Constraints of Accounting
For providing the accounting information with the qualitative characteristics which make it beneficiary and fruitful to the business, the business enterprise must regard as two dominant factors that can limit (restrain) the reporting of financial statements. These constraints are:
- (1) Cost-Benefit relationship
- (2) Materiality
There are also two other less-dominant but important constraints which are part of the financial reporting environment: these are
- (3) Industry practices
- (4) Conservatism
Users of accounting system sometimes presume that accounting information is free of cost. But the real picture is different. The preparers and providers of accounting information have to pay for providing or making the accounting report. Therefore, companies consider the cost benefit relationship to cover the expense: the company must evaluate those costs which are incurred through supplying the information against the benefits that could be resultant from using it. Rule-making bodies and governmental agencies generally apply this cost-benefit analysis prior to finalizing their informational necessities. There is a complexity of cost-benefit analysis that is the costs and the benefits are not always quantifiable. The costs could be ranges to various areas, such as, costs of collecting and processing the information, costs of publishing, the auditing cost, litigation related costs, costs for providing the disclosure to competitors, and costs of analysis and explanation. He makers or the preparers of accounting information also get benefits. For example, owing the greater management control and or having access to capital at a lower cost. Users of accounting information sometimes obtain the better information for provision of resources, tax assessment, and rate regulation. It is generally difficult to quantify benefits than costs. Besides having this difficulty in evaluation process of costs and benefits for its rules, the FASB has taken attempts which state that each proposed assertion will cover an important need thus the costs that are imposed to meet the rule are reasonable in relation to overall benefits of the resulting information.
This constraint is referred as materiality which is related with how an item impact on the overall financial operations of a company. An item of any enterprise will considered as material if its insertion or omission will change the decision of a reasonable person, otherwise the item will be referred as immaterial and irrelevant as it would have no impact on a decision making process of company. The relative size and importance of the product are also considerable here. Suppose if the amount of the item is significant when compared with the other revenues and expenses, assets and liabilities, or net income of the company then appropriate and acceptable standards and guidelines should follow in the reporting of that item. But if the amount is not so important when compared with other items, then it will be less important to follow the proper guidelines in the reporting process of that item. Materiality could vary according to relative amount and relative importance as the inclusion of such an item in the operating income would affect the amount of that income materially. So the relative size of an item is very significant to recognize its materiality. Most of the Companies and their auditors generally follow the rule of thumb that if anything under 5 percent of net income will be referred as immaterial otherwise it is material. But according to the SEC a company may use this percentage for an initial judgment of materiality, but along with this judgment they also should consider other factors. For example, companies must regard as both quantitative and qualitative factors for determining the materiality of the item. The materiality of any item is also important in internal accounting decisions. Such as, the amount of classification which is required in a subsidiary expense ledger, the degree of accuracy that is necessary in prorating expenses among the departments of a company, and the extent to which adjustments should be made for accrued and deferred items.
Though these following constraints are not so much common in the accounting system but they are also related with the financial statement of any company.
Industry practices concern with the peculiar nature of some industries and business concerns sometimes requires departure from basic theory. For example, some public-utility companies may record the non current assets first in the balance sheet to draw attention to the capital-intensive nature of the industry. Moreover Agricultural companies often report product at their fair value as it is costly to develop accurate cost figures on individual crops. Though these practices are unusual or infrequent, but some industries apply these practices or variations.
The convention of conservatism in accounting is often interpreted as the constraint .Conservatism states that if any doubt exist then choose that solution which will be least likely to overstate assets and income. The rule of conservatism rule does not refer that net assets or net income should be understated but some companies misunderstood that. If the principle of conservatism is properly applied, then it could provide an effective solution in difficult situations to refrain from overstatement of net income and net assets. An example of conservatism in accounting is lower-of-cost-or-market approach in valuing inventories. So if there is any confusion it is better to understate than overstate net income and net assets. But without any doubt there is no need to follow this constraint.