Relevance
Information should be
relevant to the decision making needs of the user. Information is relevant if
it helps users of the financial statements in predicting future trends of the
business (Predictive Value) or confirming or correcting any past predictions they
have made (Confirmatory Value). Same piece of information which assists users
in confirming their past predictions may also be helpful in forming future
forecasts.
Example:
A company discloses an increase in Earnings Per
Share (EPS) from $5 to $6 since the last reporting period. The information is
relevant to investors as it may assist them in confirming their past
predictions regarding the profitability of the company and will also help them
in forecasting future trend in the earnings of the company.
Relevance is affected by the materiality of
information contained in the financial statements because only material
information influences the economic decisions of its users.
Example:
A default by a customer who owes $1000 to a company
having net assets of worth $10 million is not relevant to the decision making
needs of users of the financial statements.
However, if the amount of default is, say, $2
million, the information becomes relevant to the users as it may affect their
view regarding the financial performance and position of the company.
Reliability
Information
is reliable if a user can depend upon it to be materially accurate and if it
faithfully represents the information that it purports to present. Significant
misstatements or omissions in financial statements reduce the reliability of
information contained in them.
Example:
A
company is being sued for damages by a rival firm, settlement of which could
threaten the financial stability of the company. Non-disclosure of this
information would render the financial statements unreliable for its users.
Reliability
of financial information is enhanced by the use of following accounting
concepts and principles:
Neutrality
Information
contained in the financial statements must be free from bias. It should reflect
a balanced view of the affairs of the company without attempting to present
them in a favored light. Information may be deliberately biased or
systematically biased.
Deliberate
bias
Deliberate
bias: Occurs where circumstances and conditions cause management to
intentionally misstate the financial statements.
Examples:
Managers
of a company are provided bonus on the basis of reported profit. This might
tempt management to adopt accounting policies that result in higher profits
rather than those that better reflect the company's performance inline with
GAAP.
A
company is facing serious liquidity problems. Management may decide to window
dress the financial statements in a manner that improves the company's current
ratios in order to hide the gravity of the situation.
A
company is facing litigation. Although reasonable estimate of the amount of
possible settlement could be made, management decides to discloses its
inability to measure the potential liability with sufficient reliability.
Systematic
bias
Systematic
bias: Occurs where accounting systems have developed an inherent tendency
of favoring one outcome over the other over time.
Examples:
Accounting
policies within an organization may be overly prudent because of cultural
influence of an over cautious leadership.
Prudence
Preparation
of financial statements requires the use of professional judgment in the
adoption of accountancy policies and estimates. Prudence requires that
accountants should exercise a degree of caution in the adoption of policies and
significant estimates such that the assets and income of the entity are not
overstated whereas liability and expenses are not under stated.
The
rationale behind prudence is that a company should not recognize an asset at a
value that is higher than the amount which is expected to be recovered from its
sale or use. Conversely, liabilities of an entity should not be presented below
the amount that is likely to be paid in its respect in the future.
There
is an inherent risk that assets and income of an entity are more likely to be
overstated than understated by the management whereas liabilities and expenses
are more likely to be understated. The risk arises from the fact that companies
often benefit from better reported profitability and lower gearing in the form
of cheaper source of finance and higher share price. There is a risk that
leverage offered in the choice of accounting policies and estimates may result
in bias in the preparation of the financial statements aimed at improving
profitability and financial position through the use of creative accounting
techniques. Prudence concept helps to ensure that such bias is countered by
requiring the exercise of caution in arriving at estimates and the adoption of
accounting policies.
Example:
Inventory
is recorded at the lower of cost or net realizable value (NRV) rather than the
expected selling price. This ensures profit on the sale of inventory is only
realized when the actual sale takes place.
However,
prudence does not require management to deliberately overstate its liabilities
and expenses or understate its assets and income. The application of prudence
should eliminate bias from financial statements but its application should not
reduce the reliability of the information
Completeness
Reliability
of information contained in the financial statements is achieved only
if complete financial information is provided relevant to the
business and financial decision making needs of the users. Therefore,
information must be complete in all material respects.
Incomplete
information reduces not only the relevance of the financial statements, it also
decreases its reliability since users will be basing their decisions on
information which only presents a partial view of the affairs of the entity.
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