Reliability Principle in Accounting: Definition | Example | Explanation

Definition:

Reliability Principle is the accounting principle that concern about the reliability of financial information that records and present in the entity’s financial statements.

The principle of the reliability principle is that the transactions or event could records and present in the entity’s financial statements only if they could be verified with the reliable objective evidence.

This accounting concept is quite an importance for the users of financial information. If the information is not reliable, then the decision making will be unlikely correct.

Reliability Principle is also important for the auditor to review the accounting records of the entity during their cause of audit.

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Explanation:

Basically, the information in the financial statements is reliable if that information could be checked, reviewed, and verified by concerning person with objective evidence.

For example, the reliable evidence for financial transactions or event that records in financial statements is including original documents (invoices, contract, receipt, banks statements, etc), information that generates from the third party, or information that prepared by the auditor. This is how reliable evident from auditor’s perspective.

Reliability Principle motivates integrity over financial reporting of an entity. Financial Statements must be true and fair and it is free from any kind of bias. This is really mean for all type of stakeholders that use financial information.

The accounting transaction is considered to be reliable if it could assure the decision maker that the information captures the condition or events its purports to represent.

Reliability Principle involved with the following accounting principle or concept:

  • Neutrality: Financial statements or information must be prepared free from any bias
  • Fair presentation: Financial statements must be prepared in the true and fair view
  • Prudence: A high degree of caution must be taken into account when the assumption is required.
  • Completeness: All financial information, transactions, and event that should be included are including.
  • Accurate: Financial information must be completed and accurate.

How to know if financial information is reliable?

The data or information is reliable unless it is able to verify by the third party, and it could be measured in a systematic manner.

Here are the key factors to consider if the accounting transactions are reliable:

  • Must be accurate: that means the information is support by reliable evidence like original invoice or contract. It must be able to check by the third party.
  • Free from bias: information is free from any kind of bias. It is present as it is.
  • Report what actually happens. The financial information must be recording what really happened. For example, if the entity got a penalty from the government amount approximately 500,000 USD. The entity should record this amount and disclose it properly in the financial statements. The users of financial information should be able to know what really happened in the entity if they use this information.
  • An individual would have arrived a similar conclusion if they are using the same information.
  • Be able to inspect by the third party. It means if an individual use the same accounting information, they will arrive the same or similar conclusion.

Conclusion:

In Reliability Principle, information:

  • Must be accurate
  • Free from bias
  • Report what happened
  • Be able to inspect
  • Can be concluded to a similar conclusion by different users

Monetary Unit Assumption: Definition | Explanation | Example

Definition:

Monetary Unit Assumption is the accounting principle that concern about the valuation of transactions or event that entity records in its financial statements.

In Monetary Unit Assumption, transactions or event could be recorded in the Financial Statements only if they could measure in the monetary term where those currencies are stable and reliable. USD is the main example of a stable currency.

If you ever read the financial statements of an entity, you will note that all the transactions and event in the financial statements are records and present in the monetary term for example USD or other currency.

The following is the detail explanation of the monetary unit assumption.

Explanation:

For example, the inventories that the company purchased for resales have their own values and can be measured in currency, USD. These kinds of inventories could be recorded in the Financial Statements.

However, the staff’s skill could not record in the financial statements as assets. And staff turnover cannot record as the lost or liabilities. Staff de-motivation will turn out to be the cost of the company.

But, we can not measures and records this de-motivation cost in Financial Statements.

Based on Monetary Unit Assumption, you cannot measure and records beautiful customer service staff in Financial Statements, but you can record telling machine based on its value even though customer staff benefit to the company better than telling machine.

The currencies that use to measure the transaction or event in the financial statements normally are stable and internationally recognized. For example, USD is the currency that internationally recognize and quite stable.

The entity could measure the transactions and event in its own country currency if that currency is stable and internationally recognized.

Example of Monetary Unit Assumption:

In general, most of the financial statements are present in USD as it is the most effective way to communicate economic activities. Whenever there is inflation or deflation, the accounting transaction could be changed and they are ignoring.

Noted: When there is inflation, the value of assets and liabilities are not change in the Financial Statements based on Monetary Unit Assumption. However, assets are impaired if carrying value is less than fair value.

For example, in 2015, the entity purchased fixed assets value 5,000 USD and then in 2016, there is inflation.

The fixed assets then require 6,000 USD to purchase. In this case, the fixes assets valuation in the financial statements could not change. However, if the entity wants to change the value of assets in the financial statements.

The entity needs to perform fixed assets revaluation for all of the fixed assets in the entity. This revaluation could not base on the selection of fixed assets.

The buildings that have original cost USD 20,000,000 can not be changed to USD 50,000,000 due to increasing of current material and labour and well as the effect of inflation and time value of money. But they could be revalued and present in the Financial Statement.

