The Purpose of Producing Accounting Information and Its Use - Essay Example

ACCOUNTING FOR BUSINESS The Purpose of Producing Accounting Information And Its Use The businesses keep a regular record of all transactions and this record is known as accounting data. Based on this accounting data, accounting information such as financial statements is produced. The purpose of accounting information is to provide the information to the decisions makers such as shareholders, investors, creditors and managers. The accounting information assists the decision makers between different courses of actions. By providing all required information to make decisions about future, it reduces the element of uncertainty. “The provision of information that is useful to the decision-making process is currently recognized as the main purpose of accounting information.”1 The Trueblood Report (AICPA, 1971)2 identified 12 objectives of accounting information such as to provide information for economic decision-making, to predict cash flows, to judge management performance, to provide information about decisions that may affect the society and to provide stakeholders (government, public, tax authorities, investors, employees etc.) information to make important decisions.3 Accounting information is being used by creditors, government and statutory bodies, research & academics and others. Horngren has classified accounting information into three categories including Score-keeping, Attention directing and Problem solving. Different users have different objectives to use accounting information. For example, the investors may need information to make investment decisions whereas statutory bodies use it for other purposes. The South African Revenue Service (SARS) uses accounting information of companies for income tax reasons and after getting information about the profits made by a company in a given year, the taxable income is determined. Since, there are various types of accounting information therefore; different users may need different kind of information. SARS may only need profit; turnover and expenses figures of the company while Statistics South Africa may require more detailed accounting information.4 Measurement Issues When Preparing Profit and Loss Account The profit and loss account is the measure of profits made by a company and it represents how well the business is going. It shows the profit or loss generated by the company during a specific time period (a year, 6 months and 3 months). Before evaluating the measurement issues that are incurred when preparing the profit and loss account, understanding the parts of profit and loss accounts is important. The three parts of profit and loss account includes the trading account, the profit and loss proper and the appropriation account. When preparing the trading account part of profit and loss account, the gross profit is calculated by subtracting costs from revenues. In the Profit and loss account proper, the overheads and other expenses are deducted from gross profit. The third part of profit and loss account is the Appropriation account that divides the profits as tax, retained earnings for future investments and returns to owners.5 While preparing profit and loss account, the first section of trading account does not incur measurement issues because the revenues are simply calculated by multiplying sales with number of units and costs are calculated by multiplying cost per unit with number of units sold. As explained by Peter and Eddie, the main measurement issue when preparing profit and loss account is raised when expenses are put into the second part of profit and loss account. It becomes really tough for the companies to accurately determine the expenses incurred during a period. Although the true position of the company gets clearer at some later point in time however, to make future estimations all relevant expenses in the profits and loss accounts have to be included. For example while measuring the utility bills, the company may not have accurate information of current period utility bills therefore, the expenses accrued at the end of period includes the amount such as telephone expenses of the last quarter’s bill. Secondly, the depreciation expense is calculated based on the estimated life of the fixed asset and its future residual value. It is again estimation and the management of the company has to use different assumptions to estimate the life of the fixed asset. The third measurement issue that is faced when preparing profit and loss account is the estimation of the amount of bad and doubtful debts incurred.6 In the third part of profit and loss account, the profit appropriations are done and no main measurement issues are incurred when this section is prepared. In short, the main measurement issues are usually raised in the second section of the profit and loss account whilst measuring expenses. Limitations Of Financial Statements The balance sheet shows the financial position of a company at a specific date. It shows the business’s liquidity, retained earnings, breakdown of its assets and liabilities. Although Balance sheet is considered as the most important financial statement however, it has various limitations while portraying the financial position of a company. Martin and Catherine highlighted various limitations of balance sheet. First, it does not give the true value of some assets because the values of transactions are entered into the balance sheet at the time of transaction and the impact of inflation is not considered. Second, the goodwill built up is not properly shown on the balance sheet because Goodwill is the amount that a buyer pays to buy an existing business above the market value of its assets. This value is recorded only at the time of transfer of ownership of business from one party to the other. Suppose if a new business starts its operation from scratch, then it is possible that its processes and worth of business is more as compared to the existing businesses however, its goodwill cannot be determined. In this way, the true financial position of the new business may not be evaluated as compared to the other existing businesses. Third, a balance sheet does not reflect the investments made by the company on the recruitment and training of its employees. Fourth, many measurements of balance sheets are made based on estimations such as the depreciation method. The selection of such methods may increase/decrease the profitability of a company in one period and show its opposite in the other period. Another limitation of balance sheet is that it shows the financial position of a business at a specified date. The businesses are changing rapidly because of the changing circumstances; therefore, a one-day financial position of a company cannot predict the overall financial position of the company throughout the year.7 Bibliography Atrill, P. & Mslaney, E.,(n.d.), Accounting and Finance for Non-Specialists. [Online] Pearson education. Available at: http://wps.prenhall.com/ema_uk_he_atrill_accfinns_4/13/3490/893506.cw/index.html. [Accessed 2 November 2009]. Bowett, Richard. (n.d.). Introduction to the profit and loss account? [Online] Available at: http://tutor2u.net/business/accounts/profit_loss_account.htm [Accessed 2 November 2009]. Jadels, M. & Catherine, E. R., 2006, Hospitality management accounting. [Online] John Wiley and Sons. Available at: http://books.google.com.pk/books?id=JApjdhPLrl8C&pg=PA86&dq=limitations+of+balance+sheet&lr=#v=onepage&q=limitations%20of%20balance%20sheet&f=false. [2 November 2009]. McLeary, Fred , 2000, Accounting and Its Business Environment. [Online] Juta and Company Limited. Available at: http://books.google.com.pk/books?id=Xt2lLSi_qgIC&pg=PA1&dq=purpose+of+accounting+information#v=onepage&q=purpose%20of%20accounting%20information&f=false. [1 November 2009]. University of Pretoria, (n.d.). Accounting and Accounting Information. [Online] Available at: http://upetd.up.ac.za/thesis/available/etd-10232001-152437/unrestricted/02chapter2.pdf [Accessed 1 November 2009] Read More