Advantages and Limitations of Accounting – SS1 Financial Accounting Lesson Note (First Term)

Accounting is the process of recording business transactions in money terms and reporting the profit or loss, assets, liabilities and financial position of a business.

Behavioural objectives

1. State the advantages of accounting.
2. Explain how accounting helps in decision making, tax assessment and planning.
3. State the limitations of accounting.
4. Explain why accounting is limited to monetary transactions.

What key terms should you know?

These terms are used throughout the topic.

• Transaction: an exchange of money or goods and services, such as a sale, a purchase or a payment of wages.
• Asset: something of value owned by the business, such as cash, stock, a shop or a vehicle.
• Liability: an amount the business owes to others, such as a bank loan or money owed to suppliers.
• Financial position: what the business owns and owes at a given date.
• Accounting convention: an accepted rule or practice that accountants follow, such as consistency, conservatism and materiality.
• Historical cost: the original price paid for an item, which stays in the books even when prices change.
• Inflation: a general rise in prices, which reduces the buying power of the naira.
• Realised gain: a gain that has actually been earned, for example when an item is sold at a profit.
• Unrealised gain: a rise in value that has not yet been earned through a sale, for example a rise in the market value of land that is still held.

What are the advantages of accounting?

The advantages of accounting fall into four groups: recording and reporting, decision making and control, comparison and planning, and legal and tax matters.

Recording and reporting

• Complete record: it keeps a full record of business transactions, so nothing depends on memory.
• Profit or loss: it shows the profit or loss made by the business at the end of a year.
• Assets and liabilities: it helps in finding out what the business owns and what it owes.
• Financial position: it shows the financial condition of the business at a given date.
• Checking errors and fraud: written records make it easier to find mistakes and dishonest practices.

Decision making and control

• Economic decisions: it provides useful information for making economic decisions, such as whether to expand, borrow or cut costs.
• Judging management: it helps owners judge how well managers use the resources of the business to reach its main goals.
• Earning power: it gives factual and interpretive information that helps users predict, compare and evaluate the earning power of the business.

Comparison and planning

• Comparative study: it allows this year’s profit, sales and expenses to be compared with those of earlier years.
• Planning: past figures guide budgets and plans for the future.

Legal and tax matters

• Legal formalities: it helps a business meet legal duties, such as filing income tax and value added tax (VAT) returns.
• Tax assessment: when accounts are properly kept, the tax authority can assess tax more easily and with fewer disputes.
• Evidence: well-kept books can serve as proof of a transaction when a dispute arises.

Who uses accounting information?

Accounting information is used by owners, managers, lenders, employees, tax authorities and suppliers.

What are the limitations of accounting?

Accounting is limited because it is historical, covers only money matters and depends on conventions and personal judgement.

Limits of time and money measurement

• Historical: accounting records past transactions, so it does not show the current financial position or worth of a business.
• Monetary transactions only: an item that cannot be stated in money is left out of the books.
• Qualitative elements excluded: good or poor management, reputation, employee morale and labour strikes are not recorded.

Limits from judgement and conventions

• Conventions and personal judgement: the figures in financial statements are influenced by accounting conventions and by the judgement of the accountant or management.
• Changing principles: accounting principles are not fixed, and different procedures can be equally acceptable, so two businesses may report the same event differently.

Limits from price changes

• Cost concept: assets are recorded at cost, so later changes in market price are not considered. Land bought many years ago stays at its purchase cost.
• Inflation ignored: statements do not show the effect of inflation, so figures from different years are not truly equal in value.
• Unrealised gains: increases in value that have not been realised, such as a rise in the market value of a property that is not sold, are not recorded.

Why is accounting limited to monetary transactions?

Accounting records only items that can be stated in naira, because money is the one common unit of measurement.

• Common unit: money (the naira) is the only unit that can add up different items such as cash, stock and buildings.
• Measurement: things like staff loyalty or goodwill with customers have no agreed money value at the time they occur.
• Effect: a business with a strong reputation and a happy workforce may look the same on paper as one without them.
• Remedy: users should read other reports and information along with the accounts before making a decision.

How do the limitations show up in practice?

Each limitation of accounting has a simple example in everyday business.

Evaluation

1. State five advantages of accounting.
2. How does proper record keeping help in the assessment of taxes?
3. Why does accounting not reflect the current worth of a business?
4. Give three examples of qualitative elements that accounting excludes.
5. Explain why accounting statements do not show the impact of inflation.

Assignment

List four limitations of accounting and explain each one in one or two sentences.