Usage of Accounting Information
Accounting is the vehicle for reporting financial information about a business entity to many different groups of people.
Explain the history of accounting and how accounting information is useful
- The American Accounting Association defines accounting as “the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information.”
- Accounting involves two main elements: (1) an information process summarizing financial events; and (2) a reporting system that communicates financial information to interested parties.
- Double-entry bookkeeping first emerged in Northern Italy in the 14th century, where trading ventures began to require transactions that involved more than one investor.
- Management (or internal) accounting and financial (or external) accounting are generally the two key branches of accounting.
- Management accounting provides relevant and useful information to people inside the business, such as employees, managers, owners and auditors. It provides information for decision making and company strategy.
- Financial accounting, on the other hand, also provides information to people outside the business, such as investors, regulators, analysts, economists, and government agencies.
- double-entry bookkeeping: A method of bookkeeping in which each transaction must have at least one debit and one credit.
- Financial statements: Standardized documents that include the financial information of a person, company, government, or organization; this information is used to make financial decisions.
- stakeholders: People outside of a company who have a special interest in the company. Some examples are suppliers, customers, and the community.
- accounting: The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information. (definition by the American Accounting Association)
Using Accounting Information
The American Accounting Association defines accounting as “the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information.” In other words, it is the process of communicating financial information about a business entity to stakeholders and managers. Economic information is generally displayed in the form of financial statements that show the economic resources that a business currently has; the goal of the business is to determine which information is useful to the outside world.
Accounting involves two main elements:
- An information process that identifies, classifies and summarizes the financial events that take place within an organization
- A reporting system that communicates relevant financial information to interested persons, allowing them to assess performance, make decisions, and/or control the economic resources in the organization.
It is important to note that accounting is not the end of the decision making process; it provides the most relevant and reliable information possible to allow for goals to be developed, implemented, and revised.
Early accounts served mainly to assist a businessperson in recalling financial transactions. The proprietor or record keeper was usually the only person to see this information. Cruder forms of accounting were inadequate when a business needed multiple investors. As a result, double-entry bookkeeping first emerged in northern Italy in the 14th century, where trading ventures began to require more capital than a single individual was able to invest.
The development of joint stock companies created wider audiences for accounts, as investors without firsthand knowledge of their operations relied on accounts to provide additional information. This development resulted in the division of accounting systems for internal (i.e. management accounting) and external (i.e. financial accounting) purposes. This also led to the separation of internal and external accounting and disclosure regulations.
Today, accounting is referred to as “the language of business” because it is the vehicle for reporting financial information about a business entity to many different groups of people. Accounting that concentrates on reporting to people inside the business entity is called management accounting. It is used to provide information to employees, managers, and auditors. Management accounting is concerned primarily with providing a basis for making management or operating decisions.
Accounting that provides information to people outside the business entity is called financial accounting. It provides information to present and potential shareholders, creditors, vendors, financial analysts, and government agencies. Because these users have different needs, the presentation of financial accounts is very structured and subject to many more rules than management accounting. The body of rules that governs financial accounting is called Generally Accepted Accounting Principles, or GAAP. The International Financial Reporting Standards, or IFRS, provides another set of accounting rules.
Through integrating accounting knowledge with strategic decision-making, organizations can improve performance, refine strategy, and mitigate risk.
Integrate a knowledge of accounting with its impact on strategic decision-making
- Through utilizing managerial accounting perspectives, strategic managers can vastly improve their understanding of performance and recognize areas of potential improvement.
- One critical difference between financial and managerial accounting is that managerial accounting is designed to flexibly align to current operations, while financial accounting sticks to global formats.
- Another key difference between financial and managerial accounting is chronological focal point. Managerial accounting is forward-looking, while financial accounting tends to look at the past.
- A few examples of managerial accounting include cost benefit analysis, life cycle costs, developing new business metrics, and geographically segmented reporting.
- financial accounting: Accounting that focuses on preparation of stakeholder documents (particularly for publicly traded companies) and collecting data on past operational performance.
- managerial accounting: Accounting that combines strategic decision-making with accounting knowledge through providing specific tools to measure the financial implications of various internal activities.
Management accounting is one of the most interesting and broad-minded applications of the accounting perspective. There exists a strong relationship between the knowledge accounting delivers to managerial teams, and the strategic and tactical decisions made by management. Through this integration, organizations can improve their decision-making to strategic value in the form of improved performance and mitigated risks.
Differentiating Managerial Accounting
When looking at traditional financial accounting, managerial accounting differs in a few key ways:
- For public organizations, a variety of reports are released quarterly and annually for stakeholders. Managerial accounting creates additional documents used for internal, strategic decision-making.
