What is Faithful Representation in Accounting? Definition, Concept and Examples
Faithful Representation Definition
Faithful representation in accounting means that the financial information shared, accurately reflects the real financial picture of the business.
In other words, faithful representation should give users of the financial statements confidence that what they are reading is honest and truthful.
For example, if a business reports that they generated £3m of annual revenue on their income statement, then that total should be able to be verified.
Faithful representation covers all of the financial statements – income statement, balance sheet and cash flow statement.
What are the Three Elements of Faithful Representation?
For financial statements to be a faithful representation of a business, they would have the following three elements:
- Complete
- Neutral
- Free from error
Let’s look at each one of these elements in more detail:
Complete
Faithful representation requires that financial information is complete, and therefore provides a full picture of the economic events and transactions of the business.
Exclusions can distort the true financial position of a business.
For example, when preparing financial statements, it is crucial for faithful representation that all relevant transactions should be included, even ones that might seem insignificant.
Neutral
Neutrality highlights the importance of presenting financial information without bias.
Information should not be manipulated to favour certain stakeholders or to achieve specific financial outcomes.
For example, when a business is determining the fair valuation of assets and liabilities, unbiased estimates are crucial for faithful representation.
Free from Error
Accuracy is another extremely important concept in faithful representation. Financial information must be free from material errors to ensure that stakeholder can rely on it for any decisions that need to be made.
This is generally achieved through internal and external audits, plus stringent internal controls within a business.
Examples of Faithful Representation in Accounting
To further help understand faithful representation, let’s look at some real-world example scenarios:
Impairment of Assets
Imagine a business that acquired another business and recorded goodwill on their balance sheet.
Over time, the performance of the acquired entity may indicate a potential impairment of goodwill.
Faithful representation requires the business to assess the value of goodwill regularly and impair it if necessary, providing a more accurate reflection of the company’s actual financial position.
Bad Debt Provisions
For businesses that sell goods or services on credit, they must create provisions for potential bad debts to faithfully represent the value of the debtor book.
If the business fails to do so, they may overstate their assets and income, giving a false impression of their financial position.
By creating sensible provisions based on historical data and current economic conditions, the financial statements can faithfully represent the true value of accounts receivable.
Contingent Liabilities
Imagine a business that is involved in a legal dispute where the outcome is uncertain.
To provide a faithful representation, they should disclose the details of a contingent liability in their financial statements.
If the business understates the potential liability, it could mislead stakeholders about the risks it faces.
In this instance, faithful representation would involves disclosing the details of the contingency, including the possible range of outcomes and the likelihood of occurrence.
Revenue Recognition
Imagine a software company that provides a subscription based service.
To faithfully represent the revenue received, the business should recognise subscription fees over the period during which the service is provided.
If the company recognises all subscription fees upfront, it might distort the financial picture, as the revenue hasn’t actually been earned yet.
By recognising revenue evenly over the subscription period, the financial statements faithfully represent the businesses performance.