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The Role and Issues Surrounding Materiality, Prudence, Etc.

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The Role and Issues Surrounding Materiality, Prudence, Etc.

Introduction

For financial information to satisfy the objectives stated it must possess attributes of a qualitative nature (Carmichael, Whittington, and Graham 2007). These characteristics ensure that financial reports present right and fair business performance view. International Accounting Standard Board developed a framework to guide businesses on reporting standards. The framework describes the characteristics that a financial report should have for it to be considered true and fair. These characteristics, if incorporated in financial reports, will help in creation of high quality reports, which the recipients will find easy to use. According to IASB, the four attributes are Materiality, relevance, comparability as well as reliability (Carmichael, Whittington, and Graham 2007). This paper will discuss the role and issues surrounding Materiality, prudence, neutrality, relevance and reliability.

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Discussion

Materiality

Materiality is the concept that guides audit reports while they are being prepared. In accounting terms, materiality is regarded as a determination of what will or will not influence the decision of a user. It should not cause unqualified decisions to any end user since not every one is conversant with these underlying characteristics. It is, therefore, the duty of a practitioner to guide those using situations, which are related, to a fair presentation of an entity’s statement of finance. Consequently, it will establish disclosures that exist with regard to equity instruments and future debt (Carmichael, Whittington, and Graham 2007).

Materiality is a concept applied, together with some other concepts, mostly by companies when preparing financial reports. As such, something might be included in making these reports that inflict mistaken judgements by the end users of those statements. This results from practitioners including or omitting information that are considered incorrect, and hence affecting their decisions (Carmichael, Whittington, and Graham 2007). The concept of materiality, therefore, arises from that omission or inclusion of some information.

An audit report must be precise to ensure true and fair financial situation of a company as presented by the reports. For this to happen, materiality characteristic of financial statements applies in every decision. However, due to inability to comprehend this concept, auditors tend to false financial reports that do not reflect the real situation of companies in recent days (Carmichael, Whittington, and Graham 2007).

In the preparation of financial reports, errors of relevant nature or size should be identified so that there is a sensible assurance that the reports are free from misstatements of materials. It becomes difficult to understand this as it is a level of materiality, which requires a deep insight (Loughran 2011). As such, for one to understand this level of materiality, he should understand that materiality has to take into consideration, the size, circumstances, cost and nature against the benefit of auditing an item.

To a large number of people, what is considered when materiality is assessed is the monetary value. They say that monetary value is relative and not absolute. According to them, materiality is only attributable to items quantifiable only in monetary terms. This is one area of misunderstanding on the issue of materiality concept (Loughran 2011). It requires a greater knowledge to establish that not only materiality is assessed in monetary value but also in qualitative factors. For instance, materiality decision affects the financial reports, and yet it is unquantifiable. Sticking to this line of argument, one must understand that the immaterial features becomes material only when they are able to influence the outcome of financial statements resulting to an impact on the decision of the recipients of the final reports (Loughran 2011).

Disclosure of thresholds of materiality gives a whopping insight concerning the judgement of the auditor, and the coverage of audit tests. As such, it has an upper hand in such a way that misstatements, which are within materiality level disclosed, cannot hold the auditor responsible (Stickney, Weil, Schipper, and Francis 2009).

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Practitioners treat materiality inconsistently where thresholds of materiality are applied. They urge that materiality cannot cover every possible circumstance. Guidelines that are perspective in nature should not take effect. Instead, to comprehend materiality, one ought to consider standards (Stickney, Weil, Schipper, and Francis 2009). The best solution that could solve this complexity is designing software that is within financial reach of the auditors.

Prudence and Neutrality

To understand, and differentiate prudence and neutrality characteristics, a person ought to understand what each means. First, prudence, as used in accounting terms, apply in such a way that inventories and profits should not be overestimated, and neither should they be understated (Stickney, Weil, Schipper, and Francis 2009). On the other hand, neutrality states that standards of accounting should be made to provide the best information to users of the information to aid in their economic decisions disregarding how the information reported may affect the political, social and economic behaviours (Thomas and Basu 2003).

In practice, these characteristics aims to ensure that where there are uncertainties, there is no overstatement of profits while both liabilities and loses are not understated. However, in this situation, a cautious bias may run counter to the need of neutrality a thing that excludes systematic bias in accounts (Stickney, Weil, Schipper, and Francis 2009).

Some tradeoffs occur where an auditor wish to remain neutral. For instance, end users may regard the financial statements as relevant. Those projections contain subjective elements. As such, a neutral practitioner may cease to evaluate those projections if a high degree of reliability does not prevail in the practitioners mind (Porter, Curtis and Norton 2010). On the other hand, if there are projections that those practitioners regard as outside the boundaries of neutrality, he or she may comment on such projections. As a result, he gives opinions as to the practices that used to come up with the figures (Thomas and Basu 2003).

The international Standards of Accounting have in indicated that prudence is in conflict with neutrality quality. The reason behind this is that, prudence is most likely to result into a bias in the final reported situation of a company about the financial position and the financial performance (Thomas and Basu 2003).

It is evident that incorporation of understatements that are biased in regards to assets in a period, mostly result to financial performance that is overstated in the long run. This is not an act of prudence. It is inconsistent with the concept of neutrality. Neutrality in practice encompasses applications where there is freedom from bias (Porter, Curtis and Norton 2010).

