Why is faithful representation important in financial reporting?

Courses > Financial Accounting > Introduction to Financial Accounting

✓ Checked for updates, April 2022. Accountingverse.com

Financial information has several qualities that make it useful. These qualities are outlined in Chapter 3 of the Conceptual Framework for Financial Reporting, approved by the International Accounting Standards Board (IASB).

Fundamental Qualitative Characteristics

1. Relevance

Relevant information is capable of making a difference in the decisions made by users. Relevance requires financial information to be related to an economic decision. Otherwise, the information is useless.

Financial information is useful if it has predictive value and confirmatory value. Predictive value helps users in predicting or anticipating future outcomes. Confirmatory value enables users to check and confirm earlier predictions or evaluations.

Materiality is an aspect of relevance which is entity-specific. It means that what is material to one entity may not be material to another. It is relative. Information is material if it is significant enough to influence the decision of users. Materiality is affected by the nature and magnitude (or size) of the item.

2. Faithful Representation

The financial information in the financial reports should represent what it purports to represent. Meaning, it should reflect what really happened, with the correct financial values.

There are three characteristics of faithful representation: 1. Completeness (adequate or full disclosure of all necessary information), 2. Neutrality (fairness and freedom from bias), and 3. Free from error (no inaccuracies and omissions).

Enhancing Qualitative Characteristics

1. Comparability

Comparable information enables comparisons within the entity and across entities. When comparisons are made within the entity, information is compared from one accounting period to another. For example: income is compared for the years 2019, 2020, and 2021. Comparability of information across entities enables analysis of similarities and differences between different companies.

2. Verifiability

Verifiability helps to assure users that information represents faithfully what it purports to represent. Financial information is supported by evidence and independent individuals can check them to see whether such information is faithfully represented. In other words, information is verifiable if it can be audited.

3. Timeliness

Timeliness means providing information to decision-makers in time to be capable of influencing their decisions. It shouldn't be significantly delayed or else it will be of little or no value.

4. Understandability

Understandability requires financial information to be understandable or comprehensible to users with reasonable knowledge of business and economic activities. To be understandable, information should be presented clearly and concisely. However, it is improper to exclude complex items just to make the reports simple and understandable.

Key Takeaways

Fundamentally, financial statement information needs to be 1) relevant and 2) faithfully represented. Faithful representation means that information is complete, neutral, and free from bias.

The quality of financial statements is enhanced by comparability, verifiability, timeliness, and understandability.

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Qualitative characteristics of financial information (2022). Accountingverse.
https://www.accountingverse.com/financial-accounting/introduction/qualitative-characteristics.html

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What is Financial Accounting?

Chapter Outline

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Introduction to Financial Accounting

IASB framework provides conceptual guidance regarding preparation and presentation of financial statements whereas IAS 1 sets out the principles and rules for preparation and presentation of financial statements. So the difference between these two documents must be clear as framework does not amount to standard and is separate from International Accounting Standards. The provisions stated under framework as opposed to the standards are not instructions based because standards provide clear cut rules that must be followed. Also when framework and standards are in conflict over any matter then standards prevail. But there is one exception to this rule which will be discussed later.

IASB Framework

Faithful representation is one of the qualitative characteristics of financial information that enhances reliability. Faithful representation is achieved by presenting the transactions and events in the way they are reasonably expected to be reported in the financial statements. For example, only the effects of those transactions should be reported that meets the recognition criteria of the elements of the financial statements. Also, to represent the transactions and events faithfully in the financial statements, the effects of transactions and events are reported on the basis of economic substance of the transactions instead of legal form of the transaction. For example, company had sold the asset but is still responsible for maintaining it or other risks then if this transaction is reported as sales instead of secured loan will not faithfully represent the transaction and thus will distort the effect of the transaction and may have the potential to influence users decisions.

Fair presentation means financial statements portrays the entity and its operations in true and fair view i.e. financial statements must be in line with the ground reality or in other words the financial position and financial performance of the entity according to the financial statements should be the same as the position and performance is in reality. According to IASB framework fair presentation is expected to achieve fair presentation by:

• the application of qualitative characteristics as discussed under framework; and
• the application of appropriate accounting standards

Simply put, fair presentation is the end result that is expected to be achieved by maintaining principle qualitative characteristics and the application of accounting standards.

Faithful presentation is one of the qualitative factor that enhances one of the four principle qualitative characteristics i.e. reliability. Whereas fair presentation is the product of all the four principle qualitative characteristics.

IAS 1 Presentation of Financial Statements

According to IAS 1 fair presentation requires the faithful representation of the effects of transactions, other events and conditions in accordance with the definitions, recognition criteria and substance of transactions. Simply put, IAS 1 almost equates the fair presentation with the compliance with accounting standards which is presumed to result in the fair presentation of financial statements.

Para 17 – IAS 1

In virtually all circumstances, an entity achieves a fair presentation by compliance with applicable IFRSs. A fair presentation also requires an entity:

• to select and apply accounting policies in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. IAS 8 sets out a hierarchy of authoritative guidance that management considers in the absence of an IFRS that specifically applies to an item.
• to present information, including accounting policies, in a manner that provides relevant, reliable, comparable and understandable information.
• to provide additional disclosures when compliance with the specific equirements in IFRSs is insufficient to enable users to understand the impact of particular transactions, other events and conditions on the entity’s financial position and financial performance.

Compliance with standards

As stated earlier the general rule is that if there is a conflict on any matter between the framework and the standard then standards prevail i.e. compliance with both framework and standards is necessary but when they are in conflict then standards will be complied and for the same reason IAS 1 almost equates the fair presentation with compliance as standards are made in a way that ensure true and fair financial statements.

However, under extremely rare circumstances management may conclude that compliance with the certain provisions of standards will be so misleading that it would conflict with the objectives of financial statements as stated in the IASB Framework. Under such circumstances management may depart from the provisions of the standard. This is known as true and fair override. In short, in extremely rare circumstances framework can prevail over standards.

Therefore, fair presentation is NOT just compliance with the standards but as standards are detailed so in virtually every circumstances compliance is presumed to achieve fair presentation. But its up to management to ensure that financial statements achieve true and fair view by achieving the objectives of the financial statements as laid down under IASB Framework.