The Qualitative Characteristics of Financial Statements

What is accounting?

Accounting can be described as being concerned with measurement and management . Measurement is largely concerned with the recording of past data, and management with the use of that data in order to make decisions that will benefit the organization. The measurement process is not always easy. One of the most common problems is that of when to recognised a transaction. For example, if we are to obtain goods from a supplier with payment to be due 60 days after the goods are received, when should the transaction be recorded?

The following possibilities may be considered:

• when we place the order; 
• when we take delivery of the goods;
• when we receive the invoice from the supplier; or
• when we pay the supplier for the goods.

Accounting, therefore, involves the exercising of judgment by the person responsible for converting data into meaningful information. It is this that distinguishes accounting from bookkeeping.

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Accounting may be defined as:

• the classification and recording of monetary transactions;
• the presentation and interpretation of the results of those transactions in order to assess performance over a period and the financial position at a given date;
• the monetary projection of future activities arising from the alternative planned courses of action.

Note the three aspects considered in this definition: recording, reporting and forecasting:

1. Accounting is partly a matter of record-keeping. The monetary transactions entered into by a business need to be controlled and monitored, and for this a permanent record is essential. For an efficient system of record-keeping, the transactions must first be classified into categories appropriate to the enterprise concerned.
2. At appropriate intervals, the individual transactions must be summarised in order to give an overall picture.
3. Finally, accounting information can be the basis for planning and decision-making.

An alternative explanation is that accounting is part of the management information system (MIS) of an organization. In this context, the accounting element is referred to as an accounting information system (AIS).

Accounting can thus be said to be a method of providing information to management (and other users) relating to the activities of an organization. In order to do this it relies on the accurate collection of data from sources both internal and external to the organization. The recording of this data is often referred to as bookkeeping.

The objectives of accounting 

The objectives of accounting are to provide financial information to the managers, owners and other parties interested in an organization. This is done by the production of financial statements.

If these objectives are to be achieved, then the information provided by the accounting system must be reliable and easily understood, and prepared consistently not only from one accounting period to the next but also between similar organizations so that meaningful comparisons may be made. This need for consistency has led to a number of accounting rules being devised. Some of these rules are contained in legislation – these rules apply particularly to companies: some are included in accounting standards; some are included in documents such as the IASB’s Framework; and others simply represent generally accepted accounting practice (GAAP). These rules are used by accountants to determine the treatment to be adopted in respect of certain financial transactions and the preparation of financial statements.

Who uses financial statements?

Accounting information is used by many people, both by individuals and in organizations. To get a feel for the purpose of accounts it is useful to classify these users into groups, and to look at the reasons why they use accounts and what they hope to get from them.

Any classification of this sort is somewhat arbitrary, and many users fall into more than one classification. However, the following groups are commonly recognised as having particular needs for accounting information:

1. The investor group. This group includes both existing and potential owners of shares in companies. They require information concerning the performance of the company measured in terms of its profitability and the extent to which those profits are to be distributed to shareholders. They are also interested in the social/economic policies of the company so that they may decide if they wish to be associated with such an organization.
2. The lender group. This group includes both existing and potential providers of secured or unsecured, long- or short-term loan finance. They require information concerning the ability of the organization to repay the interest on such loans as they fall due; and the longer-term growth and stability of the organization to ensure that it is capable of repaying the loan at the agreed time. In addition, if the loan is secured, the value of the appropriate secured assets is important as a means of recovering the amount due.
3. The employee group. This group includes existing, potential and past employees. They require information concerning the ability of the organization to pay wages and pensions today. In addition, they are interested in the future of the organization because this will affect their job security and future prospects within the organization.
4. The analyst/adviser group. This group includes a range of advisers to investors, employees and the general public. The needs of these users will be similar to those of their clients. The difference is, perhaps, that in some instances, the members of this group will be more technically qualified to understand accounting reports.
5. The business contact group. This group includes customers and suppliers of the organization. Customers will be concerned to ensure that the organization has the ability to provide the goods/services requested and to continue to provide similar services in the future. Suppliers will wish to ensure that the organization will be capable of paying for the goods/services supplied when payment becomes due.
6. The government. This group includes taxation authorities, and other government agencies and departments. The taxation authorities will calculate the organization’s taxation liability based upon the accounting reports it submits to them. Other departments require statistical information to measure the state of the economy.
7. The public. This group includes taxpayers, consumers and other community and special interest groups. They require information concerning the policies of the organization and how those policies affect the community. The public is increasingly interested in environmental issues.
8. Internal users. The management of the company require information to assist them in the performance of their duties.

