Accounting provides the reliable and relevant financial information useful in making decisions. Monetary events are first identified such as the type of sales and expenses, then recorded by documenting and entering the data, and finally presented to external parties who are outside of the company, usually through financial statements, and internal parties who are the people inside the company, usually through various reports.
Financial Accounting provides information for external parties who are interested in the company’s accounting information. Examples would be reports to investors and stockholders, creditors, taxing authorities or even customers, usually through financial statements. The two most common statements are the balance sheet and income statement. This summarized data is for the entire company as a whole, and is based on a historical performance by reporting on the past. Reliability is emphasized since information is used outside the company. Financial Accounting is driven by the rules of double entry accounting in which both sides of a transaction are entered – one debit and one credit. This keeps the books in balance. For example, the purchase of new equipment will be entered as an “increase to assets,” and also entered as a “decrease to cash or increase to debt.” Since accounting information is so important on making financial decisions, rules are established to ensure that people and organizations understand how accounting information is measured. In the USA, Generally Accepted Accounting Principles (GAAP) is the common standards that indicate how to report economic events. Following standardized rules also makes sure every asset and transaction is documented, each invoice and account is paid on time, nothing is paid more than once or left unpaid, keeps all financial matters under control, and reduces the chance of embezzlement. (Note: at least two employees should be involved anytime cash is expected to change hands).
The primary purpose for the financial accounting system is to be able to develop the needed financial statements, most commonly being the balance sheet and income statement, at the end of each month, quarter or year.
Managerial Accounting provides accounting information to internal parties for profit planning and budgeting, costs of an organizations products and services, and performance reports such as budget vs. actual results. These reports are for areas or departments of the organization and not the whole company. Analyzing the data from these reports are very useful for managers who direct, plan and control its day-to-day operations, to make decisions regarding the future. Managerial Accounting focuses on the future, rather than reporting on the past. Reporting on the past is the primary role of financial accounting. Because these reports are internal, and there are no regulations, it does not follow GAAP. The institute of Managerial Accounting sponsors the CMA (Certified Managerial Accountant) and developed the standards for ethical conduct, which are competence, confidentiality, integrity and objectivity.
Costing is also a major part of managerial accounting. Knowing the cost of goods to be sold is critical before planning for the future. Using a manufacturing company as an example, the elements that go into determining manufacturing costs are:
· Direct materials or raw materials, which include any materials that become an integral part of a finished product. It is a part of COGS as a direct cost of materials needed.
· Direct Labor costs, which are costs that can be physically traced to the actual production of the product. It is a part of COGS as a direct cost making the product.
· Manufacturing overhead, which encompasses all the costs that are not designated as direct material or direct labor such as the SG&A and indirect costs like the janitor who cleans the manufacturing warehouse, etc.
Numbers are the universal language of finance and are the raw materials of a balance sheet and income statement (or P&L – Profit and Loss - statement). We will discuss all of the major financial terms and their meanings within the balance sheet and income statement in the next two sections.