Week 8 Discussion For this discussion, your focus will be to think through what asymmetric information, moral hazard, and adverse selection have to do with hiring a police officer. Instructions….
Confirmatory value – Provides information about past events
1. Relevance refers to how helpful the information is for financial decision-making processes. For accounting information to be relevant, it must possess:
- Confirmatory value – Provides information about past events
- 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. An investor wants to invest in company ABC. Before investing, he evaluates the company’s past performance, future strategy, and growth opportunities. Based on the relevant information he prepared the decision to invest or not to invest in the company.
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:
- Complete – Financial statements should not exclude any transaction.
- 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.
- Free from error – The degree to which information is free from errors.
2. Relevance is the information that can be used to point out the performance of a business in the future, which is called predictive value, or to confirm the evaluation in the past- confirmatory value. Relevance plays an important role to process financial decision’s making, it can impact the decision-making process by the content of the information or its timeliness. For example, the number of products that a production machine had made can affect the decision-making of its buyers.
Faithful representation is the accurate number that the financial statement has achieved. There are three attributes that a financial statement should follow: Complete, Error-free, and unbiased(neutrality). For example, The United Company has reported their first net annual income will be 1 million, which means by the end of the year, they should have gross income minus expense is 1 million in net income.
In my opinion, relevance and faithful representation are two fundamental qualitative characteristics that can affect the decision-making process. However, it doesn’t have to have both because faithful representation can trade-off relevance. On the other hand, it’s necessary to balance both methods. For example: to make the decision without an accurate number from the financial statement, a company can use relevance to estimate their income, expense. However, if the estimate can strongly affect the organization such as the lack of economic substance of transactions, or legal form relevance should not be applied.