Three different levels of management can be identified:

• Strategic. This is the level of management found at the top of organizations. In a commercial organization it is referred to as the board of directors. These people require information to assist them in decisions affecting the long-term future of the organization.
• Tactical. This is often referred to as middle management. These people require information to assist them in monitoring performance and making decisions to enable the organization to achieve its short- to medium-term targets.
• Operational. This is the level of management responsible for decisions concerning the day-to-day activities of the organization. It is common for the information provided to them to be quantified in non-monetary units, such as hours worked, number of components produced, and so on.

The qualitative characteristics of financial statements

All of the above user groups, both internal and external to the organization, require the information provided to be useful. In this context, information should:

1. enable its recipient to make effective decisions;
2. be adequate for taking effective action to control the organization or provide valuable details relating to its environment;
3. be compatible with the responsibilities and needs of its recipient;
4. be produced at optimum cost;
5. be easily understood by its recipient;
6. be timely;
7. be sufficiently accurate and precise for the purpose of its provision.

The IASB’s Framework also suggests that financial statements should have certain qualitative characteristics, including relevance, reliability, completeness, comparability, understandability and timeliness.

For decisions to be made, the information must be relevant to the decision and be clearly presented, stating any assumptions upon which the information is based, so that the user may exercise judgement as appropriate.

Often, better information may be provided at additional cost or after an additional time delay. The adequacy of information is important, and factors such as the cost of the information and the speed with which it is available may be more important than it being 100 per cent accurate.

The information provided must be communicated to the person responsible for taking any action in respect of the information provided. In this regard it is better to distinguish information between that which relates to controllable aspects of the business and that which relates to non-controllable aspects. The controllable aspects may then be further divided into those that are significant and an exception reporting approach applied.

Exception reporting is the technique of reducing the size of management reports by including only those items that should be drawn to the manager’s attention, rather than including all items.

Most organizations will set targets against which actual performance can be compared. You will learn more about the setting of such targets in your studies of management accounting. Their use enables exception reports to be produced to highlight the differences between the actual and target results. The use of exception reporting avoids wasting unnecessary management time reading reports that merely advise the management that no action is required and concentrates on those issues that do require management action.

In conclusion, therefore, internal information will be much more detailed than external information, and will be prepared on a more regular basis.

Terminology

1. Bookkeeping

Bookkeeping can be described as the recording of monetary transactions, appropriately classified, in the financial records of an entity, by either manual means or otherwise.

Bookkeeping involves maintaining a detailed ‘ history ’of transactions as they occur. Every sale, purchase or other transaction will be classified according to its type and, depending on the information needs of the organization, will be recorded in a logical manner in the ‘ books ’ . The ‘ books ’ will contain a record or account of each item showing the transactions that have occurred, thus enabling management to track the individual movements on each record, that is, the increases and decreases.

Periodically a list of the results of the transactions is produced. This is done by listing each account and its final position or balance . The list is known as a trial balance and is an important step prior to the next stage of providing financial statements.

2. Financial accounting

Financial accounting can be described as the classification and recording of monetary transactions of an entity in accordance with established concepts, principles, accounting standards and legal requirements, and their presentation, by means of various financial statements, during and at the end of an accounting period.

Two points in particular are worth noting about this description:

1. Financial statements must comply with accounting rules published by the various advisory and regulatory bodies. In other words, an organization does not have a completely free hand. The reason for this is that the end product of the financial accounting process – a set of financial statements – is primarily intended for the use of people outside the organization. Without access to the more detailed information available to insiders, these people may be misled unless financial statements are prepared on uniform principles.
2. Financial accounting is partly concerned with summarising the transactions of a period and presenting the summary in a coherent form. This again is because financial statements are intended for outside consumption. The outsiders who have a need for and a right to information are entitled to receive it at defined intervals, and not at the whim of management.

