Explain the nature and limitations of Financial Accounting.

Meaning of Financial Accounting

Financial Accounting is the systematic process of recording, classifying, summarising and presenting the financial transactions of a business in a significant manner. It measures all business activities in monetary terms and prepares financial statements like Profit & Loss Account and Balance Sheet to determine the profit or loss of the business and its financial position at the end of an accounting period.
It provides reliable and factual financial information mainly for external users such as investors, creditors, government, banks and other stakeholders. limitation of financial accounting

Nature of Financial Accounting

1. Historical in Nature
   Financial accounting records only those transactions that have already occurred. It tells what has happened in the past, not what will happen in future.
   
2. Based on Monetary Transactions
   Only those events that can be measured in money are recorded. Non-monetary factors like employee skills, brand reputation, and customer loyalty are not recorded.
   
3. Maintains Systematic Records
   It provides a complete, systematic, and permanent record of all business financial transactions. limitation of financial accounting
   
4. Follows Accounting Principles and Standards
   Financial accounting is governed by accounting principles, concepts, and standards (like AS/Ind AS) to ensure reliability and uniformity in reporting.
   
5. Preparation of Financial Statements
   It involves the preparation of Trading Account, Profit & Loss Account and Balance Sheet to determine profit/loss and financial position. limitation of financial accounting
   
6. Deals with External Reporting
   Financial accounting provides financial information mainly for external parties like investors, creditors, government, tax authorities, etc.
   
7. Objective and Verifiable
   The information is based on documentary evidence such as bills, vouchers, invoices, and bank statements, making it reliable.
   
8. Business-oriented
   It records only business transactions and completely ignores personal transactions of the owner. limitation of financial accounting

Limitations of Financial Accounting

1. Historical Nature Only
   It gives information about the past and does not provide future forecasts or predictive analysis for decision-making.
   
2. Ignores Qualitative Factors
   Factors like employee morale, management efficiency, customer satisfaction, etc., are not considered because they cannot be expressed in monetary terms. limitation of financial accounting
   
3. Possibility of Window Dressing
   Financial statements can be manipulated to show a better financial position (e.g., undervaluing liabilities or overvaluing assets).
   
4. Incomplete Information for Internal Management
   It does not provide detailed cost information, product-wise data, department-wise performance, etc. Management accounting is needed for these. limitation of financial accounting
5. Affected by Personal Judgements
   Use of estimates like depreciation methods, provision for doubtful debts, stock valuation can vary from person to person, reducing comparability.
   
6. Inflation Not Considered
   Assets are shown at historical cost, not at current market value. This reduces the relevance during inflation. limitation of financial accounting
   
7. Limited Scope
   Financial accounting records only monetary transactions and ignores non-monetary but important events.
   
8. No Control Over Errors and Frauds
   It records what has happened; it does not guarantee that errors, frauds or manipulations will not occur. limitation of financial accounting

Conclusion

Financial accounting provides a systematic record and true financial picture of a business, but it is historical, ignores qualitative aspects, and cannot meet the detailed informational needs of management. Therefore, it must be supplemented by cost and management accounting for effective decision-making. limitation of financial accounting

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👉Note:- Important Questions of Financial Accounting

1. What is capital expenditure, revenue expenditure and deferred revenue expenditure? Give characteristics of each. When are revenue expenses treated as capital expenses. ( December- 2023 )
2. What are Consignment Accounts? Explain accounting treatment of consignment transactions in the books of consignor and consignee. ( December 2024 )
3. What is a Voyage Account? Explain the procedure of preparing voyage accounts. ( December- 2023 )
4. What are departmental accounts? What are its objectives? Discuss the methods of departmental accounts. ( December 2023 )