Qualitative characteristics in accounting disclosures: a desirability trade-off

Malcolm Smith Associate Professor of Accounting, School of Economics and Commerce, Murdoch University, Perth, Australia

A number of studies in the USA, UK, Australia and Canada have addressed the evaluation of the usefulness of accounting information and sought to identify criteria for assessing the quality and utility of financial reports (e.g. Institute of Chartered Accountants in England and Wales (1975), Financial Accounting Standards Board (1980), Institute of Chartered Accountants in Scotland (1988), Accounting Standards Board (1991)). The qualitative characteristics viewed as desirable for the fulfilment of the fundamental objective of communicating decision-useful measurement recognize that all of these characteristics are not simultaneously achievable and that some trade-off is necessary. Examines the nature of this conflict of objectives and attempts to quantify the extent of the conflict for different user groups.

Introduction
Since the late 1960s research efforts regarding a conceptual framework have been commissioned in response to mounting public and professional pressure with regard to the nature of corporate reporting and deficiencies in the accounting standard setting process. Peasnell[1, p. 254] with respect to the Financial Accounting Standards Board (FASB) conceptual framework observes: “it perceives a need to show that its heart and mind are in the right place: to demonstrate that it is trying by logical means to develop accounting standards based on principles of general appeal”. If accounting standards and the resulting disclosures are to meet the varying and potentially conflicting needs of all user groups, then such standards should be adaptive to the changing requirements of interested parties. The presence of a conceptual framework should guide the standard setting process by deriving relevant usergoals consistent with the definitions and qualitative characteristics of its elements. The Corporate Report of the Accounting Standards Steering Committee, Institute of Chartered Accountants in England and Wales (ICAEW) (1975)[2] identifies seven qualitative characteristics viewed as desirable for the fulfilment of their fundamental objective of communicating decision-useful measurements: 1 relevance; 2 understandability; 3 reliability; 4 completeness; 5 objectivity; 6 comparability; 7 timeliness. That these characteristics are desirable is not in doubt, rather the problem is that they are not simultaneously achievable (and may, in any case, be ambiguous in meaning). Their very nature makes a conflict of objectives inevitable and this paper seeks to examine and quantify this conflict. The Corporate Report[2] provides no indication of perceived importance of the desirable attributes. It is apparent that all may not be capable of simultaneous achievement, and it

Managerial Auditing Journal 11/3 [1996] 11–16 © MCB University Press [ISSN 0268-6902]

is evident that some compromise position is necessary in order to satisfy an inevitable conflict in objectives. The desirable compromise position, and the permitted trade-off between properties, will likely depend on both the user-group and the decision-making context. Thus, the sevenfold classification of The Corporate Report[2] might, a priori, be aggregated as shown in Figure 1. Such divisions are consistent with the approaches of the accounting standard setting bodies. Thus FASB[3] makes a clear distinction between those qualities viewed as user-specific and those inherent in the information. Relevance, reliability and comparability are apparently viewed as the key attributes, with other characteristics viewed as sub-attributes contributing to the fulfilment of the key properties. A “materiality threshold” is suggested such that the benefits provided by the disclosure of information should exceed its cost. FASB[3] admits that there may be a tradeoff between relevance and reliability, indicating that although ideally the choice of an accounting alternative should produce information that is both more reliable and more relevant, it may be necessary to sacrifice some of one quality for a gain in another. Understandability is viewed as a user-specific property in the FASB model, desirable, but one whose importance is played down, since the understandability of the information is related to both the characteristics of the information and of the information-user making it difficult to evaluate without reference to a particular set of decision makers. Given that information can only be useful if it can be understood, even though it may be reliable and relevant to the decision-making context, this lack of emphasis may not be wholly appropriate. Stamp[4], operating within a Canadian context, emphasizes that not only is “understandability” user-specific, but so is “relevance”, since any judgement of relevance must be made relative to user needs and the decision-making context. Solomons[5, p. 30] emphasizes this point: “Relevance must come first, for if information is irrelevant, it does not matter what other qualities it has”.

