Financial Management & Cost Accounting

Module 1. Introduction to financial management

Lesson 3
Finance and Accounting

3.1 Definition of Accounting

Accounting may be defined as the process of recording, classifying, summarizing, analyzing and interpreting the financial transactions of firm. It also includes the communication of the results there of to all the persons interested in such information. From the above definition, two points become important: (a) what are the various functions performed / served by accounting? And, (b) who are the persons / entities interested in such accounting information? Answers to these questions lie in the following paragraphs.

3.2 Functions of Accounting

a) Maintaining systematic records of all financial transactions :-

It is one of the primary functions of accounting to systematically record each and every financial transactions of a firm. Hence, care is taken to ensure that no financial transaction escapes accounting. Accounting ensures this by maintaining records in a chronological order in the original / subsidiary books of entry, posting to ledgers and preparation of Trial balance and final accounts.

b) To ascertain the results of operations i.e. Profit or Loss

Other primary function of accounting is to correctly measure the profit earned or loss incurred during the given period (accounting period), Correct profit can be measured only when each and every financial transaction of the firm is considered, recorded and classified systematically.

c) To ascertain the Financial position of the firm :

Accounting facilitates the preparation of a financial statement called balance sheet. It shows the assets and liabilities of the firm. The liabilities include "owner’s capital". From the balance sheet important information regarding the fixed assets, current assets, long term liabilities, short – term liabilities, working capital, liquidity of the firm can be gathered.

d) Meeting legal requirements :

It is mandatory for joint stock Company to prepare the financial accounts in a prescribed form for various returns to be filed – income tax and sales tax department are prepared with the help of financial accounts.

e) Protection and safe guarding business assets :-

Records (prepared and maintained by accounting) serve as evidence in the event of disputes regarding the title of ownership, of any plant and machinery, property etc.

f) Helps in Rational Decision Making:-

Decision making becomes more rational in the light of correct and complete data regarding costs, sales revenues, growth patterns etc.

g) Communication and Reporting:-

The financial transactions so recorded and processed are given certain concrete form to convey some information to others. The economic information contained in the financial statements and other reports is actually meant to be used by the firm itself or by different groups who are directly or indirectly interested or associated with the business enterprise.

3.3 Users of Accounting Information

Users refer to the entities who are interested in such information. The financial statements are used by the management owners (share holders, partners, and proprietors), lenders, investors, government etc for different purposes.

a) Owners (Share Holders, Partners, Proprietors):

They are very much interested in the performance of the firm. They want to know about the profit earned and the overall financial position of the firm. Their interest in accounting information is very high because they have invested their money in the business.

b) Management:

It also uses accounting information for

1. Analyzing the previous year's performance

2. Corrective action plants

3. Future planning (sales budget, purchase budget cash budget, new investment, etc.)

4. Overall achievement of the long – term organization goal.

c) Creditors :

This category may include commercial banks, financial institutions, suppliers, or any other person / entity that has (or may) extend credit to the organization. These creditors study the financial statements of the firm to take a decision regarding whether to extend or not to extend credit to the firm. They gather the data regarding profitability of the firm and soundness of its financial position. They check the ability of the firm to repay the capital as well as the interest charges.

d) Employees:

Employees of the firm are interested in financial statements because their growth depends upon the firm's growth. Moreover, accounting information creates healthier relationship between employer and employee. It can avoid unjustified strikes, salary and wages hikes, bonus demand etc. If the company is growing fast then it is possible that employees may also purchase the shares of the company.

e) Investors:

This category includes persons / institutes / financial organizations / funds etc which have invested their money in the shares of the given firm. It also includes potential investors. These investors generally look for capital protection and sufficient capital gains.

f) Government:

Primarily the government is interested in the financial statements of firm for the purpose of taxation, labour and corporate laws. It may also verify whether the financial statements are correctly prepared or not.

g) Others:

These are the residuary classes which use the accounting information for different purposes. This class includes

1. Researchers 4. Economist

2. Consumers 5. Press and Public in general

3. Stock Exchanges