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.

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.

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.

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.

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.

For example, information about financial position and pas t performance is frequently used
in predicting dividend and wage payments and the ability of the entity to meet maturing
commitments.

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

evaluations.

In other words, financial information has confirmatory value when it enables users
confirm or correct earlier expectations.
For example, a net income measure has confirmatory value if it can help shareholders
confirm or revise their expectation about an entity’s ability to generate earnings.

Often, information has both predictive and confirmatory value. The predictive and
confirmatory roles of information are interrelated.
An example is an interim income statement which provides feedback about income to date
and serves as a basis for predicting the annual income.
The interim income statement for the first quarter shows net income of ₱2,000,000. This
is the confirmatory value.

If this trend continues for the entire year, it is logical to assume that the net income
after four quarters or one year would be ₱8,000,000. This is the predictive value.

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.

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 so critical for a small entity.
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, professional 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.

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

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 be expected to influence in the new definition, material
information 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.
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.

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.

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 ₱20,000 bribe is a material event even for a very large
entity.

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 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 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
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.

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.

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.
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.

Prudence
The Revised Conceptual Framework has reintroduced the 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.

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 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 P 100,000, this is not
conservatism but fraud or inaccurate reporting.

Expressions of conservatism
"Anticipate no profit and provide for probable and measurable loss. "

"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"

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.

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.

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 from 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.

Example of substance over form

An example is when the lessee leased property from the lessor.

The terms of the lease provide that the lease transfers ownership of the asset to the
lessee by the end of the lease term.

In form, the contract is a lease as popularly understood.

But in substance, in reality, if the "transfer of ownership provision" is to be considered,

the real intent of the parties is an installment purchase of an asset by the lessee from
the lessor.

Accordingly, the lessee shall record an acquisition of right of use asset and set up a
liability to the lessor.
The periodic rental is conceived as an installment payment representing interest and
principal.

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.

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.

For information to be comparable, like things must look alike and different things must
look different.

Comparability is not enhanced by making unlike things look alike or making like things look
different.

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 across entities.

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

In 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.

An entity cannot use the FIFO method of inventory valuation in one year, the average
method in the next year, again the FIFO method in succeeding year and so on.

If the FIFO method is adopted in one year, such method is followed from year to year.
Consistency is desirable and essential to achieve comparability of financial statements.

However, consistency does not mean that no change in accounting method can be made.

If the change would result to more useful and meaningful information, then such change
shall be made.

But there shall be full disclosure of the change and the peso effect thereof.

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

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

Accordingly, the information should be presented in a form and expressed in terminology

that a user understands.

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

understandable.
An essential quality of the information provided in financial statements is that it is
readily understandable by users.

But the complex economic activities make it impossible to reduce the financial
information to the simplest terms.

Accordingly, the users shall have an understanding of the complex economic activities,
the financial accounting process and the terminology in the financial statements.

Financial statements cannot realistically be understandable to everyone.

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.

Verifiability
Verifiability means that different knowledgeable and independent observers could reach
consensus, although not necessarily complete agreement, that a particular depiction is a
faithful representation.

In other words, verifiability implies consensus.

The financial information is verifiable in the sense that it is supported by evidence so

that an accountant that would look into the same evidence would arrive at the same
economic decision or conclusion.

Verifiable financial information provides results that would be substantially duplicated by

measurers using the same measurement method.

Accordingly, verifiability helps assure users that information represents the economic
phenomenon or transaction it purports to represent.

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.

An example is verifying the carrying amount of inventory by checking the inputs in

quantities and costs, and recalculating the ending inventory using the same cost flow
assumption, such as first-in, first-out.

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.

Generally, the older the information, the less useful.

However, some information may continue to be timely long after the end of reporting
period because some users may need to identify and assess trends.

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.

What happened in the past would become the basis of what would happen in the future.

Cost constraint on useful information

Cost is a pervasive constraint on the information that can be provided by financial
reporting.

Reporting financial information imposes cost and it is important that such cost is
justified by the benefit derived from the financial information.

In other words, the cost constraint is a consideration of the

cost incurred in generating financial information against the benefit to be obtained from
having the information.

The benefit derived from the information should exceed the cost incurred in obtaining
the information.
However, the evaluation of the cost constraint is substantially a judgmental process.

Assessing whether the cost of reporting outweighs or falls short of the benefit is
difficult to measure and becomes a matter of professional judgment.