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Malcolm Smith Qualitative characteristics in accounting disclosures Managerial Auditing Journal 11/3 [1996] 11–16

Figure 1 Aggregated classification of The Corporate Report Usefulness Accuracy Validity

Reliability Timeliness Completeness Objectivity

Understandability

Readability

Stamp identifies several pairs of criteria that might be perceived to be in conflict, so much so that a trade-off is necessitated in their fulfilment. However, he makes no attempt to quantify the nature and extent of such tradeoffs, preferring to develop absolute weighting scores for each of the criteria. However, as Stamp emphasizes, there are no generally accepted definitions of the criteria employed and semantic differences may influence user preferences; the criteria employed are neither mutually exclusive nor collectively exhaustive. Their meanings clearly overlap and it is possible that all desirable aspects have not been completely covered. In any case it may be unrealistic to expect a consistent assignment of absolute numerical weightings to qualitative criteria, since such a ranking system is likely to be decision specific. In such circumstances it may be more appropriate to evaluate relative weightings by examining the trade-off between conflicting characteristics for particular user-groups. A number of studies (notably Stanga[6] and Duncan and Moores[7]) have already addressed the issue of a trade-off between relevance and reliability, concluding that a positive association exists between the two, with minimum levels of reliability necessary to achieve relevance. This study tackles the other trade-offs too. The corporate governance debate generated by the Cadbury Committee Report[8] in the UK and the COSO Report[9] in the USA have clear implications for qualitative characteristics. The COSO Report emphasizes the importance of both “information and communication” while the Cadbury Report emphasizes, in its code of best practice, the duty of the board to present an assessment of a company’s position which is both balanced and understandable. Recognition of the importance of understandability highlights the need for both words and figures in explaining a company’s position. In

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{

Relevance Comparability

Quality of content

Quality of presentation

Australia, qualitative characteristics are implicit in a number of financial reporting reforms recommended by the ASCPA/ICAA [10, para. 3026] as a consequence of this debate, which would improve relevance and comparability and highlight the need for timely information, future oriented information, consistency of accounting policies and a preference for substance over form. FASB[3] identifies three criteria for the assessment of qualitative criteria: 1 Convergent validity of operational characteristics. The same decision context should result in coincident ratings of particular characteristics. 2 Predictive validity. A comprehensive set with all important factors represented. 3 Discriminant validity. A parsimonious set of characteristics with minimum overlap. Joyce et al.[11], in an empirical study with a group of US policy makers, embracing alternative policy decisions, find such a model almost completely non-operational and highlight that: • scarcely any common meaning is attributed to the same qualitative characteristic by different policy makers; • scarcely any common meaning exists for the same qualitative characteristics across different accounting issues; • little agreement exists on the importance of characteristics ranked for different issues; • virtually no agreement exists among policy makers on which accounting alternative provided more of a particular characteristic. However, individual participants had little difficulty in expressing global policy preferences consistently through the qualitative characteristics, and characteristic rankings were a good predictor of individual participants’ policy choice. Joyce et al.[11] find that the accounting standard setters, though consistent as individuals, vary greatly between themselves with regard to the relativities accorded different qualitative characteristics. Such a finding makes group preference weightings largely inappropriate for this set of respondents, but needs testing with other, arguably more diverse, user groups. Further, the Joyce et al.[11] findings make it difficult to justify a complex experimental design with multiple policy scenarios used to provide decision contexts; individual differences are more significant than those attributable to the scenarios. In this study, therefore, global policy preferences are explored, without regard to a specific decision context. As with the earlier Stamp[4] study, Joyce et al.[11] confine their attention to accounting policy standard setters. There is no attention

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Malcolm Smith Qualitative characteristics in accounting disclosures Managerial Auditing Journal 11/3 [1996] 11–16

to the needs of other users of accounting information. This present study corrects this deficiency by seeking the participation of two other sub-groups among those with high levels of accounting sophistication: the first being accounting practitioners from a Big 6 enterprise; and the second being graduate students of an MBA Finance programme. Differences in the performance of members of these two sub-groups might be anticipated where the task domain requires measurement of their perceptions of the relative importance of different qualitative criteria. However, Ashton and Kramer[12] and Zimmer[13] suggest that students make excellent surrogates for practitioners in behavioural accounting research involving simple decision tasks. This application is concerned with 21 similarity judgements (i.e., 7C2 being all combinations of two qualitative properties from the seven (stimuli) deemed desirable by The Corporate Report[2]). Schiffman et al.[14] recommend the use of an undifferentiated 5in. scale to record respondents’ similarity judgements. They suggest that a 4in. line will compress results, while a 6in. line will encourage the non-use of the right-hand scale. The line used is not differentiated in any way (i.e. no boxes, numbers, synonyms or verbal descriptors) to avoid the potential for bias. These suggestions are incorporated into the test instrument.

