Conceptual Framework

and
Accounting Standards
Prepared by:
Ms. Alcantara, Charin R.

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 Chapter 3
Conceptual Framework
QUALITATIVE CHARACTERISTICS

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 ❖ QUALITATIVE CHARACTERISTICS

✓ Qualitative characteristics are the qualities or attributes that make

financial accounting information useful to the users.

✓ In deciding which information to include in financial statements, the

objective is to ensure that the information is useful to the users in
making economic decisions.

✓ Under the Conceptual Framework for Financial Reporting, qualitative

characteristics are classified into fundamental qualitative
characteristics and enhancing qualitative characteristics.

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 ❖ Fundamental qualitative characteristics

✓ The fundamental qualitative characteristics relate to the content or substance of

financial information.

✓ The fundamental qualitative characteristics are relevance and faithful representation.

✓ Information must be both relevant and faithfully represented if it is to be useful.

✓ Neither a faithful representation of an irrelevant phenomenon nor an unfaithful

representation of a relevant phenomenon helps users make good decisions.

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 ❖ Application of qualitative characteristics

The most efficient and effective process of applying the fundamental qualitative
characteristics would usually be:

✓ First, identify an economic phenomenon that has the potential to be useful.

✓ Second, identify the type of information about the phenomenon that would be most
relevant and can be faithfully represented.

✓ Third, determine whether the information is available.

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 ❖ Relevance

✓ In the simplest terms, relevance is the capacity of the information to influence a decision.
✓ To be relevant, the financial information must be capable of making a difference in the
decisions made by users.
✓ In other words, relevance requires that the financial information should be related or
pertinent to the economic decision.
✓ Information that does not bear on an economic decision is useless.
✓ To be useful, information must be relevant to the decision making needs of users.
✓ For example, broadly, the statement of financial position is relevant in determining
financial position, and the income statement is relevant in determining performance.
✓ More specifically, the earnings per share information is more relevant than book value per
share in determining the attractiveness of an investment.

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❖Ingredients of relevance

✓ Financial information is capable of making a difference in a decision if it has predictive

value and confirmatory value.
✓ Financial information has predictive value if it can be used as an input to processes
employed by users to predict future outcome.
✓ In other words, financial information has predictive value when it can help users increase
the likelihood of correctly or accurately predicting or forecasting outcome of events.
✓ The net cash provided by operating activities is valuable in predicting loan payment or
default.
✓ Financial information has confirmatory value if it provides feedback about previous
evaluation.
✓ Often, information has both predictive and confirmatory value. The predictive and
confirmatory roles of information are interrelated.

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 ❖Materiality

✓ Materiality is a practical rule in accounting which dictates that strict adherence to

GAAP is not required when the items are not significant enough to affect the
evaluation, decision and fairness of the financial statements.
✓ The materiality concept is also known as the doctrine of Convenience.
✓ Materiality is really a quantitative "threshold" linked very closely to the qualitative
characteristic of relevance.
✓ The relevance of information is affected by its nature and materiality.
✓ In other words, materiality is a subquality of relevance based on the nature or
magnitude or both of the items to which the information relates.
✓ The Conceptual Framework does not specify a uniform quantitative threshold for
materiality or predetermine what could be material in a particular situation.

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 ❖ Materiality is a relativity

Materiality of an item depends on relative size rather than absolute size.

What is material for one entity may be immaterial for another.

An error of P500.000 in the financial statements of a multinational entity may not be

important but may be critical for a small entity.

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When is an item material?

✓ There is no strict or uniform rule for determining whether an item is material or not.
✓ Very often, this is dependent on good judgment, profession el expertise and common sense.
✓ However, a general guide may be given, to wit:
An item is material if knowledge of it could reasonably affect or influence the economic
decision of the primary users of the financial statements.

✓ For example, small expenditures for tools are often expensed immediately rather than
depreciated over their useful lives to save on clerical costs of recording depreciation
because the effect on the financial statements is not large enough to affect economic
decision.
✓ Another example of the application of materiality is the common practice of large entities of
rounding amounts to the nearest thousand pesos in their financial statements.
✓ Small entities may round off to the nearest peso.

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 ❖ New definition of materiality

The IASB provided the following new definition of materiality.

Information is material if omitting, misstating or obscuring it could reasonably be expected to influence

the economic decisions that primary users of general purpose financial statements make on the basis of
those statements which provide financial information about a specific reporting entity.

In other words, an information is material if the omission, misstatement and obscuring of the information
could reasonably affect the economic decision of primary users.

The revised definition of materiality highlights three important aspects:

a. Could reasonably be expected to influence

b. Obscuring information
C. Primary users

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❖ Could reasonably be expected to influence

The could reasonably be expected to influence threshold adds an element of reasonability of financial
information on which economic decision is based.

By including the term could reasonably be expected to influence in the new definition, material
information shall be limited to the economic decision of primary users rather than to all users which is
too broad in scope.

Moreover, the could reasonably be expected to influence threshold insures that information capable of
influencing economic decision of the primary users shall be included in the financial statements.

