YEAR 13 ACCOUNTING Qualitative Characteristics

QUALITATIVE CHARACTERISTICS Qualitative Characteristics are attributes (features) that make the information contained in the financial statements useful to users. Qualitative Characteristics are attributes (features) that make the information contained in the financial statements useful to users. [NZ Framework, par. 24]

What are the Qualitative Characteristics? In order to make a piece of financial information useful to users, it must have the following characteristics: Understandability Understandability Relevance Relevance Reliability Reliability Comparability Comparability

Understandability An essential quality of the information provided in financial statements is that it is readily understandable by users. An essential quality of the information provided in financial statements is that it is readily understandable by users. [NZ Framework, par. 25] This means a piece of accounting information must be comprehenable by users, otherwise the information will become useless. This means a piece of accounting information must be comprehenable by users, otherwise the information will become useless.

Assumptions NZ Framework assumes users of accounting information must have a reasonable knowledge of business and economic activities, and willing to study the information with reasonable diligence. NZ Framework assumes users of accounting information must have a reasonable knowledge of business and economic activities, and willing to study the information with reasonable diligence. This means the person who uses the accounting information must have basic business and economics knowledge. This means the person who uses the accounting information must have basic business and economics knowledge.

Thinking Time If a piece of accounting information is hardly expressed in daily language due to its complexity (for example: the words Asset Revaluation Reserve), but the piece of information is useful to users. If a piece of accounting information is hardly expressed in daily language due to its complexity (for example: the words Asset Revaluation Reserve), but the piece of information is useful to users. Should the business exclude this piece of accounting information?

The answer is… The business should NOT exclude this piece of accounting information because the information is relevant to users’ economic decision making. If the business exclude the disclosure of Asset Revaluation Reserve, users might be misled because they might think the value of an asset did not increase over years.

Relevance Information has the quality of relevance when it influences the economic decisions (Materiality) of users by: Helping them evaluate past, present or future events (Predicatory Role) or; Helping them evaluate past, present or future events (Predicatory Role) or; Confirming, or correcting, their past evaluations (Confirmatory Role). Confirming, or correcting, their past evaluations (Confirmatory Role). [NZ Framework, par. 26]

Evaluate Past, Present or Future Events This is also called Predicatory Role. This is also called Predicatory Role. If a piece of information is relevant, it could help users to evaluate the past and present event and predict the future event that has direct impact on them. If a piece of information is relevant, it could help users to evaluate the past and present event and predict the future event that has direct impact on them. For example, if a Balance Sheet is relevant to users’ decision making, it could help users to evaluate the present amount of assets and liabilities (using the Solvency Test rule) and predict the possibility of receiving dividends in the future. For example, if a Balance Sheet is relevant to users’ decision making, it could help users to evaluate the present amount of assets and liabilities (using the Solvency Test rule) and predict the possibility of receiving dividends in the future.

Confirming Past Evaluations This is also called Confirmatory Role. This is also called Confirmatory Role. If a piece of accounting information is relevant, it could help users to confirm whether the present result has achieved the expected result (past evaluations) made at the beginning of a finanial period. If a piece of accounting information is relevant, it could help users to confirm whether the present result has achieved the expected result (past evaluations) made at the beginning of a finanial period. For example, a business may compare the present Income Statement with the budgeted Income Statement prepared at the beginning of the year (past evaluation), to see whether the business has achieved the expected amount of profit. For example, a business may compare the present Income Statement with the budgeted Income Statement prepared at the beginning of the year (past evaluation), to see whether the business has achieved the expected amount of profit.

