BM1802

QUALITATIVE CHARACTERISTICS AND ELEMENTS OF FINANCIAL STATEMENT

Important Note: The basis of this discussion is the Conceptual Framework for Financial Reporting issued by
the International Accounting Standards Board (IASB) in 2010. The updates issued in 2018 and effective in 2020
from the revised Conceptual Framework are provided in italics for quick reference.

Qualitative Characteristics
Qualitative characteristics are qualities or attributes that make financial accounting information useful to users.
The qualitative characteristics of useful financial information identify the types of information that are likely to be
most useful to the existing and potential investors, lenders, and other creditors (primary users of financial
information) for making decisions about the entity on the basis of information in its financial statements. These
qualitative characteristics are useful if applied in the preparation of financial statements and any other related
financial information.

Cost Constraint on Useful Financial Reporting

Cost remains the pervasive constraint on the entity’s ability to provide useful information. The application of the
qualitative characteristics and the cost constraint varies between various kinds of financial information. In
accounting, a cost constraint arises when it is excessively expensive to report certain information in the financial
statements. When it is too expensive to do so, the applicable accounting framework allows a reporting entity to
avoid the related reporting (Bragg, 2018).

Application of Cost Constraints

In applying the cost constraint, the Board assesses whether the benefits of reporting a particular information
are likely to justify the costs incurred. Usually, this kind of assessment is made to decide whether to push for
the cost or seek an alternative. When applying the cost constraint in developing a proposed standard, the Board
seeks information from providers of financial information, users, auditors, academics, and others about the
expected nature and quantity of the benefits and costs of that standard. In most situations, assessments are
based on a combination of quantitative and qualitative information.
Two (2) Types of Qualitative Characteristics
a. Fundamental Qualitative Characteristics
b. Enhancing Qualitative Characteristics
Fundamental Qualitative Characteristics
The fundamental qualitative characteristics relate to the content or substance of financial information. If
financial information is to be useful, it must be relevant and faithfully represent what it purports to
represent. As such, the following are the fundamental qualitative characteristics as provided for in the
Conceptual Framework for Financial Reporting:

• Relevance
Relevance means the capacity of information to make a difference in a decision made by users. Simply, it is
the capacity of the information to influence a decision. Financial information is capable of making a difference
in decisions if it has predictive value, confirmatory value, or both. These two (2) benefits are interrelated.
o Predictive value – financial information that can be used as an input to processes employed by users
to predict future outcomes
o Confirmatory value – financial information that provides feedback about previous evaluations.
Relevance of financial information introduces the concept of materiality. Materiality is an entity-specific aspect
of relevance based on the nature and magnitude, or both, of the items to which the information relates in the
context of an individual entity’s financial report. Information is material if omitting it or misstating it could
influence decisions that users make on the basis of financial information about a specific entity.

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• Faithful Representation
To be useful, financial information must not only represent relevant phenomena, but it must also faithfully
represent the phenomena that it purports to represent. A depiction would have three (3) characteristics:
o Complete – includes all information necessary for the user to understand the phenomenon being
depicted, including all necessary descriptions and explanations
o Neutral – without bias in the selection or presentation of financial information
o Free from error – no errors or omissions in the depiction of the phenomenon, and the process used to
produce the reported information has been selected and applied with no errors in the process
In applying the fundamental qualitative characteristics, it is important to understand the concept of substance
over form. If the information is to represent faithfully the transactions it purports to represent, it is necessary
that the transactions are accounted for in accordance with their economic substance and reality and not
merely their legal form. If there is a conflict, the economic substance of the transaction shall prevail over the
legal form.

Applying the Fundamental Qualitative Characteristics

The most efficient and effective process for applying the fundamental qualitative characteristics would usually
be as follows (subject to the effects of enhancing characteristics and the cost constraint, which are not
considered in this example):
1. Identify an economic phenomenon and information which are capable of being useful to users of the
reporting entity’s financial information.
2. Identify the type of information about that phenomenon that would be most relevant and can be faithfully
represented.
3. Determine whether that information is available.

Enhancing Qualitative Characteristics

The enhancing qualitative characteristics are intended to increase the usefulness of the financial information
that is relevant and faithfully represented. These enhancing qualitative characteristics relate to the presentation
or form of financial information. The following are the enhancing qualitative characteristics as provided for in the
Conceptual Framework for Financial Reporting:
• Comparability. This is the qualitative characteristic that enables users to identify and understand
similarities in, and differences among items. Comparability does not relate to a single item and requires
at least two (2) items. Comparability may be made:
o within the entity/horizontal comparability/intracomparability – the quality of information that
allows comparisons within a single entity through time or from one (1) accounting period to the
next; and
o across entities/dimensional comparability/intercomparability – the quality of information that
allows comparison between two (2) or more entities engaged in the same industries.
• Verifiability. This means that different knowledgeable and independent observers could reach a
consensus. Verification can be:
o Direct – verifying an amount or other representation through direct observation; and
o Indirect – checking the inputs to a model, formula or other technique and recalculating the
inputs using the same methodology.
• Timeliness. This means having information available to decision makers the moment it is needed for
specific purposes. Generally, the older the information, the less useful it is. However, some information
may continue to be timely long after the end of the reporting period because some users may need to
identify and assess trends.

