Accounting constraints

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Accounting constraints (also known as the constraints of accounting) are the practical limitations and guidelines that influence how financial statements are prepared and interpreted. These constraints acknowledge that ideal accounting practices may need to be adjusted due to factors like the availability of reliable information, the cost of providing it, and the need to balance accuracy with timeliness.

Contents

Common accounting constraints include objectivity (requiring verifiable evidence), the cost-benefit principle (weighing the cost of information against its usefulness), materiality (focusing on significant information), consistency (applying the same methods over time), industry practices (following accepted norms within a specific sector), timeliness (reporting information promptly), and conservatism (avoiding overstatement of assets and profits). They help ensure that financial reporting is both useful and practical. [1] [2] [3]

Accounting constraints is not to be confused with constraints accounting, the latter of which, much like throughput accounting or cost accounting, is a method of accounting. [4]

Types of Constraints

Objectivity

The constraint of objectivity deals with the issue of needing objective, verifiable evidence. [5]

Costs and benefits

The costs and benefits constraint, also called the cost-effectiveness constraint, is pervasive throughout the framework. [6] Companies must spend time and money to provide financial statements. [7] To be more specific, costs can constrain the range of information when providing financial reporting [8] on the grounds that the companies must "collect, process, analyze and disseminate relevant information" [3] which need time and money.

For investors, they want to know all financial information if possible in ideal condition, which may cause tremendous financial burden in the corporations. [9] Moreover, some financial information may not be valuable for external users to acquire a huge benefit, for example, how much money does a company spend for its greening of headquarters. Therefore, while deciding the components of financial reporting, companies need to measure the sense of particular financial information and the expenditure of providing particular information and the benefits they can acquire from this particular information. [10] Properly speaking, if the costs in particular information exceed the benefit they can acquire, companies may choose not to disclose this particular information. [11] For example, if there is a $0.1 difference between checkbook register and bank statement, accountant should ignore the $0.1 rather than waste time and money to find the $0.1. [12]

Materiality

Companies need to consider materiality when providing financial information. [10] Particularly, companies must disclose the material information which can influence the financial performance and some immaterial information can be excluded. [13] For example, a company owns $10 million net assets and therefore a default of customer with $1000 is immateriality and in contrast if the amount of default is $2 million, which can influence the financial decisions and thus means material. However, there are also some small items which can transfer net profit to net loss and these item can be considered as material items. [14] In order to judge whether the information is material or not, companies can based on the following materiality process: [15]

Define purpose and scope

Expected: [15]

  • Know well about your objectives: think about what you will do with the outcome of materiality process and objectives can be future trends or target setting area etc.;
  • Take your audience into consideration: who important for your financial report and who will read it;
  • Define the meaning of materiality for your company: the importance to stakeholder and is it relevant to your company;
  • Defence the scope of material topics in your company: which parts of your business will be covered in this assessment?

Advanced:

  • Embed materiality: consider the materiality results when making business plans;

Identify Potential Topics

Expected: [15]

  • Check sources to make a long list of possible material topics: internal data, external review or media reporting, etc.;
  • Assign responsibility: which team should be involved when making possible material topics: such as senior management team;
  • Contain both risks and opportunities such as cost savings or efficiency gains;
  • Take external stakeholder engagement into consideration: the impact and valuable feedback you can acquire from stakeholders;

Advanced:

  • Invest in a digital solution: collect and store documentation;
  • Establish a sustained process: capture long term changes for material topics;

Categorise

Expected: [15]

  • Classify the potential materiality themes into Categories such as group, country, etc.;
  • Check whether the topics are on the same level or not;
  • Align topics name based on the policies and strategies of your organization;
  • Each employee involved in this process need to understand the specific risks and opportunities;

Advanced:

  • Connect each material topic with relevant external changes;
  • Consider how material topics can influence each other or overlap;

Gather information about the impact and importance of topics

Excepted: [15]

  • Research every materiality theme and find the correlations between topics and business in terms of social, economic and environmental impacts;
  • Gather information about each material topics which can be used to prioritize the topics in next phase;

Advanced:

  • Utilise Methodology such as KPMG True Value to quantify social, economic and environmental impacts;

Prioritise

Expected: [15]

  • Prioritise material topics by:
    • Identifying relevant business functions and choosing which internal stakeholders need to be joined in prioritizing topics.
    • Utilising the methodology developed in phase 4 to ‘score’ each topic.
    • "Setting a threshold or cut-off point for de ning which topics will be considered material". [15]

Advanced:

  • Connect with enterprise risk management function;

Engage management

Expected: [15]

  • Materiality assessment need to be signed off by senior business manager;
  • It is important to do the review which makes the process reliable;

Advanced:

Seek stakeholder feedback

Expected: [15]

