The importance of accounting information - Essay Example

 Contents Introduction 2 Accounting Information and its Importance to Various Users 2 Sources of Income Generation 3 Financial Ratios and Decision Making 4 Accountant’s Role in Financial Analysis 6 Relevancy and Irrelevancy of Some Costs 6 Conclusion 7 References 8 Introduction Accounting information is very important for an organization as it helps to understand its financial health. Accounting information caters to the need of numerous stakeholders of an organization and different users use it for different needs. This paper is aimed at understanding the importance of accounting information along with its various aspects such as financial ratios, costs, etc. Accounting Information and its Importance to Various Users Accounting is best defined as the process of “identifying, measuring and communicating economic information to permit informed judgements and decisions” (Godwin & Alderman, 2010) by the users of the information. Hence accounting information is very useful to its various users as it helps them to make informed and calculated decisions. All stakeholders of an organization including the shareholders are potentially users of accounting information. Following are some of the user of this information: decision makers inside the organization (such as the directors, managers, etc.), employees, shareholders, customers, lenders, shareholders, suppliers, etc. Traditionally anybody who is interested in the activities and performance of an organization is a stakeholder. Accounting information is useful to different users in a different way. Accounting information such as cash inflows, expenses, fixed assets, liabilities, operating profits, can be used by decision makers inside an organization to make critical decisions such as future investments, pricing strategies, expansion plans, etc. Employees of an organization can use accounting information to analyse the financial and commercial success of a company and in turn understand the security with respect to the job that the organization promises. Lenders and suppliers can use the information to analyse the financial health of the company before lending loans and materials to the organizations. One of the primary users of the accounting statements are the current shareholders and prospective investors who use information such as profits margins and return of shareholders equity to make their investments decisions. Hence accounting information caters information to different users in different ways. In simple words, the accounting information of an organization makes it accountable to its various stakeholders (McLaney & Atrill, 2010). Sources of Income Generation For an organization to financially successful in the long term, it is very important to create more than one source of income. There are various ways in which an organization can create different sources of income. Following are some of the sources of income that an organization can generate: product sales revenue, services rendered fees, owned and copyrighted works generate royalties, interests from investments, releasing equity from existing assets, asset management, etc. The primary source of income for any organization is either the revenue from product sales or a service rendered fees and in some cases both. Every organization is built on a product or a service. Therefore, the organization has to look into maximise its income from these activities. Another income source of an organization is to make calculated investments which earn interests for the organization and will make it profitable in the long run. An organization can invest/fund new companies that have the potential to be profitable, invest in assets that can generate revenue, etc. Own and copyrighted works are an important way of generating income. This will mean that the organization with literally zero effort can create a revenue source for the efforts already put in. For example, the organization can allow other responsible companies to use the organization’s brand name or a patent and in return receive royalty for it. Every organization has some kind of an asset that is not being fully utilized. For example an equipment or even office space is not used to its full potential. In such cases, the asset can be leased or rented out to generate income. In some cases, existing unwanted assets can be sold and the resulting income can be investing in short term income generating sources. There are other sources of income that organizations can generate depending on the nature of its business and the market that it operates in. The various sources of income generation discussed above of different nature. Some account for the primary and long term income of an organization while others are short term and temporary. Therefore, it is very important for an organization to differentiate these different sources so that there would be financial clarity and also useful in making future projections (McLaney & Atrill, 2010). Financial Ratios and Decision Making Financial ratios play an important role in decision making as it enables us to make comparisons between financial performances of: A company at different time periods. A single company and its industry average Different companies Different industries Knowledgeable comparisons can be made by using financial ratios from a company’s financial statements which help us to analyse both positive and negative trends in the financial performance. Following are the some of the financial ratios that are commonly used: Performance ratios Common size ratios Solvency ratios Liquidity ratios Working capital ratios Operating ratios (Robinson et al., 2008) Let’s take the example of common size ratios and solvency ratios. Two common size ratios that are very important are net profit margin and gross profit margin ratios. Even a small change in gross profit margin ratio means that the profits of the organization have declined drastically. This means that there is something wrong and the management must start examining expenses and other aspects that could have lead to the change. Therefore, this helps in the decision making process how to manage the operations. It is important to look into these ratios and see if the fluctuations are favourable or not. On the other hand, solvency ratios indicate the stability of an organization and its ability in repaying debts. Therefore, solvency ratios are a strong indicator of the viability and financial health of an organization. This process of comparing solvency ratios helps the decision making to decide on further acquiring of loans and expenditures of the organization. Based on the solvency ratios, an organization can be more aggressive in its style of business or play safe and try to repay all debts. Accountant’s Role in Financial Analysis Financial ratios can only highlight the significant trends in the financial performance of an organization but the responsibility to identify the reason behind the trends falls upon the accountant. The purpose of the financial ratio analysis not just to collect statistics but to use it to find trends that are making an impact on the company’s performance and then respond to it accordingly. An accountant has to analyse the financial ratios and compare it with the percentages with the previous years. An accountant has to ask himself if the fluctuations are positive or negative and try to find answers why there is a difference in the ratios. It is by comparing financial ratios and analysing it that an accountant can find the reasons behind the trends. For example, if there is a decline in gross profit margins then organization must be indulged in undue expenses. So, the accountant has to analyse the various expenses and find out where exactly the organization is not monitoring its expenses. Relevancy and Irrelevancy of Some Costs There are numerous costs that are part of business operations but when it comes to decision making, some are relevant and some are irrelevant. To know which costs are relevant and which are not is important for successful decision making. Relevant costs are those which would incur based on the decision making. On the other hand, irrelevant costs are those that are not affected irrespective of the decision made (Tracy, 2008). For example, let’s assume that an organization plans to increase the number of units of its products that it is producing in order to increase its sales revenue. It expects the price of raw materials to go up in the near future. The nature of the manufacturing process is such that the organization can produce the desired number of extra products without actually increasing its workforce. That is, it can produce more products with the same workforce that is producing the current products. In this example, costs of the raw materials are relevant costs as if it is not considered during decision making, then the profit margin can be affected negatively to negate the rise in the cost of raw materials. On the other hand, the associated spending on the workforce remains the same irrespective of organization deciding on increasing the output or not. Therefore, the spending on the workforce is the irrelevant cost in this scenario. Conclusion This paper has successfully addressed various questions such as the importance of accounting information to various users, usefulness of financial ratios, how to identify reasons behind trends identified by analysis of financial ratios and difference between relevant and irrelevant costs. The paper has also identified different sources income generation for an organization. References Godwin, N.H. & Alderman, C.W. (2010). Financial ACCT 2010. OH: Cengage Learning. McLaney, E. & Atrill, P. (2010). Accounting: An Introduction. NJ: Financial Times Prentice Hall,. Robinson, T.R., Greuning, H.V., Henry, E. & Broihahn, M.A. (2008). International financial statement analysis. NJ: John Wiley & Sons. Tracy, J.A. (2008). Accounting For Dummies. NJ: Wiley Publishing Ltd. Read More