• Understandability. This requires that financial information must be comprehensible or intelligible if it is

to be useful. Accordingly, information should be presented in a form and expressed in terminology that
a user understands. Classifying, characterizing, and presenting information clearly and concisely makes
it understandable. In certain cases, complex economic activities make it impossible to reduce financial

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information to the simplest terms. Accordingly, the users should have an understanding of complex
economic activities, the financial accounting process, and the terms in financial statements.

Application of Enhancing Qualitative Characteristics

Applying the enhancing qualitative characteristics is an iterative process that does not follow a prescribed order.
Sometimes, one enhancing qualitative characteristic may have to be diminished to maximize another qualitative
characteristic. For example, a temporary reduction in comparability as a result of prospectively applying a new
standard may be worthwhile to improve relevance or faithful representation in the longer term. Appropriate
disclosures may partially compensate for non-comparability.
In the revised Conceptual Framework, the IASB reintroduced the following concepts to support the application
of fundamental and enhancing qualitative characteristics of useful financial information:
• Prudence – This is the exercise of caution when making judgments under conditions of uncertainty.
Prudence does not allow for overstatement or understatement of assets, liabilities, income, or
expenses.
• Measurement uncertainty – This does not prevent information from being useful. Where it is reasonably
possible that the amount recognized in the financial statements could change by a material amount,
this fact should be disclosed.
The Elements of Financial Statements
The elements of financial statements refer to the quantitative information shown in the statement of financial
position and statement of comprehensive income. Financial statements portray the financial effects of
transactions and other events by grouping them into broad classes according to their economic characteristics.
These broad classes are termed as elements of financial statements.
The elements directly related to the measurement of financial position in the balance sheet are as follows:
• Assets – resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity
• Liabilities – present obligation of the entity arising from past events, the settlement of which is expected
to result in an outflow from the entity of resources embodying economic benefits
• Equity – residual interest in the assets of the entity after deducting all its liabilities
From the revised Conceptual Framework:
• Assets – a present economic resource controlled by the entity as a result of past events. An economic
resource is a right that has the potential to produce economic benefits.
• Liabilities – a present obligation of the entity to transfer an economic resource as a result of past events.
An obligation is a duty of responsibility that the entity has no practical ability to avoid.
The elements directly related to the measurement of financial performance in the income statement are as
follows:
• Income – increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than those
resulting to contributions from equity participants
• Expenses – decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity other than those
relating to distributions to equity participants
From the revised Conceptual Framework:
• Income – increases in assets, or decreases in liabilities, that result in increases in equity, other than
those relating to contributions from holders of equity claims
• Expenses – decreases in assets, or increases in liabilities, that result in decreases in equity, other than
those relating to distributions to holders of equity claims

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Recognition of Elements of Financial Statements

Recognition is the process of incorporating in the balance sheet or income statement an item that meets the
definition of an element and satisfies the criteria for recognition. It involves the depiction of the item in words
and by monetary amount and the inclusion of that amount in the balance sheet or income statement.
An item that meets the definition of an element should be recognized if:
• it is probable that any future economic benefit associated with the item will flow to or from the entity;
and
• the item has a cost or value that can be measured with reliability.
From the revised Conceptual Framework:
Recognition is the process of capturing for inclusion in the statement of financial position or the statement of
financial performance an item that meets the definition of an asset, a liability, equity, income, or expenses.
Recognition is appropriate if it results to the following:
• Relevant information about assets, liabilities, equity, income, and expenses
• A faithful representation of those items

Asset Recognition Principles

An asset is recognized in the statement of financial position when it is probable that future economic benefits
will flow to the entity and the asset has a cost or value that can be measured reliably.
Thus, two (2) conditions must be present for asset recognition:
• It is probable that future economic benefits will flow to the entity.
• The cost or value of the asset can be measured reliably.
The future economic benefit embodied in an asset is the potential to contribute directly or indirectly to the flow
of cash and cash equivalents to the entity. In addition, inherent in asset recognition is the cost principle. The
principle requires that assets shall be recorded initially at original acquisition cost. Simply, the financial
statements shall be based on historical cost rather than market value. The reason is that cost is objective and
therefore verifiable while market value is subjective.