To explore the potential of the research approach two groups of respondents were identified: 1 A group of “users”. Forty MBA Finance students at a UK university business school skilled in financial statement analysis and already familiar with those properties deemed desirable in accounting communications. 2 A group of “auditors”. Eighteen practicising accountants from the London office of a “Big 6” accounting firm, comprising three partners, five managers, three assistant managers, four supervisors and three seniors. Each group was supplied with an abstract from The Corporate Report in which the properties are designated and a brief reinforcement of each of the seven properties, and their meaning. Respondents were required to quantify their ranking of characteristics by indicating their preference between pairs of properties. This preference was stated in a measurable way by showing the trade-off that each respondent thought permissible; that compromise position whereby a degree of one property might be sacrificed for part of the other. The 21 pairs of properties (all combinations of 2 from 7) are distributed randomly, for order and for position on the left-hand or right-hand of the test instrument scale of Figure 2, to ensure, as far as possible, that 21 separate decisions were made.

Figure 2 Experimental task: property trade-offs

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Malcolm Smith Qualitative characteristics in accounting disclosures Managerial Auditing Journal 11/3 [1996] 11–16

Respondents were asked to mark each line with an “X” to indicate their preferred position. Thus, for the first trade-off “reliability v. relevance” an “X” at the extreme left-hand end of the line indicates an absolute preference for “reliability” which sacrifices all “relevance”. Realistically, we would expect the “X” to be positioned part way along the line to indicate a trade-off which expressed a preference for reliability . A 40-point measurement scale was used. A score of 20 represented indifference between the two properties. The results and responses represent the satisfaction of inter-property conflict on an individual basis.

Results
Table I details each of the 21 trade-offs together with the mean preference scores corresponding to the two-user groups. In each case the lower the score, the greater the preference for the left-hand characteristic in the trade-off. Low scores are particularly apparent, in both user groups, for preferences associated with the “reliability” characteristic.

Despite some apparently large differences between groups in scores between user groups, such are the sizes of standard deviations that none of the mean differences is significant at the 5 per cent level. Aggregation of the trade–offs by characteristic (i.e. six for each) reveals a strong preference for reliability, objectivity and relevance among both sets of respondents in their perceived importance of the different properties. Table II displays the mean scores recorded. None of the differences in preference percentages or ranks is significantly different at the 0.025 level between the groups despite the likely individual differences attributable to education and experience. The preference for reliability is marked in both groups, a result significantly at variance with that of Stamp[4], who reported a clear preference for “relevance” among accounting professionals. The overriding common feature is that the scores recorded for both groups reflect a positive preference for the same three qualitative characteristics (reliability, relevance and objectivity). The distribution of properties for each respondent group is so close as to suggest that

Table I Mean trade-off scores for two user groups Trade-off 1 Relevance – understandability 2 Relevance – reliability 3 Relevance – completeness 4 Relevance – objectivity 5 Relevance – timeliness 6 Relevance – comparability 7 Understandability – reliability 8 Understandability – completeness 9 Understandability – objectivity 10 Understandability – timeliness 11 Understandability – comparability 12 Reliability – completeness 13 Reliability – objectivity 14 Reliability – timeliness 15 Reliability – comparability 16 Completeness – objectivity 17 Completeness – timeliness 18 Completeness – comparability 19 Objectivity – timeliness 20 Objectivity – comparability 21 Timeliness – comparability Note: Standard deviations in parentheses [ 14 ] Mean scores MBA group (n = 40) Accountants (n = 18) 15.65 22.30 13.78 17.75 19.35 17.90 26.45 18.35 24.10 20.53 21.88 11.65 15.53 16.05 13.00 23.45 22.40 23.18 19.73 19.32 18.87 (10.38) (8.91) (8.20) (8.99) (8.29) (9.23) (7.90) (9.52) (9.82) (9.23) (8.82) (6.52) (7.21) (8.14) (9.09) (9.52) (8.91) (8.12) (9.46) (9.57) (8.53) 19.22 21.50 18.44 20.33 17.61 19.33 24.11 18.50 21.78 18.17 20.00 13.39 18.11 16.22 15.00 23.39 18.17 18.67 15.67 18.39 22.56 (9.61) (11.80) (9.87) (10.24) (9.38) (9.39) (9.43) (11.71) (8.43) (10.73) (7.57) (7.45) (7.96) (11.32) (9.55) (8.76) (11.19) (10.85) (6.02) (7.32) (8.93)

Malcolm Smith Qualitative characteristics in accounting disclosures Managerial Auditing Journal 11/3 [1996] 11–16

Table II Relative desirability of qualitative characteristics MBA students (n = 40) Preference (%) Mean SD 18.2 15.9 14.4 14.2 13.6 12.4 11.3 100 3.5 4.0 4.2 4.7 4.5 5.1 3.9 Rank Mean 2.3 3.4 3.9 4.1 4.3 4.7 5.2 SD 1.3 1.8 1.8 2.1 1.9 2.1 1.5 Accountants (n = 18) Preference (%) Mean SD 17.0 14.7 15.4 12.3 13.6 13.9 13.1 100 4.1 4.5 2.8 4.8 3.8 3.4 5.0 Rank Mean 2.9 3.7 3.4 4.8 4.2 4.2 4.7 SD 1.7 2.2 1.6 2.3 1.9 1.4 1.9

