The qualitative characteristics of financial report preparation - Essay Example

? Finance and Accounting Inserts His/Her Inserts Grade Inserts 14 February Finance and Accounting Qualitative characteristics influence the financial information’s effecti. The research focuses on the qualitative characteristics of financial report preparation. The research centers on materiality, prudence, reliability, and relevance characteristics. The financial information must compulsorily abide by established qualitative characteristics. Financial information must incorporate several qualitative characteristics in order to meet the needs of users of financial statements. Materiality is one of the qualitative characteristics. Prudence is another qualitative characteristic. Relevance is an important qualitative characteristic. Reliability is a necessary qualitative characteristicii. The users of the financial information rely on the qualitative characteristics of the financial statements for their decision making activitiesiii. The creditors use the financial statements as one of the tools for deciding whether to grant loans or credit terms to the credit applicant. Financial statement indicating the company generated a profit trend for the past two years will persuade the creditors to grant the loans or credit applications. The net profit portion of the financial statements indicates the company will be able to pay its maturing loan and credit obligations on time. On the other hand, the creditors will be discouraged to approve the credit or loan application of a company having a net loss financial picture. The net loss financial picture indicates a strong probability that the company may close shop in the next few years. The credit or loan applicant may not be able to comply with its duty to pay its loans or credits when the maturity dates crop up. In addition, the customers use the financial statements as one of the major tools for deciding whether to grant loans or credit terms to the credit applicant. The customers use the financial statements to determine if the company will stay long enough to supply their wants, needs, and caprices. A financial statement indicating a loss will persuade the client to start looking for other competitor suppliers. A net loss figure creates an impression on the minds of the customers that the company may not qualify as a going concern entity. A net profit ensures the customers that the company will provide the clients’ needs. Furthermore, the managers use the financial statements as one of the major tools for benchmarking their performance. The managers will have a passing performance grade if the financial statements indicate the company generated net profits during the past year or years of supplying the needs of its clients. On the other hand, the manager will receive a failing performance grade if the financial statements indicate the company generated a net loss for the past year or years of service. The managers need financial statements that obey with the qualitative characteristics standard. Also, the current and prospective investors use the financial statements as one of the major tools for deciding whether to grant loans or credit terms to the credit applicant. The current and prospective investors will be encouraged to invest their hard earned cash in the company, if the financial statements indicate the company generated profits for the past year or years of service. On the other hand, the current and prospective investors will be discouraged to invest in a company that generated a trend of net loss for the past year or years of operation. The current and prospective investors need financial statements that comply with the qualitative characteristics standard. Based on the above discussion, the entities must resolve the threshold quality of materialityiv. Materiality is not easy to define and can be misunderstood. The financial information is material if the omission or misstatement could influence the economic decisions of the financial statement users. This is the general rule. Consequently, materiality depends on the size of the item or error used in the decision making activity. The description of an item may be used as a basis for the materiality or immateriality of the financial accounting information. In the same manner, the amount of an item may be used as a basis for its materiality or immateriality. In terms of clarity, materiality can be discussed in layman’s terms. Information regarding a Tesco customer having a ? 1,000 amount is not material if the total accounts receivable of Tesco is ? 5,000,000. Tesco’s managers will assume that the ? 1,000 amount will not affect their decision making activities. On the other hand, a customer of Morrisons having a ? 1,500 is material if the total accounts receivable of Morrisons is ? 10,000. Morrison’s managers will assume that the ? 1,000 amount will affect their decision making activities. In terms of type of type of financial information, the Tesco customers are more interested on the stores’ grocery inventory being sold on its stores. Thus, the store’s inventory is material to the grocery chain’s customers. The customers are not interested in the salaries of the Tesco branch manager. Thus, the Tesco branch manager’s salary is not material to the Tesco customer’s decision making activities. Similarly, the concept of prudence is not clear-cut and can conflict with neutralityv. Neutrality means that the financial information is not biased in favor of one or more financial statement users. For example, fraudulently increasing the sales figure will favor the sales manager. However, the fraudulent recording will disfavor the defrauded customers. An erroneous recording of the company’s actual liabilities of ? 10,000 as ? 