3. Management accounting

Management accounting can be described as the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources. Management accounting also comprises the preparation of financial reports for non-management groups such as shareholders, lenders, regulatory agencies and tax authorities.

Although the needs of external users of accounts are addressed in this definition, it can be seen that the emphasis of management accounting is on providing information to help managers in running the business. The kind of information produced, and the way in which it is presented, are at the discretion of the managers concerned; they will request whatever information, in whatever format, they believe to be appropriate to their needs.

The differences between external and internal information

External information is usually produced annually, though in organizations listed (or quoted) on a stock exchange, information may be produced more frequently, for example quarterly. External information is provided mainly by limited companies, in accordance with the relevant company legislation. These may prescribe the layouts to be used and the information that is to be disclosed either on the face of the financial statements or in the notes that accompany them. For other organizations that are not regulated by such legislation, accounts may have to be provided for other interested parties such as those dealing with taxation and lenders. For these organizations, the requirements of legislation are not mandatory and may not be appropriate. However, these requirements are often considered to be good accounting practice.

External information is often available publicly and is therefore available to the competitors of the organization as well as its owners and employees. Of necessity, therefore, it is important that the information provided does not allow the organization’s competitors to obtain detailed information concerning the working of the organization. Thus external information is summarised in order to protect the organization from losing any competitive edge that it may possess.

Internal information is produced on a regular basis in order for management to compare the organization’s performance with its targets and to make decisions concerning the future. Accounting information is usually produced on a monthly basis, although other non-financial performance measures may be produced more regularly. Whereas external information is almost exclusively measured in monetary terms, internal information will most likely involve reporting financial and non-financial measures together. There is a very good reason for this: many managers, particularly those in control of operational matters, will not feel competent to understand accounting reports. They will understand differences in output levels and in usage of materials and labor much more readily than they will understand the implications of these same differences upon profit.

What is a business organization?

A business is an organization that regularly enters into transactions that are expected to provide a reward measurable in monetary terms. It is thus obvious from everyday life that many business organizations exist; what is less obvious is that their organizational (legal) structure and therefore their accounting requirements may differ.

There are two main reasons for the different organizational structures that exist – the nature of their activities and their size .

1. Profit-making organizations

Some organizations are formed with the intent of making profits from their activities for their owners:

(a) Sole traders ( sole proprietors ). These are organizations that are owned by one person. They tend to be small because they are constrained by the limited financial resources of their owner.

(b) Partnerships. These are organizations owned by two or more persons working in common with a view to making a profit. The greater number of owners compared with a sole trader increases the availability of finance and this is often the reason for forming such a structure.

(c) Limited companies. These are organizations recognised in law as ‘ persons ’ in their own right. Thus a company may own assets and incur liabilities in its own name.

The accounting of these organizations must meet certain minimum obligations imposed by legislation, for example, via company law and other regulations. Some of these requirements constitute recommended accounting practice for other types of organization.

Two types of limited companies can be identified: private limited companies; and public limited companies.

Public limited companies can be further divided according to their size, and whether they are ‘ listed ’on a stock exchange. These distinctions can be important when considering the accounting requirements. A common feature of private limited companies is that their owners are actively involved in running the business. In this way they are similar to sole traders and partnerships. This is rarely true of public companies, where the owners may not become involved in the day-to-day activities of the business. Listed companies may have many thousands of owners (shareholders) who are even further removed from the running of the business.

2. Non-profit-making organizations

Other organizations are formed with the intent of providing services, without intending to be profitable in the long term:

1. Clubs and societies. These organizations exist to provide facilities and entertainments for their members. They are often sports and/or social clubs and most of their revenue is derived from the members who benefit from the club’s facilities. They may carry out some activities that are regarded as ‘ trading ’activities, in which profits are made, but these are not seen as the main purpose of the organization.
2. Charities. These exist to provide services to particular groups, for example people with special needs and to protect the environment. Although they are regarded as nonprofit-making, they too often carry out trading activities, such as running shops.
3. Local and central government. Government departments are financed by members of society (including limited companies). Their finances are used to provide the infrastructure in which we live, and to redistribute wealth to other members of society. You will not look at the accounts of government bodies in this Learning System.