Reading: The Role of Accounting

The Role of Accounting

Accounting is often called “the language of business.” Why? Because it communicates so much of the information that owners, managers, and investors need to evaluate a company’s financial performance. These people are all stakeholders in the business—they are interested in its activities because they are affected by them. In fact, the purpose of accounting is to help stakeholders make better business decisions by providing them with financial information. Obviously, you would not try to run an organization or make investment decisions without accurate and timely financial information, and it is the accountant who prepares this information. More importantly, accountants make sure that stakeholders understand the meaning of financial information, and they work with both individuals and organizations to help them use financial information to deal with business problems.

Actually, collecting all the numbers is the easy part—today, all you have to do is start up your accounting software. The hard part is analyzing, interpreting, and communicating the information. Of course, you also have to present everything clearly while effectively interacting with people from every business discipline. In any case, we’re now ready to define accounting as the process of measuring and summarizing business activities, interpreting financial information, and communicating the results to management and other decision makers.

Fields of Accounting

Accountants typically work in one of two major fields. Management accountants provide information and analysis to decision makers inside the organization in order to help them run it. Financial accountants furnish information to individuals and groups both inside and outside the organization in order to help them assess its financial performance.

In other words, management accounting helps you keep your business running while financial accounting tells you how well you’re running it.

Management Accounting

Management accounting plays a key role in helping managers carry out their responsibilities. Because the information that it provides is intended for use by people who perform a wide variety of jobs, the format for reporting information is flexible. Reports are tailored to the needs of individual managers, and the purpose of such reports is to supply relevant, accurate, timely information in a format that will aid managers in making decisions. In preparing, analyzing, and communicating such information, accountants work with individuals from all the functional areas of the organization—human resources, operations, marketing, and finance.

Financial Accounting

Financial accounting is responsible for preparing the organization’s financial statements—including the income statement, the statement of owner’s equity, the balance sheet, and the statement of cash flows—that summarize a company’s past performance and evaluate its current financial condition. In preparing financial statements, financial accountants adhere to a uniform set of rules called generally accepted accounting principles (GAAP)—the basic principles for financial reporting issued by an independent agency called the Financial Accounting Standards Board (FASB). Users want to be sure that financial statements have been prepared according to GAAP because they want to be sure that the information reported in them is accurate. They also know that they can compare the statements issued by one company to those of another company in the same industry.

While companies headquartered in the United States follow U.S.-based GAAP, many companies located outside the United States follow a different set of accounting principles called International Financial Reporting Standards (IFRS). These multinational standards, which are issued by the International Accounting Standards Board (IASB), differ from U.S. GAAP in a number of important ways. IFRS, for example, is a little stricter about the ways you can calculate the costs of inventory, but we’re not going to dwell unnecessarily on such fine distinctions. Bear in mind, however, that, according to most experts, a single set of worldwide standards will eventually emerge to govern the accounting practices of both U.S. and non-U.S. companies.

Who Uses Financial Accounting Information?

The users of managerial accounting information are pretty easy to identify—basically, they’re a firm’s managers. We need to look a little more closely, however, at the users of financial accounting information, and we also need to know a little more about what they do with the information that accountants provide them.

Owners and Managers

In summarizing the outcomes of a company’s financial activities over a specified period of time, financial statements are, in effect, report cards for owners and managers. They show, for example, whether the company did or didn’t make a profit and furnish other information about the firm’s financial condition. They also provide information that managers and owners can use in order to take corrective action.

Investors and Creditors

If you loaned money to a friend to start a business, wouldn’t you want to know how the business was doing? Investors and creditors furnish the money that a company needs to operate, and not surprisingly, they feel the same way. Because they know that it’s impossible to make smart investment and loan decisions without accurate reports on an organization’s financial health, they study financial statements to assess a company’s performance and to make decisions about continued investment.

Warren Buffet

Warren Buffet

According to the world’s most successful investor (and third-richest individual), Warren Buffett, the best way to prepare yourself to be an investor is to learn all the accounting you can. Buffett, chairman and CEO of Berkshire Hathaway, a company that invests in other companies, turned an original investment of $10,000 into a net worth of $35 billion in four decades, and he did it, in large part, by paying close attention to financial accounting reports.

Government Agencies

Businesses are required to furnish financial information to a number of government agencies. Publicly owned companies, for example—the ones whose shares are traded on a stock exchange—must provide annual financial reports to the Securities and Exchange Commission (SEC), a federal agency that regulates stock trades. Companies must also provide financial information to local, state, and federal taxing agencies, including the Internal Revenue Service.

Other Users

A number of other external users have an interest in a company’s financial statements. Suppliers, for example, need to know if the company to which they sell their goods is having trouble paying its bills or may even be at risk of going under. Employees and labor unions are interested because salaries and other forms of compensation are dependent on an employer’s performance.

Figure 1, “Management and Financial Accounting,” below, summarizes the main differences between the users of management and financial accounting and the types of information issued by accountants in the two areas.

Management accountants supply financial information to help internal users answer questions and make decisions. Internal users include owners and managers. Owners ask, Should we sell some of our assets next year? Managers ask, Did our prices optimize our profits this year? and Can we afford to expand capacity next year? Financial accountants supply financial information to help both external users and internal users. Owners ask, Did we make a satisfactory profit this year? Managers ask, Can we afford to pay dividends to stockholders this year? and Can we afford to give employees raises this year? Government agencies ask, Did the company report correct income to investors? Investors and creditors ask, Did the company generate satisfactory revenues this year? Employees ask, Did the company contribute to the pension fund this year?

Figure 1. Management and Financial Accounting

 

KEY TAKEAWAYS

  • Accounting is a system for measuring and summarizing business activities, interpreting financial information, and communicating the results to management and other stakeholders to help them make better business decisions.
  • Accounting can be divided into two major fields:
    • Management accounting provides information and analysis to decision makers inside the organization (such as owners and managers) to help them operate the business.
    • Financial accounting provides information not only to internal managers, but also to people outside the organization (such as investors, creditors, government agencies, suppliers, employees, and labor unions) to assist them in assessing a firm’s financial performance.
  • U.S. and non-U.S. companies follow different sets of standards in preparing financial accounting reports:
    • U.S. companies adhere to a uniform set of rules called generally accepted accounting principles (GAAP), which are issued by an independent agency called the Financial Accounting Standards Board (FASB).
    • Many companies outside the United States follow a set of accounting principles called International Financial Reporting Standards (IFRS), which are issued by the International Accounting Standards Board (IASB).
  • Experts expect that a single set of worldwide accounting standards will eventually emerge and be followed by both U.S. and non-U.S. companies.

 

Check Your Understanding

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