Characteristics of useful financial information
We have previously stated that financial statements should provide useful financial information to the users of financial statements when they are making decisions. The Conceptual Framework for Financial Reporting states that in order to be useful, the financial information must have certain fundamental characteristics and that its level of usefulness is dependent on certain enhancing characteristics.
Fundamental characteristics of useful financial information
There are two fundamental characteristics that must exist for financial information to be useful; Relevance and Faithful Representation.
Relevant information is capable of making a difference in the decisions made by users. To be relevant, information must either have a predictive value (so it helps the user make forecasts or predictions about what will happen) or it has a confirmatory value (so it helps the user determine whether their past forecasts or predictions were accurate or not).
Last year, an investor analyzed several years of a company’s sales and profits as reported in the company’s financial statements. As a result of this analysis, the investor identified a pattern of growth in the company’s profits which he believed would continue into the future. The investor then decided to buy shares in the company.
The financial statements contained useful information for this investor as it made a difference to his decision as to whether or not to buy shares in the company. The investor believed that the information had a predictive value as he expected profits to continue to grow.
When the next year’s financial statements are prepared they should also be relevant to the investor, even if the investor does not use them to help decide whether to sell his shares or buy more shares, as they can be used to determine whether his previous analysis was correct – that is, whether or not the company’s profits grew as expected.
Faithful representation means that the information is:
- Free from error – so it is accurate
- Complete – so it does not omit any information that would affect a user’s decision
- Neutral – so it is unbiased in its presentation
- Neutrality is supported by taking a prudent approach when preparing the financial statements (i.e. where there is uncertainty the company has sought to ensure that assets and income are not over-valued, and liabilities and expenses are not under-valued)
Faithful representation is about whether the financial statements are trustworthy and can be relied upon.
A business has been approached by a potential customer, Jarvis (Yorkshire) Ltd, whose directors have asked for a credit line. The business therefore asked Jarvis (Yorkshire) Ltd for a copy of their latest financial statements to help them decide whether credit should be offered. The financial statements received are however, for a company called Jarvis (Lancashire) Ltd. These financial statements have been audited.
When the business queries this with the customer they are told that Jarvis (Yorkshire) Ltd is a new company and therefore cannot as yet provide any financial statements. Jarvis (Yorkshire) Ltd company is however owned and managed by the same people who own and mange Jarvis (Lancashire) Ltd and offers the same products and services albeit in a different part of the country. Its directors therefore believe its performance will be similar to Jarvis (Lancashire) Ltd.
a) Is the information received relevant to the decision being taken?
b) Is the information received likely to be faithfully represented?
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Financial statements usually include some estimates and may include some errors. For example, a company with property, plant and equipment will make estimates as to the length of their useful lives and the assets’ likely values at the end of their lives. The fact that estimates have been made will not prevent the contents of the financial statements from being useful but where there is great uncertainty the usefulness of the financial statements will fall.
A company has included an estimated liability of £2m in its financial statements (which represents a considerable amount of money for this company). The liability relates to a Court case where the company has admitted wrong-doing but is waiting for the Court to decide the level of damages that the company must pay. The company’s solicitors estimate that damages could be anywhere between £1m and £8m.
The amount of uncertainty over the financial statements is therefore high and this will reduce their usefulness as the estimated liability included in them might be very different from the amount that will have to be paid.
When preparing its financial statements, a company estimated that £36,000 of its customer debts would not be received and therefore recorded a doubtful debts adjustment its financial statements accordingly. Later, the company’s accountant reviewed this estimate and found that only £29,000 of the debts were not collected (a difference of £7,000).
The company has net assets of £10m, generates sales revenue of £17m per year and made a profit for the year of £2m.
Will the company’s estimate of its doubtful debt reduce the usefulness of the financial statements?
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Enhancing characteristics of useful financial information
Enhancing characteristics do not by themselves make financial information useful but they do make it more useful.
There are four enhancing characteristics; comparability, verifiability, timeliness and understandability.
The ability to compare a set of financial statements with other companies or previous periods helps put the financial information into some sort of context – remember that user’s decisions involve choosing between alternatives.
Company accounts are prepared using financial reporting standards that are commonly used. This means that it is much easier to compare the risks and performance of different companies. In addition, financial statements include figures for both the current and previous financial periods which again helps users to identify changes in the company’s risks and performance.
Information is more useful when it can be checked to be correct or reasonable. If information is verifiable it means that two independent and knowledgeable observers would come to the same conclusions from the data.
Let’s say that a company’s directors have decided to value its property and asks two firms of Chartered Surveyors to undertake the valuation. The two valuations received can then be compared and if the valuations are the same we can say that the verifiability of the valuations is high.
Generally, the older the information that is available, the less useful it is. For example, a supplier deciding whether or not to grant a credit line to a company would want to view recent financial statements as this will be more relevant to the decision being taken.
Information is more useful when it is understandable. This is not always easy to achieve when preparing financial statements as some types of transactions are inherently complex and cannot be simplified without losing detail that may be important.
The issue of understandability is made a little easier for accountants as when we prepare financial statements we can assume that the users have a reasonable knowledge of business and economics and that they will act diligently when reviewing and analyzing the financial statements.