USE OF FINANCIAL ACCOUNTING INFORMATION

Appropriate use of financial accounting information requires a knowledge of the characteristics and limitations of financial accounting. Financial accounting information is produced for certain purposes by the use of conventional principle. Use of the information for other purposes of without a general knowledge of its characteristic and limitations may lead to misinterpretation and errors.

An important characteristic of financial statements, for example, is that the information they contain describes the past, while decision making is oriented toward the future. A record of past events and a knowledge of past position and changes in position, however, help users evaluate prior decisions and this information is also a starting point for users in predicting the future. Decision makers should not assume, however, that the conditions that produced past results will necessarily continue in the future.

Financial statements are designed to provide an important part of the information that users need for many of their decision. The information contained in the statements should not be relied on exclusively, however, and should be supplemented by other information about the specific prospects of the company, the industry in which it operates, and the economy in general.

A knowledge of the characteristics and limitations of financial statements also helps users avoid putting undue reliance on single measures or the results of a single year, for example, should not be overemphasized since these amounts are derived from complex computations, are based on estimates and judgments, and often have their meaning modified by information in the notes to the financial statements. In reaching decisions users should consider movements and judgments, the possible effects of information disclosed in notes and similar factors.
Reference: Commerce Clearing House, Inc, Chicago, 1980, “Professional Standards Volume 3 Accounting”.

Accounting As The Basis For Business Decisions

How do business executives know whether a company is earning profits or incurring losses? How do they know whether the company is solvent or insolvent, and whether it probably will be solvent, say, a month from today? The answer to both these question in one word is accounting. Accounting is the process by which the profitability and solvency of a company can be measured. Accounting also provides information needed as a basis for making business decisions that will enable management to guide the company on a profitable and solvent course.
For specific examples of these decisions, consider the following questions.
1. What prices should the firm set on its products? If product is increased,
2. What effect will this have on the cost of each unit product?
3. Will it be necessary to borrow from the bank?
4. How much the costs increase if a pension plan is established for employees?
5. Is it more profitable to produce and sell product A or product B?
6. Shall a given part be made or be bought from suppliers?
7. Should an investment be made in new equipment?

All these issues call for decisions that should depend, in part at least, upon accounting information. It might be reasonable to turn the question around and ask: What business decisions could be made intelligently without the use of accounting information? Examples would be hard to find.
In large-scale business undertakings such as the manufacture of automobiles or the operation of nationwide chains of retail stores, the top executives cannot possibly have close physical contact with and knowledge of the details of operations. Consequently, these executives must depend to an even greater extent than the small business owner upon information provided by the accounting system.
We have already stressed that accounting is a means of measuring the results of business transactions and of communicating financial information. In addition, the accounting system must provide the decision maker with predictive information for making important business decisions in a changing world.
Reference : Walter B. Meigs, Robert F. Meigs, McGraw-Hill Book Company New York, 1987, “Financial Accounting”.

FINANCIAL ACCOUNTING

Two Primary Business Objectives
The management of every business must keep foremost in its thinking two primary objectives. The first is to earn a profit. The second is to stay solvent, that is, to have on hand sufficient cash to pay debts as they fall due. Profits and solvency, of course, are not the only objectives of business managers. There are many others, such as providing jobs for people, protecting the environment, creating new and improved products, and providing more goods and services at a lower cost. It is clear, however, that a business cannot hope to accomplish these objectives unless it meets the two basic tests of survival operating profitably staying solvent.
A business is a collection of resources committed by an individual or group of individuals, who hope that the investment will increase in value. Investment in any given business, however, is only one of a number of alternative investments available. If a business does not earn as great a profit as might be obtained from alternative investments, its owners will be well-advised to sell or terminate the business and invest elsewhere. A business that continually operates at a loss will eventually exhaust its resources and be forced out of existence. Therefore, in order to operate successfully and to survive, the owners or managers of an enterprise must direct the business in such a way that it will earn a reasonable profit.

Business concerns that have sufficient cash to pay their debts promptly are said to be solvent. In contrast, a company that finds itself unable to meet its obligations as they fall due is celled insolvent. Solvency must also be ranked as a primary objective of any enterprise, because a business that becomes insolvent may be forced by its creditors to stop operations and its existence.
Reference : Walter B. Meigs, Robert F. Meigs, McGraw-Hill Book Company New York, 1987, “Financial Accounting”.