Information contained in the financial statements must be free from bias. It should reflect a balanced view of the affairs of the company without attempting to present them in a favored light. Information may be deliberately biased or systematically biased.
Deliberate bias
Deliberate bias occurs where circumstances and conditions cause management to intentionally misstate the financial statements.
Examples
- Managers of a company are provided bonus on the basis of reported profit. This might tempt management to adopt accounting policies that result in higher profits rather than those that better reflect the company’s performance inline with GAAP.
- A company is facing serious liquidity problems. Management may decide to window dress the financial statements in a manner that improves the company’s current ratios in order to hide the gravity of the situation.
- A company is facing litigation. Although reasonable estimate of the amount of possible settlement could be made, management decides to discloses its inability to measure the potential liability with sufficient reliability.
Systematic bias
Systematic bias occurs where accounting systems have developed an inherent tendency of favoring one outcome over the other over time.
Example
Accounting policies within an organization may be overly prudent because of cultural influence of an over cautious leadership.
Quiz
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Question
Under which of the following circumstances will neutrality of information be compromised?
Fixed Asset with a useful life of 5 years is depreciated over 3 years because management believes it is more prudent to charge higher depreciation expense in the earlier years of an asset's life.
Correct.
Neutrality of information will be compromised because depreciation expense will not be matched against the revenue earned over asset's entire useful life. As a result, profit will be understated for the first three years whereas it will be overstated in the last two years of the asset's life. Depreciation must therefore be charged on a reasonable basis such as reducing balance method over the entire five years' useful life.
Inventory recognized at the lower of cost or net revenue.
Incorrect.
Recognizing inventory at the lower of cost or net realizable value has the effect of valuing inventory at the amount which is not higher than what may reasonably be expected to be recovered from its sale. The policy therefore preserves neutrality of information by ensuring that inventory is not valued at unreasonably high amount in the financial statements.