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The Conceptual Framework sets out the concepts that underlie the preparation and presentation of
financial statements for external users. The Conceptual Framework deals with:
the objective of financial reporting (which is to provide financial information about the reporting
entity that is useful to existing and potential investors, lenders and other creditors in making
decisions about providing resources to the entity);
the definition, recognition and measurement of the elements from which financial statements
are constructed (assets, liabilities, equity, income and expenses).
Relevance and reliability are two of the four key qualitative characteristics of financial accounting
information. The others being understandability and comparability.
Relevance requires that the financial accounting information should be such that the users need it and it
is expected to affect their decisions.
Reliability requires that the information should be accurate and true and fair.
Relevance and reliability are both critical for the quality of the financial information, but both are
related such that an emphasis on one will hurt the other and vice versa. Hence, we have to trade-off
between them. Accounting information is relevant when it is provided in time, but at early stages
information is uncertain and hence less reliable. But if we wait to gain while the information gains
reliability, its relevance is lost.
Examples
1. After the balance sheet date but before the date of issue a company wants to dispose of one of
its subsidiaries and is in final stages of reaching a deal but the outcome is still uncertain. If the
company waits they are expected to find more reliable information but that would cost them
relevance. The information would be outdated and no longer very relevant.
2. After the balance sheet date during the time when audit is carried out, it becomes clear which
debts were realized and where were not hence it improves the reliability of allowance for bad
debts estimate but the information loses its relevance due to too much time being taken.
Timeliness is key to relevance.
Accounting Relevance
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Accounting concepts and principles >
Accounting Relevance
Example 2
A default by a customer who owes $1000 to a company having net assets of
worth $10 million is not relevant to the decision making needs of users of the
financial statements.
However, if the amount of default is, say, $2 million, the information becomes
relevant to the users as it may affect their view regarding the financial
performance and position of the company.
Which of the following methods of fixed assets valuation provides more relevant information
to users of the financial statements?
Revaluation Method
Reliability Concept
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Information is reliable if a user can depend upon it to be materially accurate and if it faithfully
represents the information that it purports to present. Significant misstatements or omissions in
financial statements reduce the reliability of information contained in them.
Example
A company is being sued for damages by a rival firm, settlement of which could threaten the financial
stability of the company. Non-disclosure of this information would render the financial statements
unreliable for its users.
Reliability of financial information is enhanced by the use of following accounting concepts and
principles:
Neutrality
Faithful Representation
Prudence
Completeness
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Accounting concepts and principles >
Timeliness Concept
Definition
Timeliness principle in accounting refers to the need for accounting
information to be presented to the users in time to fulfill their decision making
needs.
Importance
Examples
Completeness
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Completeness
Incomplete information reduces not only the relevance of the financial statements, it also decreases its
reliability since users will be basing their decisions on information which only presents a partial view of
the affairs of the entity.
Under which of the following circumstances will the completeness of information contained in
financial statements be compromised?
Contingent liability in respect of a claim against the company has not been disclosed by the
management because it believes that the likelihood of an adverse court decision is low.
Company with an annual turnover of $10 billion does not present income from sale of fixed assets of
$10,000 separately in the income statement
Company does not disclose sales made to a subsidiary (related party) as the management believes the
transactions had been made on an arm's length basis (i.e. at market prices)
Comparability/Consistency
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Comparability Concept
Financial statements of one accounting period must be comparable to another in order for the users to
derive meaningful conclusions about the trends in an entity's financial performance and position over
time. Comparability of financial statements over different accounting periods can be ensured by the
application of similar accountancy policies over a period of time.
A change in the accounting policies of an entity may be required in order to improve the reliability and
relevance of financial statements. A change in the accounting policy may also be imposed by changes in
accountancy standards. In these circumstances, the nature and circumstances leading to the change
must be disclosed in the financial statements.
Financial statements of one entity must also be consistent with other entities within the same line of
business. This should aid users in analyzing the performance and position of one company relative to the
industry standards. It is therefore necessary for entities to adopt accounting policies that best reflect the
existing industry practice.
Example
If a company that retails leather jackets valued its inventory on the basis of FIFO method in the past, it
must continue to do so in the future to preserve consistency in the reported inventory balance. A switch
from FIFO to LIFO basis of inventory valuation may cause a shift in the value of inventory between the
accounting periods largely due to seasonal fluctuations in price.
How must a change in accounting policy be accounted for to preserve comparability and consistency
in the financial statements?
Changes to accounting policy must be accounted for prospectively, i.e. resulting change should not have
impact on prior period financial statement comparatives.
Changes to accounting policy must be accounted for retrospectively, i.e. amounts recognized in previous
accounting periods are restated to account for the change in accounting policy.