- Financial accounting is generally historical, while managerial accounting is about forecasting.
- Managerial accounting tends to lean a bit more on abstraction, utilizing various models to support financial decisions.
- While financial accounting fits the mold expected by stakeholders, managerial accounting is flexible and strives to meet the needs of management exclusively.
- Financial accounting looks at the company holistically, while financial accounting can zoom in at various levels (i.e. product level, division level, etc.)
Examples of Managerial Accounting
There are countless specific examples of managerial accounting practices. Taking a look at a few will provide additional scope and perspective on the field:
Throughput Accounting: Production processes have a great deal of inter-dependency. This can create opportunity costs, as interdependent resources are being restrained. Measuring the contribution per unit of constrained resource is called throughput accounting.
Lean Accounting: During the days when the Toyota Production System was just becoming celebrated as a leaner process, accountants began to consider the restrictions of traditional accounting methods on lean processes. As a result, managerial accounts began constructing a better way to measure just-in-time manufacturing process success.
Some simpler examples of common managerial accounting tasks include developing business metrics, cost-benefit analyses, IT cost transparency, life cycle cost analysis, strategic management advice, sales forecasting, geographically segmented reporting, and rate and volume analysis.
Managerial accounting is inherently flexible, and drives towards maximizing internal efficiency through careful consideration of opportunity costs and various customized metrics.
Financial accounting is a core organizational function in which accountants prepare a variety of documents to inform stakeholders of the financial health of operations.
List the various expectations of a financial accounting statement, along with the three common statements produced
- The role of financial accounting is of high importance, both for informing external stakeholders and for providing critical information to management.
- Financial accounting statements must be relevant, material, reliable, understandable, and comparable.
- The balance sheet measures all assets, liabilities, and stakeholder equity to identify and understand the organizations leverage position.
- The income statement is a top down statement, in which revenues are considered in the context of the costs and expenses required to obtain them. This ultimately demonstrates profitability.
- The statement of cash flows is all about liquidity, and identifying how much free cash is available to the organization for investment purposes.
- Taking all of these documents into account, stakeholders can derive a clear view of the health and efficiency of operation of a given organization.
- materiality: The state of being consequential in the making of a decision.
- chronological: In order of time, usually earliest to latest.
The Role of Financial Accounting
Financial accounting focuses on the tracking and preparation of financial statements for internal management and external stakeholders, such as suppliers, investors, government agencies, owners, and other interest groups. These financial statements are consistent with accounting guidelines and formatting, particularly for publicly traded organizations. This allows individuals unfamiliar with day to day operations to see the overall performance, health, and relative profitability of a given organization.
Characteristics of Financial Accounting
Generally speaking, it is expected by financial accounting standards that an organization maintain the following qualities when submitting financial accounting information:
- Relevance – Financial statements must be applicable to the decisions being made, and presented in a way that allows for distilling useful insights.
- Materiality – The information present must be of the quality that indicates consequence in strategic or legal decisions. This is to say that nothing of materiality should be omitted as well.
- Reliability – All information must be free of error, and reported with pinpoint accuracy.
- Understandability – Clarity and efficiency in presentation is important, as it must be immediately readable and without the possibility of being misinterpreted.
- Comparability – Finally, all presented financial statements should align with current best practices in accounting to ensure that the material presented is validly compared to that of other organizations.
How to Conduct Financial Accounting
Financial accountants are tasked with producing three primary documents that indicate a health check on various aspects (or at times all aspects) of the organization. These three statements are the balance sheet, the income statement, and the statement of cash flows.
A balance sheet demonstrates the overall value of organizational assets by listing current and long-term assets (fixed or otherwise) alongside short term and long term liabilities and stakeholder equity. Through balancing the assets against the combination of liabilities and stakeholder equity, the financial accounting should encounter a zero sum game.
Simply put: Assets = Liabilities + Shareholder Equity. This is the golden rule of balance sheets (hence the name: balance). The items on a balance sheet can range from long term debt to current inventory to dividends to accounts receivable to cash on hand. Anything and everything that can be valued should be included in this calculation.
As opposed to something that balances, the income statement is more of a one directional document. Picture this as a mathematical illustration of the organizations operations, from the production floor all the way to the hands of the consumer. When organizations go through such a process (producing, shipping, storing, paying taxes, selling, providing service, etc.), the expectation is that the price point established will cover all relevant costs while producing some percentage of net income. An income statement calculates whether or not a business is accomplishing this.
