Actuarial Notes

Qualitative Characteristics of Accounting Information

Study guide: Exam DISC-IA

Qualitative Characteristics of Accounting Information are the qualities that make financial information useful to the people who rely on it. Under FASB Concepts Statement No. 8, Chapter 3, which the FASB developed jointly with the IASB, the two fundamental characteristics are relevance and faithful representation, and comparability, verifiability, timeliness and understandability enhance information that already has both. For an insurer's statutory statements, the NAIC adds its own concepts of conservatism, consistency and recognition (Statutory Accounting Principles).

\text{Useful} = \text{Relevant} \;\wedge\; \text{Faithfully represented}

\text{Report the item only if } \text{Benefit} \geq \text{Cost}

  • Relevance: Relevant information is capable of making a difference in users' decisions. It does so through predictive value, when users can feed it into their own predictions, through confirmatory value, when it confirms or changes their earlier evaluations, or both. This year's earned premium can be the starting point for next year's forecast and also a check on last year's forecast of this year.
  • Materiality: Materiality is relevance applied to one entity. An omission or misstatement is material if it is probable that the judgment of a reasonable person relying on the report would have been changed or influenced by it. Size alone does not decide it; the nature of the item and the circumstances count too.
  • Faithful representation: A perfectly faithful depiction is complete (everything a user needs, including descriptions and explanations), neutral (not slanted to make the information received favourably or unfavourably) and free from error (no errors in describing the item or in the process that produced it). Free from error does not mean exact. An estimate such as a loss reserve is faithfully represented when it is described as an estimate, the limits of the process are explained, and the process was chosen and applied without error.
  • The enhancing characteristics: Comparability lets users see similarities and differences between entities and over time; consistency, the same methods for the same items, helps achieve it but is not the same thing. Verifiability means independent, knowledgeable observers could reach consensus that a depiction is faithful, directly (counting cash) or indirectly (recomputing a model's output from its inputs). Timeliness means having information while it can still influence decisions. Understandability comes from classifying and presenting information clearly, without leaving out complex items, which would make a report incomplete.
  • How they fit together: The enhancing characteristics cannot rescue information that is irrelevant or not faithfully represented. They can, however, decide between two depictions that are equally relevant and faithful. One may be traded against another, as when a new standard reduces comparability for a while to improve relevance.
  • The cost constraint: Reporting costs money, and preparers bear most of the effort, which users pay for in reduced returns. Information should be required only when its benefits are likely to justify the cost of providing and using it.
  • Conservatism under GAAP and under SAP: FASB Concepts Statement No. 8 does not include prudence or conservatism as part of faithful representation, because a deliberate lean would be inconsistent with neutrality, and understating assets in one period tends to overstate performance in a later one. The NAIC's Statement of Concepts takes the opposite view for solvency regulation: statutory accounting should be "reasonably conservative over the span of economic cycles" to give policyholders a margin of protection against adverse variation in management's estimates.
  • SAP's recognition and consistency: Under the Preamble, only assets that can be used to meet policyholder obligations belong on the statutory balance sheet; others are charged against surplus. Liabilities are recognised as they are incurred, revenue only as the earnings process is completed, and treatments that defer expenses are generally not acceptable. Consistency means regulators get comparable information across insurers, and precedent alone does not justify keeping a practice that no longer meets regulators' objectives. How these concepts sit among the other sources of accounting rules is on Accounting Rule Hierarchy, and how they shape the statements themselves is on Accounting Standards and Financial Statements.

Which Characteristic Is at Stake? An analyst reviewing a regional insurer finds four problems. Name the characteristic each one weakens.

  1. The insurer changed its IBNR method in each of the last three years without explanation.

  2. The annual figures reached the analyst nine months after the year end.

  3. Management booked reserves at the high end of the actuary's range "to be safe" in its GAAP statements, and released the excess in a later year when earnings were weak.

  4. The notes give the loss reserve as a single figure with no description of how it was estimated.

Answer

  1. Comparability, through a lack of consistency. Results for one year cannot be compared with the next when the method keeps changing.
  2. Timeliness. Information that arrives too late to influence a decision loses value, even though some users may still use it to study trends.
  3. Neutrality, a component of faithful representation. Deliberately overstating a liability in one period and releasing it later overstates performance in that later period, which is why Concepts Statement No. 8 leaves conservatism out of the GAAP framework.
  4. Completeness, the other component at risk. A reserve is an estimate, and a faithful depiction says so and explains the limits of the process that produced it. Without that, the figure is also hard to verify.

The Same Commission Under GAAP and SAP An insurer writes a one-year policy for $1,200 and pays a $180 commission on day 1. Under GAAP the commission is deferred and expensed as the premium is earned; under SAP it is expensed immediately while the full $1,200 is held as unearned premium. Find the effect on GAAP equity and statutory surplus at inception, and name the concept that explains the statutory answer.

Answer The insurer holds $1,020 of cash, the premium less the commission, against an unearned premium of $1,200.

\begin{align*}
\Delta\text{Surplus}_{\text{SAP}} &= 1{,}020 - 1{,}200 \\
&= -180 \\
\Delta\text{Equity}_{\text{GAAP}} &= 1{,}020 + 180 - 1{,}200 \\
&= 0
\end{align*}

GAAP carries the $180 as an asset, matching it to the premium it helps earn. SAP expenses it because, in the Preamble's words, the funds spent "are no longer available to pay future liabilities". That is the recognition concept, applied conservatively: only assets that could pay policyholders are counted, and expense deferral is not acceptable statutory treatment.

How it appears on the exam

  • DISC-IA: The objective asks for the qualitative accounting information criteria. Expect a scenario, such as a late report, a method changed every year or a reserve deliberately overstated, and a question asking which characteristic it fails.
  • Fundamental versus enhancing: A question can ask which characteristics are fundamental and which only enhance, or whether an enhancing characteristic can make irrelevant information useful (it cannot).
  • SAP contrast: A question can set the FASB characteristics beside the NAIC's conservatism, consistency and recognition and ask why the statutory statements treat an item, such as acquisition costs or an overdue receivable, more conservatively.

Exam traps

  • Conservatism is not neutrality: Under the FASB framework a deliberately conservative estimate is biased. Conservatism is a statutory concept, adopted because regulators care about solvency.
  • Consistency is not comparability: Consistency is using the same methods; comparability is the goal those methods serve. Comparability also is not uniformity, because unlike things should look different.
  • Free from error is not exact: An estimate can be faithfully represented although it will turn out to be wrong, provided it is described as an estimate and the process was applied correctly.
  • Verifiability is enhancing: It is not a part of faithful representation in Concepts Statement No. 8, which moved it out of the old notion of reliability.