Constraints accounting is an accounting technique which allows some variations to the Generally Accepted Accounting Principles when reporting financial statements of a company, where these variations do not violate the GAAP in light of the recognized constraints. CA contains explicit consideration of the role of constraints in accounting and constraints related to limitations when providing financial information. The definition of a constraint is a regulation which belongs to prescribed bounds. There are four main types of constraints which are the cost-benefit relationship, materiality, industry practices and conservatism and these constraints are also accounting guidelines which border the hierarchy of qualitative information.
Types of Constraints
Cost-benefit Relationship
The cost-benefit relationship constraint is also called cost effectiveness constraints and is pervasive throughout the framework. The companies need to spend money and time in the process of providing financial statements. To be more specific, Costs can constraint the range of information when providing financial reporting on the grounds that the companies must "collect, process, analyze and disseminate relevant information" 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. 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. Properly speaking, if the costs in particular information exceed the benefit they can acquire, companies may choose not to disclose this particular information. For example, if there is $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.
Materiality
Companies need to consider materiality when providing financial information. Particularly, companies must disclose the material information which can influence the financial performance and some immaterial information can be excluded. 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. In order to judge whether the information is material or not, companies can based on the following materiality process:
Define purpose and scope
Expected:
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:
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 feedbacks you can acquire from stakeholder;
Advanced:
Invest in a digital solution: collect and store documentation;
Establish a sustained process: capture long term changes for material topics;
Categorise
Expected:
Classify the potential materiality themes into Categorise 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:
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:
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".
Include some social trends into outcomes, which can make the assessment into wider corporate strategy process;
Seek stakeholder feedback
Expected:
Identify which kind of stakeholders need to review the material topics and evaluate the outcomes;
Acquired feedbacks form stakeholders;
Advanced:
Connect the results of materiality assessment with company strategies and operations;
Industry Practices
Industry Practices is a less dominated constraint compared with cost and relationships and materiality in financial reporting. 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. 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.
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. 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. 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. In particular, firms need to choose the method that "least likely overstates assets and income or understates liabilities and losses" 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.
