Question

According to the conceptual framework, accounting information must be relevant and also representationally faithful. A) How can this supposedly turn out to be a balancing act (i.e. trying to juggle both relevance and representational faithfulness? B) Give an example of an accounting concept where relevance exists but lacks representational faithfulness or vice versa.

Answer 1

Relevance and faithful representation are the two fundamental qualities that make accounting information useful for decision-making. To be relevant, accounting information must be capable of making a difference in a decision. Information with no bearing on a decision is irrelevant. Financial information is capable of making a difference when it has predictive value, confirmatory value, or both. Faithful representation means that the item is representative of the real-world phenomenon that it purports to represent. Faithful representation is a necessity because most users have neither the time nor the expertise to evaluate the factual content of the information. In other words, faithful representation means that the numbers and descriptions match what really existed or happened. To be a faithful representation, information must be complete, neutral, and free of material error

Faithfull representation requires that transactions and events should be accounted for in a manner that represent their true economic substance rather than the mere legal form. This concept is known as Substance Over Form.

Substance over form requires that if substance of transaction differs from its legal form than such transaction should be accounted for in accordance with its substance and economic reality.

The rationale behind this is that financial information contained in the financial statements should represent the business essence of transactions and events not merely their legal aspects in order to present a true and fair view.

For Example,

A machine is leased to Company A for the entire duration of its useful life. Although Company A is not the legal owner of the machine, it may be recognized as an asset in its balance sheet since the Company has control over the economic benefits that would be derived from the use of the asset. This is an application of the accountancy concept of substance over legal form, where economic substance of a transaction takes precedence over its legal aspects. This is an instance where representative faithfulness exist where relevance not present.