The nature of financial and managerial accounting information.
Definitions
It seems fitting to begin with a more formal definition of accounting: Accounting is a set of concepts and techniques that are used to measure and report financial information about an economic unit. The economic unit is generally considered to be a separate enterprise. The information is reported to a variety of different types of interested parties. These include business managers, owners, creditors, governmental units, financial analysts, and even employees. In one way or another, these users of accounting information tend to be concerned about their own interests in the entity.
Business managers need accounting information to make sound leadership decisions. Investors hope for profits that may eventually lead to distributions from the business (e.g., “dividends”). Creditors are always concerned about the entity’s ability to repay its obligations. Governmental units need information to tax and regulate. Analysts use accounting data to form opinions on which they base investment recommendations. Employees want to work for successful companies to further their individual careers, and they often have bonuses or options tied to enterprise performance. Accounting information about specific entities helps satisfy the needs of all these interested parties.
The diversity of interested parties leads to a logical division in the discipline of accounting: financial accounting and managerial accounting. Financial accounting is concerned with external reporting to parties outside the firm. In contrast, managerial accounting is primarily concerned with providing information for internal management. One may have trouble seeing the distinction; after all, aren’t financial facts being reported? The following paragraphs provide a closer look at the distinctions.
Financial Accounting
Consider that financial accounting is targeted toward a broad base of external users, none of whom control the actual preparation of reports or have access to underlying details. Their ability to understand and have confidence in reports is directly dependent upon standardization of the principles and practices that are used to prepare the reports. Without such standardization, reports of different companies could be hard to understand and even harder to compare.
Standardization derives from certain well-organized processes and organizations. In the United States, a private sector group called the Financial Accounting Standards Board (FASB) is primarily responsible for developing the rules that form the foundation of financial reporting. The FASB’s global counterpart is the International Accounting Standards Board (IASB). The IASB and FASB are working toward convergence, such that there may soon be a single harmonious set of international financial reporting standards (IFRS). This effort to establish consistency in global financial reporting is driven by the increase in global trade and finance. Just as standardization is needed to enable comparisons between individual companies operating within a single economy, so too is standardization needed to facilitate global business evaluations.
Financial reports prepared under the generally accepted accounting principles (GAAP) promulgated by such standard-setting bodies are intended to be general purpose in orientation. This means they are not prepared especially for owners, or creditors, or any other particular user group. Instead, they are intended to be equally useful for all user groups. As such, attempts are made to keep them free from bias (neutral). Standard-setting bodies are guided by concepts that are aimed at production of relevant and faithful reports that are useful in investment and credit decisions.
Managerial Accounting
Managerial accounting information is intended to serve the specific needs of management. Business managers are charged with business planning, controlling, and decision making. As such, they may desire specialized reports, budgets, product costing data, and other details that are generally not reported on an external basis. Further, management may dictate the parameters under which such information is to be accumulated and presented. For instance, GAAP may require that certain product development costs be deducted in computing income; on the other hand, management may see these costs as a long-term investment and stipulate that internal decision making be based upon income numbers that exclude such costs. This is their prerogative. Hopefully, internal reporting is being done logically and rationally, but it need not follow any particular set of mandatory guidelines.
The accounting equation: Assets = Liabilities + Owners’ Equity.
Assets = Liabilities + Owners’ Equity
Assets
Assets are the economic resources of the entity, and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangible assets like patents and other legal rights and claims. Assets are presumed to entail probable future economic benefits to the owner.
Liabilities
Liabilities are amounts owed to others relating to loans, extensions of credit, and other obligations arising in the course of business. Implicit to the notion of a liability is the idea of an “existing” obligation to pay or perform some duty.
Owners’ Equity
Owners’ equity is the owner “interest” in the business. It is sometimes called net assets, because it is equivalent to assets minus liabilities for a particular business. Who are the “owners?” The answer to this question depends on the legal form of the entity; examples of entity types include sole proprietorships, partnerships, and corporations. A sole proprietorship is a business owned by one person, and its equity would typically consist of a single owner’s capital account. Conversely, a partnership is a business owned by more than one person, with its equity consisting of separate capital accounts for each partner. Finally, a corporation is a very common entity form, with its ownership interest being represented by divisible units of ownership called shares of stock. These shares are easily transferable, with the current holder(s) of the stock being the owners. The total owners’ equity (i.e., “stockholders’ equity”) of a corporation usually consists of several amounts, generally corresponding to the owner investments in the capital stock (by shareholders) and additional amounts generated through earnings that have not been paid out to shareholders as dividends (dividends are distributions to shareholders as a return on their investment). Earnings give rise to increases in retained earnings, while dividends (and losses) cause decreases.
Balance Sheet
The accounting equation is the backbone of the accounting and reporting system. It is central to understanding a key financial statement known as the balance sheet (sometimes called the statement of financial position). The following illustration for Edelweiss Corporation shows a variety of assets that are reported at a total of $895,000. Creditors are owed $175,000, leaving $720,000 of stockholders’ equity. The stockholders’ equity section is divided into the $120,000 that was originally invested in Edelweiss Corporation by stockholders (i.e., capital stock), and the other $600,000 that was earned (and retained) by successful business performance over the life of the company.
