financial accounting essay

financial accounting essay

The Importance of Financial Accounting

1. Introduction

In the Framework for the Preparation and Presentation of Financial Statements, financial educational services and releases by the Association of Chartered Certified Accountants for those who prepare financial statements, accounting educators, and accounting tutors, the information aspect of the financial statements, which is the main purpose of financial statements, is emphasized on one hand while discussing the financial statements. Therefore, in the introduction, the information users, the purpose of the information, and the features used in accounting will be explained briefly. Before this, I will tell you what the financial statements are, why they are necessary, and when they are prepared.

Profit and loss statement, balance sheet, and related financial accounting documents are required for a company’s financial decisions, financial statement evaluations, and legal requirements. The success of financial accounting reflects on the organization as a significant input for managerial decisions. In addition, they are crucial for third parties such as tax authorities, balance sheet department, banks, customers, suppliers, and capital markets. In fact, the organization conducts accounting not only for its own accounting problems but also so that the third parties who need the accounting information can make sound decisions about that organization. In this respect, the expectation of third parties is to access accounting information that reflects the reality and allows well-interpreted decisions about the organization.

2. Principles of Financial Accounting

Financial accounting works to provide financial information to entities outside of the organization for specific purposes. Financial accounting provides reports to help investors assess the financial performance of the company. These reports include information on assets, liabilities, equity, and the entity’s overall financial health. General and specialized financial accounting rules are ascertained through Generally Accepted Accounting Principles in the US and the International Financial Reporting Standards. To ensure that reports are clear, concise, and useful to end users, financial accounting has a set of general rules known as the conceptual framework. Following the rules creates consistency and allows for comparability between financial records. In financial accounting, all accounting transactions are measured in monetary terms and are then recorded to general ledger accounts. The results of these journal entries are then transferred to financial reports and compiled into statements. Monetary unit, historical cost, revenue recognition, full disclosure, materiality, and conservatism are accounting principles that are used in this process.

According to the American Institute of Certified Public Accountants (AICPA), “Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions, and events which are, in part at least of financial character, and interpreting the results thereof.” AICPA has been responsible for setting accounting principles for many years and recognizes the importance of accounting in the economic life of all countries. The basic function of accounting is to relate the results of economic activities to decision makers in both the private and public sectors. It is also to illustrate the organization of business activities in an economy. Accounting plays many functions in the lives of entrepreneurs, managers, investors, and public officials; hence it is an important tool for decision making.

3. Role of Financial Accounting in Decision Making

Every report included in the financial statements of a company is necessary to answer the following broad questions of the users of those reports: What is your financial position and operating results as of the most recent balance sheet and statement of operations dates? In attempting to answer that broad question and the beauty of the traditional structure of the Income Statement, the Income Statement lays out the answer to this broad question. The time periods are usually the fiscal year or quarter. The income statement answers it by using various revenue and expense accounts as well as gains and losses accounts. The expenses are identified with the main business of a company. Some of the expenses are also related to earning the revenue. The expenses are matched or allocated to a specific period and are written off against revenue earned during that period. Otherwise stated, earning of revenue and incurring of expenses are closely associated or related together.

Business organisations, in the free enterprise, are constantly interacting with the environment as dynamically as to result in a continuous exchange of feedback. During the process of this interaction, a business makes certain decisions, which in turn have an effect on the environment. Under this situation, the business organisations, unless they are in a position to measure, evaluate and monitor their operations, will not be in a position to take appropriate decisions. The measurement and the communication of the information about economic entities are the prime functions of accountants who do this through the preparation of financial reports. The accounting professional need not just be an order-taker, but they need to be aware and pay attention to the old phrase: “Let the buyer be ware”.

4. Limitations of Financial Accounting

Another major limitation of financial accounting is that it is historical in its nature. Financial accounting reports on the financial effects of dated past transactions, actions, dispositions, and events. Except for those events charged directly to stockholders’ equity (such as equity event, transactions with stockholders), financial accounting reflects the past, rather than the future. The past performance of a business is often useful in making predictions about its future. An investor may use the trailing five years of earnings per share as a point of reference in comparing projected future earnings with current share prices. Since potential investors, creditors, customers, and others are concerned with the future, not with the past, financial accounting only partially meets their needs. Nonetheless, unless investors, creditors, employees, and others understand the transactions of the past, they may be poorly positioned to understand the future and the future implications of past events.

A major limitation of financial accounting is that it is designed to meet the needs of external users. This characteristic is both a limitation and an advantage. The primary function of financial accounting is to provide relevant financial information to external users in making investment, credit, and similar decisions. The volume and nature of the information provided are regulated by an overseeing body. Many internally reported items have no effect on externally reported results: whereas employees, customers, and managers may require information about internal profits, such profits are not reported externally until they affect long-term results. The emphasis placed on the needs of external users implies that the items of direct concern to external users are given primary attention. Other items are generally focused upon only to the extent that they are needed to account for items of immediate external concern.

5. Conclusion

Risk should be, and has been, a major driver of models of equity market risk premiums. That is, the standard risk and return relations suggest that firms and projects earning their revenues during times when markets require compensation for exposure to risk naturally better explain observed equity market rates. Employing a rich dataset that features real options to postpone investments and a new measure of aggregate economic uncertainty, we find evidence consistent with the predictions of models of the real effects of financial accounting information that extends prior evidence for discretionary real actions of managers that are also increasingly recognized as a major driver of the real effects of financial accounting information. In response to economic uncertainty, future market prices fall while managers are granted more options to delay investment. These additional real options to invest appear to serve as a buffer on the demand for additional capital financing, which, in turn, reduces the degree to which equity market participants demand compensation for providing capital to the firm.

In this chapter, the authors have reviewed internal and external financial reporting and how managers rely on financial accounting to measure risk and performance. The discussion can serve as a rudimentary introduction to the many critical details, standards, qualifications, and nuances of financial reporting, including differing regulations across countries. However, the overview is sufficient for readers to appreciate the motivation for the research and provide necessary priority for issues related to integrating financial accounting and risk management. Notwithstanding the extensive research already performed in this area, how critical risk measurement can be to the enhancement of the accounting information system stands out as an open research question. We appreciate that the effort faces numerous hurdles, among them the need for greatly improved inputs for modeling prices of assets, often with very limited transaction data, and for more robust measures of dependence, particularly in financial entities that may be linked intrinsically and in many directions.