Question

Explain why neutrality is such an important quality of financial statements.

Identify examples of the lack of neutrality in accounting reports.

Answer 1

The neutrality of financial statements is promoted by the International Financial Reporting Standards (IFRS). It requires that the information contained in the financial statements must be free from bias. So many parties like shareholders, creditors, government, financial institutions etc rely on the information from the financial statements. So neutrality is very important. The financial statements should reflect the correct financial position of the company and there should not be any attempt to present the data in favor of the company.

The bias in this information can be made deliberately or systematically.

Deliberate bias occurs when the management deliberately misstate the financial statements to hide the real financial position. Systematic bias is the tendency of accounting systems have to favor one outcome over the other.

Examples for lack of neutrality in accounting reports are:

• When the managers are paid bonus based on the profits of the company, the managers will adopt such accounting policies that result in higher profits. This leads to lack of neutrality in the financial information.
• Management may ‘window dress’ the financial statements in order to hide the financial problems of the company