Accounting: The Objectivity Principle

The rules that accountants must follow sometimes confuse and occasionally frustrate business owners. If you know an asset has increased in value, for example, you may wonder why you can't "write up" its value on your books to reflect that increase. The reason is that every accounting rule is based on fundamental principles designed to ensure accuracy and transparency. This includes the objectivity principle.

The objectivity principle says that whenever possible, accounting entries should be based in fact – that is, on information that can be objectively proven – rather than on information that's open to interpretation. Such interpretations, after all, are really just opinion.

Objectivity goes hand in hand with two other bedrock accounting principles: reliability, which is the degree to which you can trust that accounting entries are accurate, and verifiability, which is the likelihood that different accountants looking at the same information would produce the same results.

A prime example of the objectivity principle in action is in the reporting of asset values on a company's balance sheet.

Say your company bought a plot of land five years ago for $50,000. You could ask five experts in commercial real estate to tell you what it's worth today, and you might get five different opinions. They'd all be expert, informed opinions – but they'd still be opinions.

The only thing that can be said with objective certainty about the value of the land is that you paid $50,000 for it five years ago. So that's the figure that will appear on your balance sheet, for as long as you own the land.

The objectivity principle explains why some incredibly valuable assets may not appear on your balance sheet at all.

Ask yourself how much your company's good name is worth. Your reputation with consumers, the customer loyalty you've earned – these are things that increase the value of your business. But any attempt to put a dollar figure on these "intangibles" would be subjective, so you don't get to list them as assets at all.

If you were to sell your company, however, then the intangibles would have an objective value: It's what the buyer paid for your business above and beyond the value of the tangible assets.

The buyer could then list those intangibles on its own balance sheet (usually as "goodwill"), and the objectivity principle has been upheld.

Accounting requires making all kinds of assumptions, forecasts and estimates – from what percentage of your accounts receivable you'll be unable to collect to the appropriate schedule for depreciating your fixed assets. It's ultimately impossible to predict the future, and it's unlikely that a given estimate or assumption will be 100 percent accurate. But that doesn't mean these things can't strive for objectivity, too.

Forecasts for future revenue and expenses, for example, should be based on the company's own experience – hard numbers about sales and costs. Profit projections should flow logically from current trends. Assumptions about future gains in productivity should be rooted in objective data from operations.