Accounting Essay: Importance of Accounting Information

2021-07-20 15:03:33
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Accounting can be defined as the process through which economic information is identified, measured and recorded and communicated to different stakeholders to aid in making informed decisions (Edwards 2013). Hoggett (2014) defines accounting information as a product of accounting. It is the financial information of the economic transactions and activities by a company. Accounting information is always reported and presented in a unique way set out by the different International Financial Reporting Standards (IFRS) and the International Accounting Standards Board (IASB). Accounting information has many users such as the management, the government, potential investors, employees, creditors and financial institutions, use accounting information.

Different users depend on accounting statements and reports to make different decisions. The management utilises accounting information to control and monitor the operations of the company. This information enables the management to identify the organisations strengths and weaknesses. The government determines whether taxes declared and paid by a company are correct using accounting information (Efendi 2007). As a potential investor, one needs to know the financial position and performance of a company before making an investment decision. Accounting provides investors with such information so that they can make informed investment decisions. The employees being the most important asset of a company need to be assured of stability of tenure. Employees determine the stability of the operations of the company using financial statements and reports. A more stable company offers more stable employment to the employees. This will, in turn, lead to a lower employee turnover. Companies may not always disclose all the information regarding their taxes. This may lead to tax evasion. Therefore the government may not always depend on financial statement to determine the taxes to be paid by a company. Organizational monitoring and control cannot be completely dependent on financial statements because organizational structure and environmental factors affecting business operation. Investment decisions by investors are determined not only by accounting information but also other factors such as time and volume of investment. The stability of an employees employment is not always dependent on a companys financial information. Employment is variable and can be affected by other factors such as health of employees.

Creditors supply goods and services to a company anticipating some future payment. Without awareness about a particular company, creditors can incur loses if they supply to a company that is not able to pay. The decision to supply goods and services on credit is dependent on the financial ability of a company. Financial Institutions such as banks and Saccos provide a lot of financial support to companies in form of loans. Such financial institutions need to know whether a company will be able to service their loans. The ability of a company to pay monthly installments to settle a loan can be determined from a company's accounts. Different companies in an industry always compete with one another. Information is very vital when it comes to competition. A company designs competitive strategies depending on their competitor's accounting information.

Reliability of Accounting Information

It is clear that many stakeholders rely on financial information to establish the financial performance of a company and make economic and financial decisions. Financial statements are part of accounting information. The statement of financial position of a company, which is one of the financial statements, is always based on the principle, which states that all total assets should be equal to a sum of equity and all liabilities (Weygandt et al., 2010). This always gives a true representation of the financial position. All users can always rely on the statement of financial position to make economic decisions. This is because a companys capital and liabilities should not exceed the available assets. If a company has, an asset base of four million and it has liabilities and capital totaling to five million, then one can confidently say that the company is making losses and cannot meet both short and long-term financial obligations. An example can be shown by an investor who decides to invest in a firm based on the balance sheet figures.

The second financial statement is the statement of comprehensive income. The statement of comprehensive income shows the net profit obtained after deducting all the expenses (Healy and Palepu, 2012). This financial statement is very important as it shows the whether a company is making profits or losses. The statement of comprehensive income gives a fair view of the company's financial performance. Given an example that a company has a Gross profit of two million and has a total expenditure of three million, the statement of comprehensive income will show a loss of one million. This information is accurate and highly reliable. A company cannot make profits if it does not make excess income to cater for expenses and surpass the breakeven point. The owners of a company can always rely on this statement to determine the performance of their company. Many companies declare their profits though the preparation of a comprehensive income statement.

Statement of cash flows are controlled by the international accounting standard 7 (IAS 7). The statement of cash flow is another financial statement that shows the effect of income and the accounts of the balance sheet on the cash and cash equivalents (DiTommaso et al., 2017). This statement categorises financial activities into three groups, which are operating, investing and financing activities. Creditors and lenders need this financial statement to understand whether a company will be able to repay and meet short-term financial obligations such as salaries. Potential investors use the statement of cash flows to judge if a company is financially viable for investment. If the net cash flow from the three activities is negative, it indicates that the company is not able to fund all the operations (DiTommaso et al., 2017). A positive cash flow statement indicates that the company is able to fund all the operations. This statement provides conclusive accounting information that is a true reflection of the companys liquidity. It is impossible for a company to have a negative cash flow statement and be able to finance all the financial activities within the company.

