Faithful representation is an accounting concept that is one of the fundamental qualitative characteristics of useful financial information as described by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). The other fundamental characteristic is Relevance.
Faithful representation implies that the financial reports of an entity are complete, neutral, and free from material error. Here’s what each of these mean:
- Completeness: All necessary information is provided in the financial statements and the accompanying disclosures. This ensures that a user of the financial report has all the facts necessary to understand the entity’s financial position and performance.
- Neutrality: The financial information is unbiased and does not favor any particular user group over another. The information should not be presented in a way that might influence a decision or outcome.
- Free from material error: While it’s understood that some estimates and judgments are necessary in accounting, the financial information should not contain any errors or misstatements that could mislead a user of the financial report.
By ensuring faithful representation, an entity provides a true and fair view of its financial performance and position. This allows stakeholders, such as investors, lenders, and others, to make informed decisions based on the entity’s financial information.
Example of Faithful Representation
Let’s consider an example of a company that owns a piece of machinery.
Completeness: If the company records the machine on its balance sheet, it also needs to provide additional information in the notes to its financial statements about the depreciation method used, the useful life of the machine, and any significant assumptions made when calculating depreciation.
Neutrality: Suppose the company expects that the machine will have a useful life of 10 years. However, in order to decrease depreciation expense and thereby increase net income, the company decides to record a useful life of 20 years. This would not be a neutral presentation because the company has manipulated the financial statements to achieve a specific outcome.
Free from material error: If the company accidentally records the cost of the machine as $100,000 when it actually cost $110,000, this would be a material error because it could mislead users of the financial statements. The company needs to correct this error to ensure faithful representation.
So, in the case of faithful representation, the company should record the cost of the machine accurately, provide complete information about how it calculates depreciation, and not manipulate the useful life of the machine in order to achieve a specific outcome on the income statement. Doing all of these things would provide a faithful representation of the company’s financial position and performance.