A layman's guide to the role of Accounting in the modern world !


What is Accounting ?

Accounting is the way in which we record, analyze & summarize business transactions. Now these transactions are first recorded in the 'Books of Prime Entry' like the Petty Cash Book. They are then analyzed & posted to the ledgers like the Fixed Asset Ledger before they are finally summarized in the financial statements.

The accounting function does not operate in a bubble, it's a part of a company's broader business systems & though it deals with the financial operations of the company it takes from & gives to, valuable information & advice to its other departments.

Accountants are required to aid the management in planning, control & decision making & to help the company comply with statutory regulations. The accounting system therefore must be adequate to fulfill all these functions. An organization's accounting systems are effected by the size of the organization (a small organization like a departmental store would have a simple accounting system whilst an industrial unit would have a much more complex accounting system), type of the organization (a not-for-profit organization would be more concerned with monitoring expenditure against targeted performance whereas a profit-making manufacturing concern would need to account for sales, units, revenue etc. in addition to costs) & organization structure (in a business that is managed by area or on geographic basis accounts may be prepared as per areas whereas in a business where a functional form of organization is employed, accounts maybe prepared as per separate departments).

The need for Accounts !

The bedrock of modern accounting revolves around the double entry bookkeeping. What this means is that every transaction would have be entered as a debit in one account & a credit in the corresponding accounting. For example if Inventory is to be recorded; its recording would involve a debit entry in the Inventory account whereas a credit entry in the Cash or Inventory Payables accounting !

The original role of the accounting function was to come up with a system that could record financial information. Incidentally this continues to be accounting's prime role to date. Many would ask is that why should a business produce accounts at all ? And the answer lies in the fact that there are various groups of people who want or need to know that information. For example a bank, before giving you a loan, may need to know what are your outstanding liabilities ? What was your profit for the year ? What are your Net Assets worth ?

Users of Financial Statements & Accounting Information !

In the last paragraph we talked about a business preparing its accounts because there are various groups which might be interested to know that information. Lets look at some of them :

(a) Managers of the Company - These are the people appointed by the owners of the company tasked with managing the day-to-day affairs of the company. They would naturally require relevant, timely & appropriate business information to run the business efficiently.

(b) Shareholders of the Company - Now these are the owners of the company & they'd, as such, want to know how effectively the management is running their company. So to asses the management's performance would requires financial information about their business that helps them to determine whether the company's working capital is being managed effectively, whether it has enough profits after tax to pay-off the interest payments etc.

(c) Suppliers & Customers of the Company - The suppliers who give goods to the company on credit & the customers who purchase from the company would want to know whether the company is heading towards future growth, whether it would be able to pay-off the debts it owes to them, whether the company is having any liquidity (cash-flow) issues etc. to ascertain whether it wants to take their business relationship further or whether they'd want to terminate it !

(d) Lenders of the Company - The lenders of the company would want to know whether the company would be able to pay its interest payments on time & finally repay the amounts loaned to them before financing them for the long-term finance !

(e) The Tax Authorities - Who'd want to know about the Company's profits in order to assess the tax payable by the company !

(f) Employees of the Company - Employees might want to know about the financial future of the company, its growth plans, its profits, its revenues, its expenses etc. to ascertain their own career future & negotiate their wages & salaries.

(g) Financial Analysts - Who'd need information for their clients to advise investors on the current financial position of the company, its current cash-flows, its financial ratios & its prospected future financial position & financial ratios to determine whether the company's stocks & shares ought to be invested in or not !

Qualities of Good Accounting Information !

When we talk about business information what we really mean is accounting information that is needed to make the day-to-day, short-term & long-term financial decisions of a company. Now good accounting information has certain features & they are as follows :

(a) Relevance - the information provided must be relevant to the user of the information. For example, within reason, the company's legal consultant might not find the figure of budgeted sales as relevant as the Head of the Sales Department would.

(b) Comprehensibility - the information might be too difficult to understand because it is far too detailed. Conversely the information might also be too difficult to understand because its far too minimal. Therefore information must be of just the correct amount of detail otherwise any decision made based on it may lead to an incorrect decision.

(c) Reliability - that information which can be independently verified is more reliable than the information obtained from those with a vested interest in it being presented in a particular way. For example for a bank that is about give a company a loan, the information obtained about the financial position of the company from the auditors, an independent & impartial third party, is more reliable than the information obtained directly from the company itself.

(d) Completeness - a company's accounts must present a complete picture of its financial position complete with any material disclosures which would be relevant to any user of the information in arriving at a decision about the company.

(e) Objectivity - the information should be as objective as possible; especially when there appears to be a conflict of interest. For example there are numerous cases in the context of preparing accounts which require subjective judgement as opposed to relying on objective facts & the management might be inclined to paint a more favorable picture for themselves when deciding on it. By contrast the auditors, being the independent & impartial third party they are, would hold a much more prudent view in the particular case & arrive at a more prudent decision in the preparation of accounts.

(f) Timeliness - the useful of information is drastically reduced if it isn't made available at the time of the decision that was required pertaining to it. For example the information about the company's total debts would be much less important if it is made available after the debt renegotiation process with the company's lenders has concluded.

(g) Comparability - the information should be produced on a consistent basis so that it is comparable to information of a similar nature from previous periods or the information produced by other sources (for example the accounts of similar companies operating in the same line of business).

The Structure of the Accounting System !

So far we've talked about what accounting is ? Who uses that information ? And what exactly is good accounting information to begin with ? Now we're going to look at how the accounting system or the accounting function exists in a company; who heads the accounting department ? What functions does the accounting department really performs ? etc.

In most companies the head of the accounting department is the finance director who sits on the company's board of directors & is responsible for its routine accounting matters & also for its broad financial policy.

Now in most companies a finance director would have one or more deputies working for him. A financial controller (who is responsible for the routine accounting duties & providing accounting reports for other departments), a Management Accountant (who is responsible for the company's cost accounting, budgets & budgetary control & financial management of its projects) & a Treasurer (who is responsible for raising funds for the company through borrowing, investing surplus funds in the money markets & arranging for the company's long term finance).

In addition to these & their relevant department; most companies would have an internal audit department as well where internal financial control is enacted to control risk of fraud & error. For this reason its usually made separate from the finance department & the chief internal auditor reports to the audit committee of the board of directors instead of the financial director.

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