What are the Basic Role of Accounting in Business?

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By: Site Engineer, Staff

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Several business transactions take place every day in a business organization. Goods are sold, purchases are made, bills are settled and salaries and wages are paid to employees. In a modern business organization, it is necessary and very important that each transaction is recorded in a clear and systematic manner.

When a customer purchases an item from a retail shop, for example, recording of that transaction may simply be done by the salesgirl using a till. Another transaction may be recorded by means of a purchase invoice. Several of these types of records take place on a continuous basis in the business organization.

These records need to be classified, summarized and reported in a form that is meaningful to the owners, managers and all those who have an interest in the business organization. The process of collecting, recording, classifying, summarizing and reporting the financial transactions of an organization is called accounting.

The accounting information are reported in two types of statements: the balance sheet or statement of the financial position of the enterprise, and the profit and loss statement. The latter is also known as the income statement.

All those who are interested in the accounting information contained in these statements have special and sometimes conflicting interests in the business organization. It is important therefore that statements reflect the true state of affairs of the business. This objective is achieved by ensuring that the statements, and indeed the records from which they are derived, are prepared according to generally accepted accounting standards and principles.

The balance sheet and income statement provide aggregate information. A closer analysis of the various items would disclose valuable information on costs and enable decisions to be made which are likely to improve performance. Accounting is therefore simply record-keeping and reporting; it is a valuable instrument for planning and control of the operations of the enterprise.

Role of Accounting in the Business

Several groups are interested in the affairs of the business enterprise. Each of these groups needs information about the operation of the business for decision-making. Accounting plays a major role in generating and making the needed information available.

Management needs information for two purposes:

  1. To measure performance for the purpose of control, and;
  2. To facilitate planning.

Performance is measured by comparing the actual results of business operations with what management planned to achieve during a specified period of time. Accounting information enables management to make this comparison efficiently and to take decisions to alter the situation where necessary. A comparison of actual production costs with projected costs, for example, enables management to make decisions to ensure that profit targets are met.

Management also uses accounting information for planning purposes. Through accounting reports, management is able to come to realistic decisions about goals, and the alternative courses of action to achieve them. A decision concerning pricing, expansion of operations and acquisition of assets cannot normally be made without knowledge of the relationships between costs and expected revenues, which accrues from these decisions. The relationships are established with the aid of accounting data.

Investors are interested in the security of and return from their investments. Accounting information enables them to determine how their money is being utilized for the purpose of generating profits, and how much profit is actually being generated.

When management is distinct from investors, the efficiency and effectiveness of the use of invested funds call for closer and proper scrutiny, this is because the goals of management and those of investors may be in conflict. Management may be more concerned with survival and satisfactory profit than with maximization of the wealth of investors.

It is only through accounting information that investors can evaluate the performance of management and decide whether or not to retain the management. Investors are also able to evaluate the risk of their investment by analyzing accounting data.

Creditors also constitute an important group who use accounting statements. Their primary interest is the repayment of the principal and interest when they become due. Creditors, such as banks and other financial institutions, want to determine the risk involved in granting a loan to the business establishment. Accounting reports are vital to this need to determine the capability of the business organization to survive and generate stable income with which to repay the loan as well as the interest due. Trade creditors and other suppliers use accounting reports to evaluate the ability of the business organization to pay their bills regularly and maintain a profitable relationship with them.

Employees depend on the business organization to provide them with conditions of service that will help them to sustain and improve their standard of living. Consequently, the survival and growth of the business organization are of vital interest to its employees and their unions. Growth means greater opportunities for advancement and enhancement of the ability of the firm to provide more and improved fringe benefits. Accounting reports are used by employees and their unions in negotiating improvements in their conditions of service.

Perhaps the best-known user of accounting reports is government and its agencies. Taxation is an important source of revenue to the government. Taxes are levied on business organizations on the basis of the surplus reported in the profit and loss statement. Without this statement, taxes would necessarily be arbitrary. The accounting information supplied must reflect the true state of affairs of the business.

Legal provisions have been made to protect the interest of the government, shareholders, and creditors, who may not be involved in the management of the business, but would base their decisions on the published accounting information. In addition, the accounts of a business are expected to be prepared according to generally accepted principles and practices of the accounting profession.

Accounting Records

As mentioned previously, accounting statements are prepared by the company’s accounting records. The systematic recording of financial transactions is an essential aspect of accounting. Every financial transaction involves two parties – the buyer and the seller, or in the case of lending, the lender and the borrower.

The recording of transactions is done separately by the parties. When a retail shop purchases ten cartons of detergent from a wholesaler, the proprietor records this transaction in his books, and the wholesaler also record the same transaction in his books. With respect to the proprietor, cash is given and stock received, while in the case of the wholesaler, cash is received and stock given.

Thus, in the view of each party, there are two aspects of the transaction, and both must be recorded to obtain complete information about the transaction. The proprietor will record the fact that cash was given and stock received. Recording transactions in this manner are generally known as Double Entry Book-Keeping. Value received is recorded as debt (Dr.) and value is given is recorded as a credit (Cr.)