To picture it, let’s create a simple example. You own a pizza shop. You sold 1000 pizzas last month. Each pizza sold for $10 on average. That gives you $10,000, but this is your revenue, not your profit. For each pizza, it costs $4 in cheese, dough, sauce and toppings. That brings you down to $6,000. You have to pay your bills and your rent, which is takes you down another $2,000. Now, you’re at $4,000, and you end up paying $1,500 to your employees in wages. Of your $2,500 remaining, 40% goes to state and federal taxes. Your overall net income for the month is $1,500. This process is what an income statement does.
Statement of Cash Flows
The final statement is the statement of cash flows, which aims to identify how much capital in the organization is liquid (i.e. easily converted into spend). This is more of a chronological statement, as it takes the previous pay period and the current pay period, and identifies the difference in overall available cash.
The purpose of this document is quite interesting. An organizations available cash could be considered their flexibility in capturing external opportunities (e.g., investing in new opportunities, such as offering a new product or acquiring a competitor).
Combine these three documents, and stakeholders have a fairly clean view of what goes on in the organization. The balance of their assets, the overall profitability of their operations, and the availability of capital for expansion. This is the role of financial accountants.
Tax accounting couples legal obligations with financial accounting to ensure adherence to current tax laws.
Understand the role of tax accounting in both small and large organizations
- Every region has specific tax accounting rules and regulations. Adhering to these rules and regulations is critical to avoiding penalties and ensuring ethical behavior in the country (and/or state) of operation.
- Tax accountants act as a bridge between the organization and the governments that collect financial obligations. As a result, it requires a combination of financial and legal knowledge.
- On the financial side, tax accounts must understand the legal implications of decisions, as both opportunities and threats exist.
- On the legal side, the preparation, assessment, and delivery of tax documents is a time-sensitive and detail-oriented process that must be regularly maintained.
- Some unique situations exist in tax accounting, such as accounting for non-profit organizations (who don’t pay taxes). This still requires considerable legal know how and operational alignment with governmental regulations.
- Tax accounting: The activity that focuses on satisfying legal accounting obligations through the preparation, analysis, and presentation of required tax documentation.
Tax accounting is relatively simple to explain, though nuanced in execution. In short, every region has specific tax accounting rules and regulations. Adhering to these rules and regulations is critical to avoiding penalties and ensuring ethical behavior in the country (and/or state) of operation. Tax accounting is therefore a combination of legal and financial knowledge.
The Financial Side
Tax accountants act as the bridge between an organization’s accounting team and the reporting bodies in the region. As a result, the primary role of a tax accountant is to understand the business’ current operating status, distill profitability before tax, and report earnings.
On the strategic side of this, tax accountants can consider any tax implications as it pertains to certain strategic decisions or tactics. Identifying and understanding opportunities in a region’s tax code is a win win. For example, some manufacturers can receive tax breaks for environmentally friendly operations, often high enough tax breaks to offset the cost of implementing them. Tax accountants should be aware of these opportunities in the legal environment.
The Legal Side
More tangibly, tax accounts will focus on the preparation, analysis, and presentation of tax payments and tax returns at all times. There are specialized accounting principles and obligations for each area of operation which must be met. Keeping up to date on what is expected, and ensuring alignment on across the organization, is their primary responsibility.
Some exceptions exist, of course, such as non-profit organizations. Non-profits have unique tax preparation requirements due to their no-tax status. This comes along with its fair share of obligations, paperwork, and approvals from the governing bodies.
Government and Nonprofit Accounting
Governmental and nonprofit accounting follow different rules from those of commercial enterprises.
Compare public vs. private accounting
- Public sector entities have different goals to the private sector, who’s main goal is to make a profit. Public entities must be more fiscally responsible. The usage of government accounting processes also differs significantly from the use in the private sector.
- Publicly elected officials and their employees must be accountable to the public, and thus government accounting provides information on whether taxpayer funds are used responsibly or not.
- Government accounting must also serve the same purpose as commercial accounting, that is to provide information for decision-making purposes. The difference in this case is the recipient of the information is a government official, with different priorities and goals.
- Nonprofits also have unique accounting systems and standards. They generally use accrual basis accounting for their funds.
- Nonprofit financial statements generally include a balance sheet, a statement of activities or statement of support, a statement of functional expenses, and a cash flow statement.
- Governmental accounting: Governmental accounting is an umbrella term which refers to the various accounting systems used by various public sector entities.
- budget: An itemized summary of intended expenditure; usually coupled with expected revenue.
Public Sector Accounting
Governmental accounting is an umbrella term which refers to the various accounting systems used by various public sector entities. In the United States, for instance, there are two levels of government which follow different accounting standards set forth by independent, private sector boards. At the federal level, the Federal Accounting Standards Advisory Board (FASAB) sets forth the accounting standards to follow. Similarly, there is the Governmental Accounting Standards Board (GASB) for state and local level government.
