Financial Accounting: Roles, Importance, Benefits, Limitations

  • Post last modified:12 May 2023
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  • Reading time:15 mins read
  • Post category:Accounting

What is Financial Accounting?

Financial accounting is the process of summarising financial data, which is taken from an organisation’s accounting records and publishing it in the form of annual or quarterly reports, for the benefit of people outside the organisation.

Financial accountancy is used to prepare accountancy data for people outside the organisation or for those, who are not involved in the ordinary administration of the company.

Role of Financial Accounting

There are some role of financial accounting is :

  1. Financial accounting generates some key documents, which includes profit and loss account, patterning the method of business traded for a specific period and the balance sheet that provides a statement, showing mode of trade in business for a specific period.

  2. It records financial transactions showing both the inflows and outflows of money from sales, wages, etc.

  3. Financial accounting empowers the managers and aids them in managing more efficiently by preparing standard financial information, which includes monthly management report tracing the costs and profits against budgets, sales and investigations of the cost.

Importance of Financial Accounting

The importance of financial accounting are:

  1. It provides legal information to stakeholders such as financial accounts in the form of trading, profit and loss account and balance sheet.

  2. It shows the mode of investment for shareholders.

  3. It provides business trade credit for suppliers.

  4. It notifies the risks of loans in a business for banks and lenders.

All financial accounting procedures should be transparent and strictly followed. If accounting principles and standards will not be practised effectively, it can cause huge losses to the company.

Satyam Computer Systems Ltd., for example, was involved in India‟s largest accounting scandal. The profits of the company were falsely inflated for many years. Satyam Chairman B. Ramalinga Raju then resigned, admitting the falsification of company accounts and inflation of revenue and profit figures. The company‟s auditors Price Waterhouse Coopers were also held responsible for the fraud.

Enron, a U.S. based power generation and distribution Company misled the public into believing that it was realising profits from legitimate trading of natural gas to energy. The company‟s traders helped in building up the “robust selling” scenario by publishing press releases about trade deals that did not actually take place.

The company paid dividends to its investors from borrowed funds and from the capital markets. However, apart from investor‟s money, there was no actual earning.

Benefits of Financial Accounting

There are some benefits of financial accounting is:

Maintaining systematic records

It is a primary function of accounting to keep a proper and chronological record of transactions and events, which provides abase for further processing and proof for checking and verification purposes. It embraces writing in the original/subsidiary books of entry, posting to ledger, preparation of trial balance and final accounts.

Accounting helps to comply with various legal requirements. It is mandatory for joint stock companies to prepare and present their accounts in a prescribed form. Various returns such as income tax and sales tax are prepared with the help of the financial accounts.

Protecting and safeguarding business assets

Records serve a dual purpose as evidence in the event of any dispute regarding ownership title of any property or assets of the business. It also helps prevent unwarranted and unjustified use. This function is of paramount importance, for it makes the best use of available resources.

Facilitating rational decision-making

Accounting is the key to success for any decision-making process. Managerial decisions based on facts and figures take the organisation to heights of success. An effective price policy, satisfied wage structure, collective bargaining decisions, competing with rivals, advertisement and sales promotion policy, etc all owe it to well set accounting structure.

Accounting provides the necessary database on which a range of alternatives can be considered to make the managerial decision making process a rational one.

Communicating and reporting

The individual events and transactions recorded and processed are given a concrete form to convey information to others. This economic information derived from financial statements and various reports is intended to be used by different groups who are directly or indirectly involved or associated with the business enterprise.

Limitations of Financial Accounting

One of the major limitations of financial accounting is that it does not take into account the non-monetary facts of the business like the competition in the market, change in the value for money, etc.

The following limitations of financial accounting have led to the development of cost accounting:

No clear idea of operating efficiency

You will agree that, at times, profit may be more or less, not because of efficiency or inefficiency but because of inflation or trade depression. Financial accounting will not give you a clear picture of the operating efficiency when prices are rising or decreasing because of inflation or trade depression.

Weakness not spotted out by collective results

Financial accounting discloses only the net result of the collective activities of a business as a whole. It does not indicate profit or loss of each department, job, process or contract. It does not disclose the exact cause of inefficiency, i.e. it does not tell where the weakness is because it discloses the net profit of all the activities of a business as a whole. Say, for instance, it can be compared with a reading on a thermometer.

A reading of more than 98.4° or less than 98.4º discloses that something is wrong with the human body but the exact disease is not disclosed. Similarly, loss or less profit disclosed by the profit and loss account is a signal of bad performance of the business in whole, but the exact cause of such performance is not identified.

Not helpful in price fixation

In financial accounting, costs are not available as an aid in determining prices of the products, services, production order and lines of products.

No classification of expenses and accounts

In financial accounting, there is no such system by which accounts are classified so as to give relevant data regarding costs by departments, processes, products in the manufacturing divisions, by units of product lines and sales territories, by departments, services and functions in the administrative division.

Further expenses are not attributed as to direct and indirect items. They are not assigned to the products at each stage of production to show the controllable and uncontrollable items of overhead costs.

No data for comparison and decision-making

It will not provide you with useful data for comparison with a previous period. It also does not facilitate taking various financial decisions like introduction of new products, replacement of labour by machines, price in normal or special circumstances, producing a part in the factory or sourcing it from the market, production of a product to be continued or given up, priority accorded to different products and whether investment should be made in new products, etc.

No control on cost

It does not provide for a proper control of materials and supplies, wages, labour and overheads.

No standards to assess the performance

In financial accounting, there is no such well-developed system of standards, which would enable you to appraise the efficiency of the organisation in using materials, labour and overhead costs.

Again, it does not provide you any such information, which would help you to assess the performance of various persons and departments in order that costs do not exceed a reasonable limit for a given quantum of work of the requisite quality.

Provides only historical information

Financial accounting is mainly historical and tells you about the cost already incurred. As financial data is summarised at the end of the accounting period it does not provide day-today cost information for making effective plans for the coming year and the period after that.

No analysis of losses

It fails to provide a complete analysis of losses due to defective material, idle time, idle plant and equipment. In other words, no distinction is made between avoidable and unavoidable wastage.

Inadequate information for reports

It does not provide adequate information for reports to outside agencies such as banks, government, insurance companies and trade associations.

No answer to certain questions

Financial accounting will not provide you with answers to such questions as:

  1. Should an attempt be made to sell more products or is the factory operating to its optimum capacity?

  2. If an order or contract is accepted, is the price obtainable sufficient to show a profit?

  3. If the manufacture or sales of product X were discontinued and efforts were made to increase the sale of Y, what would be the effect on the net profit?

  4. Why the annual profit is of a disappointing amount despite the fact that output was increased substantially?

  5. If a machine is purchased to carry out a job, which at present is done by hand, what effect will this have on the profit line?

  6. Wage rates having been increased by 50 paisa per hour, should selling price be increased and if so, by how much?

What is Financial Accounting?

Financial accounting is the process of summarising financial data, which is taken from an organisation’s accounting records and publishing it in the form of annual or quarterly reports, for the benefit of people outside the organisation.

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