Purpose of Accounting
Previous Lesson: Accounting Definition
Next Lesson: Objectives of Accounting
The primary purpose of accounting is to provide useful and reliable information. This statement primarily provides information about the performance of the enterprise. This is a statement that matches the revenue and expense of the period and reports the net position in the form of net profit or loss. It is important to note that this statement is prepared for a period, so information about the performance of an enterprise. In particular its profitability is required in order to assess the potential changes in the economic resources; it is likely to control in the future. Information about variability of performance is important in this respect. Such a variation reflects the business risk and is an important aspect for investors to invest in such a business. Retained earing is an important source for growth of business and it depends on profits made by the business. Profit also reflects the capacity of the enterprise to use additional resources.
Statement of Retained Earning
It is a statement that reports the impact of net income and its distribution as a dividend on the financial position of the business. This statement is a pointer to the dividend policy of the enterprise. Conversely, it also indicates as to how earnings are employed for the growth of the business. A firm that has no growth opportunities distributes all the profit in the form of dividend. A firm must, however, distribute a portion of the profit in the form of dividend even if all the profit can be retained for growth.
Information about financial position is primarily provided by the balance sheet. Balance sheet is a statement that shows at a point of time the resources commanded by the enterprise and how these assets are financed. The resources are called assets and they are financed by owners and lenders. What owners provide is equity and the sums the enterprise owners to lenders are called liabilities. Thus balance sheet has three elements. Two elements, namely equity and liabilities are shown on right-hand side and third element, namely assets are shown left-hand side.
The financial position of company is affected by the economic resources it controls, its financial structure, liquidity and solvency, and its capacity it adapt to changes in the environment in which business operates. Information about the economic resources controlled by the enterprise and its capacity in the past to modify these resources is useful in predicting the ability of the enterprise to generate cash and cash equivalents in future. Information about financial structure is useful in predicting future borrowing needs and how future profit and cash flows will be distributed among those with an interest in the enterprise, which also useful in predicting how successful the enterprise is likely to be in raising future finance.
Information about liquidity and solvency is useful in predicting the ability of the enterprise to meet its financial commitments as they fall due. Liquidity refers to the availability of cash in the near future after taking into financial commitments over this period. Solvency refers to the availability of cash over longer term to meet financial commitments as they fall due.
Statement of Cash Flow
This statement is prepared with the help of income statement, balance sheet and additional information. This statement which is the last one to be developed in the field of financial accounting has assumed lot of importance. A statement of cash flows primarily summarizes the cash inflows and outflows that have taken during time pan as a result of the operating, investing and financing activities of an enterprise. Information concerning changes in the financial position of an enterprise is useful in order to assess its investing, financing and operating activities of the period. This information is useful in providing the user with a basis to assess the ability of the enterprise to generate cash and needs of the enterprise to use the cash flows
All the statements discussed above are interrelated in preparation and use because they reflect different aspects of the same transactions or other events. The purpose of accounting is to prove information, although each statement provides information that is different from the others, none is likely to serve only a single purpose or provide all the information necessary for particular needs of users. For example a profit and loss account provides an incomplete picture of performance unless it is used in conjunction with balance sheet and statement of cash flow.
>> Related Course Principles of Accounting
Narayanswami, R. (2008). Financial Accounting: A Managerial Perspective. (3rd, Ed.) New Delhi: Prentice Hall of India.
Ramchandran, N., & Kakani, R. K. (2007). Financial Accounting for Management. (2nd, Ed.) New Delhi: Tata McGraw Hill.
Sehgal, A., & Sehgal, D. (n.d.). Advanced Accountancy (Vol. I & II). New Delhi: Taxmann Publication Pvt. Ltd.
Shukla, M. C., Grewal, T. S., & Gupta, S. C. (2008). Advanced Accountancy (Vol. I & II). New Delhi: S Chand & Co.