Financial reporting has been made more transparent using the objectivity concept. It demonstrates an organisation's actual financial and operational position. Accountants prepare financial statements according to various rules, procedures, and methods. A set of standard practices and policies have been implemented to ensure that personal interests don't influence reports.
Based on the objective concept, auditors can analyse financial statements and verify that the information is accurate and reliable. It ensures reliable and relevant information in reporting, auditing, and decision-making. It ensures that accounting transactions are supported or backed up by appropriate business documents.
Did You Know? The objective principle is a core principle of GAAP (Generally Accepted Accounting Principles) because it requires facts-based accounting, not opinions.
What Does Objectivity Concept Mean?
The objective concept in accounting refers to the requirement that financial statements are accurate and that a financial report should be unbiased and independent of internal and external influences. Rather than simply recording opinions in financial statements, financial information should be supported by solid evidence. This principle protects the preparation of financial statements from the influence of management and accountants at any given time.
It is possible, for example, that management accrues revenue associated with a lawsuit payout, even though the evidence suggests that the payout is unlikely to occur. Rather than making such a determination based on limited information, it would be more objective to wait for more details. Management's significant stake in the company can also skew financial results because they are motivated to report optimistic results, even though a more objective view would lead to a more conservative report.
When constructing financial statements using an objective viewpoint, the result should be financial information that investors can rely on to evaluate an organisation's results, cash flows, and financial position.
Also Read: Fund Flow Statement - Meaning, Format And Examples
Importance of Objectivity Concept
Objectivity concept in accounting is recognised as the principle that states financial statements which are objective in nature. Listed below are some of the reasons showing the importance of the Objectivity Concept.
Documentary Evidences Transactions
Each transaction includes a source document, such as a purchase invoice, cash receipt, payment voucher, and sales invoice, which makes the information provided by financial statements reliable.
Standards of Preparing Financial Statements
Financial statements will be prepared according to GAAP (Generally Accepted Accounting Principles) standards, which stress the importance of objectivity.
The management and other stakeholders will be able to make better decisions since the financial statements will be based on solid evidence.
Verifies Source Documents at any Time and Place
The concept allows and facilitates verification with source documents, making it easier to analyse financial statements over differing periods and compare them with those of other firms.
Also Read: Know All About Cost Accounting
Advantages of Objectivity Concept
There are several advantages to the objectivity concept, including the following:
1. This is a transparent and trustworthy representative that presents information unbiasedly. In addition to investors, stakeholders, suppliers, and government agencies, many users can use accounting information.
2. This illustrates that records presented in books are not based on opinions, making them completely accurate.
3. Goodwill is created for the company due to this activity.
4. It penalises the companies for misrepresenting information.
Disadvantages of Objectivity Concept
There are several disadvantages to the concept of objectivity:
1. The daily operations of companies generate many data, and the documentation of all such entries requires a lot of different procedures and a high cost.
2. The process is time-consuming and will impact the company's daily operations.
3. Hiring external resources to conduct audits reduces profit margins.
Concepts Of Objective Concept
The main objective of this principle is to keep the management team and the accounting department of an entity from producing financial statements that are viewed by their opinions and biases.
Financial information's reliability can directly impact an organisation's financial position, as emphasised by the objectivity principle. Based on the reliability concept, only transactions supported by source documents or evidence are entered into the books. There should be no bias in financial statements, and they should be accurate and fair. As an example: To prove the reliability of a transaction, the company should also have the invoice when purchasing equipment.
There is an alignment between the verifiability and objectivity concepts. Third parties according to this concept, third parties should have access to the same facts and assumptions used by the firm when preparing the financial statements. Third parties, such as auditors, can verify whether financial statements produced by a firm are accurate if they can do so.
Also Read: Accounting Equation: Overview, Formula, and Examples
Examples of Objective Concepts
Example 1: A company needed a bank loan to start a new plant. The bank asked for a copy of the company's most recent financial statements to grant the loan. An accountant of the company sent financial statements that an independent auditor did not audit. To prove the reliability of the financial statements, the officer would reject the loan because it violated the objectivity concept.
Example 2: ABC company's owner asks his accountant to prepare financial statements. In response to the accountant's request for bills and invoices, the owner says that it will take some time to fetch the information and that it would be best to use the accounting system's data. A statement should be based on solid evidence and supporting documents, which violates the concept of objectivity in this case.
Real-life Examples of Objective Concepts.
In 2016, Monsanto Company, based in the United States, misstated the company's earnings by employing internal accountants to violate accounting rules. Penalties totaling ₹6,61,85,99,360 crores were assessed against the firm due to the violation.
In the United States, Enron Corporation was a major energy company. There were billions of dollars of debt hidden within the enterprise in 2001. Enron's president and CEO, Jeff Skillings, was sentenced to 24 years in prison for breaching accounting principles, which resulted in shareholders losing more than ₹6,13,36,78,700 crores.
Objectivity Principles in Auditing
An audit is the inspection of a company's books by internal and external auditors. While examining records, auditors should be extremely careful and substantiate each record with proper documentation, such as receipts, bills, and other documents. Consequently, auditors ensure every description is accurate and objective based on the objectivity principle.
The company's books include Balance Sheets, Profit and Loss Statements, Cash Flow Statements, and Shareholder Equity statements. Accordingly, all entries in the respective books should adhere to the objective principle. Any false record will question the credibility of the entire book. As a result, auditors are extremely careful when auditing books and scrutinise every detail minutely.
Advantages of Objectivity Principles in Auditing
Several parties follow the company's financial records. The information must be accurate and transparent for the books to be accurate and transparent. As a result, the books become objective and trustworthy. Objectivity in accounting proves a firm follows the standard. In this book, all records are factual and backed up by documentation.
In books, it proves there is no reliance on opinions. Due to its factual nature, the records make the book transparent.
The company gains goodwill as a result. In the past, misrepresenting information has dramatically damaged the image of companies. A company's share price increases when investors trust and believe its books are clean.
In addition to jail terms, misrepresenting information carries severe penalties. Therefore, companies that adhere to good accounting standards are not subject to government sanctions.
Disadvantages of Objectivity Principles in Auditing
The data will need to be recorded and stored in sound software, and each entry will require documentation and the high cost of establishing and maintaining this type of record.
Collecting documents and proofs to meet the objectivity principle takes a tremendous amount of time. The management spends more time documenting everything accurately, affecting the business's daily operation.
External auditing teams are expensive to hire. As a result, normal business operations become more expensive, and profit margins shrink.
Accounting principles change over time. Therefore, the company must appoint a team to keep track of the changing accounting principles and act as necessary.
Also Read: What are Consolidated Financial Statements?
Business organisations must apply the objectivity principle in today's fast-paced world since it improves the accuracy and reliability of the financial statement. Stakeholders can also evaluate a business's position more quickly. Accordingly, it is recommended that all firms use the objectivity concept of GAAP.
Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.