Reading: Lesson 3 : Financial Accounting versus Managerial Accounting

An accounting information system provides data to help decision makers both outside and inside the business. Decision makers outside the business are affected in some way by the performance of the business. Decision makers inside the business are responsible for the performance of the business. For this reason, accounting is divided into two categories: financial accounting for those outside and managerial accounting for those inside.

Financial accounting information appears in financial statements that are intended primarily for external use (although management also uses them for certain internal decisions). Stockholders and creditors are two of the outside parties who need financial accounting information. These outside parties decide on matters pertaining to the entire company, such as whether to increase or decrease their investment in a company or to extend credit to a company. Consequently, financial accounting information relates to the company as a whole, while managerial accounting focuses on the parts or segments of the company.

Management accountants in a company prepare the financial statements. Thus, management accountants must be knowledgeable concerning financial accounting and reporting. The financial statements are the representations of management, not the CPA firm that performs the audit. The external users of accounting information fall into six groups; each has different interests in the company and wants answers to unique questions. The groups and some of their possible questions are: 

• Owners and prospective owners. Has the company earned satisfactory income on its total investment? Should an investment be made in this company? Should the present investment be increased, decreased, or retained at the same level? Can the company install costly pollution control equipment and still be profitable? 
• Creditors and lenders. Should a loan be granted to the company? Will the company be able to pay its debts as they become due? 
• Employees and their unions. Does the company have the ability to pay increased wages? Is the company financially able to provide long-term employment for its workforce? 
• Customers. Does the company offer useful products at fair prices? Will the company survive long enough to honor its product warranties? 
• Governmental units. Is the company, such as a local public utility, charging a fair rate for its services? 
• General public. Is the company providing useful products and gainful employment for citizens without causing serious environmental problems?
  

General-purpose financial statements provide much of the information needed by external users of financial accounting. These financial statements are formal reports providing information on a company's financial position, cash inflows and outflows, and the results of operations. Many companies publish these statements in annual reports. (See The Limited, Inc., annual report in the Annual report appendix.) The annual report also contains the independent auditor's opinion as to the fairness of the financial statements, as well as information about the company's activities, products, and plans.

Financial accounting information is historical in nature, reporting on what has happened in the past. To facilitate comparisons between companies, this information must conform to certain accounting standards or principles called generally accepted accounting principles (GAAP). These generally accepted accounting principles for businesses or governmental organizations have developed through accounting practice or been established by an authoritative organization. We describe several of these authoritative organizations in the next major section of this Introduction.

Managerial accounting information is for internal use and provides special information for the managers of a company. The information managers use may range from broad, long-range planning data to detailed explanations of why actual costs varied from cost estimates. Managerial accounting information should:

• Relate to the part of the company for which the manager is responsible. For example, a production manager wants information on costs of production but not of advertising. 
• Involve planning for the future. For instance, a budget would show financial plans for the coming year. 
• Meet two tests: the accounting information must be useful (relevant) and must not cost more to gather and process than it is worth. Managerial accounting generates information that managers can use to make sound decisions. The four major types of internal management decisions are: 
• Financial decisions—deciding what amounts of capital (funds) are needed to run the business and whether to secure these funds from owners (stockholders) or creditors. In this sense, capital means money used by the company to purchase resources such as machinery and buildings and to pay expenses of conducting the business. Resource allocation decisions—deciding how the total capital of a company is to be invested, such as the amount to be invested in machinery. 
• Production decisions—deciding what products are to be produced, by what means, and when. 
• Marketing decisions—setting selling prices and advertising budgets; determining the location of a company's markets and how to reach them.