Definition: The relevance principle is an accounting principle that states in order for financial information to be useful to external users, it must be relevant. GAAP goes on to describe the concept of relevance. Relevant information is useful, understandable, timely, and needed for decision making.
What Does Relevance Principle Mean?
Without relevance, financial information would be useless to investors and creditors. The main purpose of financial accounting is to aid external users like investors and creditors in making decisions about the company.
Example
If these external users can’t understand the financial information, it loses meaning. That is why GAAP requires a standardized format for all financial statements. This way investors and creditors will understand the numbers and be able to compare them with other companies with financial ratios.
Financial information must also be timely. A 5-year old income statement doesn’t an investor a lot of good when he is trying to understand the current financial position of the company. In order to be relevant to the investor’s decision making process, the financial information must be current and timely.
Finally, relevance requires that the financial information given must be needed by the decision maker. For instance, companies could report the type of car their CEO drives in an understandable and timely manner, but this doesn’t make this information relevant. Conversely, the company might report useful financial information that creditors aren’t interested in like employee salaries. Creditors are more concerned about cash flow and profitability—not smaller operational details.
Investors and creditors need information that is useful. That is why the relevance principle is so important to financial accounting.
