Relevance and Faithful Representation
Relevance and faithful representation are the two fundamental qualitative characteristics of useful financial information. Relevance refers to the property of information being capable of making a difference in decisions made by users of that information. Faithful representation refers to an information’s ability to represent underlying economic phenomena faithfully.
Information is relevant if either it can be used as input in processes used to identify future outcomes (i.e. it has predictive value) or it can confirm past evaluations about economic phenomenon (i.e. it has confirmatory value) or both. For example, disclosure about current year revenue is useful in making predictions about revenue next year but it also helps in confirming whether last year prediction was correct. Similarly, impairment charge revises a user’s valuation of an entity’s net assets, and so on.
Faithful representation is achieved when the financial information represents not just the legal form but the underlying economic substance of transactions. This is achieved when the information is complete, neutral and free from error.
Completeness means disclosure of all information necessary for proper understanding of the underlying phenomena.
Neutrality requires an unbiased depiction of economics and involves exercise of prudence such that neither current period earnings are overstated or understated nor those of future periods.
Free from error means that the underlying process used to prepare the financial information being presented. It does not mean 100% accuracy because the cost of achieving it might be too high.
Trade-off between relevance and faithful representation
In many cases, it is easy to present information which is both relevant and which presents the transactions faithfully but in some instances, we might need to strike a balance between both requirements. Relevance and faithful representation 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.
- After the balance sheet date but before the date of issuance of financial statements, 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, the uncertainty would resolve and it can disclose more certain information which would represent the underlying phenomena more truthfully. But this would be at the cost of reduction in relevance. The information would be outdated and no longer very relevant.
- The uncertainty surrounding a company’s potential liability in a legal claim might be too high thereby making the estimate not very accurate. However, the company might still present an estimate, even if not fully true and fair, and explain the sources of uncertainty for the sake of relevance.