Financial Accounting – Definition, Nature, Scope and Limitations

MEANING OF ACCOUNTING

Accounting is the process of recording, classifying, summarizing, analyzing and interpreting the financial transactions of the business for the benefit of management and those parties who are interested in business such as shareholders, creditors, bankers, customers, employees and government. Thus, it is concerned with financial reporting and decision making aspects of the business.

The American Institute of Certified Public Accountants Committee on Terminology proposed in 1941 that accounting may be defined as, “The art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof”.

DEFINITION OF FINANCIAL ACCOUNTING

The term ‘Accounting’ unless otherwise specifically stated always refers to ‘Financial Accounting’. Financial Accounting is commonly carries on in the general offices of a business. It is concerned with revenues, expenses, assets and liabilities of a business house. Financial Accounting has two-fold objective, viz,

• To ascertain the profitability of the business, and
• To know the financial position of the concern.

NATURE AND SCOPE OF FINANCIAL ACCOUNTING

Financial accounting is a useful tool to management and to external users such as shareholders, potential owners, creditors, customers, employees and government. It provides information regarding the results of its operations and the financial status of the business. The following are the functional areas of financial accounting:-

• Dealing with financial transactions: Accounting as a process deals only with those transactions which are measurable in terms of money. Anything which cannot be expressed in monetary terms does not form part of financial accounting however significant it is.
• Recording of information: Accounting is an art of recording financial transactions of a business concern. There is a limitation for human memory. It is not possible to remember all transactions of the business. Therefore, the information is recorded in a set of books called Journal and other subsidiary books and it is useful for management in its decision making process.
• Classification of Data: The recorded data is arranged in a manner so as to group the transactions of similar nature at one place so that full information of these items may be collected under different heads. This is done in the book called ‘Ledger’. For example, we may have accounts called ‘Salaries’, ‘Rent’, ‘Interest’, Advertisement’, etc. To verify the arithmetical accuracy of such accounts, trial balance is prepared.
• Making Summaries: The classified information of the trial balance is used to prepare profit and loss account and balance sheet in a manner useful to the users of accounting information. The final accounts are prepared to find out operational efficiency and financial strength of the business.
• Analyzing: It is the process of establishing the relationship between the items of the profit and loss account and the balance sheet. The purpose is to identify the financial strength and weakness of the business. It also provides a basis for interpretation.
• Interpreting the financial information: It is concerned with explaining the meaning and significance of the relationship established by the analysis. It should be useful to the users, so as to enable them to take correct decisions.
• Communicating the results: The profitability and financial position of the business as interpreted above are communicated to the interested parties at regular intervals so as to assist them to make their own conclusions.

LIMITATIONS OF FINANCIAL ACCOUNTING

Financial accounting is concerned with the preparation of final accounts. The business has become so complex that mere final accounts are not sufficient in meeting financial needs. Financial accounting is like a post-mortem report. At the most it can reveal what has happened so far, but it cannot exercise any control over the past happenings. The limitations of financial accounting are as follows:-

1. It records only quantitative information.
2. It records only the historical cost. The impact of future uncertainties has no place in financial accounting.
3. It does not take into account price level changes.
4. It provides information about the whole concern. Product-wise, process-wise, department-wise or information of any other line of activity cannot be obtained separately from the financial accounting.
5. Cost figures are not known in advance. Therefore, it is not possible to fix the price in advance. It does not provide information to increase or reduce the selling price.
6. As there is no technique for comparing the actual performance with that of the budgeted targets, it is not possible to evaluate performance of the business.
7. It does not tell about the optimum or otherwise of the quantum of profit made and does not provide the ways and means to increase the profits.
8. In case of loss, whether loss can be reduced or converted into profit by means of cost control and cost reduction? Financial accounting does not answer this question.
9. It does not reveal which departments are performing well? Which ones are incurring losses and how much is the loss in each case?
10. It does not provide the cost of products manufactured
11. There is no means provided by financial accounting to reduce the wastage.
12. Can the expenses be reduced which results in the reduction of product cost and if so, to what extent and how? No answer to these questions.
13. It is not helpful to the management in taking strategic decisions like replacement of assets, introduction of new products, discontinuation of an existing line, expansion of capacity, etc.
14. It provides ample scope for manipulation like overvaluation or undervaluation. This possibility of manipulation reduces the reliability.
15. It is technical in nature. A person not conversant with accounting has little utility of the financial accounts.