Conclusion:

Monetary Unit Assumption:

  • The transaction and even that can measure in currency, Example.
  • Can not record the transaction that could not measure in currency.
  • The dollar is the most effective way to communicate economic activities.
  • Only transaction that can express in the monetary term that can record in financial statements.
  • Inflation and deflation are ignored in accounting records.
  • Money is universal, understandable, comprehensible, and the simplest way to convey financial activities.

Hope you find this article importance and if you have any comment, please leave it below.

Written by Sinra

Materiality Principle in Accounting: Definition | Explanation | Example

Overview

Materiality Principle or materiality concept is the accounting principle that concern about the relevance of information, and the size and nature of transactions that report in the financial statements.

The main objective of the materiality principle is to provide guidance for the accountant to prepare the entity’s financial statements.

And the most important thing is to make sure that information using by shareholders and investors is sufficient enough for them in making the correct decision.

The information, size, and nature of transactions are considered material if the omission or error of it could potentially lead to the decision of users of financial information.

The materiality concept is not only used by the accountant as the basis to prepare the entity’s financial statements but also used by auditors to assess the correctness of financial statements’ disclosure and use in their audit testing.

Normally, the auditor determines what is the performance materiality and what is the tolerable error for their testing.

There are some differences from one accounting standard to another accounting standard. For example, in IFRS, information is material if the omission could lead to misleading in decision making.

And the filter of materiality hand to management for decision making. IFRS is a kind of principle base accounting standard. Therefore, many shareholders and investors find it difficult in dealing with materiality.

In US GAAP, for example, items should be separately disclosed in the financial statements if they have value over 5% of total assets. This is also the same the security and exchange in the US and it is used to apply to the items in the balance sheet.

But, for items in income statements, items that could affect the net income from positive to negative are also considered as material items even they are small.

Basically, materiality applies in US GAAP sound easy and helpful for shareholders and investors that IFRS. Because in US GAAP if the transaction meets the requirement, then the accountant must be complying with it.

But in IFRS, the accountant still could disclose the transactions with others even the value is high enough to disclose alone. If they could interpret that it will not misleading.

In general, in the materiality principle, the size, information, and nature of the transaction are considering as materiality is different from one entity to another entity. The difference is mainly because of the size of the entity.

Conclusion:

The materiality Principle is not only protected the shareholder’s and investors’ interest but also help to account for preparing its Financial Statements.

Base on this principle, the account could know what is material and what is immaterial. They also know what should be separately disclosed and what should be included with other transactions.

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Full Disclosure Principle: Definition | Example | Checklist

Definition:

Full Disclosure Principle is the accounting principle that requires an entity to disclose all necessary information in its financial statements and other related signification.

This is to ensure that the users of financial information are not misled by the lack of information. The idea behind the Full Disclosure Principle is that management might try not to disclose any information that could impair the entity’s financial statements as well as its reputation as a whole.

In doing so, the financial statements still look good and healthy so that all of the stakeholders still happy about the company.

full-disclosure-principle

Full Disclosure Principle requires the entity to disclose both, Financial Related Information and No Financial Information Related to the company.

This kind of non-financial information including major changed in the business, contracts, related parties transactions, and any other significant information.

Example of Full Disclosure:

The entity might lose large contracts with its customers to its competitor. And the subsequent loss of contract could turn the entity into bankruptcy. In such a case, management probably doesn’t want outsiders, especially investors to know the real situation of an entity.

And base on the Full Disclosure Principle, the entity is required to disclose such a situation in its financial statements.

Another example is related to the full disclosure of contingency. It can be contingent assets or contingent liabilities. For example, the company is facing a lawsuit as the result of disposing of poison material into the water and it going to be a large penalty.

Based on the Full Disclosure Principle, the entity required to fully disclose this information in its Financial Statements. Once the users of Financial Statements noted this information, they will understand what are the current contingent liabilities of the entity.

Related: Best know Accounting Principle

But, how do we know if the entity complies with the Full Disclosure Principle?

Well, basically, to ensure that whether the entity complies with the Full Disclosure Principle or not, the entity should go to the standard that they are following.

Remember, Full Disclosure is just the principle to help entity especially accountant in prepare and present financial statements.

In practice, you are highly recommended to see the specific requirement of each accounting standard. For example, in IFRS, each standard has the requirement of disclosing accounting transactions or even that entity deal with and do so US GAAP.

Different accounting standard has different requirement of disclosure. IFRS is the kind of principle base and the requirement still based on the judgment of the practitioner. However, US GAAP is the role base where the disclosures are the must.

If your Financial Statements use IFRS, IAS 1 Presentation of Financial Statement should be applied. Here is the general disclosure that the financial statements of an entity are required to have.