Liability Recognition Principles

A liability is recognized in the statement of financial position when it is probable that an outflow of resources
embodying economic benefits will be required for the settlement of a present obligation and the amount of the
obligation can be measured reliably. Thus, two (2) conditions must be present for the recognition of a liability:
• It is probable that an outflow of economic benefits will be required for the settlement of a present
obligation.
• The amount of obligation can be measured reliably.
The present obligation of an entity may be:
• Legal – legally enforceable as a consequence of a binding contract or statutory requirement
• Constructive – arises from normal business practice, customs, and a desire to maintain good business
relations or act in an equitable manner

Income Recognition Principles

The basic principle is that income shall be recognized when earned. The Conceptual Framework provides that
income is recognized when it is probable that an increase in future economic benefit related to an increase in
an asset or a decrease in liability has arisen and that the increase in economic benefits can be measured
reliably. Thus, two (2) conditions must be present for the recognition of income, namely:
• It is probable that future economic benefits will flow to the entity as a result of an increase in an asset
or a decrease in a liability.
• The economic benefits can be measured reliably.

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Both conditions are present at point of sale. Accordingly, the point of sale is the point of revenue recognition.
The reason is that the entity has transferred to the buyer the significant risks and rewards of ownership. The
definition of income encompasses both revenue and gain:
• Revenue – arises in the course of the ordinary regular activities
• Gain – represents an item that meets the definition of income and does not arise in the course of
ordinary regular activities
Specifically, for the recognition of revenue from the sale of goods, the Philippine Accounting Standards (PAS)
18 provides the following conditions for recognition:
• The entity has transferred to the buyer the significant risk and rewards of ownership of the goods.
• The entity retains neither continuing managerial involvement nor effective control over the goods sold.
• The amount of revenue can be measured reliably.
• It is probable that economic benefits associated with the transaction will flow to the entity.
• The costs incurred or to be incurred with respect to the transaction can be measured reliably.
Specifically, for the recognition of revenue from rendering of services, PAS 18 provides the following conditions
for recognition:
• The amount of the revenue can be measured reliably.
• It is probable that economic benefits associated with the transaction will flow to the entity.
• The stage of completion of the transaction at the end of reporting period can be measured reliably.
• The costs incurred for the transaction and the costs to complete can be measured reliably.

Expense Recognition Principles

The Conceptual Framework provides that expenses are recognized when it is probable that a decrease in future
economic benefit related to a decrease in an asset or an increase in liability has occurred and the decrease in
economic benefits can be measured reliably. Thus, two (2) conditions must be present for the recognition of
expenses:
• It is probable that a decrease in future economic benefit has occurred.
• The decrease in economic benefits can be measured reliably.
The definition of expense encompasses both expenses and losses:
• Expenses – arise in the course of ordinary regular activities of the entity
• Losses – represent other items that meet the definition of expenses and do not arise in the course of
ordinary regular activities of the entity
The expense recognition principle is the application of the matching principle. The generation of revenue is
without any cost. Expenses are incurred in conformity with the three (3) applications of the matching principle,
namely:
• Cause and effect association – means that the expense is recognized when the revenue is already
recognized on the basis of a presumed direct association of the expense with specific revenue
• Systematic and rational allocation – costs are expensed by allocating them over the periods benefited
• Immediate recognition – costs incurred are expensed outright because of the uncertainty of future
economic benefits or difficulty of reliably associating certain costs with future revenue.
From the revised Conceptual Framework:
Recognizing assets, liabilities, equity, income, and expenses depicts an entity’s financial position and financial
performance in structured summaries (the statement of financial position and financial performance). The
amounts recognized in a statement are included in the totals and, if applicable, subtotals, in the statement. The
statements are linked to changes in assets and liabilities.

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Measurement Bases
Measurement is the process of determining the monetary amounts at which the elements of financial statements
are to be recognized and carried in the balance sheet and income statement. The four (4) measurement bases
are as follows:
• Historical cost – the amount of cash or cash equivalent paid or the fair value of the consideration given
to acquire an asset at the time of acquisition
• Current cost – the amount of cash or cash equivalent that would have to be paid if the same or an
equivalent asset was acquired currently
• Realizable value – the amount of cash or cash equivalent that could currently be obtained by selling the
asset in an orderly disposal
• Present value – the discounted value of the future net cash inflows that the item is expected to generate
in the normal course of business
From the revised Conceptual Framework:
Current value provides information updated to reflect conditions at the measurement date. Current value
measurement bases include:
• Fair value – the price that would be received to sell an asset, or paid to transfer a liability, in an orderly
transaction between market participants at the measurement date
• Value-in-use (for assets) and fulfillment value (for liabilities) – reflects entity-specific current
expectations about the amount, timing, and uncertainty of future cash flows
• Current cost – reflects the current amount that would be paid to acquire an equivalent asset or received
to take on an equivalent liability

References
International Accounting Standards Board. (2018). NZ conceptual framework. United Kingdom: International
Financial Reporting Standards Foundation.
Valix, C. T. (2018). Theory financial accounting. Manila: GIC Enterprises & Co. Inc.

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