Financial accounting is one kind of accounting different from the management accounting in the accounting system. As management accounting is for “internal” whereas financial accounting is for “external”. The following is a detailed explanation and analysis of the major objective and role of financial accounting. The purpose of financial accounting is to measure the performance of the entity and therefore provides the financial information to different stakeholders.
Stakeholders will have their decision – making according to the financial report issued. James, Arthur and Robert(1978) have stated that: “Most decisions are made on the basis of summary-type reports rather than firsthand information. ” A comprehensively summarized financial report provides interaction of firm and stakeholder. Before more deeply understanding financial accounting, it needs to first know that what relevant information is when taking about financial accounting. Financial report is composed by a great deal of relevant information.
Relevant information is that information must fulfill two fundamental qualitative characteristics, Relevance and Faithful representation, and have necessity to conform several enhancing qualitative characteristic to ensure its usefulness. According to Statement of FASB (2010), Relevance means financial information should be capable of making a difference in the decisions made by users. For example, to replace old equipment, the relevant information is the cost of the new equipment but not the original cost of the old equipment.
Also, to ensure the financial information is capable to make a difference, it should have either predictive value or confirmatory value: the former is about users’s anticipation of an entity’s prospect and the latter is about providing feedback for users to examine whether their prediction suits the present, or in other word, compare the reality with their prediction. Besides this, Faithful Representation make up the inadequacy of relevance characteristic. It requires that the information must be complete, neutral and accurate. For “complete”, it means information is able to completely eflect the financial phenomenon. “Neutral” means information need to be objective and no involvement of personal prejudice. “Accurate” refers to having no material error (FASB 2010, p17). So faith representation is one indispensable element to support the reliability of relevant information. However, having relevance and faithful representation does not mean that information can be used without any suspension. If information also possesses some enhancing qualitative characteristics, there will be a large degree of improvement.
The first one is timeliness, information should be more updated to meet the current environmental requirement. Outdated information cannot help users to take action correctly. Also, it should be comparable. So information users can distinguish similarities and differences among information. The advantage is that it can produce a more objective outlook since comparability of information enable users pick up the reasonable parts of different information and combine them. At the same time, users neglect the unreasonable ones.
On top of this, information needs to be understandable. It means information should be clear to make user easier to understand (Walter , Charles and William 2010). Now, it will analyse which types of people use the financial report and why the financial market needs the financial report. There are a large number of decision makers using financial information, like investors, creditors, government, employees, community. In terms of urgency, the investors and creditors may have critical need for the financial information (FASB 2010).
If the financial report reveals that the financial position of the company is pessimistic, it alerts investors to reduce the investment and creditors to recover the debt to prevent the loss. There are also some examples to explain more about this issue. Information of cash flow can help users evaluate its financial activities. Moreover, if the current ratio is too low, it shows that the corporation may have financial difficulty. Moreover, there are also some of the other external users. Their need to receive financial information is not immediate, but also important.
As the regulatory body, government is responsible for monitoring different companies so as to maintain the financial stability. More than that, the listed companies which issue their shock publicly usually need to report their activities to the government. The community can distinguish whether the company’s finance is steady through financial report and therefore the community’s feelings can directly influence the image of the company. The employee can use information to know the possibility of bankruptcy of their company to decide whether they should leave the company to prevent the wages.
Suppliers may pay attention to the cash flow of the buyers so that they can decide whether provide the trade credit to it. In fact, financial accounting provides a great deal of assistance in efficient resources allocation. It can be explain in “external” and “internal”. “External” means social resources allocation. The effective use of social resources is from entrepreneur and market, but not the government. Companies can use financial statement to induct capital to a correct direction because users will use financial information for the best investment to maximize their benefits.
It helps to avoid the loss of resources in the economy. It can see that financial accounting lead to an efficient social resource allocation. In terms of “internal”, Companies will understand what is lacking when they want to achieve the maximum of income or make ends meet. Sometimes it may involve the managers because managers are also part of the human resources. For example, shareholders who vote on whether to retain or replace directors and decide how members of management should be rewarded for their services need financial to make their decision.
Along with this, because of limited resource, businesses need to consider ways to create effective production combination. It can be well reflected in liquidity ratio. If the firm’s current ratio is too high, it reveals that the excess current asset probably have an adverse effect on the long-run profitability. Since there may be too much cash held, it lose the chance to receive interest on fixed investment. So the firm need to consider put some current asset into long-term investment. Another example is the ROA which measures how efficiently a firm has used its resources to generate profit.
When ROA reported by a financial statement is unsatisfactory, there is a warning to the firm’s ways to use its total asset. So the firm will discover its resources allocation problem and can seek way to overcome it. Generally, financial accounting is closely related the stakeholder of a firm. It provides financial information to external users to evaluate and predict its performance. Any unfairness, subjectivity, incompletion and human manipulation will greatly destroy the reliability of financial accounting. The victims will not be only the external users, but also business itself.
James J, Arthur J and Robert H(1978).Financial accounting.Dame publications Inc.
Walter T, Charles T and C. William(2010).Financial accounting,8th edition. Pearson Education Inc.
Chapter 3: Qualitative Characteristics of Useful Financial information(2010).Statement of Financial Accounting Concepts No.8. Financial Accounting Standards Board.