Materiality (Importance) Information is material if its omission or misstatement could influence users’ decision making taken on the basis of financial statements. Information is material if its omission or misstatement could influence users’ decision making taken on the basis of financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. [NZ Framework, par. 30]

The meaning of ‘Omission’ Omission means ignorance of disclosing a piece of accounting information. Omission means ignorance of disclosing a piece of accounting information. For example: A business ignores to disclose allowance for doubtful debts in the Balance Sheet, which is important for users’ decision making. For example: A business ignores to disclose allowance for doubtful debts in the Balance Sheet, which is important for users’ decision making. If users cannot see the Allowance for Doubtful Debts on the Balance Sheet which means they might be misled on the amount of accounts receivable to be collected in the future. If users cannot see the Allowance for Doubtful Debts on the Balance Sheet which means they might be misled on the amount of accounts receivable to be collected in the future.

The meaning of ‘Misstatement’ Misstatement means incorrect placement of an item onto a wrong financial statement. Misstatement means incorrect placement of an item onto a wrong financial statement. For example: An accountant reports 1,000 rubbish bins (cost $ 100,000) as an office expense instead of Office Furniture (which is an asset). For example: An accountant reports 1,000 rubbish bins (cost $ 100,000) as an office expense instead of Office Furniture (which is an asset). Such misstatement would affect users’ decision making due to a big difference in net profit. Such misstatement would affect users’ decision making due to a big difference in net profit.

Materiality depends on… SIZE (i.e. the $ amount) or SIZE (i.e. the $ amount) or The NATURE of the item (i.e. the importance of the item in relation to users’ economic decision making) The NATURE of the item (i.e. the importance of the item in relation to users’ economic decision making)

Examples Example 1: A business omitted to report $50,000 wages in the Income Statement (where its total sales is $400,000). Such an omission would influence users’ economic decision (i.e. Material) in terms of size.

Example 2 A business omitted to disclose a court case (possible fine of $2,000) as a note to balance sheet. Such an omission might mislead users because they cannot assess the risks that the business is facing and may make a wrong judgement (therefore it is material in terms of NATURE).

Reliability Information has the quality of reliability when it is free from material error (Completeness) and bias (Neutrality, Prudence) and can be depended upon by users to represent faithfully (Representational Faithful, Substance over form) that which it either purports to represent or could reasonably be expected to represent. Information has the quality of reliability when it is free from material error (Completeness) and bias (Neutrality, Prudence) and can be depended upon by users to represent faithfully (Representational Faithful, Substance over form) that which it either purports to represent or could reasonably be expected to represent. [NZ Framework, par. 31]

Free from Material Error (Completeness) Relates to the accounting concept of ‘Completeness’. Relates to the accounting concept of ‘Completeness’. This means information contained in financial statements must be complete (i.e. fully presented). This means information contained in financial statements must be complete (i.e. fully presented). Otherwise, financial statements could become misleading and influence users to make a wrong judgement. Otherwise, financial statements could become misleading and influence users to make a wrong judgement.

Example The Income Statement has included all the Income and Expense items. The Income Statement has included all the Income and Expense items. If not, the Income Statement will become unreliable because of incompleteness. Users would be misled and making a wrong decision. If not, the Income Statement will become unreliable because of incompleteness. Users would be misled and making a wrong decision.

Free from Biases (Neutrality) This relates to the accounting concept of ‘Neutrality’. This relates to the accounting concept of ‘Neutrality’. This means information contained in financial statements are free from bias, i.e. not intend to influence users’ decision making. This means information contained in financial statements are free from bias, i.e. not intend to influence users’ decision making. This can be achieved by: This can be achieved by: Market Transaction Market Transaction Valuation done by an independent party Valuation done by an independent party Past Experience (supported by documents) Past Experience (supported by documents)

Example The amount of a building shown on the Balance Sheet is free from bias if the amount is resulted from a market transaction, or revalued by an independent valuer. The amount of a building shown on the Balance Sheet is free from bias if the amount is resulted from a market transaction, or revalued by an independent valuer. The value of this house is neutral because of a market transaction.

Represent Faithfully (Representation Faithfulness) Information in a financial statement is represented faithfully by a transaction/s. Information in a financial statement is represented faithfully by a transaction/s. For example, items in the balance sheet should represent faithfully the transactions/events that result in assets, liabilities and equity (after the recognition criteria are met). For example, items in the balance sheet should represent faithfully the transactions/events that result in assets, liabilities and equity (after the recognition criteria are met).

