Conceptual Framework Assignment
The introduction to the IFRS conceptual framework explains that all financial statementsare produced to provide useful information that satisfies the needs of users. Further, both the IFRS and Not for Profit (NFP) conceptual frameworks agree to the fact that the cost benefit constraint on financial reporting makes it impracticable for firms to report financial information to satisfy the unique needs of all constituents. Hence, both frameworks are designed to facilitate the production of information that is useful to a target group of users, not every potential user. Each framework defines the objective of financial reporting differently, and this difference comes from the fact that the information in the financial statements produced in accordance with each framework focuses on addressing the needs of different user groups.
Representational faithfulness is a component of reliability and is a quality embodied by useful information. It is listed as a stand-alone qualitative characteristic under IFRS, but it is not under NFP reporting standards. Under NFP it is listed as one of three means by which the qualitative characteristic of reliability is achieved. As we know, it is the qualitative characteristics listed under a framework that must be reflected by the information produced in accordance with that framework. If these characteristics are not reflected, then the information is not useful. Hence, the IFRS conceptual framework states that information will be of no use to investors if it does not faithfully represent what it purports to represent.
The NFP framework on the other hand appears to give faithful representation lesser importance to the production of useful information. It is not a stand-alone qualitative characteristic but rather one of three means by which the qualitative characteristic of reliability is achieved. It can therefore by inferred that under the NFP framework, while it is desirable, faithful representation does not have to be present for information to be useful. The information within the statements could still meet the qualitative characteristic of reliability without being faithfully represented, provided that the other two components of reliability are sufficiently strong to satisfy investors of the reliability of the information. Does this then mean that the users of NFP statements do not value information that faithfully represents the economic phenomena underlying the financial statements? Obviously the answer is no.
The general purpose of NFP statements is to inform contributors of how management has discharged its stewardship over the assets that have been donated. As these assets were donated for specific purposes, users need the information within the financial statements to inform them of the responsibility of management in this regard. With this in mind, the users of NFP statements are equally, if not more so, concerned with faithfully represented information. The reason why faithful representation is a qualitative characteristic under IFRS and not under NFP is not because representational faithfulness is more important to IFRS. Rather, it is due to the fact that reliability and relevance carry different degrees of importance under each framework, stemming from the fact that IFRS and NFP reporting have different general purposes which aim to satisfy different user needs.
The effects of increased relevance and reliability on the main and off main diagonal probabilities within an information system show that an increase in one of either relevance or reliability often causes a reduction in the other. Both conceptual frameworks agree that reliability, and therefore representational faithfulness, must be traded off for higher relevance, and vice versa.
For the financial statements to faithfully represent economic phenomena in accordance with the NFP definition of representational faithfulness, assets acquisitions and revenue should be recognized by the entity only when the risks and rewards of ownership are transferred to the buyer and cash flows are known with reasonable certainty.
This recognition procedure, which has high reliability, has little relevance as it suggests cash flows are not anticipated early but rather are recognized when they can be verified. This is a reason why reliability is not a qualitative characteristic under IFRS. As the objective of IFRS is to provide relevant information to investors to aid them in making informed decisions with the expectation of gaining a return on their investment, relevance is far more of a concern under IFRS.
Since the accounting standards that are developed in accordance with each framework stem from the framework's general purpose, and relevance and reliability must inevitably be traded off for one another, if a framework seeks to satisfy the needs of users to whom relevant information is most useful, then the qualitative characteristics under that framework must stress relevance at the cost of lower reliability. If this were not the case, the information produced under the framework would be inconsistent with its purpose. Herein lies the reason that representational faithfulness, as opposed to reliability, is a qualitative characteristic under IFRS.
The purpose of IFRS reporting is to provide useful information to investors upon which to base their investment decisions, which they hope will bring financial gain. Accordingly, investors, creditors and lenders consider information to be useful if it enables them to reasonably estimate the future cash flows that the firm will receive. In order for financial statement information to achieve this purpose, the information must forecast future cash flows; it must be highly relevant. On the basis of this evidence, assisting in the production of relevant information is the main goal of the IFRS conceptual framework. It is for this reason relevance has a position as a qualitative characteristic. Where then does reliability fit in?
Reliability must be present to a degree in all financial information or it will not be useful, regardless of its relevancy. Hence, reliability needs to be reflected in all financial statement information. It needs to be a qualitative characteristic. Since reliability is not given the utmost importance, and representational faithfulness is a means by which reliability is achieved, IFRS standard setters have deemed it an appropriate reliability standard against which all financial statement information is to be measured.
In contrast, the focus user group of NFP statements has a preference for reliability over relevance as a result of their informational needs. These users, who are listed as members, contributors, and creditors expect information that will aid them in assessing management's stewardship of assets. NFP financial statements users' higher concern with management's discharge of its stewardship responsibility as compared to the users of IFRS statements is why reliability is so important. The lesser desire for relevance comes from the fact that contributors to NFP organizations are not interested in financial gain. As such, they do not to a great extent need information that predicts future cash flows.
The stronger desire to assess stewardship and the lesser need for profitability projections calls for information higher in reliability than relevance. Accordingly, in contrast to the IFRS framework, the NFP framework names reliability as a qualitative characteristic that useful information must embody.
The representational faithfulness subsection within the NFP framework reflects this heightened importance of reliability. These two paragraphs stress the importance of accounting for transactions in a manner that portrays their substance over their legal or other form. This comes in response to the fact that contributors need an accurate depiction of how their donations are being spent. If transactions were not required to be recorded in a manner that reflects their true substance then a moral hazard problem would result stemming from asymmetrical information. Since users do not have direct access to inside information, managers would have far more opportunity to conceal improper fund uses if transactions were instead permitted to be recorded to reflect their legal form.