In general, all transactions are recorded in two types of books – the journal and the ledger. The journal is the primary book in which all transactions are recorded in chronological order. It shows the date of the transaction, a description of the transaction, the ledgers in which the two aspects of the transaction are recorded, and the amount involved.

The journal is also referred to as a book of prime entry. The volume of transaction in a business enterprise may necessitate the use of specialized or subsidiary journals for particular types of transactions. Thus, a business enterprise may also have a purchases’ journal and a sales’ journal.

Financial Statements

As pointed out before, accounting information are summarized and reported in two financial statements – the balance sheet and the income statement.

Balance Sheet

The balance sheet is a statement of the financial condition of the firm on a specific date. It is prepared for a business organization at the end of an accounting period, usually a year. It may, however, be prepared at any time it is needed since it is simply a snapshot of the financial condition of the enterprise on any given date.

The balance sheet has two major sections: assets, on the one hand, equity, and liabilities on the other.

Assets are the resources that have been acquired by the business organization for operations. They include cash; accounts receivable or debts due from customers in respect of goods sold on credit, inventory of raw materials (if any) and finished goods, vehicles, furniture, land, and buildings. Cash accounts receivable and inventory are collectively known as current assets, while other assets are known as fixed assets.

The distinguishing factor between current and fixed assets is that current assets can generally be turned into cash within one year, while fixed assets cannot.

Liabilities are the indebtedness of the business organization. They include accounts payable, or debts due to creditors in respect of goods bought on credit, notes payable, taxes due, and loans which may be in the form of mortgages or bonds. Accounts payable, notes and taxes due are current liabilities because they fall due within one year, while mortgages and bonds are long-term liabilities, as they are normally not repaid within a year.

Owners or stockholders’ equity is the investment of owners in the business. This includes sums paid in by the owners or ordinary shareholders, preference shareholders and profits that have been retained over the years. The firm’s capital consists of long-term liabilities and owner equity.

The accounting equation of the balance sheet is:

Assets = liabilities + owners’ equity

Or

Owners’ equity = assets – liabilities

As the balance sheet equation suggests, the assets are equal to the total liabilities and owner’s equity. They each have the same total of the figure (amount). They are equal because, as explained earlier, every transaction is recorded twice, first as debt and then as credit. Since the balance sheet summaries all the entries made, the assets (debts) must be equal to the sum of the liabilities and owners’ equity (credits).

Profit and Loss Statement

The results of operations over a defined period of time are summarized and reported in a profit and loss statement. It shows the revenue earned during the period, the cost of the products or service exchanged, other expenses incurred, taxes and residual sum known as profit or loss. This statement is also often called an income statement.

The profit and loss statement is made up of various sections. The first section contains the sales and cost of sales during the accounting period. The cost of sales is deducted from net sales to obtain the gross profit for the period. Cost of sales is simply the value of the goods sold, plus transportation expenses incurred in moving the goods from the wholesaler to the retail shop.

Out of the gross profit, operating expenses are deducted, to obtain operating income. Operating expenses are selling expenses which include salesmen’s salaries, expenses on other office personnel, and the depreciation on fixed assets for that period.

The next section of the profit and loss statement shows the impact on an operating income of financial decisions, such as the decision to raise funds through a bonds issue, rather than from owners. Interest represents the returns to lenders. Interest expense is deducted from operating profit to net income before taxation. Net income available to owners or stockholders is the balance of income after taxes have been deducted.

Financial Analysis

Analysis of the data contained in financial statements enables internal as well as external users of the statements to evaluate the performance of the firm and to predict its function financial prospects. Financial statements provide data which in themselves have no real significance. However, when the data are related to others, or to past data, they begin to have some meaning for the reader.

It is important here to clear certain misconceptions about accounting information. Financial statements are surfeit with quantitative data, and therefore give the impression of being mathematically exact. This is not often the case. The values of most of the items in the statements are the results of managerial decisions, guided of course by certain principles and policies. For example, the value of an asset shown in the balance sheet depends on the depreciation policy adopted. Two firms may acquire the same amount of assets in Year 1, and have different values for the assets in Year 2, simply because they adopted different depreciation policies. These policies and principles may be provided as footnotes to the financial statements. The interpretation of the financial data must, therefore, recognize the underlying assumptions in the preparation and presentation of the data.

The balance sheet is literally a snapshot of the relationship between assets and liabilities, including owners’ equity on a specified date. Similarly, the income statement shows the results of operations in terms of gain or loss, also specified over a period. At the time of analysis and interpretation, the circumstances of the firm may have changed. Therefore, the information contained in the statements must be interpreted with reference to the period stated.

Accounting data have meaning for the user only if compared with some sort of standard. The fact that a supermarket store had a total sales revenue of $30,000.00 at the end of a year is vital information. However, such information can have meaning for the user only if he is also told that the same supermarket store had a total sales revenue of say, $40,000.00 the previous year, or that a comparable supermarket store had a total sales revenue of say, $60,000.00 during the same period. Thus, the analysis of accounting statements is simply a comparison of the firm’s data with some standards. The standards generally adopted are the firm’s past performance, the firm’s generated performance, or the industry performance during the same period.

