Question

In: Accounting

Define ‘relevance’ and ‘faithful representation’. a. Is there a trade-off between the two? b. Which is...

Define ‘relevance’ and ‘faithful representation’.

a. Is there a trade-off between the two?

b. Which is more important – relevance or representational faithfulness?

Solutions

Expert Solution

Relevance – financial information is regarded as relevant if it is capable of influencing the decisions of users.

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.

Faithful representation – this means that financial information must be complete, neutral and free from error.

The financial information in the financial reports should represent what it purports to represent. Meaning, it should show what really are present and what really happened, as the case may be.

a) There is sometimes a trade-off between relevance and faithful representation — and judgement is required to provide the appropriate balance. Faithful representation is affected by the use of estimates and by uncertainties associated with items recognised and measured in financial statements. These uncertainties are dealt with, in part, by disclosure and, in part, by exercising prudence in preparing financial statements. 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. However, prudence can only be exercised within the context of the other qualitative characteristics in the conceptual framework, particularly relevance and the faithful representation of transactions in financial statements. Prudence does not justify deliberate overstatement of liabilities or expenses or deliberate understatement of assets or income, because the financial statements would not be neutral and, therefore, not have the quality of reliability.

The conceptual framework does not include concepts or principles for selecting which measurement basis should be used for particular elements of financial statements or in particular circumstances. The qualitative characteristics do provide some guidance, particularly the characteristics of relevance and faithful representation.

b) Relevance implies that the information should have predictive and confirmatory value for users in making and evaluating economic decisions. Faithful representation implies that the information fully represent the phenomena it purports to represent. This means that the financial information will be complete, neutral and free from error.

Two of our prior columns critiqued the Financial Accounting Standards Board's recent preliminary views document on its new Conceptual Framework project, which, like many other FASB efforts, is a joint undertaking with the International Accounting Standards Board. Those columns examined the boards' take on financial reporting objectives and relevance, both of which are basically enhanced versions of FASB's first framework from the 1980s. While we see some improvement, we wish that the boards had pushed the envelope further and set the stage for more reformation in practice.

This column focuses on faithful representation, which occupies the place held by reliability in the original framework. The new basic definition of faithful representation is the "correspondence or agreement between the accounting measures or descriptions in financial reports and the economic phenomena they purport to represent."

That is, a measure is a faithful representation if it is a dependable depiction of what is being described in the financial statements. The original framework broke reliability down into the sub-qualities of representational faithfulness, verifiability and neutrality, where representational faithfulness included both completeness and freedom from bias.


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