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❖ Obscuring information

Obscuring information is a new concept added to the new definition of materiality.

Information is obscured if presenting or communicating it would have a similar effect as omitting or

misstating the information.

Obscuring information means the presentation of financial information not readily understood or not clearly
expressed.

Obscuring information may be characterized by deliberate vagueness, ambiguity and abstruseness.

Examples of obscured material information are:

a. The language is vague or unclear.
b. The information is scattered throughout the financial statements.
c. Dissimilar items are aggregated inappropriately.
d. Similar items are disaggregated inappropriately.

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❖Primary users

✓ The new definition of materiality narrows the definition to primary users who are
primarily affected by general purpose financial statements.
✓ The primary users include the existing and potential investors, lenders and other
creditors.
✓ The other users include the employees, customers, government agencies and the
public in general.
✓ The new definition specified that only primary users of financial statements are
considered because these groups are the users to whom general purpose financial
statements are primarily directed.
✓ Such primary users cannot require reporting entities to provide information directly
to them and therefore must rely on general purpose financial reports for how much
financial information is needed.

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❖Factors of materiality

✓ Materiality depends on the magnitude and nature of the financial information.

✓ In the exercise of judgment in determining materiality, the relative size and nature of an
item are considered.
✓ The size of the item in relation to the total of the group to which the item belongs is taken
into account.
✓ For example, the amount of advertising in relation to total selling expenses, the amount of
office salaries to total administrative expenses, the amount of prepaid expenses to total
current assets and the amount of leasehold improvements to total property, plant and
equipment.
✓ The nature of the item may be inherently material because by its very nature it affects
economic decision.
✓ For example, the discovery of a P20,000 bribe is a material event even for a very large
entity.

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❖ Faithful representation

✓ Faithful representation means that financial reports represent economic phenomena or

transactions in words and numbers.
✓ Stated differently, the descriptions and figures must match what really existed or happened.
✓ Simply worded, faithful representation means that the actual effects of the transactions shall be
properly accounted for and reported in the financial statements.
✓ For example, if the entity reports purchases of P5,000,000 when the actual amount is P8,000,000
the information would not be faithfully represented.
✓ To record a sale of merchandise as miscellaneous income would not also be a faithful
representation of the sale transaction.

❖ Ingredients of faithful representation

To be a perfectly faithful representation, a depiction should have three characteristics, namely:
a. Completeness
b. Neutrality
c. Free from error

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 ❖Completeness

Completeness requires that relevant information should be presented in a way that

facilitates understanding and avoids erroneous implication.

Completeness is the result of the adequate disclosure standard or the principle of full
disclosure.

A complete depiction includes all information necessary for a user to understand the
phenomenon being depicted, including all necessary descriptions and explanations.

For example, a complete depiction of a group of assets would include description of the
assets, numerical depiction and description of the numerical depiction, such as cost, current
cost or fair value.

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 ❖ Standard of adequate disclosure

The standard of adequate disclosure means that all significant and relevant information leading to the
preparation of financial statements shall be clearly reported.

Adequate disclosure however does not mean disclosure of just any data.

The accountant shall disclose a material fact known to him which is not disclosed in the financial
statements but disclosure of which is necessary in order that the financial statements would not be
misleading.

The standard of adequate disclosure is best described by disclosure of any financial facts significant
enough to influence the judgment of informed users.

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 ❖ Notes to financial statements

Actually, to be complete, the financial statements shall be accompanied by "notes to

financial statements".

The purpose of the notes is to provide the necessary disclosures required by Philippine
Financial Reporting Standards.

Notes to financial statements provide narrative description or disaggregation of the items

presented in the financial statements and information about items that do not qualify for
recognition.

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 ❖ Neutrality

✓ A neutral depiction is without bias in the preparation or presentation of financial

information.
✓ A neutral depiction is not slanted, weighted, emphasized, de-emphasized or otherwise
manipulated to increase the probability that financial information will be received favorably
or unfavorably by users.
✓ In other words, to be neutral, the information contained in the financial statements must
be free from bias.
✓ The financial information should not favor one party to the detriment of another party.
✓ The information is directed to the common needs of many users and not to the particular
needs of specific users.
✓ Neutrality is synonymous with the all-encompassing principle of fairness.
✓ To be neutral is to be fair.

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 Prudence

✓ The Revised Conceptual Framework has reintroduced concept of prudence.

✓ Prudence is the exercise of care and caution when dealing with the uncertainties in the measurement
process such that assets or income are not overstated and liabilities or expenses are not
understated.
✓ Neutrality is supported by the exercise of prudence.

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 ❖Conservatism

✓ Conservatism is synonymous with prudence.

✓ Conservatism means that when alternatives exist, the alternative which has the least effect on
equity should be chosen.
✓ In, the simplest words, conservatism means "in case of d doubt, record any loss and do not
record any gain,"
✓ For example, if there is a choice between two acceptable asset values, the lower figure is
selected.
✓ Accordingly, inventories are measured at the lower of cost and net realizable value.
✓ Contingent loss is recognized as a "provision" if the loss is probable and the amount can be
reliably measured.
✓ Contingent gain is not recognized but disclosed only.
✓ It is to be emphasized that conservatism is not a license to deliberately understate net income
and net assets.
✓ For example, if an entity has a cash of P500,000 and reports only P100,000, this is not
conservatism but fraud or inaccurate reporting.