Property Reliability Relevance Objectivity Timeliness Comparability Understandability Completeness

they provide user groups of similar needs, forming sub-groups within a “sophisticated” accounting audience. In fact, a linear discriminant analysis, treating accounting practitioners and MBA students as separate groups, classifies only 69 per cent of subjects correctly based on their preference profiles for qualitative characteristics.

differences between these two sets of users certainly appears insufficient to justify a difference in financial reporting approach.

References
1 Peasnell, K., “The function of the conceptual framework for corporate financial reporting”, Accounting and Business Research, Vol. 12 No. 48, Autumn 1982, pp. 243-56. 2 Institute of Chartered Accountants in England and Wales (ICAEW), The Corporate Report, Accounting Standards Steering Committee, London, 1975. 3 Financial Accounting Standards Board (FASB), Statement of Financial Accounting Concepts No 2. Qualitative Characteristics of Accounting Information, 1980. 4 Stamp, E., “First steps towards a British conceptual framework”, Accountancy, Vol. 93, March 1982, pp. 123-30. 5 Institute of Chartered Accountants in England and Wales (ICAEW), Guidelines for Financial Reporting: The Solomons Report, ICAEW, London, 1989. 6 Stanga, K.G., “The relationship between relevance and reliability: some empirical results”, Accounting and Business Research, Winter 1980, pp. 29-39. 7 Duncan, K. and Moores, K., “Usefulness of CCA information for investor decision making: a laboratory experiment”, Accounting and Business Research, Vol. 18 No. 70, Spring 1988, pp. 121-32. 8 Cadbury Committee, Report of the Committee on the Financial Aspects of Corporate Governance, Cadbury Committee, London, 1992. 9 Committee of Sponsoring Organisations (COSO) of the Treadway Commission, Internal Control – Integrated Framework, Washington DC, 1992. 10 Australian Society of Certified Accountants/ Institute of Charted Accountants Australia, Bridging the Expectations Gap: a Research

Conclusions
The empirical findings for both MBA Finance students and accounting practitioners demonstrate preferences which suggest that these users are prepared to sacrifice completeness, comparability, timeliness and understandability in disclosures in return for reliability, objectivity and relevance. This preference for reliability and relevance is consistent with the proposals of accounting standard–setters worldwide, and may be attributable to a correspondence of the user groups concerned with the sophisticated target user designated by the accounting standard-setters. Respondents perception of the relative importance of understandability is apparently also consistent with the subservience attached to it by the accounting standard setters though at odds with the Cadbury Committee’s “Code of Best Practice”[8]. This study demonstrates considerable homogeneity within sophisticated user groups, greater than that evident in studies of accounting standard setters. By highlighting the conflict inevitable in seeking to satisfy simultaneously mutually incompatible characteristics, this paper demonstrates common preferences in user groups sufficient to provide encouragement to standard setters in their desire to target a single sophisticated target user group. The

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Malcolm Smith Qualitative characteristics in accounting disclosures Managerial Auditing Journal 11/3 [1996] 11–16

Study on Financial Reporting and Auditing, Melbourne/Sydney, 1994. 11 Joyce, E.J., Libby, R. and Sunder, S., “Using the FASB’s qualitative characteristics in accounting policy choices”, Journal of Accounting Research, Vol. 20 No. 2, Part 2, Autumn 1982, pp. 654-75. 12 Ashton, R.H. and Kramer, S.S., “Students as surrogates in behavioural accounting research: some evidence”, Journal of Accounting Research, Vol. 18, Spring 1980, pp. 1-15. 13 Zimmer, I., “A lens study of the prediction of corporate failure by bank loan officers”, Journal of Accounting Research, Vol. 18, Autumn 1980, pp. 629-36.

14 Schiffman, S.S., Reynolds, M.L. and Young, F.W., Introduction to Multidimensional Scaling: Theory, Methods and Applications, Academic Press, New York, 1981.

Further reading
Accounting Standards Board (ASB), Qualitative Characteristics of Financial Information, ASB, London, July 1991. Institute of Chartered Accountants in Scotland (ICAS), Making Corporate Reports Valuable, ICAS, Edinburgh, 1988. Jensen, R.E., Phantasmagoric Accounting, American Accounting Association, Sarasota, FL, 1976.

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