Full Disclosure Principle Check List:

  • Full Financial Statements. Generally, Statement of Financial Position, Income Statements, Statement of Change in Equity, Statements of Cash Flow and Noted to Financial Statements
  • Significant Accounting Policies: State the basis and accounting policies of each significant accounting policy. For example, Revenue Recognition, Depreciation, Asset Measurement and Recognition…etc
  • Accounting Standard use to prepare financial statements. For example, IFRS, US GAAP, or other local GAAP.
  • Nature of business
  • The significant event happens in the business
  • Going Concern Assumption
  • Changes in accounting estimates

Full Disclosure Principle simply mean disclose all information that requires by an accounting standard, and the best way to check this is going to the specific standard.

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By Sinra

Consistency Principle (Definition and Example)

Definition:

The consistency principle is the accounting principle that requires an entity to apply the same accounting methods, policies, and standards for preparing and reporting its financial statements.

The main objective of the consistency principle is to avoid any intention from management using an inconsistent approach to manipulate the financial information to ensure their financial statements look healthy.

And sometimes, management could use the inconstancy principle on the same accounting transactions or accounting even in their financial records. It is a huge risk to the user of financial statements if they are not fairly present.

IFRS also requires the entity to apply the same accounting policies in reporting its financial statements. In case there is any change in accounting policies and estimates, IAS 8 should be used.

In addition, this concept, consistency principle, also quite important for users of financial statements, investors, and shareholders.

As long as the financial statements are consistently use accounting policies and principles, the financial statements will be more accurate and reliable.

The correctness of decision making highly depends on the accuracy of financial information.

Why is the accounting principle inconsistent?

There are many cases that caused the entity to apply inconsistent accounting principles or policies. For example, there is a requirement to change accounting policies by the standard setter.

There is a requirement from the regulator of those jurisdictions and also the requirement from the entity itself.

All of these things cause the entity to apply the inconsistency principle. And the solution is the find the guideline on how to deal with it.

Different accounting standards probably use different guidelines. For example, if the financial statements use IFRS. The Consistency Principle that you should follow is IAS 8.

Example of the consistency principle:

For example,

Company A’s Financial Statements report base on IFRS. Its accounting policies for depreciation are using a straight-line basis. In 2014 and 2015, it uses a straight line.

But, the company subsequently wants to change its accounting policies from a straight line to a declining balance.

In this case, the entity should apply with IAS 8 whether it is a retrospective or prospective change. All of the change requires full disclosure in the financial statements and how the change affected. This is how we apply the Consistency Principle.

Sometimes, management’s performance is based on Net Sales or Net Profit and the way how management not complying the Consistency Principle in their Financial Statements also based on this.

For example, if the performance is base on Net Sales, management might not recognize revenues by using the same accounting policies.

And if management performance is base on Net Profit, management might play around with operating expenses to ensure that net profit looks favorable. For example, through depreciation, accrual, and other expenses.

If you have any comments related to the Consistency Principle, please drop it here or create a new topic in our forum.

Written by Sinra

Conservatism Principle: Definition | Example | Explanation

Definition:

Conservatism principle is the accounting principle that concern about the reliability of Financial Statements of an entity. The conservatism principle provides guidance to accountants on how to records and recognizes the uncertainty outcome of revenues, expenses, assets, and liabilities in financial statements.

This principle also intends to ensure that the users who use financial statements receive enough and reliable information as they should be.

Under the conservatism principle, assets and revenue could be recorded or recognize unless it is clear that the entity could measure those transactions reliably. In addition, the expenses and liabilities are records at the highest value where assets and revenues are records at the lowest value.

This principle could help to minimize the entity to overstate the revenue and assets and understate the liabilities and expenses in its financial statements.

For example, without using this concept, the accountant could manipulate the accounting records where those transactions are not reliable.

Then, the financial statements result unreliable. Subsequently, there is an effect on the users of Financial Statements.

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In real life, smart CFO and CEO might play some tricks on how to ensure that Financial Statements of the company look healthy while the reality doesn’t.

Over recognition of revenues and assets, and negligently relay to recognize liabilities are the basic place to start.

Example of Conservatism Principle:

For example, the entity should recognize the liabilities that claim to the employee for the legal case even the entity not sure if they are failing. And the recognition should be at the highest value.

But, the entity should recognize assets for legal claims from an employee unless there is a clear statement from the court.

And if assets are recognized, it should be at the lowest value. In this case, it is helping users of FS to understand all types of liabilities and expenses that probably happen to the entity. And, it assures that the revenues recorded are realistic.

Conservatism principle assumes the entity could possibly try to overstate assets and revenues, and understate expenses and liabilities.

For recognition revenue, conservatism principle, the entity could recognize the revenue if the revenue transaction could not measure reliably and the outcome of those transactions are unpredictable.

Conclusion:

This concept seems difficult, but it is quite straight forward. Here is the summary of principle:

  • Assets and Revenue are recognized at the lowest value and unless we can measure it is reliably
  • Expenses and Liabilities as soon as possible when there is uncertainty

In case, you found Conservatism Principle difficult. I give you one statement and hope it helps.

The same to in real life, you recognize bad news first, and for goods news, wait until it come true.

Feel free to leave a comment here.

Written by Sinra