Understandability concept of accounting

Definition and explanation

The understandability concept of accounting states that the information communicated by a company through its financial statements and related notes should be easily understandable to its readers. This concept bears much importance because difficulties in understanding the financial statements may seriously impact the decision-making of investors and other stakeholders of the company.

Companies mostly run their operations with the help of funds provided by shareholders and creditors, who expect a reasonable return on their investment. Directors and managers manage these funds to generate profits for the company. They are therefore also responsible for preparing the company’s financial statements at regular intervals. Financial statements are the primary source of information for investors to review how directors and managers have performed to meet their goals during a particular period. On the basis of these statements, they also predict the company’s future performance and make decisions about their connection with the company. The concept of understandability, therefore, aids this very need of the fund providers.

The understandability concept basically suggests that the financial statements prepared must be clear and explicit for their users. The information in the financial statements 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 general or easy-to-understand language. The use of proper headings, graphs, formats, etc. can also make the statements more legible and useful for their users.

Examples:

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

The format used above to present revenues, cost of sales, other expenses, and profits is more precise and understandable than the one given below:

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

(2). Some areas of financial statements mention specific accounting terminologies like EBITDA, amortization, free cash flows, etc., and others use complex calculations and presentations, like pension funds, gratuity funds, goodwill, reconciliations, etc. These areas often require explanation with appropriate disclosure notes, along with the basis for their calculation.

Importance of the understandability concept:

The understandability concept is significant for many reasons. For example, it promotes attributes like comparability and consistency within financial statements. If the information, like financial data, non-financial measures, disclosures, presentations, etc., becomes complicated for the readers, the purpose of educating the users about the matters of their business weakens, and ultimately, they are compelled to base their planning and decisions on less reliable sources of information.