Changes occur from one accounting period to another due to economic activities of a company. The statement of changes in equity illustrates how the financial operations of a company have changed the owners equity. It explains the changes in owners equity and the process of retained earnings. Retained earnings are surplus profits from one period to the next period. The owners equity is the difference between a companys assets and liabilities (Ramiro and Ganan, 2010). This statement is very crucial especially to the owners of the company. Increased owners equity indicates that the owners investment is growing in value and a decrease in the same indicates the company performance is declining.

As part of accounting, financial ratios are obtained from financial statements (Lewellen, 2004). Financial ratios are often used in accounting to predict and evaluate the financial condition and performance of the company. Different ratios can be used to evaluate the strengths and weaknesses of a particular company. There are four categories of ratios in accounting, which are, liquidity ratios, activity ratios, profitability ratios and market ratios.

Liquidity ratios measure the cash equivalence of a company. Liquidity of a company shows the ability to pay debts (Saleem and Rehman, 2011). A company that has high liquidity has the ability to settle debts. The major liquidity ratios include the cash ratio, current ratio and the quick ratio. The current ratio is obtained by dividing all current assets with current liabilities. This ratio measures the ability of the company to meet its short-term obligations. A higher current ratio shows higher liquidity which in translates to availability of finances to settle current liabilities. This ratio is very important to creditors in evaluating the companys ability to short-term credit. All other users can rely on the current ratio to make decisions, as it is a direct translation of the companys liquidity. The cash ratio, operating cash flow ratio and the quick ratio are all measured against the companys current liabilities. Activity ratios are also known as the efficiency ratios. They measure how fast a company converts the non-cash assets into cash. Activity ratios show the ability of the company to generate revenue. Among the activity, ratios are the average collection period ratio, the degree of operating leverage ratio, asset turnover ratio, stock turnover ratio, inventory conversion ratio and the cash conversion cycle. Efficiency ratios help the management to determine if the company will generate enough revenue to keep the company operating. A good example for the use of the cash ratio is a creditor who decides not to supply goods on credit to a company as a result of their low cash ratio.

As the name suggests, profitability ratios measure profitable a company is. Among the profitability ratios are the gross margin ratio, operating margin ratio, profit margin ratio return on equity ratio and return on assets ratio. The profitability ratios assist potential investors in making investment decisions to select the most profitable companies. The financial information obtained from profitability ratios is important to all other users who require information regarding the companys profitability. For a company to maintain daily operations, the company should be able to achieve long-term goals as well as settle long-term liabilities. Debt ratios are used to measure the financial leverage of a company and the companys ability to pay long-term debts. Among the debt ratios are the debt to equity ratio, debt service coverage ratio and the long-term debt to equity ratio. This information is of great importance to the creditors and financial institutions.

Conclusion

The accounting process utilizes unique procedures to generate financial information. These accounting standards have been designed to ensure that the financial statements, financial ratios and other financial information give a true reflection of the financial position of an organisation. Considering that accounting information is obtained from financial statements, people without any accounting information knowledge will be unable to understand financial statements. This will be foreign jargon to them. Therefore, it follows that all users can rely on accounting information to make informed decisions as the accounting information is assured of quality by the different accounting standards and procedures that govern accounting.

 

Reference list

DiTommaso, M., Ruppel, W. and Larkin, R.F., 2017. STATEMENT OF CASH FLOWS. Wiley NotforProfit GAAP 2017: Interpretation and Application of Generally Accepted Accounting Principles, pp.41-56.

Edwards, J.R., 2013. A History of Financial Accounting (RLE Accounting) (Vol. 29). Routledge.

Efendi, J., Srivastava, A. and Swanson, E.P., 2007. Why do corporate managers misstate financial statements? The role of option compensation and other factors. Journal of Financial Economics, 85(3), pp.667-708.

Hoggett, J., Edwards, L., Medlin, J., Chalmers, K., Hellmann, A., Beattie, C. and Maxfield, J., 2014. Financial accounting.

Healy, P.M. and Palepu, K.G., 2012. Business analysis valuation: Using financial statements. Cengage Learning.

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