Six Principle Constraints of Accounting

Constraints of accounting are actually the limit or boundaries that are necessary for providing information with the qualitative in characteristics.

To make the information useful, the basic assumptions and principles discussed earlier’, have to be modified and find their limitation. Thus creation of constraints of accounting. The five constraints of accounting are;

  1. Cost-Benefit Principle,
  2. Materiality Principle,
  3. Consistency Principle,
  4. Conservatism Principle,
  5. Timeliness Principle, and
  6. Industry Practice.

They are described below;

Cost-Benefit Principle

According to this principle, the cost of applying an accounting principle should not be more than its benefits. If the cost is more, this principle should be modified.

Too often, users assume that information is free. However, providers of accounting information know that it is not. Therefore, companies must consider the cost-benefit relationship.

They must consider the costs of providing the information against the benefits that can be derived from using it.

Rule-making bodies and governmental agencies use cost-benefit analysis before making final their informational requirements. In order to justify requiring a particular measurement or disclosure, the benefits perceived to be derived from it must exceed the costs perceived to be associated with it.

The difficulty in cost-benefit analysis is that the costs and especially the benefits are not always evident or measurable.

The costs are of several kinds: costs of collecting and processing, of disseminating, of auditing, of potential litigation, of disclosure to competitors, and of analysis and interpretation.

Benefits to preparers may include greater management control and access to capital at a lower cost. Users may receive better information for allocation of resources, tax assessment, and rate regulation. As noted earlier, benefits are generally more difficult to quantify than are costs.

Despite its difficulty in its implications, the FASB attempts to regulate that each proposed pronouncement will fill a major need and that the costs imposed to meet the rule are justified in relation to overall benefits of the resulting information. In addition, the Board seeks input on costs and benefits as part of its due process.

Materiality Principle

This principle is basically an exception to the full disclosure principle.

The full disclosure principle requires that all facts necessary to ensure that the financial statements are not misleading, must be disclosed, whereas the materiality principle requires that the items or events having an insignificant economic effect or not being relevant to the user’s need not be disclosed.

According to the materiality principle, all relatively relevant items, the knowledge of which might influence the decision of the users of the financial statements, should be disclosed in the financial statements. Which information is more relevant than others is largely a matter of judgment.

For instance, recording and accounting of a small Calculator as an asset in the balance sheet may not be justified due to the excess of cost of recording over the benefits in terms of usefulness of recording and the accounting of calculators as an asset.

The materiality depends not only upon the amount of item but also upon the size of business, level and nature of information, level of the person/department who makes the judgment about materiality, e.g. a worker reporting to his foreman about the production in grams (e.g. part of kilogram), a foreman to his supervisor in kilograms, a supervisor to his production manager in quintals and the production manager to the top management in tones, may be justified with regard to the circumstances.

It hardly makes any difference if the production manager reports to the top management that the production is 1,99,000.90 kilograms or simply 200 tones (nearly).

Consistency Principle

According to this principle, whatever accounting practices (whether logical or not) are selected for a given category of transactions, they should be followed on a horizontal, basis from one accounting period to another to achieve compatibility, e.g., if the inventory is valued on (LIFO) basis, this basis should be followed year after year and if a particular asset is depreciated according to (WDV) method, this method should be followed year after year.

The consistency should not be confused with mere uniformity or inflexibility and should not be allowed to become an impediment to the introduction of improved accounting standards.

It is not appropriate for an enterprise, to leave its accounting policies unchanged when more relevant and reliable alternatives exist.

The users should be informed of the accounting policies employed in the preparation of the financial statements, any change in these policies and the effects of such changes.

Conservatism Principle

According to this principle, the principle of ‘anticipate no profit but provide for all probable losses’ should be applied.

The valuation of stock-in-trade at a lower cost or net realizable value and making the provisions for bad and doubtful debts are the applications of this principle.

In other words, the principle of conservatism requires that in the situation of uncertainty and doubt, the business transactions should be recorded in such a manner that the profits and assets are not overstated.

When the stock is valued at cost in one accounting period and at a lower cost or net realizable value in another accounting period; this principle conflicts with the principle of consistency.

When excessive provisions for bad and doubtful debts and depreciation are charged, it leads to the creation of secret reserves, and thus, this principle conflicts with the principle of full disclosure.

The estimation of probable losses is a subjective judgment and thus, this principle conflicts with the principle of objectivity.

The practice of making provisions for bad and doubtful debts, etc. implies lesser charges in the following accounting periods. In other words, it reduces the current income and raises the future income and thus it conflicts with the matching principle.

Nowadays, the conservatism principle is being replaced by the prudence principle which requires that the conservation principle should be applied only in circumstances in which great uncertainty and doubt exist.

Timeliness Principle

According to this principle, timely information (though less reliable) should be made available to the decision makers.

If the quarterly reports are made available on half-yearly basis, the information contained in the quarterly report would not be very useful to the decision makers since the information has lost its capacity to influence the decision during the period of half year, after the expiry of which the quarterly report had been submitted.

Industry Practice

The peculiar characteristics of an industry may require departure from the accounting guidelines discussed above.

For example, in case of an agricultural industry, it is a common practice to disclose the crops at market value rather than at a cost price since it is costly to obtain accurate cost figures of individual crops. Such differences from basic theory are rare, but they do exist.

Whenever we find what appears to be a violation of basic accounting theory, we must fix whether some peculiarity of the industry explains the reasons of violation before we try to censure the procedures followed.