Building a solid foundation requires strong pillars. This article presents a brief of the Statements of Financial Accounting Concepts (SFACs) 1 and 2. Knowing the concept behind these SFACs is important because they are intended to set forth objectives and fundamentals of future developments of financial accounting and reporting.
SFAC 1 Objectives of Financial Reporting by Business Enterprises.
A financial report may or may not include financial statements. Financial reports document transactions that have already occurred and may be based on estimates, which limits the usefulness of financial statements. The benefits users obtain from financial reports must be greater than the cost of producing them. Financial reports help investors, bankers, creditors, and the government in making sound economic decisions. These users are called stakeholders because they have an interest vested in the enterprise. Basically financial reports provide information about resources and uses of resources of an enterprise in a manner that generates a favorable cash flow. Financial reports are a valuable tool for management performance measurement. Since numbers don’t lie truthful financial information reveals if goals set forth by managers have been achieved.
SFAC 2 Qualitative Characteristics of Accounting Information
Primary qualitative characteristics of accounting information are relevance and reliability. Comparability, including consistency, is a secondary quality.
Information is relevant if it is capable of making a difference in a decision by helping users to predict possible outcomes of past, present, or future events, or to confirm or correct prior expectations. For example Bernard Madoff’s clients received information that was relevant to investors because they believed it would provide higher returns than normal returns existing in the market. A due diligence process by regulators and investors could have proven that the financial statements and information was biased and inaccurate, as investigators have proven. Three elements make financial information relevant: timeliness, predictive value, and feedback value. To be useful for decision-making information must be available at the time decisions are made. If financial information helps users predict outcomes, such as return on investments, it meets the predictive value characteristic. When confirming or correcting prior expectations, information provides users with feedback value. In the case of Madoff’s investors, the feedback value provided by financial and non-financial information brought them to the realization that expectations on returns were unrealistic and that not only did not achieve the desired return but also lost their investments.
Coupled with relevance the concept of reliability increases the usefulness of accounting information. Three characteristics make accounting information reliable: representational faithfulness, verifiability, and neutrality.
Representational faithfulness, means it represents what it intends to represent. Obviously there was not representational faithfulness when Madoff presented investors with financial statements on which they based their investing decisions. It purported to be safe and provide high returns. None of it was true. Accounting information is verifiable when different and independent observers come up with the same results. For example financial analysts from a bank, from the Securities and Exchange Commission, and forensic accountants should determine exactly the same financial ratios when analyzing the financial statements of Art for the Soul, LLC as of December 31, 2009. Neutrality implies that financial information is free of bias. It means that it does not serve an agenda. It means that the results reflect was derived from information on the financial statements, independently of the disappointment it could bring to investors and for extension, to management members who did not meet expectations.
Relevance and reliability are crucial qualitative characteristics of financial information. When accountants depart from them fraudulent reports are prepared. Fraudulent financial statements are a field where forensic accountants play an important role uncovering the actions of unethical financial professionals that have undermined the image of the accounting profession.
Be aware that although SFACs create a consistent framework for consistent financial accounting and reporting, they are not considered authoritative pronouncements nor supersede or modify Generally Accepted Accounting Principles.