Neutrality And Historical Cost In Financial Statements

The Importance of Neutrality in Financial Statements

As per the framework of AASB Chapter 3, QC 12 regarding the faithful representation, financial statements reveals the economic occurrence of any company in numbers and words. To be relevant, the information included in the financial statement must be presented in relevant and faithful manner. the statement must be neutral, complete and free from any kind of error. These criteria must be fulfilled keeping in mind the perfection factor. The objective of any company’s board is to maximise these qualities as far as possible (Henderson et al., 2015).

A neutral representation is free of any kind of biasness for revealing the presentation. A neutral presentation is not emphasised, weighted, slanted or manipulated to increase the favourability of the statement. Moreover, it does not mean the data with no influence or no purpose with regard to its characteristics. On the other hand, important financial data is capable to differentiate the view of the users. It is the prominence on the accuracy of the information and the independency of the standard setters to be saved from undue influence (Burc?, Mate? & Pu?ca?, 2015). To preserve the interest of the public, the requirement is of the good sense of business. It is generally expected that the accounting principles are modified or determined with regard to attain the other objectives apart from the measurement in economic terms. Neutrality is crucial in setting the standards it is incorporated with the concept of AASB. Neutrality states that in implementing and formulating the standards, the major concerns are regarding the reliability and relevance of the information that have a impact on the result (Tan?Kantor, Abbott & Jubb, 2017).

Financial reports are not neutral if the presentation or selection of the information influences the taking of any decision or giving any judgement with regard to attain a pre-decided outcome or result. The standard setters wish to mention the faithfulness in representation of financial statements due to the following reasons:

• Independent practice and standard: The accountants are expected to follow the practices that are free from any influence to maintain the accuracy and ethics. The accountant is further expected to maintain the accounting standards presented under the AASB while preparing the financial reports (Barth, 2015).
• Favouring the interested person: An accountant while preparing the statements must follow the neutrality and cannot favour any person who is interested in the result of the analysis of the company’s records and book. For instance, if the stockholders are interested regarding the profitability of the organization, the accountant must not try to present the data that will look more profitable (Cordery & Sinclair, 2016).

Maintaining neutrality is possible if the accountant has strong determination to remain neutral. For instance, investors and lenders consider their estimation of cash flow as highly significant. This estimation generally involves individual elements. On the contrary, if the estimation involves assumption regarding the consideration of the accountant that is out of the boundaries of reliability, he may give some comments on his estimation. To present the information in neutral way, it must be relevant, comparable, reliable and consistent and must be appropriate to be used by the creditors, lenders, investors and others who who take their decisions based on the financial reports. High quality  standards of accounting are required to be maintained for the market economy to function efficiently as the distribution of capital are highly dependent on the reliability of the financial information (Mazhambe, 2014).  

Neutral Representation and Accounting Principles

In few instances, maintenance of neutrality is very tough, for example, when an accountant follow more than one set of accounting standards, they may face difficulty in explain the investors the accurateness of both the sets of financial reports, if the operating results, cash flow amounts and financial positions vary significantly. Questions are likely to be raised if the different approaches make the statement less profitable and poor performing (Cheung, 2014).

Neutrality is implanted in the concept of accounting and is likely to be aligned with the personality of most of the accountants. This is one of the most crucial reasons that the accountants are stated as pessimistic, prudent, cautious and conservative. The neutrality approach can be obtained through cautious estimation of of the amounts such as amounts of bad-debts, depreciation. Further, to be neutral, the estimation of probable loss shall be the maximum amount of expected obligation or loss and the minimum amount of profit or gain (McGregor-Lowndes et al., 2014).

The method of historical cost is the approach of valuing the asset in the balance sheet on the basis of the asset’s original cost or nominal cost when obtained by the organization. Historical cost assists in distinguishing the asset’s original cost from the current cost, replacement cost or adjusted cost (Taplin, Yuan & Brown, 2014). The main principle of historical cost is that an asset must be reported at the original cost at the moment of transacting the exchange and it must involve that are incurred to b ring the asset in the place and preparing it to be used. Historical cost can be proven easily through accessing the recording of accounts and purchase source. As per the standards of accounting the historical costs are required to be adjusted over the time (Ellul et al., 2014).

Financial reports that are prepared based on the historical cost system are suffered from various weaknesses as follows:

• Do not consider the changes in price level: Financial reports that are prepared under the historical cost method are generally states the historical facts. Alteration in the money value is not taken into consideration. Therefore, the statements fail to reveal a true and fair view of the financial position of the organization.
• Unrealistic valuation of fixed assets: Under the historical method, fixed assets are transacted and shown at the cost at which they were obtained. Moreover, the fluctuations in the market value of such assets are also not considered (Andersson & Titov, 2014).
• Inadequate depreciation provision: Depreciation is a method of creating funds to substitute any fixed asset at the time of replacement. However, under the historical cost method the depreciation is charged on the basis of original cost which is not adequate for replacing the asset.
• Mixing up the operating and holding gain: Under this method, the loss or gain for holding the inventories may be mixed up with the operating losses or gains. Holding losses or gains must be differentiated from the operating losses or gain to verify the actual performance.
• Unrealistic profit: Revenue statements prepared under this method does not present the real profit. Earnings are transacted on the basis of present value whereas the expenditures are transacted at the historical cost. Therefore, during the inflation period the profits are overstated (Barlett, 2016).
• Does not present true value of financial position: Balance sheet involves monetary items such as creditors, debtors, loan and cash and the non-monetary items like land, building and inventory and they are presented at historical cost rather than at present value.

