Accounting › Section A · Accounting and the financial statements › Topic A.1
Why accounting matters: financial and managerial
Almost every decision about money, from signing a flat lease to launching a product line, leans on accounting information. This topic explains what accounting is and introduces its two great branches: financial accounting for people outside an organisation and managerial accounting for the people who run it.
Accounting: the language of business
Accounting is the process of identifying an organisation's economic events, recording them in a consistent way, and communicating the results to people who must make decisions. It is often called the language of business because owners, lenders, managers and regulators all use its vocabulary (revenue, expense, asset, profit) to talk about how an organisation is doing. Like any language, it has grammar: agreed rules about what to record, when, and at what amount. Learning those rules lets you read a company's reports the way a fluent speaker reads a newspaper, quickly and with confidence that you understand what is meant.
Accounting in everyday decisions
You do not need to be an accountant to use accounting. A student comparing a cheaper flat far from campus with a dearer one nearby is weighing rent against bus fares and travel time. A café owner deciding whether to buy a second espresso machine compares its cost with the extra drinks it could serve. Notice that good decisions mix financial facts with nonfinancial ones: the student also cares about safety and sleep, and the café owner about queue length and staff workload. Accounting supplies the financial half of the picture in an organised, reliable form, so the judgement about the other half rests on solid numbers.
Bookkeeping versus accounting
Bookkeeping is the recording part of the job: entering each sale, purchase, payment and receipt in the records accurately and on time. Accounting is broader. It includes designing the recording system, deciding how unusual events should be measured, preparing reports, and analysing and interpreting what the figures mean. A bookkeeper might record that a delivery van cost $38,000; an accountant decides how that cost is spread over the van's useful life and explains to the owner how the purchase affects profit and cash. Good bookkeeping is essential, but it is the starting point of accounting rather than the whole of it.
Financial accounting
Financial accounting measures an organisation's performance and position and reports them to users outside it: investors, lenders, suppliers and government agencies. Because outsiders cannot ask for custom reports, the information follows a common rulebook. In the United States that rulebook is generally accepted accounting principles (GAAP), set by the Financial Accounting Standards Board (FASB). Financial reports are prepared for fixed periods, such as a quarter or a year, and look mainly backwards at what has already happened, although they include some estimates. Standard rules make the reports comparable from year to year and from company to company, which is exactly what an outside reader needs.
Managerial accounting
Managerial accounting produces information for decision makers inside the organisation. It answers questions such as what each product costs to make, what price to charge, whether to repair or replace a machine, and how many staff next season will need. No outside rulebook governs it, so reports take whatever form is most useful and are prepared whenever a decision calls for them. It is often forward-looking, built on budgets and forecasts, and it blends financial data with nonfinancial measures such as delivery times, defect rates or customer complaints. Because it may reveal strategy, managerial information is usually kept confidential.
The two branches side by side
The differences line up neatly. Users: financial accounting serves outsiders; managerial accounting serves insiders. Rules: financial reports follow GAAP; managerial reports follow whatever management finds useful. Timing: financial reports cover regular periods; managerial reports appear as needed, sometimes daily. Focus: financial accounting summarises the past for the whole organisation; managerial accounting looks ahead and often zooms in on one product, department or decision. Content: financial reports are almost entirely in dollars; managerial reports add nonfinancial measures. Both draw on the same underlying records, which is why the two branches are taught together and why the later managerial sections of this course build on the financial ones.
Who guards the rules
Outside readers can rely on financial reports partly because several bodies oversee them. The Securities and Exchange Commission (SEC), a federal agency, has legal authority over the reporting of public companies and has long relied on FASB to write the standards. The American Institute of Certified Public Accountants (AICPA) is the national professional body for certified public accountants and maintains their code of professional conduct. After major corporate frauds, the Sarbanes-Oxley Act of 2002 created the Public Company Accounting Oversight Board (PCAOB) to set auditing standards for public company audits and to inspect the firms that perform them. FASB writes accounting standards, not auditing ones. You do not need the details yet; the point is that a framework exists to protect people who rely on the numbers.
Worked example: opening on Sundays
Hearthstone Bakery, a fictional shop, is closed on Sundays. The owner estimates a Sunday would bring sales of $1,800, with ingredients costing 35% of sales, two staff working 8 hours each at $18 an hour, and $42 of extra utilities. 1. Ingredients: 35% of $1,800 is $630. 2. Wages: 2 × 8 × $18 = $288. 3. Extra costs in total: $630 + $288 + $42 = $960. 4. Extra profit per Sunday: $1,800 − $960 = $840, or $43,680 over 52 Sundays. 5. Add nonfinancial factors: staff who want a day off, the owner's own rest, and whether Saturday customers would simply shift to Sunday. The $840 is a strong reason to open, but not the only consideration. This is managerial accounting: internal, forward-looking and tailored to one decision.
Worked example: financial or managerial?
Hearthstone's accountant receives four requests. Classify each by asking who will use it, whether outside rules apply, and whether it looks back or ahead. 1. The bank wants last year's statements before renewing a loan: an outside user, prepared under GAAP, looking back, so financial. 2. The owner wants the cost of each loaf recipe: an inside user, no required format, so managerial. 3. The manager wants a staffing plan for the holiday rush: internal and forward-looking, so managerial. 4. A potential investor asks for the annual results: an outsider relying on standard reports, so financial. The same sales and cost records feed all four answers; what changes is the user and the purpose.
Common mistakes to avoid
First, treating accounting as mere bookkeeping; recording is only the first step, and measurement, reporting and interpretation follow. Second, assuming managerial reports must follow GAAP; GAAP governs reports for outside users, and internal reports can take any useful form. Third, thinking financial accounting is purely factual; it is mostly historical but relies on estimates, such as how long equipment will last. Fourth, ignoring nonfinancial factors in a decision because the numbers look attractive, as the Sunday example shows. Fifth, believing managerial accounting is only for large companies; a one-person bakery uses it every time the owner prices a new cake.
Key takeaways
Accounting identifies, records and communicates financial information for decision-making, and is the common language of business. Bookkeeping records; accounting also measures, reports and interprets. Financial accounting serves outside users with periodic, mostly historical reports prepared under GAAP, which FASB sets and the SEC oversees for public companies. Managerial accounting serves inside users with flexible, often forward-looking reports that mix financial and nonfinancial information. Both branches draw on the same records, and good decisions combine their figures with judgement about factors money cannot measure.
Flashcards
Flashcard
Identifying, recording and communicating financial information for decisions
Test your understanding
Question 1 of 5
Which statement best distinguishes bookkeeping from accounting?
Question 2 of 5
A manufacturer's production manager asks for the cost of making each product next quarter under a new supplier contract. Which kind of accounting is this?
Question 3 of 5
Which body sets US generally accepted accounting principles?
Question 4 of 5
A bakery expects Sunday sales of $2,000, ingredients at 30% of sales, wages of $300 and extra utilities of $50. What extra profit would one Sunday bring?
Question 5 of 5
Which feature belongs to financial accounting rather than managerial accounting?