What is Accounting?

Accounting is often referred to as the language of business. More formally, it is described as the information system that measures business activities, process the information into reports, and communicates the results to decision makers. You can also think of it as the scorecard of business. Most businesses are formed in order to make a profit, which in essence is an increase in the wealth of the owners, and the way to measure and report that increase in wealth is through accounting.

Balancing your checkbook is an essential accounting function if you want to know exactly how much money you have in the bank, but it’s only a small piece of business accounting, because stakeholders such as business owners, investors, bankers, and other users of financial information want to know more. They want to know what the business owns, how much debt it has, how much revenue it generated, how much it cost the company to make that amount of revenue, and how much new wealth was generated. In addition, those stakeholders want to be assured that the financial reports are accurate, and not just made up numbers.

The accounting profession in general can be divided into two distinct fields: financial accounting, and managerial accounting. Financial accounting focuses on external users, such as lenders (including vendors that extend credit to the company), regulatory agencies (such as the Internal Revenue Service), and investors. Managerial accounting focuses on internal users, such as production managers, sales managers, and employees. For example, a sales report used to calculate and pay commissions would be an internal, managerial accounting document, while a balance sheet informing shareholders of the assets and liabilities of the company would be an external, financial accounting report.

Financial Accounting

Since financial accounting is geared toward parties outside of the organization, it needs to be useful, understandable, accurate, and accessible. At times in history, certain organizations, like the now iconic Enron, Corp., have been less than faithful in their financial representations to the public, and investors, including individuals, have seen millions of dollars of investment become worthless. This still happens, despite the fact that long before Enron and other financial disasters, the government had stepped in and, with the help of the American Institute of Certified Public Accountants, created an accounting framework, commonly known as Generally Accepted Accounting Principles (GAAP), that provide a set of standard accounting rules for the industry to follow. Publicly traded companies are required to submit their financial statements to an examination by a Certified Public Accountant (CPA) before submitting them to the public with a letter from the CPA firm attesting to the fact that the financial statements are in compliance with GAAP.

Managerial Accounting

Unlike financial accounting, which is governed by a set of published guidelines, managerial accounting is governed by what management needs to know. It needs to be just as accurate and useful, and it arises from the same financial data, but it also includes other sources such as marketing data, volume data, demographic data, production data like turn-around time on a process, time and cost budgets, and cost/benefit analysis on equipment purchases. Some reports are standard, produced every month so that management can stay on top of trends, both good and bad, and some are ad hoc, as needed.

What Do Accountants Do?

Accountants turn data into information. Next time you are at Home Depot or a large department store like Macy’s or even ordering on-line through Amazon, try to imagine the sheer volume of financial data that is being generated each day as customers buy products. In addition to recording the sale itself, the store has to buy the product in order to sell it to you, or they have to make it (i.e. McDonalds) and so they incur costs that have to be tracked and reported. They have to pay employees, rent, insurance, utilities, transportation costs, outside consultants like accountants, and an incredible number of other costs of doing business. A common saying in the business world when it comes to costs like that is, “You have to spend money to make money.” All of that is data.

Information is the data sorted, compiled, and turned into useful reports, either managerial or financial. That is the job of the accountant. Financial accountants follow GAAP to produce statements that summarize the data into four general categories: the income statement, that tells how much wealth was generated by the company during a certain time period, usually a year; the statement of owners’ equity, that tells how much the owners put in to the company and how much they took out; the balance sheet, that shows the company’s assets (what it owns) and it’s liabilities and equity (who owns it), and the statement of cash flows, that describes in detail the changes in the cash balance from the beginning of the reporting period to the end. We’ll take a look at each of these in a later section. These are published in an annual report available to the general public.

One of the drawbacks of financial accounting from a manager’s perspective is that the information represents past performance. This is useful in giving out bonuses, and of course in reporting to the public, but proactive internal decisions have to come from the most current data available, and have to be tailored to the decision being considered. That is the purview of the managerial accountant. For instance, if management is considering replacing a machine to improve production, a managerial accountant could produce an ad hoc report comparing the cost of the new machine with lower maintenance costs and higher production yields against keeping the old machine and putting more dollars into maintaining and improving it, and maybe even options to lease a machine or outsource that particular process.

In summary, the difference between financial accounting and managerial accounting can be summed up by examining the users of the information:

What is Finance?

Finance and accounting sometimes get lumped into one category in conversations, but in business there is a difference between the two. If you think of balancing your checkbook as an accounting function, then planning to buy a car, shopping for it, and getting a loan to pay for it would be a finance function. Finance activities in business are more future focused, and, like managerial accounting, the information is only available to inside users such as purchase managers, the controllers, the chief executive officer, and other people in charge of short and long-term financial planning. However, finance managers use both financial accounting and managerial accounting information to help make decisions, just as you would use your own financial information if you were planning to buy a car.

In short, the most distinctive characteristics of financial accounting are its focus on past performance and it’s availability to the general public. Both managerial accounting reports and information generated by the finance department are rarely shared outside the organization.