What is Relevance in Accounting?
Relevance in accounting means the information we get from the accounting system will help the end-users to take important decisions. End users can be either internal or external stakeholders. Internal stakeholders include managers, employees, and business owners. By external stakeholders, we mean investors, lenders etc. Therefore relevance in accounting indicates the capacity of influencing the end-users of the financial statement in their decision-making process.
As per GAAP, the information should be useful, understandable, timely and pertinent for the end-users in taking important decisions.
A ten-year-old income statement doesn’t hold much significance to an investor. The financial information must be timely in order 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 current salary of the employees in an understandable and timely manner, but this doesn’t make this information relevant to an investor.
Relevance in Accounting for Whom?
Next thing we should understand which information would be relevant for whom?
- The annual report of the company which is prepared by the managers of the company is of great importance for 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 price of the share per day. The share price will never be mentioned in a balance sheet or the income statement. The balance sheet and the income statement shows the ability to generate future cash flows. In this way, the shareholders will find meaning in it and will be useful for their decision making the purpose of investment.
- A manager who is an insider to the company will be in charge of taking some 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 is generally prepared by the managers will help the manager for the pricing of a product. So by taking the annual report and keeping in mind the accounting principles and going backward in a calculation, the manager can calculate the price/profitability of a product.
- Whereas 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 be also understood that the shareholders should not jump to a conclusion by only seeing the current financial report. It should also understand the assumptions and accounting policies followed in making the report. Then by using the numbers for a period of time, it will be able to understand the profit generated and profit distributed which the annual reports will also throw light on. In this way, the information will be relevant for the shareholders in making a decision.
Every stakeholder needs information that is useful. This is the reason why the relevance principle is of prime importance to financial accounting.
If a company wanted 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 interests. Therefore the financial statements of the company should be relevant for the bank in making their decision regarding granting a loan to the company.
Financial statements like balance sheets, income statement, and cash flow present important information to the banker in taking decisions. It should also be noted that the information should be timely. The banker will not consider the financial statements which are more than 10 years old.
The information should be understandable. The financial statement should be in proper accounting format and lastly, the information should be useful for the banker in making the important decision of whether to grant a loan to the company or not.
A company ABC announces that it’s earning per share has 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.
In mergers and acquisitions, the acquirer will be willing to pay the premium as it will expect the synergies (expected increase in revenue, cost savings) which will be generated by the acquisitions. The acquirer can estimate the synergies from the enterprise value of the firm 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 then the acquirer might underestimate or overestimate the company which in turn will be a great loss for the acquirer.
A financial statement 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 of importance to the investors in making decisions.
Many stakeholders also use past financial statements to analyze the future performance of the company regarding profitability. It should be of 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 for the company in making decisions.
In short, accounting relevance should contain accurate and orderly information. The relevance in accounting numbers depends on the person who is using it and it will hold more meaning if it has been used over a period of time and more useful if one understands the generally accepted accounting principles on the basis of which the financial report has been prepared.
This has been a guide on Relevance in Accounting. Here we discuss examples of relevance in accounting and how it is useful to managers, small shareholders as well as large shareholders. You can learn more about accounting from the following articles –