A little over a decade ago, when people thought of accounting, they got a bad taste in their mouths, what with all the headlines concerning the scandalous and improper techniques that were utilized by the biggest accounting firms and the companies they represented (Arthur Andersen, Enron, et al.), resulting in the bankruptcy of several huge corporations. Though malfeasance and duplicity can be easily tucked away into the many convoluted details of the accounting process, especially when it comes to the financial statements, there are actually safeguards in place that are meant to keep financial misrepresentations at bay, whether they’re on purpose or not. Today, we will be discussing one of these safeguards – the concept of faithful representation, and how it’s used to keep companies and their accountants honest. If you’d like to learn more about the basics of accounting, this course on accounting made easy, along with this article on the basic accounting ratios will give you a good introduction to this subject.
Faithful Representation Explained
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: For accounting information to be relevant, it must be predictive and/or confirmatory, meaning the information must take into account the firm’s ability to generate cash in the future, as well as the investors’ confirmation that this ability is possible.
- Faithful Representation: While it’s integral for information to be relevant, it means nothing if there is no credence behind the information offered, and this is where faithful representation comes in. When faithful representation is present, there is an agreement that a measure or description of a phenomena or action found in a financial statement is accurately represented. To learn more about balance sheets and income statements, check out this course on financial statements to get a simple explanation of these useful accounting tools.
There are three characteristics that are required for information to be considered faithfully represented:
- Completeness: All pertinent information must be present for a complete and accurate assessment to be possible. Any omissions of relevant information can lead to a false or misleading depiction of accounting activities and phenomena, thus rendering the information useless to whomever would use or need it.
- 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.
- Free From Material Error: Finally, the desire to keep any financial assessments free from error can only be done by checking the work. Unfortunately, this is something that cannot be completely eradicated, as humans make mistakes, but it does happen, and all that can be hoped for is that the information is accurately portrayed and reported.
A Quick Example
A brief example of faithful representation is illustrated with the following situation. 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.
Despite the bad press that accounting may get sometimes, rest assured that there is a system in place to keep everyone honest. Like anything else in this world, this system is only as effective as the people who use it, and it may break down, either due to user error, our dishonesty. Because accounting relies heavily upon accuracy and honesty, these safeguards are essential to keeping this practice relevant and full of integrity. If the introductory accounting course linked to above wasn’t enough for you, try out these more involved financial accounting courses, part one and part two, and really dig into this complex world.