Constraint of Financial Statements

Constraints of financial statements refer to the limitations that are essential for giving aggregate information with characteristics of qualitative nature. As such, they solve the problem of there being no qualitative information in financial statements. These constraints are those that limit us from reporting certain things on cash flow statements, income statements, and balance sheets. However, it does not mean that there is vital information missing here. These constraints are in accordance with the generally accepted accounting principles, also known as GAAP. Also, constraints of financial statements allow certain variations in fundamental accounting principles when reporting. Let us look at the various constraints of financial statements that have a positive impact on aggregate information.

Costs and Benefits Analysis

One of the biggest constraints of financial statements pertains to the costs of giving financial information. It is a mistake to assume financial reporting is a cost-free procedure. This is simply not true because time and money must be invested by an organisation for the collection, processing, analysing, and disseminating of financial information. 

So, to make a decision regarding what must be included in a financial report, the costs of providing financial information must be weighed against the benefits that can be derived from utilising it. The scope of the financial information gets reduced due to the cost-benefit constraint of financial statements.  Therefore, care must be taken to ensure that there is no vital information missing when preparing a financial report.

Materiality Factor

The materiality constraint permits organisations to omit certain information that is considered to be immaterial. This immaterial information is one that will not have a significant impact on the users of the financial information.  In other words, organisations must include all aggregate information that is bound to have a material influence on the overall performance of the company.

The materiality of information is determined by the organisation on the basis of its relative size and importance. When the amount involved is relatively minute or the information is not of significance, organisations may go for the materiality constraint. This way, they avoid reporting the information. However, care must be taken that no qualitative information is left out.

Certain Industry Practices

One can describe cost-benefit and materiality as the overriding constraints of financial statements. Let us now move on to a constraint that is relatively less dominant- the industry practices. There are certain industry practices in financial reporting that may result in a departure from fundamental standards of financial reporting for organisations in specific industries. 

For example, sometimes, organisations may forego the GAAP requirement of recording asset value at historical cost. This is particularly true for agricultural industry companies. Such companies do report their crops at their market value. This is due to the difficulty in estimating the costs of original crops. 

Conservatism

Conservatism is another constraint of financial statements that is less popular.  Nevertheless, its observance must take place in the financial reporting of aggregate information whenever possible. According to this constraint, whenever in doubt or confusion, that accounting method must be chosen that has the least probability to overstate or understate reporting. Usually, overstating takes place in the case of assets and income, while understating takes place in the case of liabilities and losses. 

Consistency Principle

The Consistency Principle states that accounting practices chosen for a particular transaction’s category must be obeyed on a horizontal basis. This is irrespective of the fact whether they are logical or not.  This should be the case from one accounting period to another. 

The advantage of the Consistency Principle is that it helps in achieving compatibility. So, if the valuation of the inventory takes place on the basis of (LIFO), the same approach should be followed in the subsequent years. Similarly, if the WDV method is adopted for measuring depreciation, it should be followed in the subsequent years. 

Timeliness Principle

The Timeliness principle states that timely aggregate information should be made accessible to the decision-makers. According to this principle, this should be the case even though such information may not be highly reliable.

Suppose the quarterly reports become accessible to the decision-makers on a half-yearly basis. Now, such information would not hold significant value to them. This is due to the fact that the quarterly report has expired and the information in it is not suitable to impact decision-making during mid-year. 

Conclusion

Constraints of financial statements are limitations that give us aggregate information with qualitative characteristics. These constraints are those that limit us from reporting certain things on cash flow statements, income statements, and balance sheets. They follow GAAP (generally accepted accounting principles). In total, there are six major types of constraints of financial statements. These are costs and benefits, materiality, certain industry practices, conservatism, consistency principle, and timeliness principle.