What is the Purpose of Accounting?
What is the Purpose of Accounting?
Importance of Financial Information
Before we dig deeper into the purpose of accounting, let us first define what is an economic entity. An economic entity refers to an identifiable organization that has its own or borrowed resources used to achieve its goals and objectives.
It, therefore, refers to both for-profit and nonprofit organizations. Both of these require financial information in making decisions for their respective organizations.
Purpose of Accounting
It is therefore clear that the purpose of accounting is to provide useful financial information to its users in order for them to make informed economic decisions.
This purpose is clearly laid down by the definition of accounting by another accounting body. The AICPA (American Institute of Certified Public Accountants) defines Accounting as follows:
“Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions, in making reasoned choices among alternative courses of action."
Another accounting body, The AAA (American Accounting Association) also defined accounting as follows:
"Accounting is the process of identifying, measuring and communicating economic information to permit informed judgment and decision by users of the information."
Both of these definitions tell us the purpose of accounting. That is to provide useful financial information to users in order to make economic decisions that are relevant and timely.
Financial Information
Below are the types of information that users may take a look at from the accounting records of an entity in the form of its FINANCIAL STATEMENTS.
Results of operation
This refers to the profit generated by the business in a given period of time (monthly, quarterly, semi-annually, or yearly) The business’ net profit is computed by deducting the business expenses from its income. This is the INCOME STATEMENT
Financial Position
Refers to the Assets, liabilities, and capital of the business. Assets are the resources it currently has. Liabilities are the amount the business owes to others. Capital refers to the amount left after deducting all liabilities from the assets of the business. This is the BALANCE SHEET
Solvency and liquidity
Solvency is the ability of the business to pay its obligations when they become due. Liquidity is the ability of the business to pay its short-term obligations. This is done by analyzing the financial statements of the business.
Other information
The financial statements also provide qualitative, quantitative, and financial information. It is important to know that the financial statements must be relevant and all information that could affect the decision of its users must be included therein.
Users of Financial Statements
The purpose of accounting is to provide financial information to users in order for them to make informed economic decisions.
Owners and Investors
Small business owners need financial information to be able to know if the business is profitable or not, whether to continue or not, and to determine whether it is time to expand or shut down.
Potential investors need financial information for them to know if the business is worth putting their money into and if it's going to be profitable or successful.
For large businesses, like corporations, stockholders and investors need financial information to determine what to do with their investments, to buy more, to sell or hold them for the time being.
Management
Owners of small businesses usually act as their managers. But large organizations hire professionals to run and manage the day-to-day operations of the business. They act as agents of the owners.
Managers are faced with so many economic decisions daily, like do we have enough supplies? How much cash do we have? Is it enough to pay our short and long-term obligations and operational costs? How much did we make last year? Did we hit our budget? Why did we spend more or less than the budget? All these and many more management questions need an analysis of the accounting information in order for the managers to make decisions and better run the business.
Lenders
These lenders of funds can be Banks, Financial institutions, and bondholders. They are interested in the solvency of the business. Solvency is the ability of the business to pay its liabilities upon maturity.
Suppliers/Creditors
Like the lenders, Suppliers or trade creditors are interested in whether or not the business has the ability to pay its obligations. But they are most interested in its liquidity, and its ability to pay short-term obligations.
Government institutions
Government authorities are interested in the financial information of the business for regulatory and tax purposes. They want to know how much tax, fees, or licenses the business will have to pay based on the financial information on their results of operation for a given period.
Employees
Employees are interested mainly in the business’ stability and profitability. They want to know the capacity of the business to pay their salaries and other benefits. They are also interested in knowing whether the business will be able to expand based on their financial position and performance for career development.
Customers
Customers, most especially those with a long-term commitment to the business would want to know if the business is capable of maintaining stability for a long period of time.
The stability of the business would also mean stability on the part of the customers as they do business transactions.
The Public
Anyone outside of the company such as students, researchers, analysts, and common people are interested in the business operations of an organization as they affect their daily lives.
Example:
The students may be interested in the operations of the business for their school projects and assignments. Researchers and analysts may be interested in whether or not the business is above or below the sector or industry benchmark. The common people may want to know the organizations' waste management and environmental policy regarding their products. Or maybe just to satisfy anyone’s curiosity, they would want to know how the business is doing.
INTERNAL AND EXTERNAL USERS OF THE FINANCIAL STATEMENTS
From the enumeration above we can classify the users of the financial statements into:
Internal users. Those that are directly involved with the operation of the business. Like the owners and managers who use accounting information in order to make relevant and timely business decisions.
External users. Those that are not involved with the operations of the business but still have a financial interest therein.
- Direct Financial Interests - owners, investors, and creditors
- Indirect Financial Interest - government authorities, employees, customers, and others.
