The objectivity principle in accounting states that the financial statements a company produces must be based on solid evidence. The aim of this principle is to ensure that management and accounting do not allow any personal opinions or biases from making their way into the financial statements.
The objectivity principle depends on two factors: relevance and reliability. The relevance concept says that financial statements will have predictive value and feedback value. The predictive value helps accountants forecast the accuracy of events that occurred in the past, while the feedback value confirms or corrects the previous expectations of accounting through the decision-maker.
All accounting transactions are supported or proven by business documents such as invoices, which is a source document, which records all sales transactions made by a business. Cash memos are also regarded as source documents, which signifies cash received for a sale of a particular good or service. There are also many other documents which serve as evidence and increases the accuracy of accounting transactions.
Perfect use of the objectivity principle is worked by auditors who conduct audits of various companies. An audit is an official inspection of the books of accounts by a certified public most of the businesses operating in a certain country.
The basic purpose of an audit is to investigate whether there is an error in a company’s books of accounts or not, in correspondence with the objectivity principle.
Financial Statements Used for Auditing
The income statement shows the revenues and expenses of a company along with the profit before expenses, known as the gross profit, and the profit calculated after incurring expenses known as the net profit.
The balance sheet shows the financial position or liquidity of a firm at a specific date. This is done by recording an owner’s assets, liabilities, and equity at a certain date.
The cash flow statement shows the inflows and outflows of cash in a business at a certain accounting period.
Auditors need to audit these financial statements to ensure accuracy and unbiased opinion.
Objectivity Principle Examples
A company trying to get an extra vehicle, financed through a bank for the business must provide financial statements to the bank before receiving the cash.
If the company bookkeeper provides the financial statements in an unaudited format printed from the accounting system, the bank will most likely deny the request for financing the vehicle, as the objectivity principle is being violated.
If, however, the financial statements are prepared by an independent firm, the bank will more likely accept the request of the firm, as the accounts will be free of bias and opinions.
Rebecca is an accountant working for Toys 4 You, Inc. In order to prepare the accounts, she asks the company for records to support its accounts payable and receivables.
The company tells Rebecca to use the figures that are displayed in the accounting system as it is a lot of work to get the supporting documentation.
This would violate the objectivity principle because the information in the financial statements need to be verifiable and reliable records.
Bob is an accountant who worked as CFO at Innovative Technologies Ltd. He leaves the company after he is offered a better position at an audit firm known as Sydney Auditors. After a few months, Bob is designated to do an audit on his previous company, Innovative Technologies. This is a violation of GAAP rules, including the objectivity principle.
Real-Life Examples of Objectivity
- The Monsanto Company based in The United States of America, violated accounting rules and the objectivity principle in 2016, by misstating the earnings of the company through internal accountants. The violation led to the firm paying an $80 million penalty.
- Enron Corporation was an energy company which existed in the US. In 2001, it was discovered that the enterprise was hiding billions of dollars of debt. The violation of the accounting principles resulted in shareholders losing more than $74 billion as the price of Enron’s share price collapsed massively and Jeff Skillings, the CEO of the company, was sentenced to 24 years in prison.
Advantages of The Objectivity Principle
As mentioned earlier, the objectivity concept enables investors to get a clear and transparent picture of the firm. The financial statements are prepared without any bias and opinion which helps investors trust the authenticity of financial statements.
Secondly, companies need to act in accordance with the accounting principles and learn from companies who have suffered losses because of misstating accounting data, to be safe from auditing firms and the government to avoid heavy penalties.
The use of the objectivity principle also helps businesses report accurate information which enables banks and creditors to rely on the firm paying back what they owe.
Disadvantages of The Objectivity Principle.
Although there are many uses of the objectivity concept, there are also many drawbacks. It is very expensive for firms to outsource their preparations of accounting statements through auditing organizations, which may increase costs and minimize gains for the company in the future.
It is very time-consuming for companies to record accurate data and act in correspondence with the objectivity concept to avoid massive fines and punishments from the government.
Lastly, the GAAP rules seem to change time to time, which means that companies would need to take into account the transitions and make amendments in their accounting statements eventually.
In today’s fast-flowing world business organizations need to use the objectivity principle, as it improves the accuracy and increases the reliability of financial statements. It also makes it easier for stakeholders to evaluate the position of a business. Therefore, it is recommended for every firm to use the objectivity concept in relativity to the GAAP rules.