Two fundamental, four enhancing, one constraint

What makes information useful

The objective of financial reporting is to give investors, lenders and other creditors information useful for deciding whether to provide resources to the company. The Conceptual Framework then asks: useful how? Its answer is a short hierarchy. Two fundamental characteristics that information must have to be useful at all; four enhancing characteristics that make useful information more useful; and one constraint that caps the whole thing.

Worked example — a property at fair value or at cost?

Tamarack Outfitters Inc. owns the warehouse it operates from. It cost $3.2 million in 2014; a broker's letter now puts it at about $5.1 million. Should the balance sheet show $3.2 million or the estimate?

Relevance asks whether the number can make a difference to a decision. It can, in two ways: predictive value (what could the property fetch, what could it secure as collateral) and confirmatory value (was last year's estimate borne out). And relevance has an entity-specific threshold, materiality: $1.9 million of unrecorded value on a $4 million balance sheet would clearly influence a user; the same figure at a bank would not. The fair value wins on relevance.

Faithful representation asks whether the number depicts what it claims to. Its three components are completeness (all the information needed to understand the item, including how it was estimated), neutrality (no slant toward a wanted outcome — supported by prudence, meaning caution under uncertainty, which is not the same as deliberate understatement), and freedom from error (no mistakes in the process or description). Note what freedom from error does not mean: it does not mean the number is exactly right. A broker's estimate can be free from error if the estimation process was sound and is described as an estimate. The cost figure wins on faithful representation, but the estimate is not disqualified.

Both fundamentals must be present. A perfectly verifiable number nobody uses fails; a highly relevant number that is a guess fails. Then the enhancers rank the survivors:

• Comparability — can users compare Tamarack with other retailers, and with itself over time? Consistency (the same method period to period) is a component of comparability, and comparability is not uniformity — like things should look alike, unlike things should not.
• Verifiability — could independent observers reach consensus that the depiction is faithful? Cost, yes; one broker's letter, weakly.
• Timeliness — is the information there in time to affect a decision?
• Understandability — is it presented clearly for a user with reasonable business knowledge?

And over all of it sits the cost constraint: the benefit of a disclosure must justify the cost of producing it. An annual professional appraisal of every property is possible; whether it is worth it is a judgement the standard-setter makes on users' behalf.

IFRS's answer for a warehouse under the cost model is cost less depreciation on the face, with fair value disclosed where relevant — a resolution that gets relevance into the notes and verifiability onto the statement.

The pitfalls the midterm sets

Three confusions recur. Materiality is not a separate characteristic — it lives inside relevance. Consistency is not comparability — it is one component of it. And prudence is not systematic understatement — writing assets down "to be safe" violates neutrality; prudence is caution in exercising judgement, no more.