Understandability


Transactions and events must be accounted for and presented in the financial statements in a manner that is easily understandable by a user who possesses a reasonable level of knowledge of the business, economic activities and accounting in general provided that such a user is willing to study the information with reasonable diligence.

Understandability of the information contained in financial statements is essential for its relevance to the users. If the accounting treatments involved and the associated disclosures and presentational aspects are too complex for a user to understand despite having adequate knowledge of the entity and accountancy in general, then this would undermine the reliability of the whole financial statements because users will be forced to base their economic decisions on undependable information.

Example

One of the main problems with the financial statements of ENRON was that it contained a very complicated structure of special purpose entities that were presented in a manner that concealed the financial risk exposure of the company. The accounting treatments of ENRON were not comprehensible by the capital market participants who consistently overvalued its worth until the inevitable collapse of its share price in 2001 upon the news of its bankruptcy.

Test Your Understanding

Which of the following may improve the understandability and quality of financial statements?

Consistency in accounting policies

Increase in non-financial disclosures in annual reports

Off balance sheet financing

Use of International Financial Reporting Standards (IFRS)