Accounting: Functions, Objectives, Users, Advantages, and Limitations

Accounting Introduction

Accounting is rightly called the language of business because it serves as the primary means of communicating financial information. Just as language enables communication among people, accounting conveys the results and financial position of a business to its stakeholders.

Every business aims to earn profit and, at the end of each year, seeks to know how much profit or loss has occurred, the value of stock on hand, liabilities owed, and amounts receivable. To obtain such information, it is essential to maintain a complete and systematic record of all business transactions.

Learning accounting is similar to learning a new language. With the rapid changes in business practices, accounting has become more complex and continues to evolve to improve communication. To ensure uniform understanding, accounting must be standardized so that financial information conveys the same meaning to all users.

Accounting: Functions, Objectives, Users, Advantages, and Limitations

Meaning and Definition of Accounting

1. Accounting is an art of recording, classifying and summarizing the monetary transactions in an efficient manner and interpreting the results.
2. Accounting is the process of identifying, recording, classifying, summarising, interpreting and communicating financial information of business to its users for judgement and decision making.
3. American Institute of Certified Public Accountants - “The process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information”.

Nature and Scope of Accounting

Accounting plays a vital role in business and society by providing essential financial information for decision-making. Its nature and scope can be understood from the following perspectives:

1. Accounting as an Art - Accounting is regarded as an art of recording, classifying, and summarizing financial transactions and events in a systematic manner. It requires skill and judgment in applying accounting principles and methods to ensure accuracy and reliability.
2. Accounting as a Science - Accounting may also be viewed as a science, as it applies systematic procedures and analytical techniques for measuring and interpreting financial data. It uses established principles and standards to solve managerial and financial problems logically.
3. Accounting as an Information System - Accounting serves as an information system by collecting, processing, and communicating financial information to various stakeholders such as management, investors, creditors, and government authorities. This information supports effective decision-making and control.
4. Accounting as a Service Function - Accounting performs a service function by providing valuable information not only to business entities but also to society at large. Through social accounting, it assesses the social and environmental impact of business activities, thereby serving the broader interests of the community.
5. Accounting as the Language of Business - Accounting is often described as the language of business, as it enables the communication of financial information in a standardized and universally understood form. Both preparers and users of financial statements rely on this common language to interpret business performance accurately.

Functions of Accounting

Accounting performs several important functions that help in systematically managing and communicating financial information. The major functions are as follows:

Identifying 

Identifying is the first and most fundamental step in the accounting process. It involves observing all business activities and selecting those that are of a financial nature. Only transactions that can be measured in monetary terms are recorded in accounting. This step requires identifying financial transactions from various source documents such as invoices, agreements, and cash memos. In essence, the primary function of accounting begins with recognizing and selecting those business transactions that are relevant and measurable in financial terms.

Recording 

Recording is the second essential function of accounting, following the identification of financial transactions. Only transactions that can be measured in monetary terms are recorded. This process involves maintaining a systematic and chronological record of all business transactions in appropriate books of accounts, primarily the Journal or subsidiary books. The process of recording transactions, commonly referred to as bookkeeping, is narrower in scope than accounting, as it focuses solely on documenting financial events. For accurate recording, accountants maintain a set of books following systematic procedures. In modern practice, computers are often used to automatically record transactions as they occur. The main books used for recording financial transactions include:

• Cash Book / Bank Book – for recording all cash and bank transactions
• Purchase and Sales Books – for documenting purchases and sales of goods
• Bills Receivable and Bills Payable Books – for tracking receivables and payables
• Purchase and Sales Return Books – for recording returned goods
• Journal Book – for all other transactions not recorded in the above books

In essence, the recording function ensures that every financial transaction is permanently and systematically documented for further processing and analysis.

Classifying

Classifying is the third function of accounting, which follows the recording of transactions. It involves grouping together transactions of a similar nature in one place to facilitate analysis and interpretation. This process is carried out in the Ledger, where each account represents a specific type of transaction.

For example, separate ledger accounts may be maintained for Sales, Purchases, GST, Salaries, Rent, Office Expenses, Taxes Paid, Advertisement Expenditure, and so on. By classifying transactions in this manner, accountants can systematically organize financial data and prepare a Trial Balance to verify the arithmetical accuracy of the accounts.

In summary, classification ensures that all transactions of similar type are grouped together, providing a clear structure for further summarization and financial analysis.

Summarising

Summarising is the fourth function of accounting, which involves condensing classified financial information into a format that is useful for decision-making. After transactions are recorded and classified, their balances are brought together in one place, typically in the Trial Balance, to ensure arithmetical accuracy and provide a foundation for preparing financial statements.

The summarized information is then used to prepare key financial statements such as:

• Trial Balance
• Profit and Loss Account
• Balance Sheet
• Cash Flow Statement

Recording transactions generates raw data, which by itself is of limited value for decision-making. Summarisation organizes this data into meaningful categories, often defined in the Chart of Accounts, so that both individual records and cumulative summaries are maintained simultaneously.

For example, a sale of Rs 100 to Mr. X would be recorded individually as:

• Sale to Mr. X for Rs 100 and simultaneously update the summary total of sales, e.g., increasing total sales from Rs 500 to Rs 600.

In essence, summarising transforms detailed and classified data into concise, understandable, and actionable information for internal and external users.

Interpreting and Communicating

The final function of accounting involves interpreting the summarized financial data and communicating the results to management and other stakeholders for informed decision-making.

