Question

QUESTION 8 a) Explain the fundamental qualitative characteristics of accounting information. (5 Marks) b) Explain the enhancing qualitative characteristics of accounting information. (5 Marks) c) Financial statements are the summary of the financial results of the operation of a business for a specified period of time and the financial position as at that date. What are the components of financial statements? (2.5 marks) d) Financial statements are prepared to meet the demands and aspirations of certain group of people Mention five (5) users of financial satements and state any two reasons why such user needs financial statements. (2.5 marks) e) DuPont is said to be the better way of analyzing Return On Equity (ROE). What are the components of DuPont Analysis? (3 marks)

Answer 1

Answer: 8-

A) There are six qualitative characteristics of accounting information. Two of the six qualitative characteristics are fundamental (must have), while the remaining four qualitative characteristics are enhancing (nice to have).

Fundamental (Primary) Qualitative Characteristics

Qualitative characteristics of accounting information that must be present for information to be useful in making decisions:

1. Relevance-

   Relevance refers to how helpful the information is for financial decision-making processes. For accounting information to be relevant, it must possess:

   1. Confirmatory value – Provides information about past events
   2. Predictive value – Provides predictive power regarding possible future events.

Therefore, accounting information is relevant if it can provide helpful information about past events and help in predicting future events or in taking action to deal with possible future events. For example, a company experiencing a strong quarter and presenting these improved results to creditors is relevant to the creditors’ decision-making process to extend or enlarge credit available to the company.

2. Representational faithfulness-

Representational faithfulness, also known as reliability, is the extent to which information accurately reflects a company’s resources, obligatory claims, transactions, etc. To help, think of a pictorial depiction of something in real life – how accurately does the picture represent what you see in real life? For accounting information to possess representational faithfulness, it must be:

1. Complete – Financial statements should not exclude any transaction.
2. Neutral – The degree to which information is free from bias. Note that there are subjectivity and estimation involved in financial statements, therefore information cannot be truly “neutral.” However, if a company polled 1,000 accountants and took the average of their answers, that would be considered neutral and free from bias.
3. Free from error – The degree to which information is free from errors.

Answer B) Enhancing (Secondary) Qualitative Characteristics are as follows:

1. Verifiability- Verifiability is the extent to which information is reproducible given the same data and assumptions. For example, if a company owns equipment worth $1,000 and told an accountant the purchase cost, salvage value, depreciation method, and useful life, the accountant should be able to reproduce the same result. If they cannot, the information is considered not verifiable
2. Timeliness- Timeliness is how quickly information is available to users of accounting information. The less timely (thus resulting in older information), the less useful information is for decision-making. Timeliness matters for accounting information because it competes with other information. For example, if a company issues its financial statements a year after its accounting period, users of financial statements would find it difficult to determine how well the company is doing in the present.
3. Understandability- Understandability is the degree to which information is understood. In today’s society, corporate annual reports are in excess of 100 pages, with significant qualitative information. Information that is understandable to the average user of financial statements is highly desirable. It is common for poorly performing companies to use a lot of jargon and difficult phrasing in its annual report in an attempt to disguise the underperformance.
4. Comparability- Comparability is the degree to which accounting standards and policies are consistently applied from one period to another. Financial statements that are comparable, with consistent accounting standards and policies applied throughout each accounting period, enable users to draw insightful conclusions about the trends and performance of the company over time. In addition, comparability also refers to the ability to easily compare a company’s financial statements with those of other companies.

   The qualitative characteristics of accounting information are important because they make it easier for both company management and investors to utilize a company’s financial statements to make well-informed decisions.

Answer C) Financial Statements are a set of following 5 components:

1. Statement of Financial Position commonly known as Balance Sheet
2. Statement of Profit and Loss and other Comprehensive Income commonly known as Profit & Loss Account
3. Cash flow statement
4. Statement of changes in equity
5. Note to the financial statements

All of above complement each other in explaining the operational results of a Company.

Answer D) Following are users of financial Statements:

1. Owners and investors- Stockholders of corporations need financial information to help them make decisions on what to do with their investments (shares of stock), i.e. hold, sell, or buy more. Prospective investors need information to assess the company's potential for success and profitability.

2. Management- In huge organizations, however, management is usually made up of hired professionals who are entrusted with the responsibility of operating the business or a part of the business. They act as agents of the owners. The managers, whether owners or hired, regularly face economic decisions – How much supplies will we purchase? Do we have enough cash? How much did we make last year? Did we meet our targets? All those, and many other questions and business decisions, require analysis of accounting information.

3. Trade creditors or suppliers - Like lenders, trade creditors or suppliers are interested in the company’s ability to pay obligations when they become due. They are nonetheless especially interested in the company's liquidity – its ability to pay short-term obligations.

4. Government - Governing bodies of the state, especially the tax authorities, are interested in an entity's financial information for taxation and regulatory purposes. Taxes are computed based on the results of operations and other tax bases. In general, the state would like to know how much the taxpayer makes to determine the tax due thereon.

5. Employees - Employees are interested in the company’s profitability and stability. They are after the ability of the company to pay salaries and provide employee benefits. They may also be interested in its financial position and performance to assess company expansion possibilities and career development opportunities.