Ratio Analysis

There are several ratios that can be used to analyze accounting statements. The ratios that are selected in particular instances depend on the objectives of the analyst. The most frequently used ratios are liquidity ratios, indebtedness ratios, effectiveness ratios, and profitability ratios.

1. Liquidity Ratios

There are two types of liquidity ratios: current ratio and quick ratio. These ratios are used to measure the firm’s short-term solvency. A firm is considered solvent if it is able to meet its short-term financial obligations as they fall due. The ratios measure the firm’s ability to meet its financial obligations due during the year. The current ratio is obtained by dividing current assets by current liabilities.

(i) Current Ratio       =          Current Assets/Current Liabilities

The current ratio indicates the number of times that current liabilities are covered by current assets.

The quick ratio, also known as Acid Test Ratio, is obtained by dividing current assets less inventory by current liabilities.

(ii) Quick Ratio          =          (Current Assets – Inventory) / Current Liabilities

The rationale for computing the acid – test ratio is because inventory is the least liquid of all the items making up current assets. The quick ratio, therefore, indicates the coverage of current liabilities by cash and near – cash current assets. A high quick ratio means that the firm can easily mobilize cash to pay for financial obligations that are due.

2. Indebtedness or Leverage Ratio

These ratios measure the extent to which the firm depends on borrowed funds. The more the owners depend on borrowed funds to finance the business, the greater the risk borne by creditors in the event of failure of the business. The proportion of funds employed in the business also determines the number of fixed interest charges which must be paid from current earnings of the firm. Indebtedness ratios, therefore, measure the riskiness due to the method of financing the business.

The firm’s indebtedness may be measured by any of the following ratios:

(a)        Long-term Debt/ Total Capital

150/150+68     =          50/218             =          0.69

(b)       Long-term Debt / Owners’ Equity

150/68             =          2.20

(c)        Total Debt / Total Asset

202/270           =          0.75

All three indebtedness ratios indicate a substantial level of debt financing. The long-term debt to total capital ratio indicates debt financing of 69%, while the ratio of the total assets indicates 75% debt financing. From the long-term debt to owners’ equity ratio, for every $1.00 invested by the owners of the business, creditors have invested $2.20.

However, in spite of these high ratios, the financial condition of the firm can only be evaluated by comparing the ratios to the average ratios of competitors (industry ratio), and to the historical ratios of the business enterprise. The coverage of total interest from current operations of the firm is measured by the Times Interest Earned ratio.

Times Interest Earned Ratio = Operating income / Interest Charge

Or

Times Interest Earned Ratio = Profit before taxes – Interest Charges/ Interest Charges

This ratio indicates the ability of the firm to pay interest charges from earnings.

3. Effectiveness Ratios

These ratios measure the effectiveness with which management used the resources at its disposal. Effectiveness is measured by the inventory turnover ratio and asset turnover ratio.

Inventory turnover is obtained by dividing sales during the year by the average inventory during the same period. Average inventory is computed by adding up the inventory at the beginning and end of the year and dividing by 2.

Inventory Turnover  =          Net Sales / Average Inventory

Inventory Turnover  =          1490/(27+35)/2

                                    =          1490/(62/2)

                                    =          1490/(31)

                                    =          1490/31

                                    =          48.06

The inventory turnover ratio indicates the sales generated by one naira investment in inventory. Similarly, asset turnover indicates the sales generated by the total assets employed in the business.

The use of ratio is not limited to financial statements alone. They can be used in other areas of the business, where a relationship between two variables can be established and more information can be gained by computing a ratio.

Designing an Accounting System

The accounting system of a business organization is a system of business records, such as journals and ledgers, forms, reports and procedures for preparing these records and reports. The objective of an accounting system is to collect, analyze, summarize and make accounting system is to collect, analyze, summarize and make accounting data available to all those who need to have the information for decision-making. Although accounting principles upon which any accounting system is based are standardized, the design of the accounting system must take the special needs of the business organization into consideration. Thus, no single accounting system is suitable for all business organizations.

The factors that need to be taken into consideration in designing an accounting system include the nature and size of the business, the training, and experience of the accounting personnel engaged in the business, the cost of running the accounting system and the generally accepted accounting principles and practices. The nature of operations and size of the business determine the information needed for decision-making. The accounting system of a wholesale business cannot be the same as that of a manufacturing plant, because of obvious differences in the types and volume of transaction. The training and experience of personnel employed in the organization influence the design of the accounting system. Similarly, the capacity of management to use the information generated must be considered. There is no use in developing a sophisticated system when it is common knowledge that management is not capable of, or willing to use it for decision-making purposes. Above all, existing personnel in the organization must be involved in designing the system; otherwise, it might be quickly abused and discarded.

Accountants have a tendency to introduce accounting forms, regardless of cost. The cost of running the accounting system should be considered in the system design. The basic principle should be that the cost of the accounting system must not exceed the expected benefits. The bedrocks of accounting are the generally accepted principles and standards of the profession. The accounting system should, therefore, be designed around these principles while ledgers, journals, and forms can be adapted to suit the business organization.

 

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