Understandability concept of accounting

Definition and explanation

The understandability concept of accounting states that the information provided in the financial statements must be easily understandable by the end users of those financial statements.

Any company primarily runs on the funds of shareholders and directors are the people who manage those funds with the intention to generate profits. It is the responsibility of directors to prepare financial statements and shareholders can assess the performance of their directors by reviewing these statements. The concept of understandability aids this very need of the fund providers of the company. Basically the concept suggests that the financial statements prepared by directors must be clear and explicit for their users. They must be presented in such a way that the users do not get confused or deluded. This does not mean that complex data must be excluded from these statements, but this data must be explained enough, so that even the users possessing considerably less accounting or business knowledge could understand and interpret it easily. Additionally too much use of jargon must be avoided and where possible intricate terms and statements must be substituted with easy to understand language. The use of proper headings, graphs, formats etc. can also make the statements more legible.

Examples:

(1). A simple income statement looks like the following:

A format shown above is more understandable and precise than the information presented below:

Revenues: 250,000 less cost of Sales: $180,000 less other expenses: $530,000 equals profit: $170,000.

(2). There are many areas of financial statements that mention accounting related terminologies like EBITDA, amortization, free cash flows etc. and other areas that make use of complex calculations and presentations e.g. pension funds, gratuity funds, goodwill, reconciliations etc. These must be explained with proper disclosure notes along with the basis for their calculations.

Importance of the understandability concept:

This concept is very important as the understandability of the information provided in financial statements is necessary for many reasons. It promotes attributes like comparability and consistency within financial statements that raise their relevance. If the information provided in financial statements including financial data, non-financial measures, disclosures, presentations etc. becomes complicated for the readers, the purpose to educate the users about the matters of their business weakens and ultimately they are compelled to make their planning and decisions based on less reliable sources of information.