Question

The AASB Conceptual Framework (2.12-2.19) refers to ‘faithful representation’ as being necessary for financial information to be useful. This section of the AASB Conceptual Framework also makes reference to ‘neutrality’ (eg. 2.16). Define what is meant by ‘faithful representation’ and ‘neutrality’. Do you believe it is possible for financial reports to be 'representationally faithful' and 'neutral'? Justify your position. In your response, evaluate why you think the IASB (and AASB) include these terms within the Conceptual Framework.

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Answer 1

ANSWER:

PART - I

FAITHFUL REPRESENTATION:

Faithful representation is one of the fundamental qualitative characteristics that accounting information must possess. As opposed to quantitative information, which is based on amounts and numbers, or quantity, qualitative information refers to the quality, or the descriptions and legitimacy of values presented. There are two fundamental qualitative characteristics in financial accounting:

• Relevance
• Faithful Representation:

Faithful representation is the concept that financial statements be produced that accurately reflect the condition of a business.

For example: In a company’s balance sheet, under the heading of “Inventory”, it’s understood by external users that included in this account are items that are intended strictly for sale only in the course of regular business. If it later comes to the external users’ attention that the company also included in this inventory account are the machinery and parts that were used in the production of the actual inventory, then faithful representation is lacking in this situation.

Financial statements that faithfully represent these aspects of a business should have the following three attributes:

• Complete: All of the information that a user needs in order to form a clear picture of the results, financial position, and cash flows of a business are included in the financial statements. This also means that no information is omitted that might have led a user to have a different opinion of the business. For example, a business could report that it had a $500,000 loan as of the balance sheet date, but this would not be considered complete unless additional information about the loan were provided, such as its maturity date.

• Error free: The financial statements should contain no errors, so that the information contained within them presents a fair view of the organization. If there is a continuing series of "errors" that tend to bias the results of the financial statements in a certain direction, this may be considered a case of financial reporting fraud.

• Neutrality: The idea that accounting information should be neutral, or free from any bias, is related to the fact that information should not be altered, or presented in any way that is meant to influence a decision to be made with a predetermined result in mind. The idea behind this neutrality is so that overall societal goals and accounting guidelines should be adhered to, rather than the desires of any one person, or group of people, with their own agendas.

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.

“Neutrality means that both in formulating or applying standards, the primary concern should be the relevance and reliability of the information that results, not the effect that the new rule may have on a particular interest.”

PART- II

I do no think, it is possible for financial reports to be 'representationally faithful' and 'neutral', because according to me accounting information is subjective and it requires judgements, estimates and interpretations and must, therefore, be biased and cannot be representationally faithful. Also,there are various instances where the financial reports of the companies are manipulated to portray a better image of the company by maintaining accounting standards.

One of the example is the Satyam scandle, On 10th January 2009 Satyam shares fell to 11.5 rupees the lowest since 1998. The market capitalization fell from Rs. 1,607,04 crores to Rs. 15,262 crores within a day. This fall was due to the management’s falsified accounts and income tax returns, and fabricated invoices.

The main reasons for doing so include providing higher bonuses for executives or attracting investors. Almost Every company manipulates its numbers to a certain extent to make sure budgets balance, executives score bonuses, and investors continue to offer up funding.

PART- III

The Conceptual Framework for the Financial Reporting is a basic document that sets objectives and the concepts for general purpose financial reporting. The main reason behind the IASB (and AASB) including the terms,  'representationally faithful' and 'neutral' within the Conceptual Framework is because:

• To ensure that the companies do not manipulate there financial reports.
• To make sure that the information present in the financial reports are complete, error free, and free from bias and is not manipulated at any circumstance.
• It is basically, certain rules to be followed by the company while preparing their financial reports.