Accounting is the process of recording, organizing, analyzing, and presenting financial information concerning a business entity. Every transaction is recorded at the time of occurrence, organized, and analyzed together with others to give periodic reports on the financial position of the business. The most important information in developing accounting statements regards sales, purchases, and expenses. These are the basic determinants of performance for businesses. This paper discusses the importance of accounting, the main measurements considered in the preparation of the profit and loss account, and the limitations of the balance sheet inaccurately and comprehensively exhibiting the true financial position of a business (Future a/ccountant, 2009 Par 5).
The general purpose of accounting is to help in the decision-making process. Accurate information about the business performance is critical for both external and internal parties to a business. The management is interested in knowing whether the firm’s performance is improving or not to make informed decisions. Investors on the other hand need to understand the ability of their investments to give returns. Creditors need to know the safety of the credit advanced to the firm. The government is also interested in the firm’s performance for taxation purposes (Taylor 2009 Par 3).
In any business, the management is most interested in accounting information. This is because they are involved in the daily running of the business and their decisions directly affect the business. Indeed, the poor performance of a business is mainly attributed to the failure of the management and vice versa. In a case where the financial statements show that the business is making a loss, the management is tasked to identify the reasons for the losses and apply the right strategies that will turn around the firms’ performance. In a case where the firm is profitable, the management’s task is to ensure that the profitability track is maintained and better business practices are encouraged to improve and take advantage of opportunities to enhance the positive performance. The actions taken by the management may include engaging in more aggressive sales campaigns, producing better quality products, employing cost reducing measures and investing in a variety of products. The magnitude of the decision taken is informed by how serious the firms’ performance is as reported by the accounting information (Karimi 2009 Par 3).
The two main reports used in presenting accounting information are the Profit and Loss account (P&L a/c) and the balance sheet. The P&L a/c reports on the annual performance of the business in terms of profits or losses made. The balance sheet statement shows the financial standing of a business by demonstrating how the business’s assets are financed by liabilities and capital (Robert 2007 p 24).
In reporting on the profitability of a business, the P&L a/c makes several considerations. First is the gross revenue. Revenues are got from sales activities of the business. The annual sales largely determine the profits attained. The cost of sales is then deducted from the sales figure to determine the gross profit. The cost of sales comprises the costs incurred in obtaining the inputs used to produce the products which are later sold. The resulting gross profit represents the margin of profit obtained in selling the products (Welch 2009 Par 4).
Expenses incurred in the business operations are then deducted from the gross profit to determine the net profit. The expenses here are highly varied due to the different nature of businesses. The most common categories are costs of transportation, rental costs, financing costs such as interest rates, administrative costs, salaries, and other payments made in the process of doing business (Welch 2009 Par 5).
A simple business model of a shop can illustrate the considerations made in preparing a profit and loss account. The total amount of money gotten in a year of doing business represents the total sales revenue for the shop. The cost of sales is calculated by considering the value of stocks present at the start of the year together with the total cost of purchasing stocks in the year and reduced by the value of stocks at the year-end. Deducting the resulting figure from the cost of sales gives the shops gross profits. Expenses for the shop would include the rent paid to the owner of the building where the firm operates, utility bills paid for water and electricity, salaries paid to shop attendants, and transportation costs incurred in sourcing the products sold at the shop. combining these costs and deducting them from the gross profit gives the net profit for the firm. It should be noted that only the revenues or costs incurred during the period of concern should be included in the preparation of the profit and loss account. This is to ensure that the profits or losses are not overestimated or underestimated (Eisen 2007 Par 3-6).
As mentioned above the balance sheet presents the financial position of the firm. It shows whether the firm’s financial health is improving or not from one financial year to another. It operates on a basic fact which states that all the businesses assets are financed either by the capital invested by the owner(s) or through funding from external parties such as loans from banks, credits from suppliers as well as unpaid bills, and salaries. This is information is summarized by the equation below:
Assets = Liabilities + Capital
As mentioned above, the balance sheet is a fundamental financial statement for consideration in any investing activity. However, relying solely on this report may not lead to informed decisions. This is because it has some limitations which can only be overcome by incorporating other reports such as the P&L a/c and the statement of changes in equity in analyzing the business. The most important limitation is that it only gives the financial position of a business at a point in time. This means that it does not give the direction the business is headed financially (Kennon 2009 Par 5-8).
A business may be financially sound probable due to its success in early years but maybe moving downwards based on the recent performances. This means that the balance sheet can be very misleading for investment decisions. Secondly, the information on the balance sheet has to be further analyzed to get the true picture of the health of the business. Ratios and percentages have to be developed in search of some information (Pirraglia 2009 Par 4)
Despite these weaknesses, the balance sheet remains a critical document for financial analysis. Complete information on the business is best attained when the balance sheet is read together with the profit and loss account as well as the statement of changes in equity. Incorporating some relevant ratios also helps to better understand all the elements of the businesses’ financial standing (Investopedia 2009 Par 4).
It is thus important that every business regardless of the size develops some financial statements to continually measure progress and enable proper decision-making for all stakeholders.
Reference
Eisen, P., 2007. Financial Accounting. QuickMBA. [Online]. Web.
Future a/ccountant, 2009. Deriving information needed from accounting records. [Online]. Web.
Investopedia 2009. Reading The Balance Sheet. [Online]. Web.
Karimi, S., 2009. What is the Purpose of Accounting? eHow. [Online]. Web.
Kennon, J., 2009. Putting It All Together. About.com: Investing for Beginners. [Online]. Web.
Pirraglia, W., 2009. What are The Limitations of a Balance Sheet? eHow. [Online]. Web.
Robert, P., 2007. Financial Accounting for Non-Specialists. 2nd-ed. McGraw-Hill.
Taylor, C., 2009. Why Is Accounting So Important? Articlebase, [Online]. Web.
Welch, C., 2009. Basic Purpose of Accounting. eHow. [Online]. Web.