Ensuring `faithful representation' in financial reports
August, 31st 2006
The IASB and the FASB have brought out a discussion paper on the qualitative characteristics of decision-useful financial reporting information. `Reliability' came out very strongly as being one of the key characteristics
Financial statements are being churned out by companies at quarterly intervals, thanks to listing regulations and the corporates' intention to give shareholders an update on performance. The moot question is: What do the users of financial statements expect from them in terms of qualitative characteristics?
An immediate answer could be that this would depend on the user the lay shareholder would expect to know details about the future of the company, while the analyst would concentrate on the fine-print to give his recommendation to clients. One factor everyone expects from the financial statements is reliability.
The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) recently met as part of their ongoing effort to make the International Financial Reporting Standards (IFRS)futuristic. They brought out a discussion paper on the qualitative characteristics of decision-useful financial reporting information. `Reliability' came out very strongly as being one of the key characteristics of financial reporting.
Given that key companies in the US have gone back to uttering the dreaded word "restatement" this time courtesy an accounting scam involving back-dating of stock options the need for reliability has become all the more necessary.
Components of reliability
The FASB has its Concepts Statement No 2 to refer to, while the IASB has a framework to understand what the components of reliability are.
The Concepts Statement identified representational faithfulness, verifiability, neutrality, completeness and freedom from bias as its components.
The IASB framework identified substance over form, neutrality, prudence and completeness as the components. Both Boards concluded that faithful representation the quality of faithfully representing what information purports to represent and neutrality the absence of bias intended to attain a predetermined result or to induce a particular behaviour could be taken to be the key components in exhibiting decision-useful information to users of financial statements.
Indian accounting standards too place some faith on substance over form as one of the components of reliability of financial statements. Giving an example of an entity disposing of an asset to another party in such a way that the documentation purports to pass legal ownership to that party but agreements could exist that ensure that the entity continues to enjoy future economic benefits embodied in the asset, the discussion paper concludes that if one agrees to the concept of substance over form and reports this as a sale, it would not be faithfully representing the transaction that has been entered into.
In what could be a message to the standard-setters in India to move away from the concept of substance over form, the discussion paper concluded that substance over form could not be used as a component to ensure that financial statements are reliable.
The discussion paper questioned the need for the term reliability itself. Experience shows that the term has been rather loosely used. The discussion paper found a new buzzword faithful representation which could be used in the place of reliability.
The technical definition of the term would mean correspondence or agreement between the accounting measures or descriptions in financial reports and the economic phenomena they purport to represent.
Since the goal of financial reporting is to faithfully represent real-world economic phenomena and changes in them, use of the term faithful representation seems appropriate.
A good example could be the new concept of "fair value." Representations of fair values should change when the values change. And the changes should reflect the degree of volatility in these changes. The term faithful representation could soon find its way into the accounting standards set by the regulators as well as into the annual reports of companies.
Mohan R. Lavi
(The author is a Hyderabad-based chartered accountant)