Relevance and reliability are two accounting terms that occupy an important place in accounting. When it comes to the conceptual frameworks in accounting, it is impossible to ignore relevance and reliability and still give out accurate information.
Accounting information is prepared for different reasons. The importance of this information to individuals and businesses cannot be overemphasized.
Accounting data is vital in the decision-making process of individuals and organizations alike.
For accounting information to be useful and produce the result for which they are collated, it must be relevant and reliable.
Relevance and reliability are therefore basic attributes of every accounting information that cannot be done without.
What is the Relevance of Accounting information?
Accounting information is said to be relevant if such information can affect the decision-making process positively or negatively. There are key players and decision makers in every organization and business.
Some of these key players are business owners, shareholders, investors, and even creditors. These key players rely on the accounting information made available by the business to determine the financial position of the business or organization.
Take the investor, for example, he or she looks at the balance sheet of the business to know at a glance it’s financial standing.
No rational investor would want to invest funds into a dying business but rather a business that is a going concern.
If the financial information provided on the balance sheet is not relevant, it becomes difficult to use them in decision-making.
For accounting information to be relevant, it must have the following attributes:
- The values provided must be predictive in nature. Accounting information is relevant to the extent it can predict the possible future moves in business. Predictive accounting information makes it possible for stakeholders to make strategic moves to maximize profits and cut down on possible losses in the future.
- The values must be confirmatory. Accounting information does not stand alone. They are most times a reflection of general trends in the business. For accounting information to be considered relevant, it must be able to provide feedback on the overall state of the business or organization. It is not just enough for such information to be predictive.
Relevant accounting information must provide helpful information on what has happened in the past, what is currently happening, and what will most likely happen in the nearest future.
For instance, if at the end of the quarter a business experiences a boom in sales, such information can affect the decision of investors and shareholders.
To the investor, this could be a sign that the next quarter would be productive. As a result, investors may decide to expand their investments in the company.
A creditor viewing the same information may decide to extend the credit limit. This is because, from the financial report, the business is doing well and therefore in a better financial position to repay debts.
Once you have been able to determine that the information being provided by your accountant is relevant, the next step is to find out how much you can rely on that information.
Reliable accounting information has been explained in different ways.
The Financial Accounting Standards Board (FASB) has tried to define reliable information.
According to the FASB definition, accounting information is said to be reliable; the descriptions are verifiable as well as representationally faithful.
The determine if accounting information is reliable, such information should have all of the following attributes:
Accounting information is said to have passed the verifiability test if similar results can be obtained using other independent mediums.
Accounting data fails the verifiability test if different competent individuals review the same financial statements under similar conditions without arriving at the same conclusion
Accounting information is said to be faithfully represented if it is neutral, free from error, as well as complete.
The data presented in the financial reports or statements should be a true picture of what is in existence.
For instance, if the total profit made by a business in a quarter is $500,000, that should be the same amount on the reports and statements.
Anything higher, or lower flaws the faithful representation test and makes the information unreliable.
Accounting information must be unbiased to pass the neutrality test. When it comes to the sharing of accounting information, no selective preference is made to favor one party at the expense of another.
Take for instance a situation where a company is on the verge of going bankrupt.
Omitting such information from a financial report or notes can be considered to be biased. Such a report cannot be considered to be reliable as it does not show the true position of things.
If investors decide to use such a report, it may not be favorable to them. Neutrality ensures transparency in the presentation of accounting information.
A tradeoff between Relevance and Reliability
In accounting, relevance and Reliability are mostly viewed as two attributes that are competing for a place in a given piece of information.
What this means is that most times, for information to become more reliable, a tradeoff has to be done. This, therefore, makes the information less relevant. The reverse is the case if the aim is to get more relevant information.
The tradeoff between Relevance and Reliability has become more or less a challenge in presenting accounting information. This trade-off can be showcased with an example.
If a business makes a credit sale, this sale is recorded as revenue to the business. However, the cash equivalent has not yet been paid to the company by the buyer.
The reflection of the credit sale as a revenue makes the revenue information on the statements relevant.
However, it lowers the reliability of the information because the business has not yet received the cash into its bank account. There is also the possibility of the customer defaulting in paying the cash.
There are different parameters for measuring items that are reported in a company’s financial statement.
Some of the parameters include cash flows, prevalent market values as well as current and historical costs.
These attributes can have an effect on financial reports, thereby affecting either the relevance or reliability of such information.
The tradeoff between reliability and relevance of accounting information is more evident in certain sectors.
The oil and gas sector for example constantly experiences the tradeoff between reliability and relevance. Oil and gas firms give recognition to the current value of reserves in the calculation of net income.
Relevance and reliability are accounting attributes that increase the integrity of accounting reports and statements. These attributes should therefore be present in any accounting information.