  • Identify which kind of stakeholders need to review the material topics and evaluate the outcomes;
  • Acquired feedback form stakeholders;

Advanced:

  • Connect the results of materiality assessment with company strategies and operations;

Consistency

Accounting statements made over a long period of time should be consistent or similar to one another. If they are formatted similarly then comparisons can more easily be made between these documents. [5]

Industry Practices

Industry Practices is a less dominant constraint compared to cost-benefit and materiality in financial reporting. [3] This constraints means in some industries, it is hard and costly to calculate the production costs and therefore companies in these particular industries choose to only report the current market prices instead of production costs. [16] For example, in agriculture industry, calculating cost per crop is difficult and expensive and hence they choose to report the price in the current market which is easier for farmers. [17]

Conservatism

Accountants estimate the transactions and then choose whether to record the transactions or not based on their own judgment. In terms of that, conservatism is helpful for accountants to make a choice between two similar alternatives and it makes accountants choose to record the less optimistic choice. [18] For example, If there is a possibility that customers will sue the company and they may also not to sue the company. In this case, accountants need to disclose this situation to investors. [12]

Moreover, the Conservatism is also a less dominated constraint, which means firms also need to consider more about bad news than good news when reporting financial statements. [18] In particular, firms need to choose the method that "least likely overstates assets and income or understates liabilities and losses" [3] when encountering accounting issues. For example, if the staff believe there will be 2% bad debt in terms of receivables based on historical information and another staff believe there will be 5% because of a sudden drop, the company needs to use the 5% figure when providing financial statements. [19]

Timeliness

Perhaps most obviously, statements should be relevant in terms of date. Quarterly reports should not be made available only on a half-year basis, as some of the information in the report would not be very useful. [20]

Financial Constraint

Financial Constraint is defined as a temporary restriction of internally generated funds which may require resources to be cut for investments [21] including marketing resources, so that managers can achieve their financial goals.

During the past two decades, researchers have conducted a large number of empirical studies related to financial constraints, and the measurements they use have generated controversy, Fazari et al. (1987) in their seminal work, find a positive relationship between resources available for investment and cash flow. [21] Because external financing, such as taking on debt or acquiring capital, is not immediately available, such firms are heavily dependent on their internal cash flow. [22] However, many research papers show doubt on the idea that the relationship between investment and cash flow indicates financial constraint. The authors of another seminal study on the subject, Kaplan and Zingales (1997), find that firms classified as having financial constraint, such as in Fazzari et al (1987), appear to have less constriction and less sensitivity to cash flow, [23] which contradicts the initial hypothesis. [22] Therefore, Kaplan and Zingales (1997) and Whited and Wu (2006) present new financial-constriction indexes. Whited and Wu (2006) develop a widely use financial constriction called index WW. [24] Despite controversy regarding financial constraint measurement, the literature recognizes its generalized use of cash flow as measure of financial constraint. [22] [25] [26] [27]

Recent research demonstrates that financial constraint is continue present in firms from The US and Latin America. The uncertain and volatile environment of global markets causes companies financial constraints. In addition to the fact that financial markets have increased the pressure on companies to obtain positive short-term results, in a situation of financial constraint, managers generally address this situation by decreasing the intensity of marketing to show acceptable short-term results to shareholders; however, these decisions impact negatively the long-term firm value. [28]


Related Research Articles

In management accounting or managerial accounting, managers use accounting information in decision-making and to assist in the management and performance of their control functions.

International Financial Reporting Standards, commonly called IFRS, are accounting standards issued by the IFRS Foundation and the International Accounting Standards Board (IASB). They constitute a standardised way of describing the company's financial performance and position so that company financial statements are understandable and comparable across international boundaries. They are particularly relevant for companies with shares or securities publicly listed.

Generally Accepted Accounting Principles (GAAP) is the accounting standard adopted by the U.S. Securities and Exchange Commission (SEC), and is the default accounting standard used by companies based in the United States.

This page is an index of accounting topics.

<span class="mw-page-title-main">Audit</span> Independent examination of an organization

An audit is an "independent examination of financial information of any entity, whether profit oriented or not, irrespective of its size or legal form when such an examination is conducted with a view to express an opinion thereon." Auditing also attempts to ensure that the books of accounts are properly maintained by the concern as required by law. Auditors consider the propositions before them, obtain evidence, roll forward prior year working papers, and evaluate the propositions in their auditing report.

A financial audit is conducted to provide an opinion whether "financial statements" are stated in accordance with specified criteria. Normally, the criteria are international accounting standards, although auditors may conduct audits of financial statements prepared using the cash basis or some other basis of accounting appropriate for the organization. In providing an opinion whether financial statements are fairly stated in accordance with accounting standards, the auditor gathers evidence to determine whether the statements contain material errors or other misstatements.