Does the stockholders’ equity total mean the business is worth $720,000? No! Why not? Because many assets are not reported at current value. For example, although the land cost $125,000, Edelweiss Corporation's balance sheet does not report its current worth. Similarly, the business may have unrecorded resources, such as a trade secret or a brand name that allows it to earn extraordinary profits. Alternatively, Edelweiss may be facing business risks or pending litigation that could limit its value. If one is looking to buy stock in Edelweiss Corporation, they would surely give consideration to these important non-financial statement valuation considerations. This observation tells us that accounting statements are important in investment and credit decisions, but they are not the sole source of information for making investment and credit decisions.
Assets ($895,000) = Liabilities ($175,000) + Stockholders’ equity ($720,000)
The Four Core Financial Statements
Financial Statements
Financial accounting seeks to directly report information for the topics noted in blue. Additional supplemental disclosures frequently provide insight about subjects such as those noted in red. One would also need to gain additional information by reviewing corporate websites (many have separate sections devoted to their investors), filings with securities regulators, financial journals and magazines, and other such sources. Most companies will have annual meetings for shareholders and host webcasts every three months (quarterly). These events are very valuable in allowing investors and creditors to make informed decisions about the company, as well as providing a forum for direct questioning of management. One might even call a company and seek “special insight” about emerging trends and developments. Be aware, however, that the company will likely not be able to respond in a meaningful way. Securities laws have very strict rules and penalties that are meant to limit selective or unique disclosures to any one investor or group. It is amusing, but rarely helpful, to review “message boards” where people anonymously post their opinions about a company.
Financial accounting information is conveyed through a standardized set of reports. The balance sheet has already been introduced. The other financial statements are the income statement, statement of retained earnings, and statement of cash flows. There are many rules that govern the form and content of each financial statement. At the same time, those rules are not so rigid as to preclude variations in the exact structure or layout. For instance, the earlier illustration for Edelweiss was first presented as a “horizontal” layout of the balance sheet. The subsequent Edelweiss examples were representative of “vertical” balance sheet arrangements. Each approach, and others, is equally acceptable.
Income Statement
A summary of an entity’s results of operation for a specified period of time is revealed in the income statement, as it provides information about revenues generated and expenses incurred. The difference between the revenues and expenses is identified as the net income or net loss.
The income statement can be prepared using a single-step or a multiple-step approach, and might be further modified to include a number of special disclosures relating to unique items. These topics will be amplified in a number of subsequent chapters. For now, take careful note that the income statement relates to activities of a specified time period (e.g., year, quarter, month), as is clearly noted in its title:
Statement Of Retained Earnings
Previous illustrations showed how retained earnings increases and decreases in response to events that impact income. Retained earnings is also reduced by shareholder dividends.
The statement of retained earnings provides a succinct reporting of these changes in retained earnings from one period to the next. In essence, the statement is nothing more than a reconciliation or “bird’s-eye view” of the bridge between the retained earnings amounts appearing on two successive balance sheets.
If one examines very many sets of financial statements, one will soon discover that many companies provide a statement of stockholders’ equity in lieu of the statement of retained earnings. The statement of stockholders’ equity portrays not only the changes in retained earnings, but also changes in other equity accounts. An expanded statement of stockholders’ equity is presented in a future chapter.
Balance Sheet
The balance sheet focuses on the accounting equation by revealing the economic resources owned by an entity and the claims against those resources (liabilities and owners’ equity). The balance sheet is prepared as of a specific date, whereas the income statement and statement of retained earnings cover a period of time. Accordingly, it is sometimes said that balance sheets portray financial position (or condition) while other statements reflect results of operations. Quartz’s balance sheet is as follows:
Statement Of Cash Flows
The statement of cash flows details the enterprise’s cash flows. This operating statement reveals how cash is generated and expended during a specific period of time. It consists of three unique sections that isolate the cash inflows and outflows attributable to (a) operating activities, (b) investing activities, and (c) financing activities.
Notice that the cash provided by operations is not the same thing as net income found in the income statement. This result occurs because some items hit income and cash flows in different periods. For instance, remember how Edelweiss (from the earlier illustration) generated income from a service provided on account. That transaction increased income without a similar effect on cash. These differences tend to even out over time. Other cash flow items may never impact operations. For instance, dividends paid are an important financing cash outflow for a corporation, but they are not an expense. They are a distribution of income. The proceeds of a loan would be an example of a nonoperating cash inflow. It would be shown as a financing cash flow item.
The statement cash flows require a fairly complete knowledge of basic accounting. Do not be concerned by a lack of complete comprehension at this juncture. Comprehension develops as studies progress, and a future chapter is devoted to the statement of cash flows.
Self-balancing
It is important to note that the income statement, statement of retained earnings, and balance sheet articulate. This means they mesh together in a self-balancing fashion. The income for the period ties into the statement of retained earnings, and the ending retained earnings ties into the balance sheet. This final tie-in causes the balance sheet to balance. These relationships are illustrated in the following diagram.
