Reliability Principle
The reliability principle, often referred to in the context of accounting, asserts that financial reporting should be trustworthy, verifiable, and free from bias. In other words, information reported on financial statements should be reliable enough that other knowledgeable and independent external parties can arrive at the same figures given the same data and methodologies.
Key aspects of the reliability principle include:
- Verifiability: Information should be backed by evidence (like receipts, invoices, or bank statements) that can be used to verify or corroborate the amounts reported.
- Representational Faithfulness: The financial statements should accurately depict the economic events and transactions that have occurred. This means that the information should be a faithful representation of the actual events, free from any kind of bias or distortion.
- Neutrality: Financial information should be presented in a neutral manner, without the intention of swaying users toward a particular interpretation. It shouldn’t favor one set of stakeholders over another.
It’s worth noting that while the reliability principle emphasizes the need for information to be accurate and verifiable, it sometimes comes into tension with the relevance principle. The relevance principle stresses the importance of timely information that can influence decision-making. In some cases, obtaining perfectly reliable information may take time, making it less timely and therefore less relevant for users. Accountants often have to balance the trade-offs between relevance and reliability when preparing financial statements.
Example of the Reliability Principle
Let’s delve into a more concrete example that highlights the reliability principle in action.
Suppose “TechGadgets,” a retail electronics store, has a stock of a specific smartphone model which they bought a year ago. The company initially purchased these phones for $300 each. Due to advancements in technology, newer models have been released, and the value of the stocked phones in the current market is around $180 each. Additionally, TechGadgets has received a buyback offer from a wholesaler to take the stock back for $200 each.
Application of the Reliability Principle:
- Historical Cost Method:
- TechGadgets can record the inventory at its historical cost of $300 each. This value is backed by the purchase invoices and is completely verifiable. This approach aligns with the reliability principle as it provides a concrete and neutral value.
- Market Value:
- If TechGadgets considers the current market price of the phone, which is $180, it becomes less objective. Market prices can be influenced by various external factors and can fluctuate based on supply, demand, and perceptions. Although this might give a more relevant view of the inventory’s worth, it lacks the same level of reliability as the historical cost.
- Buyback Offer:
- The offer from the wholesaler to buy back the inventory for $200 each provides another verifiable price. It’s a concrete offer, backed by a proposal from the wholesaler. In this sense, it’s more reliable than the market value but still less reliable than the original purchase price.
Decision and Analysis: Given the principles of accounting, TechGadgets might choose to keep the inventory valued at the historical cost of $300 on the balance sheet due to its verifiability, even though this may not reflect the most current worth of the inventory. However, an astute financial statement user or investor would be interested in the note disclosures or management discussion to understand the inventory’s market relevance.
This example emphasizes the balance that companies must strike between presenting information that’s both reliable (verifiable and objective) and relevant (useful for decision-making). The reliability principle steers companies towards presenting information that stakeholders can trust as accurate and unbiased.
