Understandability definition
/What is Understandability in Accounting?
Understandability is the concept that financial information should be presented so that a reader can easily comprehend it. This concept assumes a reasonable knowledge of business by the reader, but does not require advanced business knowledge to gain a high level of comprehension. Adherence to a reasonable level of understandability would prevent an organization from deliberately obfuscating financial information in order to mislead users of its financial statements.
Guidelines for Understandability
In order to be understandable, financial information should be presented using the following guidelines:
Complete. The text presented should not be missing any key information. For example, a table of future lease payments should include all future periods for which lease payments will be made, so that a reader can understand the entire scope of future obligations.
Concise. Do not bury the users of financial information with an excessive amount of detail. This means presenting a sufficient amount of information that is easily scanned for highlights. Also, do not replicate disclosures throughout the financial statements; instead, set forth information in one place, and then insert references to it elsewhere in the financial statements, as needed. The use of references can significantly decrease the size of financial reports.
Clear. Use a presentation methodology that is easy for the reader to scan. This typically means that charts and tables take the place of text, or are at least the preferred form of presentation.
Organized. The reader should be able to easily locate cross-referenced information within the financial statements. This means that all supporting schedules should be identified with a footnote number or letter, with this identifier listed in the main financial statements.
The preceding concepts do not mean that complex information should be excluded from the financial statements. For example, the concepts related to pensions and derivatives are not easy to understand. In these situations, apply the understandability concept as much as possible, but still present the required information.
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Examples of Understandability
Here are several examples of understandability, as the concept pertains to the financial statements of an organization.
Clear financial statements presentation. A company's income statement separates revenues, expenses, and net income into distinct sections with descriptive headings and straightforward language. For instance, listing “Cost of Goods Sold” instead of a vague term like “Direct Costs” helps readers quickly understand which expenses are directly tied to production. The use of subtotals, clear labels, and well-organized formats makes it easy for stakeholders to follow the financial performance.
Explanatory notes and disclosures. In its annual report, a company provides notes to the financial statements that explain complex items like derivative instruments, pension liabilities, or revenue recognition policies. For example, if a business uses a new accounting standard to recognize revenue, the notes would describe the standard in simple terms, explain its impact on reported earnings, and include examples to clarify the changes. This practice enhances understandability by making complex information accessible to users.
Use of graphs and charts. A company presents its cash flow trends over five years using line graphs in the management discussion and analysis (MD&A) section of the annual report. By visually representing data—such as increases in operating cash flow or reductions in financing cash flows—stakeholders can quickly grasp the company’s liquidity and financial health without having to interpret dense tables of numbers.
These examples illustrate how clear language, well-organized information, and visual aids contribute to the understandability of financial reports, enabling users to interpret and act on the information more effectively.