Learning outcomes of this lesson:
- Why do we need accounting?
- What purpose does accounting serve?
- What is the importance of accounting?
Accounting systems help organizations in achieving their objectives by providing a reliable framework that is able to consistently produce accurate financial information.
Key objectives of accounting are summarized below.
The fundamental role of accounting is to maintain a systematic, complete, accurate and permanent record of all transactions of a business which could be retrieved and reviewed whenever necessary.
A reliable financial record is the backbone of any accounting system without which all other objectives of accounting will be compromised.
Organizations need to plan how they intend to allocate their limited resources (e.g. cash, labor, materials, machinery and equipment) towards competing needs in the future. An effective way of doing so is by using various forms of budgets.
Budgeting is a major component of managerial accounting. Budgets enable organizations to plan ahead by anticipating business needs and resources. Budgeting helps in the coordination of different segments of an organization.
Accounting helps managers in making a range of business decisions and developing policies to make the organizational processes more efficient. Examples of management decisions that are based on accounting information include:
- How much price should be charged for products and services to achieve maximum profit;
- Which products should be produced in case of shortage of resources such as cash, labor or material in order to maximize profit;
- Whether a business needs to acquire financing;
- Whether an business should invest in a business opportunity;
- Whether a business should discontinue a product that is under-performing;
- Whether a business should offer credit to a certain customer.
Accountancy helps in determining how well a business is performing by summarizing the financial information into quantifiable measures (e.g. sales revenue, profit, expenses, etc.).
It is important for organizations to have a reliable source of measuring their key performance indicators so they could improve by comparing themselves against their past performance as well as against competitors.
Financial statements show the financial position of a business. Financial position reflects the financial condition of a business at that time and shows for example:
- How much capital has been invested in the business
- How have the funds been utilized in the business
- The cumulative profit or loss of the business
- How much the business owes to others (i.e. liabilities)
- The amount of cash, inventory, machinery and other assets owned by the business
Mismanagement of cash is often the reason for failure in many businesses. Accounting helps businesses in determining how much cash and other liquid resources are at its disposal to pay for its financial commitments. This information is necessary for working capital management and helps organizations to reduce the risk of bankruptcy through the timely detection of financial bottlenecks.
Accounting information is necessary in securing finance. Whether an organization applies for a bank loan or an investment by shareholders, it will be required to provide historic financial record (e.g. profit or loss for past five years) as well as financial projections (e.g. forecast sales for the next 3 years). In many cases, such information will be required by the financiers to be verified by external accounting experts known as auditors.
One of the key objectives of an accounting system is to place sufficient internal controls within an organization for the safeguarding of its valuable resources. Assets of a business (e.g. cash, buildings, inventory, etc.) are susceptible to losses arising from theft, fraud, error, obsolescence, damage and mismanagement. Accounting ensures that such risks are reduced to an acceptable level by placing various checks across the organization. For example, accounting policy of an organization may require payments above a certain threshold to be approved by a senior member of management to ensure the accuracy and minimize the risk of fraudulent payment.
Accounting provides a basis for performance assessment of a business over a period of time which promotes accountability across several tiers of an organization.
Shareholders can ultimately hold the directors responsible for the overall performance of their company on the basis of accounting information published in the financial statements.
Accounting is a legal requirement for most businesses. Law requires businesses to maintain an accurate financial record of their transactions and to report their financial results to shareholders, tax authorities and regulators.
Accounting also helps organizations to determine their financial rights and obligations accurately by recording the correct amounts of payable, receivables, payments, and receipts.
Role of accounting is not just limited to the information needs of employees and investors of a business. Accounting nowadays fulfills the information needs for a diverse group of stakeholders each with its own information requirement as discussed in the article: users of accounting information.