What does understandability mean in accounting

Furthermore, references to faithful representation need to be understood in the context of the Statement as a whole, which limits the kind of information that may properly be included in financial statements. For example, an entity may pass legal ownership of an item of property to another party, yet, when the circumstances are looked at as a whole, it may be found that arrangements exist that ensure that the entity continues to have access to the future economic benefits embodied in that item of property.

In such circumstances, the accounting needs to reflect this continuing interest. Financial information is not neutral if it has been selected or presented in such a way as to influence the making of a decision or judgement in order to achieve a predetermined result or outcome.

Information that contains a material error or has been omitted for reasons other than materiality can cause the financial statements to be false or misleading and thus unreliable and deficient in terms of their relevance.

In particular, under such conditions it requires more confirmatory evidence about the existence of, and a greater reliability of measurement for, assets and gains than is required for liabilities and losses. Nor is it appropriate to use prudence as a reason for, for example, creating hidden reserves or excessive provisions, deliberately understating assets or gains, or deliberately overstating liabilities or losses, because that would mean that the financial statements are not neutral and, therefore, are not reliable.

Information about an entity is also much more useful if it can be compared with similar information about other entities in order to evaluate their relative financial performance and financial position.

Furthermore, to help users to make comparisons, such information needs to be prepared and presented in a way that enables users to discern and evaluate similarities in, and differences between, the nature and effects of transactions and other events taking place over time and across different reporting entities.

This can usually be achieved through a combination of consistency and disclosure of accounting policies. However, consistency is not an end in itself nor should it be allowed to become an impediment to the introduction of improved accounting practices. Consistency can also be useful in enhancing comparability between entities, although it should not be confused with a need for absolute uniformity.

For example, information that does not properly reflect and communicate the substance of transactions and other events will not help users to understand the entity's financial performance or financial position. This is considered further in Chapter 7. Those preparing financial statements are entitled to assume that users have a reasonable knowledge of business and economic activities and accounting and a willingness to study with reasonable diligence the information provided.

While the paragraphs above describe the characteristics that, if present, will mean that the usefulness of the financial information has been maximised, the materiality test asks whether the resulting information content is of such significance as to require its inclusion in the financial statements. Furthermore, when immaterial information is given in the financial statements, the resulting clutter can impair the understandability of the other information provided.

In such circumstances, the immaterial information will need to be excluded. The principal factors to be taken into account are set out below. This also leads to consistency in financial reporting. Consistency means a company handles its business transactions the same way each time they occur. When a company comes to rely on these attributes, then reasonable expectations begin.

For example, stakeholders believe they can predict how a company will perform financially based on previous financial information. Comparability is a secondary aspect of understandability. Without understandability, comparability reduces, even to the point of its absence. Stakeholders who cannot make decisions based on financial data lose benefits gained from this information.

A reasonable amount of financial acumen is often an inherent assumption with understandability. Immaterial or minor items are grouped together and it is not necessary to disclose them separately.

It is important to remember that disclosure and presentation of immaterial items is costly comparing to the usefulness of such data to the users of the financial statements. The other two accounting concepts applicable to preparation of financial statements is relevance and reliability.

The essence of this concept is that only relevant information, which might be useful for the users of financial statements should be presented thereof. Information presented in the financial statement also should be reliable. All economic substance of the event, transaction must be reflected.

Financial statements must include complete records about the business, its results of operations, assets and liabilities and equity. It has to be ensured that users of the financial statements are able to compare financial data about the business with other businesses and also across several accounting periods covering the same business.

Therefore the notes to the financial statements become very important and must explain any reasons or circumstances, if there are any, why such comparison is not possible. One more accounting concept is substance over form.