Financial Accounting Importance Nature and Limitations

Financial Accounting Importance, Nature, and Limitations

Financial accounting is a system that collects information, processes, and reports about changes in the performance, financial status and financial status of an entity. A person’s ability to track the financial transactions of a person’s business, during which, as a result of his operation, he is known as financial accounting skills. Do you study to learn: If Yes? Then read the lot. Let’s Study Financial Accounting Importance, Nature, and Limitations.

It is done by recording, summarizing and presenting all such financial figures in the form of financial reports or statements using standardized guidelines. Such financial statements generally include balance sheets, income details and cash flow details, which summarizes the performance of a company over time. Financial accounting skills generally do not include the ability to report the value of a company but are able to provide enough information for the evaluation of others.

Every Company Current year or the end of the year want to know their the financial status of the business. Financial Accounting Importance, Nature, and Limitations.

Definition of Financial Accounting:

Financial Accounting is concerned with providing information to external users. It refers to the preparation of general purpose reports for use by persons outside a business enterprise, such as shareholders (existing and potential), creditors, financial analysts, labor unions, government authori­ties, and the like. Financial accounting is oriented towards the preparation of financial statements which summarise the results of operations for selected periods of time and show the financial position of the business at particular dates.

Every entity, whether for-profit or not-for-profit, aims at creating maximum value for its stakeholders. The goal of maximum value addition is best achieved when there is a mechanism to monitor the management and the board of directors. Financial accounting helps in such monitoring by providing relevant, reliable and timely information to the stakeholders.

Inputs to a financial accounting system include business transactions which are supported by source documents, such as invoices, board resolutions, management memos, etc. These inputs are processed using generally accepted accounting principles (GAAP). The processed information is reported through standardized financial statements.

Importance of Financial Accounting:

Financial accounting is integral to companies of all sizes because it helps in the following: They are three important points.

  1. Communication of information externally.
  2. Communicate information internally, and.
  3. Comparison through analysis.

First Point: This point explains Communication on information externally. The statements and reports generated by financial accounting are used to communicate information about the overall health and well-being of the company to the external parties. Such external users may include suppliers, banks and leasing companies etc. who are not part of the company but require all this information to analyze the progress of the company and compare it with their expectations.

  How to Explain Nature and Scope of Financial Management?

Second Point: This point explains Communicate on information internally. A company’s finance team or its employees who are interested in stock-based compensation etc. constitute the internal users of the information generated by financial accounting practices. The reports generated with the help of financial accounting skills are helpful for this purpose as well.

Last Point: This point explains Comparison on through analysis. Since financial accounting requires the use of standardized guidelines, the financial statements generated by all companies are comparable, providing a standard method of analysis.

Scope and Nature of Financial Accounting:

The following points are important to understand the scope and nature of financial accounting:

  • Contents: The end product of the financial accounting process is the financial statements that communicate useful information to decision-makers. The financial statements reflect a combination of recorded facts, accounting conventions and personal judgments of the preparers. There are three primary financial statements for a profit-making entity in India, viz., the Income Statement (statement of revenues, expenses, and profit), and the Balance Sheet (like the statement of assets, liabilities and owner’s equity) and cash flow statement. The accounting information generated by financial accounting is quantitative, formal, structured, numerical and past-oriented material.
  • Accounting System: The accounting system includes the various techniques and procedures used by the accountant (preparer) in measuring, describing and communicating financial data to users. Journals, ledgers and other accounting techniques used in processing financial accounting information depend upon the concept of the double-entry system. This technique includes generally accepted accounting princi­ples (GAAP). The standard of generally accepted accounting principles includes not only broad guidelines of general application but also detailed practices and procedures.
  • Measurement Unit: Financial accounting is primarily concerned with the measurement of economic resources and obligations and changes in them. Financial accounting measures in terms of monetary units of a society in which it operates. For example, the common denominator or yardstick used for accounting measurement is the rupee in India and dollar in the U.S.A. The assumption is that the rupee or the dollar is a useful measuring unit.
  • Users of Financial Accounting Information: Financial accounting information is intended primarily to serve external users. Some users have the direct interest in the reported information. Examples of such users are owners, credi­tors, potential owners, suppliers, management, tax authorities, employees, customers. Some users need financial accounting information to help those who have the direct interest in a business enterprise.

Examples of such users are financial analysts and advisers, stock exchanges, financial press and reporting agencies, trade associations, labor unions. These user groups having direct/indirect interest have different objectives and diverse informational needs. The emphasis in financial accounting has been on general-purpose information which, obviously, is not intended to satisfy any specialized needs of individual users or specific user groups.