2,000 will favor the business owners or investors. However, the liability reduction will disfavor the creditors. In terms of prudence, recording of financial transactions is influenced by uncertainties. Prudence focuses on implementing the minimum degree of caution in exercising judgments or decisions needed in estimating the amount or description of the financial information being recorded in the company’s book of journal entries. Prudence must be exercised at all times. Prudence entails the company’s gains or profits are not overstated. In addition, prudence includes the company’s current assets, property, plant, and equipments, goodwill, and other assets are not overstated. In the same manner, prudence indicates the entities must not understate its losses. The losses include losses from sales of the company’s plant, equipment, and other fixed asset accounts. The losses include losses from the sale of the company’s store inventories and services. In certain occasions some companies fraudulently overstate their revenues, violating the prudence qualitative characteristic. The fraudulent entities’ overstated revenues will persuade the creditors, banks, and other financial institutions to approve the entities’ loan or credit application. The Enron accounting scandal violated the prudence principle. The company understated its liabilities. The understatement window- dressed the true picture of the company’s net assets. By understating the liabilities, Enron Company overstated its stockholders’ equity portion of the balance sheet. The discovery of the fraud precipitated to the company’s filing for bankruptcy. In addition, the Enron case violated the neutrality qualitative characteristic. By understating the company’s liabilities, the false financial statements benefitted the managers of Enron. Many investors placed their hard earned cash into the coffers of Enron because the fraudulent financial statements did not reliably present the true picture of the company’s financial health. The true financial health of the company, without the false accounting information, indicated the company was generating net losses for several years. The late discovery of the understated liabilities convinced the investors to withdraw their investments from the Enron stocks. Other accounting activities the violated the prudence and reliability qualitative characteristics included the Enron’s fraudulent sale of its Bammel gas storage facility to SPE company resulted to the improper claims of $ 232 million revenue, cash flow from operating activities of the same amount, and the omission of that same fraudulent amount from its total liabilities report. By reassuring the lenders that the purchasers will be protected from the sale losses, the SPE company sale is not a reliable and prudent “true sale” business transactionvi. Bringing the two together, the qualitative characteristic, prudence, can be sacrificed if the amount in question is not material. Likewise, prudence can be if the amount in question is not material. The prudence qualitative characteristic violation will not affect the decision making activities of the financial statement users if immaterial financial information is used. This is the very essence of Auditing. Auditing focuses on the frauds (intentional overstatement of gains, profits, and assets, and understatement of losses, and liabilities) and errors (unintentional acts of overstatement and understatement) that are material when the audit is under audit cost constraints (clients try to save on audit costs by reducing the audit period and audit procedures). In addition, the two qualitative characteristics of relevance and reliability can be conflicting targetsvii. Reliability is the qualitative characteristic that states all financial information must be reliable. The business owners must present information that can be backed up by supporting documents and other evidences. Relevant information is one that influences the economic decisions of the financial statement users. The marketing manager is not interested (not relevant) in the overtime salaries of the accounting personnel. The accounting personnel’s salary is not relevant to the marketing manager’s determination if sales goals will be met. The creditor is not interested in the salaries of the marketing department; the marketing department salary is not relevant to the creditors’ determination if the company will be able to pay its maturing obligations on time. In terms of reliability, financial statements must be free from material error or fraud. To reliable, the financial statement accounts can be validated. For example, the company’s balance sheet indicating the receivables total includes Customer A’s ? 1,000 amount can be validated by scrutinizing the supporting documents. The documents include the statement of accounts, sales invoice, official receipts for paid receivables, and confirmation from customer A on the genuineness of the ? 1,000 amount. Reliability includes ensuring the recording of all business transactions in compliance with international accounting standards. Consequently, a trade-off needs to be made between relevance and reliability. Some relevant information can qualify as reliable. For example, the branch manager uses one’s personal and biased view when instructing the accounting personnel to record an investment in Tesco or Morrisons. The investment amount is relevant to management’s decision making activity. However, the investment amount recordviii is unreliable. In addition, some reliable financial information is not relevant to the decision making process. The manager’s stating that the company’s building premises is 300 meters from the nearest street corner is reliable information. However, the distance between the street corners is not relevant to the accounting personnel’s computation of the manager’s salary. The trade off differs in each unique decision making activity. Based on the above discussion, qualitative characteristics affect financial information. The qualitative characteristics are incorporated in the financial statement preparation. The research centers on materiality, prudence, reliability, and relevance characteristics. Indeed, the financial statement must incorporate the qualitative characteristics to enhance the financial statement users’ decision making activities. References Kieso, Donald, (2011) Intermediate Accounting. London, J. Wiley & Sons Press, p. 47. The book focuses on the qualitative characteristics of financial reporting. Markham, Jerry, (2006) Financial History of the Modern United States Corporate Scandals. London, M Sharpe Press, p. 95 The book focuses on the qualitative characteristics of Financial reporting. Nikolai, Loren (2009) Intermediate Accounting. London, Cengage Press, p. 46. The book focuses on the qualitative characteristics of financial reporting. Paterson, R. (2002), Whatever Happened to Prudence?, Accountancy, January, p. 105. The book focuses on the qualitative characteristics of financial reporting. Porter, Gary, (2010) Financial Accounting: The Impact on Decision Makers. London, Cengage Press, p. 64. The book focuses on the qualitative characteristics of financial reporting. Weetman, Pauline, (2006) Financial and Management Accounting. London, Pearson Press, p. 12.The book focuses on the qualitative characteristics of financial reporting. Weetman, Pauline, (2006) Financial and Management Accounting. London, Pearson Press, p. 75. The book focuses on the qualitative characteristics of financial reporting. Read More