financial accounting

financial accounting

The Importance of Financial Accounting

1. Overview of Financial Accounting

A corporation is created and governed through legal statutes. It offers shares to the public, raises money, and has a social goal to produce goods and services at a low cost, so as to benefit society. Accounting is a system that allows for an agreement between business entities and their environment, using systems, principles, regulations, and values needed for that agreement. The modern accounting system is the system of financial accounting, which collects, processes, and communicates information. This method is not the only accounting system available. Tax accounting, managerial accounting, and nonprofit-entity accounting are other areas of focus within the accounting field. Financial accounting chooses information that is relevant and reliable for external users of the accounting process. External users are the stakeholders who, having no role in the company, can only obtain knowledge about it through financial statements and related information. These stakeholders include stockholders, investors, taxpayers, suppliers, legal entities, and employees. Knowing the importance of external financial data, financial accounting is crucial for modern corporations. Financial accounting traditionally also incorporates concepts, and increasingly the methods, from other disciplines related to accounting. These include various mathematical disciplines, also behavioral economics, and several social, legal, and cultural aspects on which financial accounting is dependent.

The quality of information that financial accounting provides is important in helping people make decisions, particularly those that involve money. Investors use financial statements to decide whether to invest in a company or sell its stock, while applicable laws like the Sarbanes-Oxley Act regulate these financial decisions. Companies depend on financial accounting to supply lenders with money for growth and ongoing operations, information necessary to make such financial decisions. Financial accounting is also essential in guiding company executives in making ethical decisions. For example, when accounting for a product that can potentially harm people, economic benefits should not prevail if the potential harm poses serious risks. In other words, policy makers can depend on accounting information to define new laws and statutes based on society’s needs. Ultimately, financial accounting is the backbone of all business decisions, which allows companies to uphold regulations when providing their goods and services to benefit society. From this point of view, accounting practices provide information that benefits society’s interest.

2. Principles and Standards of Financial Accounting

Financial accounting doesn’t aim to depict the exact result, but it provides a useful platform for making economic decisions than without providing it. These are essential for the economic stability of the production and utilization of the product and services, thus enriching the standard of living of the masses through successful operations of these business enterprises. Financial accounting is thus regarded as a means of safeguarding the interest of various social and economic entities.

These rules and principles of financial accounting are developed for the conventional type of business organization, i.e. the proprietary concern. This may not be applicable in some special circumstances. However, professionals, users, and others can interpret and modify them as per their individual requirements.

Objectivity: According to objectivity, the accounting information should be free from prejudice or bias. The accounting information should be truthful and should be based on authentic evidence.

Materiality: According to this principle, an item should be treated as immaterial (trivial, insignificant, unimportant) if its inclusion would not influence the decision about a particular matter.

Historical cost: According to this principle, the asset should be recorded at its acquisition cost. In the absence of a reliable cost, an estimate should be made. Market value and replacement cost should not be used for this purpose.

Principle of full disclosure: According to this principle, the financial statements should disclose all events which are significant enough to influence the decision of stakeholders. That is to say that the financial statements should include all the required information. None of the information should be construed.

3. Financial Statements and Reporting

When financial statements are misleading due to managerial opportunistic behavior, stock prices are likely to go wild, implying what investment analysts refer to as “price distortion”. Even small shareholders and portfolio managers who are not well conversant of the determinants of stock prices expect dividends or price appreciation to be the future development that has started current security valuation. Both high and low profits are just potential cash flows unless managers and their staff engage in what is termed “efficient expenditures” that assure that potential profits actually get generated.

When outside analysts are examining financial statements, a key attribute they focus on is earnings persistence, the degree to which current profits can be expected to continue. The investing public would prefer earnings on the part of their companies that are likely to sustain substantial growth unmatched in other companies. Investors would also prefer company profits that are unlikely to lead to financial statement restatements, unfortunately a too common occurrence – about 60 percent of the time the initial statement is restated, according to research by Chuck Mulford and Gene Comiskey, who concluded that more than 50 percent may have to do with revenue recognition issues. There is lots of evidence that the most successful firms, those with very high return on capital, can only sustain this level of performance for a number of years. To replicate this success, investors and managers often have to make sizeable investment commitments. Investors are especially interested in recent profitability of defecting managers before they leave.

4. Analysis and Interpretation of Financial Data

Financial accounting serves the interests of the enterprise’s numerous external users, who rely almost entirely on financial statements to make decisions in which the welfare of many other individuals may be at stake. Among the more commonly encountered external users are investors who desire to know how their funds have been used and how the investment now stands. They rely upon the financial statements in making their judgments. Either because of government intervention, commercial regulations, or both, it is mandatory that the proprietors and managers file periodic reports with a government department, such as the U.S. Securities and Exchange Commission, or certain other regulatory bodies. These reports are immediately made available to the general public. The financial statements are examined for compliance with established norms and standards. Such reviews have general acceptance and thus are relied upon for intelligent decision-making by the investing public.

Accounting has been defined as the process of identifying, measuring, recording, and communicating economic data in a manner that permits interested parties to make informed judgments and decisions. The first three parts of accounting, up through the recording of economic data, comprise what is known as financial accounting. Its objective is to provide the pertinent economic data concerning an enterprise to those individuals who use accounting data and who typically have no prior knowledge of the enterprise or its current operations.

5. Role of Financial Accounting in Decision Making

2. Similarly, if in some cases we observe that companies have very profitable products or lines of activity, however, these are not implemented to their maximum production capacity because their sale does not manage to cover the costs, or giving such minimum profitability that it is not worthwhile devoting passive assets. The retention or detachment in a short term of certain projects, businesses, or lines of action should lead to the proximity of this method of analysis, as it would prove to be ruinous to keep a leaky water pipe and it is equally ruinous to make initiatives and entrepreneurship when there are no economic benefits that support them.

1. This section explores the role of financial accounting in decision making. The first result of comparison is represented by the net sales made by the company. This result (the turnover) is one of the most informative because it measures the degree of success of the company in its relationship with the market. However, it is not sufficient to have good sales to see the company performing well. In fact, if these sales were obtained in such a way that they were not covering costs or generating a return that was well suited to the capital invested, then the result would probably be poor. Therefore, we must also analyze the way in which sales are reflected in the profit and loss account and in the account of the results, to know the degree of profitability of the company and, in this way, be able to value the different models of management applied.