In finance, valuation is the process of determining the value of a (potential) investment, asset, or security. Generally, there are three approaches taken, namely discounted cashflow valuation, relative valuation, and contingent claim valuation.

Financial accounting is a branch of accounting concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of financial statements available for public use. Stockholders, suppliers, banks, employees, government agencies, business owners, and other stakeholders are examples of people interested in receiving such information for decision making purposes.

In financial accounting, a cash flow statement, also known as statement of cash flows, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and out of the business. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard 7 is the International Accounting Standard that deals with cash flow statements.

Throughput accounting (TA) is a principle-based and simplified management accounting approach that provides managers with decision support information for enterprise profitability improvement. This approach that identifies factors which limit an organization's ability to reach its goals, and then focuses on simple measures that drive behavior in key areas towards reaching organizational goals. TA was proposed by Eliyahu M. Goldratt as an alternative to traditional cost accounting. As such, Throughput Accounting is neither cost accounting nor costing because it is cash focused and does not allocate all costs to products and services sold or provided by an enterprise. Considering the laws of variation, only costs that vary totally with units of output e.g. raw materials, are allocated to products and services which are deducted from sales to determine Throughput. Throughput Accounting is a management accounting technique used as the performance measure in the Theory of Constraints (TOC). It is the business intelligence used for maximizing profits, however, unlike cost accounting that primarily focuses on 'cutting costs' and reducing expenses to make a profit, Throughput Accounting primarily focuses on generating more throughput. Conceptually, Throughput Accounting seeks to increase the speed or rate at which throughput is generated by products and services with respect to an organization's constraint, whether the constraint is internal or external to the organization. Throughput Accounting is the only management accounting methodology that considers constraints as factors limiting the performance of organizations.

An annual report is a comprehensive report on a company's activities throughout the preceding year. Annual reports are intended to give shareholders and other interested people information about the company's activities and financial performance. They may be considered as grey literature. Most jurisdictions require companies to prepare and disclose annual reports, and many require the annual report to be filed at the company's registry. Companies with issued shares publicly listed are also required to report at more frequent intervals.

Capital budgeting in corporate finance, corporate planning and accounting is an area of capital management that concerns the planning process used to determine whether an organization's long term capital investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structures. It is the process of allocating resources for major capital, or investment, expenditures. An underlying goal, consistent with the overall approach in corporate finance, is to increase the value of the firm to the shareholders.

The following outline is provided as an overview of and topical guide to accounting:

<span class="mw-page-title-main">Sustainability accounting</span> A term of financial accounting

Sustainability accounting originated in the 1970s and is considered a subcategory of financial accounting that focuses on the disclosure of non-financial information about a firm's performance to external stakeholders, such as capital holders, creditors, and other authorities. Sustainability accounting represents the activities that have a direct impact on society, environment, and economic performance of an organisation. Sustainability accounting in managerial accounting contrasts with financial accounting in that managerial accounting is used for internal decision making and the creation of new policies that will have an effect on the organisation's performance at economic, ecological, and social level. Sustainability accounting is often used to generate value creation within an organisation.

In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything that can be used to produce positive economic value. Assets represent value of ownership that can be converted into cash . The balance sheet of a firm records the monetary value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business. Total assets can also be called the balance sheet total.

The philosophy of accounting is the conceptual framework for the professional preparation and auditing of financial statements and accounts. The issues which arise include the difficulty of establishing a true and fair value of an enterprise and its assets; the moral basis of disclosure and discretion; the standards and laws required to satisfy the political needs of investors, employees and other stakeholders.

A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are publicly listed, the market price of the shares is used in certain financial ratios.

<span class="mw-page-title-main">Corporate finance</span> Framework for corporate funding, capital structure, and investments

Corporate finance is an area of finance that deals with the sources of funding, and the capital structure of businesses, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.

The convergence of accounting standards refers to the goal of establishing a single set of accounting standards that will be used internationally. Convergence in some form has been taking place for several decades, and efforts today include projects that aim to reduce the differences between accounting standards.

Management accounting principles (MAP) were developed to serve the core needs of internal management to improve decision support objectives, internal business processes, resource application, customer value, and capacity utilization needed to achieve corporate goals in an optimal manner. Another term often used for management accounting principles for these purposes is managerial costing principles. The two management accounting principles are:

  1. Principle of Causality and,
  2. Principle of Analogy.

References

  1. ↑ "6 Constraints of Accounting". iEduNote.com. 20 June 2018. Retrieved 4 August 2020.
  2. ↑ "2.1 GAAP – Generally Accepted Accounting Principles | Principles of Accounting I". courses.lumenlearning.com. Retrieved 4 August 2020.
  3. 1 2 3 4 Way, Jay. "What Are the Constraints of Accounting?". Sapling.com. Sapling. Retrieved 3 August 2020.
  4. ↑ Caspari, John A.; Caspari, Pamela (23 November 2004). Management Dynamics: Merging Constraints Accounting to Drive Improvement. John Wiley & Sons. ISBN   978-0-471-68741-2.
  5. 1 2 Brown, Michael (3 April 2014). "Accounting Constraints". Double Entry Bookkeeping. Retrieved 7 August 2020.
  6. ↑ Kieso, D. E.; Weygantdt, J. J.; Warfield, T. D. (2013). Intermediate Accounting. WILEY.
  7. ↑ Dauberies, H.; Annand, D (2014). Introduction to Financial Accounting. David Annand. ISBN   978-0-9936701-2-1.
  8. ↑ FASB. "Cost - Benefit Analysis" . Retrieved 18 October 2015.
  9. ↑ "Cost and Benefit Principles" . Retrieved 20 October 2015.
  10. 1 2 Leiwy, D. (2015). Principles of Accounting.
  11. ↑ Hermanson, Edwards, and Maher (2011). Accounting Principles: A Business Perspective, Financial Accounting.{{cite book}}: CS1 maint: multiple names: authors list (link)
  12. 1 2 "Key Principles of Accounting Constraints". 5 December 2023.
  13. ↑ Corporation for Public Broadcasting (2005). Application of Principles Accounting and Financial Reporting To Public Telecommunications Entities.
  14. ↑ "The Materiality Principle" . Retrieved 20 October 2015.
  15. 1 2 3 4 5 6 7 8 9 KPMG (2013). The Essentials of Materiality Assessment.
  16. ↑ "Industry Practices Constraint" . Retrieved 18 October 2015.
  17. ↑ My Accounting Course. "Industry Practice Constraints" . Retrieved 19 October 2015.
  18. 1 2 Basu, S. (1997). "JOURNAL OF Accounting & Economics". The Conservatism Principle and the Asymmetric Timeliness of Earnings.
  19. ↑ "The Conservatism Principle" . Retrieved 20 October 2015.
  20. ↑ "6 Constraints of Accounting". iEduNote.com. 20 June 2018. Retrieved 7 August 2020.
  21. 1 2 Fazzari, Steven; Hubbard, R. Glenn; Petersen, Bruce (1987). Financing Constraints and Corporate Investment (PDF) (Report). NBER Working Paper Series. Vol. 2387. Cambridge, MA: National Bureau of Economic Research. doi:10.3386/w2387. S2CID   51804837.
  22. 1 2 3 Chen, Huafeng (Jason); Chen, Shaojun (Jenny) (2012). "Investment-cash flow sensitivity cannot be a good measure of financial constraints: Evidence from the time series". Journal of Financial Economics. 103 (2): 393–410. doi:10.1016/j.jfineco.2011.08.009. S2CID   155028040.
  23. ↑ Kaplan, S. N.; Zingales, L. (1 February 1997). "Do Investment-Cash Flow Sensitivities Provide Useful Measures of Financing Constraints?". The Quarterly Journal of Economics. 112 (1): 169–215. doi:10.1162/003355397555163. ISSN   0033-5533.
  24. ↑ Whited, Toni M.; Wu, Guojun (2006). "Financial Constraints Risk". Review of Financial Studies. 19 (2): 531–559. doi:10.1093/rfs/hhj012. ISSN   0893-9454.
  25. ↑ Grullon, Gustavo; Hund, John; Weston, James P. (2018). "Concentrating on q and cash flow". Journal of Financial Intermediation. 33: 1–15. doi:10.1016/j.jfi.2017.10.001.
  26. ↑ Ughetto, Elisa (2016). "Investments, Financing Constraints and Buyouts: the Effect of Private Equity Investors on the Sensitivity of Investments to Cash Flow: Investments, Financing Constraints and Buyouts". The Manchester School. 84 (1): 25–54. doi:10.1111/manc.12085. S2CID   154694432.
  27. ↑ Hall, Bronwyn H.; Moncada-Paternò-Castello, Pietro; Montresor, Sandro; Vezzani, Antonio (2 April 2016). "Financing constraints, R&D investments and innovative performances: new empirical evidence at the firm level for Europe". Economics of Innovation and New Technology. 25 (3): 183–196. doi:10.1080/10438599.2015.1076194. ISSN   1043-8599. S2CID   18628145.
  28. ↑ Palomino-Tamayo, Walter; Timana, Juan; Cerviño, Julio (2020). "The Firm Value and Marketing Intensity Decision in Conditions of Financial Constraint: A Comparative Study of the United States and Latin America". Journal of International Marketing. 28 (3): 21–39. doi:10.1177/1069031X20943533. ISSN   1069-031X. S2CID   221113382.
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