Despite of having so many limitations, historical cost has some advantages as follows:

• Simplicity: This method is cost effective and simple method of valuation and does not need continuous working as the current market value consideration is not necessary.
• Objectivity: This method assures that the statement of financial position can be analysed through independent documents like vouchers, invoices and receipts (Deegan, 2013).
• Conservative: It does not take into account the appreciation of assets that are not secured or proven yet by the actual sale in the market. Analysis of assets based on the market value will help the creative accounting.
• Consistency: Historical cost approach is regular with the bigger goals and the objective of accounting is to report and record the past transaction of the company (Greenberg et al., 2013).

Alternatives of historical cost method: There are some alternatives of historical cost approach as follows:

• Accrual method of accounting: The organization keeps records of expenses and incomes as and when the transaction takes place, irrespective of whether the amount is received or not actually during the period. Various big organizations follow this method of accounting.
• Cash based accounting: Under this method revenue and expenditures are recognized after they are actually received r the payment is actually made. Generally, this approach is used in small scale businesses and for income tax report.
• Complete method of contracting: Under this method, the long-term accounts and contracts are taken into account under the period of accounting in which they are completed.
• Percentage completion method: Under this method the long-term contracts of the company are considered on the basis of percentage of completion of work during the period (Drury, 2013).

The main objective of general purpose of financial statement is to offer the information regarding the reporting organization that can be used by the lenders, creditors and probable investors in taking decisions regarding offering the resources to the organization. These decisions involve holding, selling or buying the debt instrument or equity and settling or offering loans or credit in any other form. The reporting of financial information is based on the general purpose as it is determined to fulfil the requirements of various external users. These users do not have any influence on the information they require from the organization and have to depend on the reports offered by the company. The financial reports are useful to the particular users as follows:

Challenges in Maintaining Neutrality

Investors: The investors are those persons who have a right on the resources of the company and thus, are the most crucial and require the general purpose financial information most. The investors are the lenders, creditors and equity investors who have the requirement of common information. Objective of general purpose information are as follows:

• Lenders: Lenders involve the buyers of debt securities and financial institutions. Generally the lenders expect some returns on their lending in terms of interest and repayments of the amounts.  Thus, the lenders are interested in the timing, amount, and uncertainty level of future cash flow of the organization and the level of the company’s ability to create value for their debt securities. Further, they are also interested in assessing the company’s ability of discharging the debt (Baker & Haslem, 2015).
• Equity investors: The equity investors involve the holders of the partnership interests, equity securities and any other type of equity interests. These investors generally invest cash with regard to receive return on it. In other words, they wish to increase the amount of their invested cash. Thus, they are directly interested in timing, amount, and uncertainty level of future cash flow of the organization (Lawrence, 2013).
• Other creditors: Other investors provide capital to the organization on account of the relation that exists between the investor and the organization. For instance, the employees offer human capital for wages or any other form of compensation, distributors may extend the credit period for selling the equipment or inventories. These persons are able to make decisions regarding the offering of capital to organization and thus, are considered as the providers of capital (Pratt, 2013).

The resources and the economic activities of any organization are primarily measured by using the exchange price that exists at the time of the transaction. Many organizations generally hold the exchange price at historical cost in their accounting statement until the organization sells or consumes it. Therefore, the organization delays I recording the losses or gains that results from the changes in the value of an asset or liabilities until the further exchange takes place. The reason behind using the historical cost against the fair value approaches that to confirm the recorded value. Moreover, the historical method offers confirmations that the seller and the buyer both were under an agreement for the exchanged good and thus presents the confirmation of faithful presentation (Schlötterer et al. 2014).

The major criticism against the historical value approach arises from the alternative evaluation approaches like fir value approach. The accountants realize that the historical approach is not appropriate for all the valuation. In few cases, the accounts are required to use methods for valuation other than the historical approach to reveal the fair value of particular items. These approaches are required particularly when they offer more relevant and reliable information as compared to the historical method. However, sometimes it is experienced that the inherent measurement problems under the alternative method are bigger as compared to the historical cost strategy (Nas, 2016).

From the above discussion, it can be suggested that the historical cost method is simple and easy to apply and further, it does not take into account the appreciation of assets that are not secured or proven yet by the actual sale in the market. Therefore, it is not required to keep an eye on the fluctuation in the market value.  However, if the alternative approach results in unfair representation of the events or transactions the method that offers less relevant data but results in more faire representation, that method may be used for the valuation purposes.

References

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