However, to understand these conflicts and avoid them, competing demands of these concepts must be reconciled. This is done by striking a balance, and as a result, systematic and deliberate understatements of profits as well as assets do not arise. Similarly, the same should supersede so that overstatement concerning liabilities and losses does not come to happen (Porter, Curtis and Norton 2010).

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In order to avoid bias in representation of facts, description and knowledge, on neutrality should be incorporated. Trade off exist on perceptions that accounting practitioners should not at any time influence any predetermined result.

Financial information practitioners sometimes measures liabilities on the intended prudent basis lacking neutrality as required by the accounting framework. Phase one in preparation of financial reports do not describe what prudence is appropriate. As such, there is a tendency to do away with excessive prudence (Kieso, Weygandt and Warfield 2011). As a result, IFRS do not prohibit measurements that exist of liabilities, which lack neutrality since they favour prudence. IFRS do prohibit the introduction of excessive prudence if the practitioner measures liabilities guided by sufficient prudence.

Relevance and Reliability

Both relevance and reliability are critical for financial information quality. They are related in such a way that underscore in one characteristic tend to bias the other. It is for this reason that tradeoffs occur (Kieso, Weygandt and Warfield 2011). As such, financial information is relevant if provided in a timely manner. Trade off here exists since the information if presented exceptionally early, it will be uncertain and, as such, it is unreliable. Again, if the information is withheld to go by the guideline of reliability, relevance characteristic tend to be lost (Kieso, Weygandt and Warfield 2011).

Natural tradeoffs exist in most cases where reliability and relevance are put into consideration. Consider the following example. The value of an asset, which that is not frequently traded, is supremely relevant if there is an intention that the asset will be sold to meet certain liabilities. The valuation of such an asset can be difficult when it comes to determining its reliability. Different practitioners may place values on that asset and hence the value reported becomes hard or even impossible to verify by the end user. The original cost is usually the only reliable value but considering the end users; it might not be relevant. As such, choice exists between a hugely relevant and yet unreliable value. Similarly, it is between a remarkably reliable and yet irrelevant source (Kieso, Weygandt and Warfield 2011).

Usually, conflict arises between these two concepts where a degree of uncertainty crops. In such circumstances, some paradigms of accounting need prudence. This is because; an asset whose value is uncertain cannot be relied upon. Consequently, to some assets, there is delayed recognition since it is not until their value tends to have effect, as it would lead to reporting of liability values that are exaggerated to a point that, becomes unlikely to have a final settlement value that is more than the reported value (Fischer, Taylor, and Cheng 2008).

Reliability and consistency are, therefore, the dangers that these approaches entail in their applications. Since information uses differ, how one user understands prudence may not be the same to as another person would do. For instance, a person who intends to buy an asset would apply prudence when he chooses a low estimate of the value of that asset (Fischer, Taylor, and Cheng 2008). Still, researches maintain that users have different tolerance of risks and, as such, a bias in information is a risk as it results to misleading information. This can only be otherwise if the bias is qualified for the sake of the end user of the financial information. Consequently, when faced with uncertainty, concepts opt to report estimates that are unbiased supported by disclosure of the uncertainties.

In the preparation of financial reports, relevance is applied first, and then followed by reliability to avoid these tradeoffs (Fischer, Taylor, and Cheng 2008). The reason behind this is that relevance is considered the most vital. This idea should not confuse practitioners. Both characteristics are useful for the sake of the user of these reports, and that they work in harmony with each other. There exists different levels of reliability and relevance and this result to trade offs. These tradeoffs are prominent features in the present framework. As such, they are invoked frequently since they do not incorporate use of fair measurements (Fischer, Taylor, and Cheng 2008).

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Conclusion

Financial statements facilitate process involved in auditing. The characteristics of financial statement discussed above help the public to know the role of an auditor. Financial reports should present real performance and financial position of an entity as well as satisfy objectives of the users. To achieve this, it must have a full coverage of financial statement characteristics, which are the reason behind favourable reports.. If one fails to comprehend the characteristics discussed above, it will lead to misinterpretations of information, and hence the reported financial statements will be distorted and not useful to the potential investors (Fischer, Taylor, and Cheng 2008). It is mandatory to observe keenness while applying such characteristics as materiality as it is confusing and not easily understood. It requires wide knowledge and reasoning and not just assumptions.

Trade offs should be reviewed and adequately addressed by people who prepare the financial reports since they lead to misinterpretations. Consequently, if care is not taken, the reports prepared will be biased, and present the wrong financial information regarding the financial state of the company. Flawed financial reports are of no use to investors or the company (Fischer, Taylor, and Cheng 2008).

References

Carmichael, D.R., Whittington, R., and Graham, L., 2007. Accountants’ Handbook: Financial accounting regulations and organizations, John Wiley and Sons, New York.

Fischer, M., Taylor, W.J., and Cheng, H.R., 2008. Advanced Accounting, Cengage Learning, Mason.

Kieso, D.E., Weygandt, J.J., and Warfield, T.D., 2011. Intermediate Accounting, John Wiley and Sons, New York.

Loughran., 2011. Financial Accounting for Dummies, John Wiley and Sons, New York.

Porter, G.A., Curtis L., and Norton, C.L., 2010. Using Financial Accounting Information: The Alternative to Debits and Credits. Cengage Learning, Mason

Stickney, C.P., Weil, R.L., Schipper, K., and Francis. J., 2009. Financial accounting: an introduction to concepts, methods, and uses, Cengage Learning, New York.

Thomas, A.L., and Basu S., 2003. Basic financial accounting, Wadsworth Pub, Mason.

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