• Interpreting: Interpretation is concerned with explaining the meaning and significance of financial information. It involves analyzing relationships among various financial elements to provide insights that are useful for decision-making. Through interpretation, accounting helps users understand not only what has happened, but also why it happened and what is likely to happen under specified conditions. Analysis often involves comparing profits, cash, sales, assets, and other key indicators to evaluate business performance.
• Communicating: Communication ensures that the analyzed and interpreted information reaches the relevant users in a clear and understandable form. This enables stakeholders to make rational and timely decisions. The process typically involves preparing and distributing financial statements, reports, and annual accounts, which convey the financial position and performance of the business.

In essence, this function of accounting transforms summarized data into actionable knowledge, guiding management, investors, creditors, and other users in making well-informed decisions.

Objectives of Accounting

Accounting is an essential function of every business, serving multiple objectives that support effective management, decision-making, and accountability. The key objectives of accounting are outlined below:

1. Maintaining a Permanent Record - Accounting provides a permanent record of all business transactions. These records serve various purposes, including internal management, taxation, legal compliance, and reference for future decisions. Every transaction involving resources of monetary value, whether within or outside the firm, is recorded systematically and can be retrieved whenever required.
2. Measurement of Outcome - Accounting enables businesses to measure their financial performance over a period. By preparing regular financial statements, including daily, weekly, monthly, and annual reports, accounting provides insights into profits, losses, and overall operational efficiency. These reports help management evaluate performance and adjust operations as necessary.
3. Determining Profit or Loss -  One of the primary objectives of accounting is to ascertain the net profit or loss resulting from business operations during a specific period. Accounting also helps identify the factors leading to profit or loss, facilitating informed managerial decisions.
4. Assessing Financial Position - Accounting provides a clear picture of the financial position of the business through the preparation of statements such as the Balance Sheet. This allows stakeholders to understand the company’s assets, liabilities, and equity at a given point in time.
5. Ensuring Creditworthiness - Businesses often require external resources for growth and operations. Accounting records help establish credibility with investors, banks, and other creditors by demonstrating past performance and the firm’s ability to generate returns. Detailed financial records enhance investor confidence and facilitate access to funds.
6. Efficient Use of Resources - Accounting helps management analyze the allocation and utilization of resources. By comparing the returns from different activities with the resources committed, businesses can optimize operations, improve efficiency, and minimize wastage.
7. Tracking Business Progress and Detecting Errors - Through systematic recording and analysis, accounting allows businesses to monitor progress over time. It helps detect errors, discrepancies, and potential fraud, thereby safeguarding organizational assets.
8. Providing Information to Stakeholders -  Accounting delivers essential financial information to various interested parties, including owners, creditors, employees, and regulatory authorities. Stakeholders use this information to make decisions, conduct analysis, and evaluate the firm’s performance and stability.
9. Facilitating Projections and Planning - Historical accounting data forms the basis for forecasting future costs, revenues, and growth trends. By analyzing past records, management and investors can make reasonable assumptions about the company’s likely future performance and plan strategically.

Users of Accounting Information

The primary objective of accounting is to provide information that is useful to both internal and external users of an organization.

I. Internal Users

Internal users are individuals or groups within the organization who use accounting information to manage and evaluate the business effectively. These include:

• Owners: To assess the profitability and financial soundness of the business.
• Management: To make informed and timely decisions for efficient business operations.
• Employees and Trade Unions: To evaluate the earning capacity of the business, as their remuneration, bonuses, and benefits often depend on the company’s financial performance.

II. External Users

External users are individuals or groups outside the organization who rely on accounting information for various purposes. These include:

• Creditors, Banks, and Other Lending Institutions: To determine whether the principal and interest on loans will be repaid on time.
• Present Investors: To evaluate the progress, financial position, and overall prosperity of the business, ensuring the safety of their investment.
• Potential Investors: To decide whether to invest in the business based on its financial health and growth prospects.
• Government and Tax Authorities: To assess the earnings of the business and determine applicable tax liabilities.
• Regulatory Agencies: To monitor compliance with relevant laws and regulations, and evaluate business operations.
• Researchers: To use financial information for academic, analytical, or professional research purposes.

In summary, accounting information serves as a vital tool for decision-making, monitoring, and evaluation for both internal and external stakeholders, ensuring transparency, accountability, and informed business decisions.

Advantages of Accounting

Accounting plays a crucial role in business management by providing reliable and structured financial information. Its main advantages include:

1. Permanent Record of Transactions - Accounting provides a systematic and permanent record of all business transactions, which serves as a reliable reference for management, investors, creditors, and other stakeholders.
2. Determination of Profit or Loss - Accounting enables businesses to determine the net profit or loss for a given period, helping evaluate operational performance.
3. Facilitates Comparative Analysis - By maintaining consistent records over time, accounting allows comparative studies of various aspects of business, such as sales, purchases, and profits. This facilitates informed decision-making and strategic planning.
4. Basis for Performance Evaluation - Accounting provides essential information to assess the performance of employees, departments, or business activities, enabling management to take corrective measures and improve efficiency.
5. Legal Evidence - Accounting records are recognized as valid and approved evidence in legal matters, including disputes, audits, and regulatory compliance.

Limitations of Accounting

Despite its numerous advantages, accounting has certain limitations:

1. Focus on Monetary Transactions Only - Accounting considers only transactions that can be measured in monetary terms, ignoring non-monetary factors such as quality, honesty, skill, and customer satisfaction.
2. Historical Nature of Data - Financial statements reflect past transactions and do not account for current price level changes, making them less useful for predicting future conditions.
3. Influence of Personal Judgement -  Accounting is sometimes influenced by the accountant’s personal judgment or bias, which may affect the objectivity and reliability of financial statements.
4. Possibility of Manipulation - Financial records may be subject to window dressing, where accounts are manipulated to present a more favorable picture than the actual financial position.
5. Unsuitability for Forecasting - Since accounting primarily records past events, it is not inherently suitable for forecasting or predicting future performance without additional analysis or adjustments.

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