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 Expressions of conservatism

"Anticipate no profit and provide for probable and measurable."

"In the matter of income recognition, the accountant takes the position that no matter how sure
the businessman might be in capturing the bird in the bush, he, the accountant, must see it in
the hand.”

“Don't count your chicks until the eggs hatch"

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Free from error

Free from error means there are no errors or omissions in the description of the phenomenon or
transaction.

Moreover, the process used to produce the reported information has been selected and applied
with no errors in the process.

In this context, free from error does not mean perfectly accurate in all respects.

For example, an estimate of an unobservable price or value cannot be determined to be accurate

or inaccurate.

However, a representation of that estimate can be faithful if the amount is described clearly and
accurately as an estimate.

Moreover, the nature and limitations of the estimating process are explained, and no errors have
been made in selecting and applying an appropriate process for developing
the estimate.
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 Measurement uncertainty

Measurement uncertainty arises when monetary amounts in financial reports cannot be observed
directly and must instead be estimated.

Measurement uncertainty can affect faithful representation if the level of uncertainty in providing an
estimate is high.

However, the use of reasonable estimate is an essential part of providing financial information and
does not undermine the usefulness of the financial information.

As long as the estimate is clearly and accurately described and explained, even a high level of
measurement uncertainty does not affect the usefulness of the financial information.

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Substance over form

If information is to represent faithfully the transactions and other events it purports to represent, it is
necessary that the transactions and events are accounted in accordance with their substance and
reality and not merely their legal form.

The economic substance of transactions and events are usually emphasized when economic
substance differs legal form.

Substance over form is not considered a separate component of faithful representation because it
would be redundant.

Faithful representation inherently represents the substance of an economic phenomenon or

transaction rather than merely representing the legal form.

Representing a legal form that differs from the economic substance of the underlying economic
phenomenon or transaction could not result in a faithful representation.

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 Enhancing qualitative characteristics

The enhancing qualitative characteristics relate to the presentation or form of the financial
information.

The enhancing qualitative characteristics are intended to increase the usefulness of the financial
information that is relevant and faithfully represented.

The enhancing qualitative characteristics are comparability, understandability, verifiability and

timeliness.

Relevant and faithfully represented financial information is useful but the information would be most
useful if it is comparable, understandable, verifiable and timely.

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Comparability

Comparability means the ability to bring together for the purpose of noting points of likeness and
difference.

Comparability is the enhancing qualitative characteristic that enables users to identify and understand
similarities and dissimilarities among items.

Comparability may be made within an entity or between and across entities.

Comparability within an entity is the quality of information that allows comparisons within a single entity
through time or from one accounting period to the next.

Comparability within an entity is also known as horizontal comparability or intracomparability.

Comparability between and across entities is the quality of information that allows comparisons between
two or more entities engaged in the same industry.

Comparability across entities is also known as intercomparability or dimensional comparability.

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Consistency
Implicit in the qualitative characteristic of comparability is the principle of consistency.

Consistency is not the same as comparability.

In a broad sense, consistency refers to the use of the same method for the same item, either from period
to period within an entity or in a single period accross entities.

Comparability is the goal and consistency helps to achieve that goal.

ln a limited sense, consistency is the uniform application of accounting method from period to period
within an entity.

On the other hand, comparability is the uniform application of accounting method between and across
entities in the same industry.

It is inappropriate for an entity to leave accounting policies unchanged when better and acceptable
alternatives exist.

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Understandability

Understandability requires that financial information must be comprehensible or intelligible if it is to

be most useful.

Classifying, characterizing and presenting information "clearly and concisely" makes it

understandable.

Financial reports are prepared for users who have a reasonable knowledge of business and
economic activities and who review and analyze the information diligently.

At times, even well-informed and diligent users may need to seek the aid of an adviser to understand
information about complex phenomena or transactions.

Understandability is very essential because a relevant and faithfully represented information may
prove useless if it is not understood by users.

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Verifiability

Verifiability means that different knowledge able and independent observers could reach
consensus, although no necessarily complete agreement, that a particular depiction is a faithful
representation.

In other words, verifiability implies consensus.

Types of verification

Verification can be direct or indirect.

Direct verification means verifying an amount or other representation through direct observation,
for example, by counting cash.

Indirect verification means checking the, inputs to a model, formula or other technique and
recalculating the inputs using the same methodology.

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Timeliness

Timeliness means that financial information must be available or communicated

early enough when a decision is to be made.

Relevant and faithfully represented financial information furnished after a

decision is made is useless or of no value.

For example, the most important attribute of quarterly or interim financial

information is its timeliness.

Timeliness enhances the truism that without knowledge of the past, the basis for
prediction will usually be lacking and without interest in the future, knowledge of
the past is sterile.

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