a particular way to achieve a desired end.
To protect the public interest in useful accounting information, what is needed is not “good business sense,” nor even “good public policy,” but rather “neutrality” (i.e., “absence in reported information of bias intended to attain a predetermined result or to induce a particular mode of behavior”). The chairman of the SEC made the point about the importance of neutrality in his statement on oil and gas accounting:
“If it becomes accepted or expected that accounting principles are determined or modified in order to secure purposes other than economic measurement—even such virtuous purposes as energy production—we assume a grave risk that confidence in the credibility of our financial information system will be undermined.”
Comparing alternative investment or lending opportunities is an essential part of most, if not all, investment or lending decisions. Investors and creditors need financial reporting information that is comparable, both for single enterprises over time and between enterprises at the same time.
Comparability is a quality of the relationship between two or more pieces of information—“the quality of information that enables users to identify similarities in and differences between two sets of economic phenomena” (Concepts Statement 2, glossary). Comparability is achieved if similar transactions and other events and circumstances are accounted for similarly and different transactions and other events and circumstances are accounted for differently.
Comparability has been the subject of much disagreement among accountants. Some have argued that enterprises and their circumstances are so different from one another that comparability between enterprises is an illusory goal, and to include it as an aim of financial reporting is to promise to investors and creditors something that ultimately cannot be delivered. In that view, the best that can be hoped for is that individual enterprises will use their chosen accounting procedures consistently over time to permit comparisons with other enterprises and that honorable auditors will be able to attest to the consistent application of “generally accepted accounting principles”
The problem with that view of comparability is that it allows an excessive degree of latitude in reporting practice. It was the dominant view during the 1930s and 1940s and did permit, or even encouraged, the proliferation of alternative accounting procedures that characterized the period, many in situations in which few significant differences in enterprises or circumstances were ever reasonably substantiated. The result was an intolerable lack of comparability, which was responsible for much of the criticism directed toward financial accounting and eventually led to the replacement of the Committee on Accounting Procedure by the APB.
Today, with the objectives of financial reporting focused on decision making, comparability is one of the most essential and desirable qualities of accounting information. Investors and creditors can no longer be expected to tolerate blanket claims of differences in circumstances to justify undue use of alternative accounting procedures. Only actual differences in transactions and other events and circumstances warrant different accounting.
A word needs to be said about conservatism, an important doctrine in most accountant’s minds, but not a separate qualitative characteristic in the FASB’s hierarchy of qualities that make accounting information useful. The FASB has described conservatism as “a prudent reaction to uncertainty to try to ensure that uncertainties and risks inherent in business situations are adequately considered” (Concepts Statement 2, paragraph 95).
That is quite different from the traditional meaning of conservatism in financial reporting, which usually connoted deliberate, consistent understatement of net assets and profits, summed up by the admonition to “anticipate no profits but anticipate all losses.”
That view developed during a time when balance sheets were considered the primary (and often only) financial statement, and bankers or other lenders were their principal external users. Since understating assets was thought to provide a greater margin of safety as security for loans and other debts, deliberate understatement was considered a virtue.
The traditional application of conservatism introduced into reporting a preference “that possible errors in measurement be in the direction of understatement rather than overstatement of net income and net assets” (APB Statement 4, paragraph 171).
In practice that often meant depressing reported net income by excessive depreciation or undervaluation of inventory or deferring recognition of income until long after sufficient evidence of its existence became available.
That kind of conservatism has now become discredited because of it conflicts with the information’s comparability, with its representational faithfulness and neutrality, and thus with its reliability. Any kind of bias, whether overly conservative or overly optimistic, influences the timing of recognition of net income or losses and may mislead investors as they attempt to evaluate alternative investment opportunities. Information that adds to uncertainty is inimical to informed and rational decision making and betrays the fulfillment of the objectives of financial reporting.
The appropriate way to treat uncertainty is to disclose its nature and extent honestly, so that those who receive the information may form their own opinions of the probable outcome of the events reported. That is the only kind of conservatism that can, in the long run, serve all of the divergent interests that are represented in a business enterprise.
It is not the accountant’s job to protect investors, creditors, and others from uncertainty, but only to inform them about it. Any attempt to understate earnings or financial position consistently is likely to engender skepticism about the reliability and the integrity of what is reported. Moreover, it will probably be ultimately self-defeating.
The final item on the hierarchy, characterized as a constraint or threshold for recognition, is materiality, which is a quantitative, not a qualitative, characteristic of information. Materiality judgments pose the question: “Is this item large enough for users of the information to be influenced by it?” (Concepts Statement 2, paragraph 123).
“the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement” [Concepts Statement 2, glossary]
Popular usage of “material” often makes it a synonym for “relevant,” but the two are not synonymous in Concepts Statement 2. Information may be relevant in the sense that it is capable of making a difference and yet the amounts involved are immaterial—too small to matter in a decision. To illustrate the difference between materiality and relevance, Concepts Statement 2 (paragraph 126) provides an example of an applicant for employment who is negotiating with an employment agency.
- On one hand, information about the nature of the duties, salary, hours, and benefits is relevant, as well as material, to most prospective employees.
- On the other hand, whether the office floor is carpeted and whether the cafeteria food is of good quality are relevant, but probably not material, to a decision to accept the job.
The values placed on them by the applicant are too small to influence the decision.
However, materiality judgments go beyond magnitude itself to the nature of the item and the circumstances in which the judgment has to be made. Items too small to be thought material if they result from routine transactions may be considered material if they arise in abnormal circumstances. Therefore, one must always think in terms of a threshold over which an item must pass, considering its nature and the attendant circumstances as well as its relative amount, that separates material from immaterial items.
Where the threshold for recognition occurs with regard to a materiality decision is a matter of judgment. Many accountants would like to have more quantitative guidelines or criteria for materiality laid down by the SEC, the FASB, or other regulatory agency.
The FASB’s view has been that materiality judgments can best be made by those who possess all the facts. In recognition of the fact that materiality guidance is sometimes needed, the appendices to Concepts Statement 2 include a list of quantitative guidelines that have been applied both in the law and in the practice of accounting.
However, if and when those guidelines specify some minimum size stipulated for recognition of a material item, they do not preclude recognition of a smaller segment. There is still room for individual judgment in at least one direction.
F. Costs and Benefits
Information is subject to the same pervasive cost-benefit constraint that affects the usefulness of other commodities; Unless the benefits to be derived from information equal or exceed the cost of acquiring it, it will not be pursued.
Financial information is unlike other commodities, however, in being a partly private and partly public good since “the benefits of information cannot always be confined to those who pay for it” (Concepts Statement 2, paragraph 135), and the balancing of costs and benefits cannot be left to the market.
Cost-benefit decisions about accounting standards generally have to be made by the standards-setting body—now the FASB. Both costs and benefits of accounting standards cut across the whole spectrum of the Board’s constituency, with the benefits only partly accruing to those who bear the costs and the balance between costs and benefits reacting very imperfectly to supply and demand considerations. Moreover, individuals, be they providers, users, or auditors of accounting information, are not in a position to make cost-benefit assessments due to lack of sufficient information as well as probable biases on the matter.
Cost-benefit decisions are extremely difficult because both costs and benefits often are subjective and difficult or impossible to measure reliably. Cost-benefit analysis is at best a fallible tool. Although the Board is committed to doing the best it can in making cost-benefit assessments and Board members indeed have taken the matter seriously in facing the question in several standards in which it has arisen, cost-benefit measures and comparisons are too unreliable to be the deciding factor in crucial standards-setting decisions.