Public vs. Private Accounting
There is an important difference between private sector accounting and governmental accounting. The main reasons for this difference is the environment of the accounting system. In the government environment, public sector entities have differing goals, as opposed to the private sector entities’ one main goal of gaining profit. Also, in government accounting, the entity has the responsibility of fiscal accountability which is demonstration of compliance in the use of resources in a budgetary context. In the private sector, the budget is a tool in financial planning and it is not mandatory to comply with it.
Government accounting refers to the field of accounting that specifically finds application in the public sector or government. The unique objectives of government accounting do not preclude the use of the double entry accounting system. There can, however, be other significant differences with private sector accounting practices, especially those that are intended to arrive at a net income result. Thus, a special field of accounting exists because:
- The objectives to which accounting reports to differ significantly from that for which generally accepted accounting practice has been developed for in the private (business) sector; and
- The usage of the results of accounting processes of government differs significantly from the use thereof in the private sector.
The objectives for which government entities apply accountancy can be organized in two main categories:
- The accounting of activities for accountability purposes. In other words, the representatives of the public, and officials appointed by them, must be accountable to the public for powers and tasks delegated. The public, who have no other choice but to delegate, are in a position that differs significantly from that of shareholders and therefore need financial information, to be supplied by accounting systems, that is applicable and relevant to them and their purposes.
- Decision-making purposes. The relevant role-players, especially officials and representatives, need financial information that is accounted, organized and presented for the objectives of their decision-making. These objectives bear, in many instances, no relation to net income results but are rather about service delivery and efficiency. The taxpayer, a very significant group, simply wants to pay as little taxes as possible for the essential services for which money is being coerced by law.
The governmental accounting system has a different focus for measuring accounting than private sector accounting. Rather than measuring the flow of economic resources, governmental accounting measures the flow of financial resources. Instead of recognizing revenue when they are earned and expenses when they are incurred, revenue is recognized when there is money available to liquidate liabilities within the current accounting period, and expenses are recognized when there is a drain on current resources.
Nonprofit organizations generally use the following five categories of funds:
- Current fund – unrestricted. This fund is used to account for current assets that can be used at the discretion of the organization’s governing board.
- Current funds – restricted use current assets subject to restrictions assigned by donors or grantors.
- Land, building and equipment fund. Cash and investments reserved specifically to acquire these assets, and related liabilities, should also be recorded in this fund.
- Endowment funds are used to account for the principal amount of gifts the organization is required, by agreement with the donor, to maintain intact in perpetuity or until a specific future date or event.
- Custodian funds are held and disbursed according to the donor’s instructions.
Consumers of Accounting Information
Most of a company’s stakeholders consume its accounting information in one form or another.
Explain the history of accounting
- Double-entry bookkeeping first emerged in Northern Italy in the fourteenth century.
- As companies grew bigger, accounting standards were required for those without firsthand knowledge of operations to be able to understand the finances and operations of the company.
- Managers, employees, owners, and auditors all desire the information provided by management accounting.
- On the other hand, external auditors, potential and actual shareholders, creditors, analysts, economists, and government agencies rely on financial accounting statements to provide them with the information they need.
- GAAP: Generally Accepted Accounting Principles (GAAP) refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards.
- IFRS: International Financial Reporting Standards (IFRS) are designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries.
Early accounts served mainly to assist the memory of the businessperson, and the audience for the account was the proprietor or record keeper alone. Cruder forms of accounting were inadequate for the problems created by a business entity involving multiple investors, so double-entry bookkeeping first emerged in northern Italy in the fourteenth century, where trading ventures began to require more capital than a single individual was able to invest.
The development of joint stock companies created wider audiences for accounts, as investors without firsthand knowledge of their operations relied on accounts to provide the requisite information. This development resulted in a split of accounting systems for internal (i.e., management accounting) and external (i.e., financial accounting) purposes and, subsequently, also in accounting and disclosure regulations and a growing need for independent attestation of external accounts by auditors.
Today, accounting is called “the language of business” because it is the vehicle for reporting financial information about a business entity to many different groups of people. Accounting that concentrates on reporting to people inside the business entity is called “management accounting” and is used to provide information to employees, managers, owner-managers, and auditors.
Management accounting is concerned primarily with providing a basis for making management or operating decisions. Accounting that provides information to people outside the business entity is called “financial accounting” and provides information to present and potential shareholders and creditors, such as banks or vendors, financial analysts, economists, and government agencies. Because these users have different needs, the presentation of financial accounts is very structured and subject to many more rules than management accounting. The body of rules that governs financial accounting in a given jurisdiction is the Generally Accepted Accounting Principles, or GAAP. Other rules include International Financial Reporting Standards, or IFRS, or U.S. GAAP.