Understandability
“Understandability” is one of the qualitative characteristics that financial information should possess according to accounting standards and principles. The concept is endorsed by standard-setting bodies like the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) internationally.
Definition and Importance
Understandability in accounting refers to the clarity and ease with which users can comprehend financial statements and related disclosures. Financial information is considered understandable when it is presented in a clear, straightforward manner that allows investors, creditors, and other stakeholders to quickly grasp its implications.
The quality of understandability is vital because users of financial information come from diverse backgrounds and may not be experts in the field of accounting or finance. For these users to make informed decisions—such as whether to invest in a company, lend money, or understand a company’s financial health—the financial information must be not only accurate but also easily interpretable.
Characteristics that Enhance Understandability
- Simplicity: Financial statements should avoid unnecessary complexity.
- Use of Standard Terms: The use of standard accounting terms and classifications helps to maintain consistency and understandability.
- Clear Layout and Design: Proper formatting, use of headings, and logical organization can enhance the readability of financial documents.
- Notes and Disclosures: Additional information should be provided to clarify complex transactions or accounting methods used.
- Comparability: Using standard accounting practices allows users to compare the financial information of different companies easily.
By striving for understandability, accounting professionals make it easier for stakeholders to use financial information in a meaningful way, facilitating more effective decision-making.
Example of Understandability
Let’s look at an example of understandability in accounting through the lens of an investor examining a company’s financial statements.
Scenario: Assessing Two Companies as Potential Investments
You are considering investing in one of two companies: Company A or Company B. Both companies operate in the same industry and have similar profitability and size. You decide to evaluate their financial statements to make an informed decision.
Company A’s Financial Statements
- Simplicity and Clarity: Company A’s financial statements are straightforward and easy to follow. They avoid the use of jargon or complex financial instruments that might be hard to understand for a layperson.
- Standard Terms: The statements use standard accounting terms, like “Accounts Receivable,” “Long-term Liabilities,” etc., which makes it easy to understand what each line item represents.
- Clear Layout : The financial statements are well-organized, with distinct sections for assets, liabilities, and equity on the balance sheet, and revenues and expenses on the income statement.
- Notes and Disclosures: Company A includes clear, concise notes that explain their accounting methods and any unique transactions that took place during the financial year.
- Comparability : Company A follows generally accepted accounting principles (GAAP), allowing you to easily compare its financial health with other potential investments.
Company B’s Financial Statements
- Complexity: Company B’s financial statements are complex and filled with industry-specific jargon. They involve several financial instruments that are not easily understood without specialized knowledge.
- Non-standard Terms: The statements use non-standard classifications and terms that make it hard to understand what each line item represents.
- Confusing Layout: The layout of the financial statements is not organized logically, making it hard to follow the flow of money within the company.
- Limited Notes and Disclosures : Company B provides limited or no additional information to explain their accounting methods or unique transactions, making it hard to understand the rationale behind certain numbers.
- Comparability Issues: Company B does not strictly adhere to GAAP, making it difficult to compare its financial standing with other companies directly.
Decision Time
Based on understandability alone, you find Company A’s financial statements much easier to interpret. This clarity enables you to make a more informed investment decision. You might feel more comfortable investing in Company A because its transparent financial reporting demonstrates a level of integrity and accountability that is critical for investor trust.
This example illustrates the importance of understandability in accounting, especially for stakeholders like investors who rely on clear and comprehensible financial information for decision-making.
