The advantages and limitations of accounting

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The Accounting Structure

According to American Institute of Certified Public Accounts, "Accounting is the art of recording, classifying and summarising, in a significant manner, and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof." Accounting is concerned with the analysis and interpretation of the recorded accounting information.

OBJECTIVES OF ACCOUNTING: The main objectives of accounting are:

To maintain accounting records: There should be no doubt that written records or information is always better than the information based on memory. Because only written records can be used by the persons interested in accounting information. Moreover, the large number of transactions in almost every type of business organisation cannot be simply kept in human theory.

To calculate the profit for the given period: This is done by preparing profit and loss account at regular intervals, say at the end of each accounting period.

To calculate the financial position: The financial position of the firm can be calculated by preparing the balance sheet on a particular date.

To communicate the accounting information: The accounting information must be communicated to different persons such as creditors, investors, bankers, government, etc.

To provide additional information: Accounting must provide additional information for research purposes by making special disclosures.

FUNCTIONS OF ACCOUNTING: Financial accounting performs the following major functions:

Maintaining systematic records: Business transactions are properly recorded, classified under appropriate accounts and summarised into financial statements - income statement and balance sheet.

Communicating the financial results: Accounting is used to communicate financial position information in respect of net profits (or loss), assets, liabilities, etc. to the interested parties.

Meeting legal needs: The provisions of various laws such as Companies Act, Income Tax and Sales Tax Acts require the submission of various statements, i.e., annual accounts, income tax returns, returns for sales tax purposes, etc.

Protecting business assets: Accounting maintains proper records of various assets and thus enables the management to exercise proper control over them with the help of following information regarding them:

How much is the balance of cash in hand and cash at bank?

What is the position of inventories?

How much money is owed by the customers?

How much money is owing to the creditors?

What is the position of various fixed assets and how these are being used?

Stewardship: In the case of limited companies, the management is entrusted with the resources of the enterprise. The managers are expected to act true trustees of the funds and the accounting helps them to achieve the same.

Fixing responsibility: Accounting helps in the computation of the profits of different departments of an enterprise. This would help in fixing the responsibility of departmental heads.

ADVANTAGES OF ACCOUNTING: The main advantages of accounting are:

Assistance to management: The accounting information helps the management to plan its future activities by preparing budgets in respect of sales, production, expenses, cash, etc. Accounting helps in coordination of various activities in different departments by providing financial details of each department. The managerial control is achieved by analysing in money terms the departures from the planned activities and by taking corrective measures to improve the situation in future.

Records rather than memory: It is not possible at all to do any business by just remembering the business transactions which have grown in size and complexity. Transactions, therefore, must be recorded early in the books of accounts so that necessary information about them is available in time and free from bias.

Intra - period comparisons: Accounting information when recorded properly can be used to compare the results of one year with those of previous year(s).

Aid in legal matters: Systematically recorded accounting information can be produced as evidence in a court of law.

Help in taxation matters: Income tax and sales tax authorities could be convinced about the taxable income or actual turnover (sales), as the case may be, with the help of written records.

Sale of a business: In case, a sole trader or partnership firm or even a company wants to sell its business, the accounting information can be utilised to determine proper value of the business.

LIMITATIONS OF ACCOUNTING: Accounting suffers from the following limitations:

Accounting information is expressed in terms of money. Non - monetary events or transactions, however important they may be, are completely omitted.

Fixed assets are recorded in the accounting records at the original cost, that is, the actual amount spent on them plus, of course, all incidental charges. In this way the effect of inflation (or deflation) is not taken into consideration. The direct result of this practise is that balance sheet does not represent the true financial position of the business.

Accounting information is sometimes based on estimates which are often inaccurate. For e.g., it is not possible to predict with any degree of accuracy the actual useful life of an asset for the purpose of depreciation expense.

Accounting information cannot be used as the only test of managerial performance on the basis of more profits. Profit for a period of one year can readily be manipulated by omitting such costs as advertisement, research and development, depreciation, etc.

Accounting information is neither neutral nor unbiased. Accountants calculate income as excess of revenue over expenses. But they consider only selected revenues and expenses. They do not include cost of items like, water or air pollution, employee's injuries, etc.

Accounting like any other discipline has to follow certain principles which in certain cases are contradictory. For e.g., current assets are valued on the basis of cost price or market price whichever is less following the principle of conservatism. Accordingly the current assets may be valued on cost basis in some year and at market price in another year. In this way, the rule of consistency is not followed regularly.