Representational Faithful (Substance over Form) Accountants need to look at the economic substance of the item rather than the legal form of the item. Accountants need to look at the economic substance of the item rather than the legal form of the item. Economic substance means who enjoys the economic right of the item. Economic substance means who enjoys the economic right of the item. Legal Form means who holds the legal title of the item. Legal Form means who holds the legal title of the item.

Question Time Air NZ leased its planes from Air Bus Ltd and both companies treat the planes as their assets. Why do they do so?

Answer… Air NZ leased planes from Air Bus Ltd. Air NZ would report the planes as its assets because Air NZ enjoys the economic right from the planes (i.e. carry customers to earn revenue). Air NZ leased planes from Air Bus Ltd. Air NZ would report the planes as its assets because Air NZ enjoys the economic right from the planes (i.e. carry customers to earn revenue). Air Bus Ltd would also report the planes as its assets because Air Bus Ltd would earn interest and have cash inflow from Air NZ. Air Bus Ltd would also report the planes as its assets because Air Bus Ltd would earn interest and have cash inflow from Air NZ.

Prudence Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. [New Zealand Framework, par. 37]

What does this mean? This means when accountants face an uncertainty, they need to make their judgements with a cautious manner. This means when accountants face an uncertainty, they need to make their judgements with a cautious manner. Cautious manner means assets and incomes are NOT overstated, liabilities and expenses are NOT understated. Cautious manner means assets and incomes are NOT overstated, liabilities and expenses are NOT understated.

Example Accountants report the amount of inventory at the lower of cost or realisable value (how much cash the business could receive in selling the inventory). Accountants report the amount of inventory at the lower of cost or realisable value (how much cash the business could receive in selling the inventory). This illustrates the concept of prudence because accountants do NOT want to overstate the assets (i.e. inventory) because accountants cannot ascertain how much cash would the business from selling its inventory. This illustrates the concept of prudence because accountants do NOT want to overstate the assets (i.e. inventory) because accountants cannot ascertain how much cash would the business from selling its inventory.

Question Time Should accountants exercise over prudence when making their judgement? Should accountants exercise over prudence when making their judgement?

Over-prudence Over-prudence means accountants delibrately understate assets and incomes, or delibrately overstate liabilities and expenses. Over-prudence means accountants delibrately understate assets and incomes, or delibrately overstate liabilities and expenses. Over-prudent information will result with less neutrality (because the information has been biased). Over-prudent information will result with less neutrality (because the information has been biased). Hence, accountants should not exercise over- prudence when making a professional judgement. Hence, accountants should not exercise over- prudence when making a professional judgement.

Comparability Users must be able to compare the financial statements of an entity through time in order to identify trends in its financial position and performance. Users must be able to compare the financial statements of an entity through time in order to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different entities in order to evaluate their relative financial position, performance and changes in financial position. Users must also be able to compare the financial statements of different entities in order to evaluate their relative financial position, performance and changes in financial position. [New Zealand Framework, par. 39]

Comparability is important because… It can help users to identify trends. It can help users to identify trends. It can help users to compare a business result with another business using the same base. It can help users to compare a business result with another business using the same base.

Comparability is achieved by… Consistency – accounting policies and the length of an accounting period should be the same over years unless it is required by law or accounting standard, to change the accounting policies and the length of an accounting period. Consistency – accounting policies and the length of an accounting period should be the same over years unless it is required by law or accounting standard, to change the accounting policies and the length of an accounting period.

Example A business uses straight-line method for depreciating its vehicles over the useful life of the vehicles. A business uses straight-line method for depreciating its vehicles over the useful life of the vehicles. This illustrates the concept of ‘consistency’ because the business uses the same accounting policies over time. This illustrates the concept of ‘consistency’ because the business uses the same accounting policies over time. Straight-line Depreciation Method