What is Relevance in Accounting?

Explained

As per GAAP, the information should be useful, understandable, timely, and pertinent for end-users to make important decisions.

A ten-year-old income statement doesn’t hold much significance to an investor. The financial informationFinancial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc.read more must be timely to be relevant to the investors.

Finally, relevance in accounting also means that it should be useful for the decision-making process for the end-users. For example, companies could report the employees’ current salary in an understandable and timely manner, but this doesn’t make this information relevant to an investor.

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Relevance in Accounting for Whom?

The next thing we should understand is which information would be relevant for whom?

  • The company’s annual report, which the company managers prepare, is important to the shareholders. Now there may be different kinds of shareholders in a company. The shareholders who hold some shares in the company are more interested in the share price per day. The share price will never be mentioned in a balance sheet or the income statement. The balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more and the income statement show the ability to generate future cash flows. In this way, the shareholders will find meaning in it, and it will be useful for their decision making the purpose of investment.A manager who is an insider of the company will be in charge of making strategic or operational decisions based on the situation. Like the manager has to estimate the price/profitability of a product. This information will directly not be available in the annual report. The annual report, which the managers generally prepare, will help the manager with the pricing of a product. So by taking the annual report, keeping in mind the accounting principlesAccounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts.read more and going backward in a calculation, the manager can calculate the price/profitability of a product.The shareholder who holds a large number of shares in the company will be more interested in knowing the profit generated and distributed by the company. But it must also be understood that the shareholders should not jump to a conclusion by only seeing the current financial report. It should also understand the assumptions and policies followed in making the accounting report. Then by using the numbers for some time, it will be able to understand the profit generated and profit distributed, which the annual reportsAnnual ReportsAn annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company’s performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements.read more will also throw light on. In this way, the information will be relevant for the shareholders in making a decision.

Every stakeholder needs useful information. It is why the relevance principle is of prime importance to financial accounting.

Examples

Example #1

If a company wants to take a loan from a bank, then the bank will want to know first whether the company will be able to pay them back the loan with interest. Therefore, the company’s financial statements should be relevant for the bank in making its decision regarding granting a loan to the company.

Financial statements like balance sheets, income statements, and cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more present important information to the banker in making decisions. It should also be noted that the information should be timely. The banker will not consider the financial statements which are more than ten years old.

The information should be understandable. In addition, the financial statement should be in proper accounting format. Lastly, the information should be useful for the banker in deciding whether to grant a loan to the company or not.

Example #2

A company, ABC, announces that its earning per shareEarning Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more have increased from $40 to $45. It is important and relevant information for the investors in making their decision as growing earnings provide a good return for the investors.

Example #3

In mergers and acquisitionsMergers And AcquisitionsMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion.read more, the acquirer will be willing to pay the premium as it will expect the synergies (expected increase in revenue, cost savings) generated by the acquisitions. The acquirer can estimate the synergies from the enterprise value of the firmEnterprise Value Of The FirmEnterprise value (EV) is the corporate valuation of a company, determined by using market capitalization and total debt.read more, which again will be calculated from the balance sheet of the Target Company, and EBITDA, which could be taken from the financial report of the target company.

It is a piece of important and relevant information for the acquirer as it will influence its decision, whether paying a premium for the target company is worthwhile or not. If timely and accurate information is not provided, the acquirer might underestimate or overestimate the company, which will be a great loss for the acquirer.

Final Thoughts

A financial statementFinancial StatementFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more is relevant when it has data that is valuable enough to make predictions /estimations about future events like calculating the future cash flows, which will be important to the investors in making decisions.

Many stakeholders also use past financial statements to analyze the company’s future performance regarding profitability. It should be accurate data following accounting standards. Any inaccurate information may be misleading. Therefore any such false data doesn’t come under the definition of accounting relevance. This kind of information cannot be of any use to the company in making decisions.

In short, accounting relevance should contain accurate and orderly information. The relevance of accounting numbers depends on the person using them. And it will hold more meaning if it has been used over some time and is more useful if one understands the generally accepted accounting principlesThe Generally Accepted Accounting PrinciplesGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more based on which the financial report has been prepared.

This article is a guide on Relevance in Accounting. Here we discuss examples of relevance in accounting and how it is useful to managers, small shareholders, and large shareholders. You can learn more about accounting from the following articles –

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