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.
Quiz
How much do you know about understandability principle?
Take the free quiz below and find out!
Question
Which of the following may improve the understandability and quality of financial statements?
Consistency in accounting policies.
Correct.
Frequent changes in accounting policies can make it hard for users to make valid comparisons of entity's performance over time and with other entities.
Increase in non-financial disclosures in annual reports.
Correct.
Increase in non-financial disclosures by companies in recent past such as environmental reports and balances scorecard analysis has arguably improved the overall quality of financial statements by giving users a better all round view of company affairs.
Off balance sheet financing.
Incorrect.
Off balance sheet financing hides the nature and extent of credit and market risk a company is exposed to and may therefore mislead investors regarding the potential volatility of their investment. This was witnessed widely in the US debt crises where financial institutions were able to hide their exposure to low quality financial instruments through the use of complex accounting policies and practices.
Use of International Financial Reporting Standards (IFRS).
Correct.
Growing use of IFRS across the globe facilitate comparison and understandability of between companies operating in different jurisdictions.