Importance of an Accounting System

Business enterprises are created for achieving one or more objectives – profit motive being the most dominant among all objectives. For accomplishing objectives efficiently and effectively, the firm needs resources which must be optimally utilized. The firm faces the question of the use and allocation of resources at two levels.  First, at the macro level, the firm has to compete for resources with other firms in the capital market.  The criterion used by the capital market to allocate resources is efficiency, which is conventionally measured in terms of profits.  A firm would thus succeed to obtain funds from the capital market if it has been profitable in the past, or has a profit making potential in the future. The capital market consists of investors-individuals and institutional-who decide about the allocation of funds to the firms on the basis of information regarding the financial performance of the firms. Accounting, through its financial reports, furnishes this information to investors. Financial reports or statements in the form of balance sheet and profit and loss account inform investors how the firm has performed.  Accounting has come to be known as financial accounting when it served the purpose of reporting financial information to investors. Once the firm has been able to gather resources from the capital market, at the micro level o fits internal operations, it has to decide allocation of resources to its various projects, activities and assets. The firm needs relevant information for making decisions of internal uses of resources. Specifically, it requires information on the cost benefit aspect of a particular uses of resources.  Again, accounting fills this gap. When accounting caters to the internal uses, it is known as management accounting.

Importance of an Accounting System

Accounting System: Objectives and Functions

Financial information is needed by both investors and management. Financial information is required to predict, compare and evaluate the firm’s earnings ability.  It is also required to aid in economic decision-making, investment and financing decision-making.  Every enterprise should know the activities carried by it together with their financial implications.  The financial score of an enterprise is kept by the accounting system. It points out the problems faced or likely to be faced by the enterprise.  It also brings to the notice of the firm opportunities that are likely to arise.  It indicates possible action, when needed.  In fact, accounting is the guidepost and language of management. Accounting is the process of identifying, measuring, and communicating economic information to permit information judgment and decisions by users of the information.

The objectives of accounting are to provide information for:

  1. Making decisions concerning the use of limited resources, including the identification of crucial decision areas, and determination of objectives and goals;
  2. Effectively directing the controlling of an organization’s human and materials resources;
  3. Maintaining and reporting on the custodianship of resources; and
  4. Facilitating social functions and controls.

The main objective of accounting is to provide information to the users to make relevant decisions and form judgments.

Accounting performs three functions:

  1. Accumulation – The accounting system identifies and gathers relevant data. The process of data accumulation involves recording and analysis of economic events.  These records are essentially historical in nature, as the events recorded are the ones which have already occurred.
  2. Measurement – accounting also performs the measurement function.  It assigns monetary values to economic events.  While performing this function, it acts in accordance with the generally accepted principles.  Some economic events cannot be measured accurately; they are estimated.
  3. Communication – Accounting is the source of business information.  Therefore, the information accumulated and measured should be periodically communicated to users.  The information is communicated through statements and reports.

The financial statements and reports should be reliable and accurate.  For the internal use of management, a variety of reports, depending on the information need, may have to be prepared.  In communicating information to outsiders – investors-standard criteria of full disclosure, materially, consistency and fairness should be adhered to.

Users of Accounting Information

The following are the important users of the accounting information:

  1. Owners have the primary interest in the financial information.  They have entrusted their financial resources to the firm and, therefore, would like to know periodically its performance.  Managers are the custodians of their investments and, therefore, they must submit periodical financial reports to owners.
  2. Managers are responsible for the overall performance of the firm. They make several decisions and, therefore, need information.  Accounting provides relevant information in which managers have a direct interest.
  3. Creditors supply financial resources to the firm. They are interested in the continuing profitable performance of the firm so that they may regularly receive interest and repayment of the principal sum. They need accounting information to evaluate the firm’s performance and to determine the degree of risk to which they are exposed.
  4. Potential investors, creditors or owners, get an idea about the firm’s financial strength and performance from its financial reports. They are generally interested in the earnings, dividend and growth trends of the firm. Usually they take the services of financial analysis in evaluating the performance of the firm.
  5. Employees and trade unions also make use of the financial information revealed in the financial statements. They can bargain matters relating to salary determination, bonus, fringe benefits, or working conditions on the basis of the accounting information.  Thus, financial information is useful to employees and  trade unions, as they get insight into matters affecting their economic and social interests.
  6. Customers might be interested in the financial information because a careful study of the financial statements may provide information about the prices being charged by the firm.
  7. Government also has an interest in the financial statement for regulatory purposes.  The tax department of government has an interest in determining the taxable income of the firm.

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