Business, Accounting and Financial Studies | Purposes and Role of Accounting

BAFS Study Notes: Purposes and Role of Accounting

Welcome to the world of accounting! Don't worry if it sounds complicated; it's actually a logical and powerful tool. Think of it as learning the 'language of business'. In these notes, we'll explore what accounting is, why it's so important for making smart decisions, and the key steps involved. Let's get started!

Why Does Accounting Matter? It's All About Making Smart Decisions!

At its heart, accounting is the process of recording, summarising, and communicating financial information about a business. It's like a fitness tracker for a company—it measures performance (profit), checks its condition (what it owns and owes), and helps it plan for the future.

This information is crucial for various people, who we can group into two main categories: internal users and external users.

1. Internal Users (The Insiders)

These are the people working inside the business who need information to run it effectively.

Who are they?

- Owners & Managers: The people in charge of daily operations and long-term strategy.

What decisions do they make?

- Should we increase the price of our product? (They need to see cost and sales data.)
- Can we afford to hire more staff or give a pay rise? (They look at profits and cash.)
- Which of our shops is performing the best? (They compare the financial results of different branches.)
- Do we have enough cash to pay our bills next month? (They need to manage cash flow.)

2. External Users (The Outsiders)

These are individuals and organisations outside the business who are interested in its financial health for their own reasons.

Who are they and what do they want to know?

- Investors: "Should I invest my money in this company? Will I get a good return?" They look at profitability and stability.
- Lenders (like banks): "If we lend money to this business, can they pay it back with interest?" They check the company's ability to repay debt.
- Suppliers: "Should we sell goods to this business on credit? Are they reliable payers?" They want to be sure they will get paid for their goods.
- Government (e.g., Inland Revenue Department): "How much profit did the company make? How much tax do they owe?" They use financial reports to ensure the correct amount of tax is paid.

Key Takeaway

Accounting isn't just about numbers; it's about providing the right financial information to the right people at the right time so they can make smart, informed decisions.

The Four Key Jobs of Accounting (Its Functions)

To provide this useful information, accounting performs four main functions in a logical order. A great way to remember them is with the mnemonic RCSC:

Really Cool Students Communicate!

1. Recording

This is the starting point. Every single financial transaction a business makes is written down. A transaction is any event that has a financial impact, like making a sale, buying materials, or paying rent.

Analogy: Think of it like keeping a personal diary of every dollar you spend and earn each day. You record the date, what it was for, and the amount.

2. Classifying

Once transactions are recorded, they need to be sorted into meaningful groups or categories. All sales transactions go together, all rent payments go together, all electricity expenses go together, and so on.

Analogy: After writing in your diary, you group your spending into categories like 'Food', 'Transport', and 'Entertainment' to see where your money is going.

3. Summarising

Raw data is not very useful. In this step, the classified information is organised and presented in a clear and understandable format. This involves preparing key reports and financial statements.

Analogy: At the end of the month, you create a simple summary table showing the total amount you spent on 'Food', 'Transport', etc. This is much easier to understand than reading every single diary entry.

4. Communicating

This is the final and most important function. The summarised financial information (the financial statements) is shared with the internal and external users who need it to make their decisions.

Analogy: You show your monthly spending summary to yourself to decide on a budget for next month, or perhaps to your parents to discuss your allowance!

Quick Review: The 4 Functions

- Recording: Write down all transactions.
- Classifying: Group similar transactions together.
- Summarising: Present the data in reports.
- Communicating: Share the reports with users.

The Accounting Cycle: From Daily Sales to Annual Reports

Businesses repeat the accounting functions in a continuous process each financial period (e.g., every year). This process is called the accounting cycle. It's the journey that a single transaction takes to become part of the final company reports.

Analogy: Think of the school year. You have daily lessons (recording), you organise your notes by subject (classifying), you study for exams (summarising), and you get a final report card (communicating). The accounting cycle is the business version of this!

Here are the key steps in the flow, as required by the syllabus:

Step 1: Books of Original Entry

This is where transactions are first recorded chronologically (in date order). Examples include the cash book or sales journal. It's the business's financial diary.

Step 2: Ledgers

The information from the books of original entry is then 'posted' to ledgers. Ledgers are where transactions are classified by account type. There will be a separate ledger account for 'Cash', 'Sales', 'Rent Expense', etc.

Step 3: Trial Balance

At the end of the period, a trial balance is prepared. This is a list of all the accounts from the ledger and their balances. Its main purpose is to check that the accounting records are arithmetically correct before preparing the main reports. It's an important internal check.

Step 4: Period-end Adjustments

Sometimes, at the very end of a period, adjustments are needed to make sure all revenues and expenses for that period are correctly reported, even if the cash hasn't been received or paid yet. This is a key step to ensure the financial reports are accurate.

Step 5: Financial Statements

This is the final output! The adjusted information is used to prepare the financial statements. This is where the summarising and communicating functions happen. The two most important statements are:
- Income Statement: Shows the company's financial performance (revenue, expenses, and profit/loss) over a period of time.
- Statement of Financial Position (or Balance Sheet): Shows the company's financial position (assets, liabilities, and capital) at a single point in time.

Key Takeaway

The accounting cycle is a systematic, step-by-step process that ensures all transactions are properly handled, from initial recording to their final presentation in the financial statements that people use for decision-making.

The Flow: Books of Original Entry -> Ledgers -> Trial Balance -> Period-end Adjustments -> Financial Statements

Did you know?

The system of accounting we use today, called double-entry bookkeeping, was first documented in detail by an Italian mathematician named Luca Pacioli in 1494. That's why he is often called the "Father of Accounting"!