What is Objectivity in Accounting?
Definition of Objectivity in Accounting
Objectivity in accounting means being fair, unbiased, and neutral when preparing financial information.
It requires accountants to report the financial facts accurately without letting personal opinions or preferences influence the numbers.
The goal of objectivity in accounting is to provide an honest and reliable picture of a company’s finances that can be trusted by all stakeholders.
Principles of Objectivity in Accounting
Objectivity in accounting is guided by several principles that ensure financial information is prepared and presented in a fair, unbiased, and impartial manner.
The key principles of objectivity in accounting include:
- Independence
- Verifiability
- Consistency
- Prudence
Let’s look at each principle in more detail:
Independence
Objectivity requires accountants to be independent and avoid any conflicts of interest.
This means that they should not have personal or financial relationships that could jeopardise their ability to make impartial judgments.
When preparing financial statements, accountants should operate autonomously and resist being influenced by other departments or individuals within the company.
For example, if a senior leader wants to recognise additional revenue in the financial year to trigger their bonus, but doing so is not in line with accounting standards or company revenue recognition policies, then the accountant should refuse the request.
This separation helps to maintain independence in financial reporting.
Verifiability
Financial information should be based on evidence which can be verified and confirmed by independent third parties.
This promotes transparency and builds trust in the financial reporting process.
For example, if a company reports the fair value of an asset, there should be appropriate evidence or market data to support that valuation (ie recent market transactions for similar assets or valuations from independent professionals).
Consistency
Accounting policies and methods should be consistently applied across the financial statements, to ensure that financial information is comparable over time.
This helps stakeholders make informed decisions based on reliable historical data.
For example, if a company uses the straight-line depreciation method, they should continue with this approach unless they have a valid reason to change.
Prudence
Prudence suggests that in situations where there is uncertainty, accountants should adopt a cautious and conservative approach
This helps prevent the overstatement of assets and income and understatement of liabilities and expenses.
For example, a retail business anticipates changes in consumer preferences and technology, and therefore prudently assesses its inventory for potential obsolescence.
Rather than valuing all inventory at the original cost, they reduce the value of items that are outdated and items with low demand to value this asset more realistically.
Examples of Objectivity in Accounting
To further help with the understanding of objectivity in accounting, let’s look at some real-world examples:
Fair Value Accounting
Objectivity is crucial in fair value accounting where the market value of assets and liabilities are determined.
For example, imagine a company that owns a significant amount of real estate.
Under fair value accounting, the company regularly evaluates the current market value of their properties.
During an economic upswing, the fair value of the properties would be increased, which reflects their potential market sale prices.
Conversely, in an economic downturn, the fair value of the properties would decrease, again reflecting their potential market sale prices.
This method of valuing assets provides an objective estimate, and ensures accuracy in financial reporting during fluctuating market conditions.
Impairment Testing
Regular impairment testing, particularly for long-term assets such as goodwill, also upholds the principle of objectivity in accounting.
For example, consider a technology company that acquired a smaller startup a few years ago.
The purchase included the recognition of goodwill on the balance sheet, which represents the premium paid over the acquired company’s net assets.
As technology quickly becomes outdated, the valuation of the acquired company may also fluctuate, highlighting the need for objective impairment testing of this goodwill.
This process ensures that the financial statements accurately and objectively reflect the changing economic landscape.
Bad Debt Provisions
A retail company that sells to customers on credit will experience customers that will struggle to repay their debts.
Therefore, a bad debt provision will be posted into the financial statements to estimate the likelihood of customer defaults.
To objectively predict this amount, the company would analyse historical data on customer payment patterns, assess current economic conditions and monitor any changes in customer behaviour.
This approach would ensure a factual and objective estimation of potential bad debts.
Audit
External auditors play a central role in upholding objectivity.
Audit procedures are designed to independently verify the accuracy and reliability of financial information.
The audit process involves testing and validating evidence to ensure that financial statements are free from material misstatements and errors.
Advantages of Objectivity in Accounting
There are several advantages that objectivity in accounting can bring:
Credibility and Trust
When financial statements are prepared with objectivity, stakeholders such as investors and creditors, can trust that the information accurately reflects the true financial position.
Informed Decision Making
Investors will rely on financial information to make informed decisions about whether to buy, hold, or sell stakes in the company.
Objectivity ensures that the information presented is unbiased and reliable, which will enable investors to make more informed decisions.
Comparability
Objectivity ensures consistency in accounting practices, which allows for reliable comparisons of financial information over different periods.
For example, if a company consistently applies the same depreciation method, stakeholders can easily compare its financial performance from year to year.