Financial accounting deals with the external financial statements reported by businesses. Accounting involves more than preparing a company’s external financial statements, although this is certainly one of the most important functions. Every business must install an accounting system including forms, procedures, records, reports, computers, and personnel to keep the day-to-day activities of a business running smoothly and to prevent delays and stoppages. Internal accounting controls should be enforced to deter and detect errors and fraud. Computer programs have to be written or adapted to the needs of the business. Many tax returns have to be filed by every business—for income taxes, property taxes, sales taxes, and payroll taxes. Accountants are in charge of tax compliance.
Accounting systems, tax accounting, and financial accounting (preparing external financial statements) are three bedrock functions. Accounting has another primary function—to provide information needed by managers for their decision-making, planning, and control. This fourth fundamental function of accounting is called “management accounting” or “managerial accounting“.
A brief excursion into this branch of accounting is very helpful for understanding the limits of external financial statements, and to appreciate the differences between external financial reports to investors and lenders and internal accounting reports to managers of a business.
Management Accounting Is Designed for Managers
Management accounting is an internal function that operates within the boundaries of a business to help managers make sound decisions, develop plans and goals, and exercise control. The basic purpose of management accounting is to help managers be better managers. Management accounting, more than anything else, involves providing useful information to managers and helping them use this information in the most effective manner.
The design of accounting reports for managers is very dependent on the nature of the business and how the business is organized. If a business is divided into several sales territories, for example, accounting reports are organized by sales territories. Within each sales territory the business may be organized by major product lines. So, the accounting reports separate out each product line in each territory.
In short, management accounting follows the organizational structure of a business. This is not a knock on external financial statements, which are designed for the outside investors and lenders of the business and not for its managers. Managers should understand their company’s external financial statements like the backs of their hands. But they need additional accounting reports that are much more detailed, the “Profit behavior”, which is obviously a part of a management accounting report type.
In particular, the external income statement is not a good explanation of profit behavior—especially for management analysis. All managers who have profit responsibility need a hands-on model that provides a clear pathway to profit. A profit model or schematic should make transparent the basic factors and variables that drive profit and how they all fit together to arrive at bottom-line profit (net income). A profit model should serve as a blueprint for constructing, maintaining, and improving the bottom line of the business.
Management Accounting Is an Art [Not A Science]
There are no authoritative standards, and no generally accepted management accounting principles that govern management accounting. Tax accounting must follow tax laws and regulations, and use prescribed tax forms. External financial statements have to be prepared in accordance with GAAP. Management accounting is a wide-open game with few ground rules.
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