  Financial Accounting: Meaning, Nature, and Scope!

Users or Role of the Financial Accounting:

The most basic objective of financial accounting is the preparation of general purpose financial statements, which are financial statements meant for use by stakeholders external to the entity, who do not have any other means of getting such information, i.e. people other than the management. These stakeholders include:

  • Investors and Financial Analysts: Investors need the information to estimate the intrinsic value of the entity and to decide whether to buy, hold or sell the entity’s shares. Equity research analysts use financial statements to conduct their research on earnings expectations and price targets.
  • Working as Employee groups: Employees and their representative groups are interested in information about the solvency and profitability of their employers to decide about their careers, assess their bargaining power and set a target wage for themselves. 
  • Lead as Lenders: Lenders are interested in information that enables them to determine whether their loans and the interest earned on them will be paid when due.
  • Suppliers and other trade creditors: Suppliers and other creditors are interested in information that enables them to determine whether amounts owing to them will be paid when due and whether the demand from the company is going to increase, decrease or stay constant.
  • One of the Customers: Customers want to know whether their supplier is going to continue as an entity, especially when they have a long-term involvement with that supplier. For example, Apple is interested in the long-term viability of Intel because Apple uses Intel processors in its computers and if Intel ceases operations at once, Apple will suffer difficulties in meeting its own demand and will lose revenue.
  • His also Governments and their agencies: Governments and their agencies are interested in financial accounting information for a range of purposes. For example, the tax collecting authorities, such as IRS in the USA, are interested in calculating the taxable income of the tax-paying entities and finding their tax payable. Antitrust authorities, such as the Federal Trade Commission, are interested in finding out whether an entity is engaged in monopolization. The governments themselves are interested in the efficient allocation of resources and they need financial accounting information of different sectors and industries to decide on federal and state budget allocation, etc. The bureaus of statistics are interested in calculating national income, employment, and other measures.
  • Also as Public: the public is interested in an entity’s contribution to the communities in which it operates, its corporate social responsibility updates, its environmental track record, etc.

Limitations of Financial Accounting:

Financial accounting is significant for management as it helps them to direct and control the firm activities. It also helps business management in determining appropriate managerial policies in different areas, such as production, sales, administration, and finance.

  Explanation of Financial Statements: Objectives, Importance, and Limitations

Financial accounting suffers from the following limitations which have been responsible for the emergence of cost and manage­ment accounting:

  • Financial accounting does not provide detailed cost information for different departments, processes, products, jobs in the production divisions. Management may need information about different products, sales territories and sales activities which are also not available in financial accounting.
  • Financial accounting does not set up a proper system of controlling materials and supplies. Undoubtedly, if material and supplies are not controlled in a manufacturing concern, they will lead to losses on account of misappropriation, misutilization, scrap, defectives, etc.
  • The recording and accounting for wages and labor are not done for different jobs, processes, products, departments. This creates problems in analyzing the costs associated with different activities.
  • It is difficult to know the behavior of costs in financial accounting as expenses are not classified into direct and indirect and therefore cannot be classified as controllable and uncontrol­lable. Cost management which is the most important objective of all business enterprises, cannot be achieved with the aid of financial accounting alone.
  • Financial accounting does not possess an adequate system of standards to evaluate the per­formance of departments and employees working in departments. Standards need to be developed for materials, labor, and overheads so that a firm can compare the work of workers, supervisors, and executives with what should have been done in an allotted period of time.
  • Financial accounting contains historical cost information which is accumulated at the end of the accounting period. The historical cost is not a reliable basis for predicting future earnings, solvency, or overall managerial effectiveness. Historical cost information is relevant but not adequate for all purposes.
  • Financial accounting does not provide information to analyze the losses due to various factors, such as idle plant and equipment, seasonal fluctuations in the volume of business, etc. It does not help management in taking important decisions about the expansion of business, dropping of a product, alternative methods of production, improvement in product, etc.
  • Financial accounting does not provide the necessary cost data to determine the price of the product being manufactured or the service being rendered to the consumers.

In spite of the above limitations, financial accounting has utility and is an important and conceptually rich area. Because of growing business complexities and advances in knowledge of human behavior and decision processes, the scope and methods of financial accounting are chang­ing. Financial accounting theory and practice will probably be broadened and improved considerably in the future.

Financial Accounting Importance Nature and Limitations