Users and purposes of financial accounting information
Financial accounting is a branch of accounting that produces for external decision-makers a mandatory, periodic, standardized and synthetic financial representation of an organization’s transactions with, as well as rights and duties towards, other constituencies.
This definition highlights several key characteristics of financial accounting. First and foremost, it is produced for external users who need this information to decide whether or how they should deal with the focal organization. Such users are typically actual or potential shareholders, creditors, suppliers, customers or governmental authorities (Atkinson, Kaplan, Matsumura, Young, & Mukherjee, 2012; Whitecotton, Libby, & Phillips, 2020).
These external constituencies typically use financial accounting information to determine whether the company creates value, can reimburse its debts on the long term (solvability), can pay what it must on the short term (liquidity), and is likely to be a reliable partner because of a healthy financial situation. This is typically the point of any financial statement analysis, a course you will probably attend later in your studies. But this is not the point of management accounting.
At the level of an economy, financial accounting information is crucial to help all these external decision-makers identify financially sustainable organizations and allocate efficiently their resources among them to maximize value creation. You will probably study these resource allocation decisions in courses about corporate finance and market finance. But this is not the point of management accounting either.
Qualities of financial accounting information
This focus on reporting for external stakeholders has a huge impact on the specific qualities that financial accounting must have. First, the information provided should allow external users to make comparisons between firms. An information is comparable when all companies use consistently similar concepts and measurement. Therefore, all firms should follow the same set of rules to produce and communicate information to ensure that financial statements are comparable1.
This is why financial accounting is both regulated and audited. Financial accounting is guided by generally accepted accounting standards or international financial reporting standards (Bhimani, Horngren, Datar, & Rajan, 2019). Moreover, external auditors are mandated to check whether companies follow this guidance or comply with these rules. This ensures that numbers that have the same label have indeed the same meaning.
Second, standardization also ensures that financial accounting is general enough to describe a very wide variety of organizations that belong to different industries, run different operations, and are characterized by different business models. This means that financial accounting must to some extent disregard what differentiates organizations, what makes them unique, and on the contrary stress what they have in common.
Financial accounting records in great details every transaction between an organization and external constituencies. However, it aggregates these transactions to only communicate a highly comprehensive and synthetic representation of the organization. This helps keep organizations comparable while avoiding the leakage of sensitive information. Indeed, financial accounting is public, and therefore available to competitors as well. A high level of aggregation does not only make a wide variety of businesses comparable; it also prevents communicating too much about how each company creates value. That way, it does not compromise competitive advantages companies have sometimes spent years building.
Finally, financial accounting accounts for the results of past transactions with third parties. This retrospective approach allows it to limit the reliance on estimates and therefore makes it relatively more accurate. Moreover, by focusing on external transactions which are documented by all parties, financial accounting produces an information which is objective and verifiable and therefore more reliable because more difficult to manipulate.
You will see more about financial accounting, but not here…
Financial accounting is not a frozen monolith and these qualities vary over time and across countries despite a clear trend towards harmonization (Carmona & Trombetta, 2008). There are many debates about specific standard choices and many relate directly to some of the qualities we just reviewed. For instance, segment reporting dis-aggregates a bit the information, introducing greater transparency at the expense of comparability (Hinson, Tucker, & Weng, 2019). Another debate is about value relevance versus conservatism (Balachandran & Mohanram, 2011), i.e. the asymmetric recognition of revenues and expenses. Yet these broad properties of financial accounting still differentiate it systematically from management accounting, as we will see later.
Financial accounting is so deep, complex and refined that an introductory course can only give you a glimpse over some of its most basic mechanisms. You will have to wait for other courses, like financial statements analysis, to really start grasping the full power of financial accounting. But this is not at all the point of management accounting. To really understand where management accounting begins, you need to understand where financial accounting ends. This it the purpose of the next section.
Atkinson, A. A., Kaplan, R. S., Matsumura, E. M., Young, S. M., & Mukherjee, A. (2012). Management Accounting (6th ed.). Harlow, UK: Pearson.
Balachandran, S., & Mohanram, P. (2011). Is the Decline in the Value Relevance of Accounting Driven by Increased Conservatism. Review of Accounting Studies, 16(2), 272–302. http://doi.org/10.1007/s11142-010-9137-0
Bhimani, A., Horngren, C. T., Datar, S. M., & Rajan, M. (2019). Management and Cost Accounting (7th ed.). Harlow, UK: Pearson.
Carmona, S., & Trombetta, M. (2008). On the Global Acceptance of Ias/Ifrs Accounting Standards: The Logic and Implications of the Principles-Based System. Journal of Accounting and Public Policy, 27(6), 455–461. http://doi.org/10.1016/j.jaccpubpol.2008.09.003
Hinson, L., Tucker, J. W., & Weng, D. (2019). The Tradeoff Between Relevance And Comparability In Segment Reporting. Journal of Accounting Literature, 43, 70–86. http://doi.org/10.1016/j.acclit.2019.11.003
Whitecotton, S., Libby, R., & Phillips, F. (2020). Managerial Accounting (4th ed.). New York, NY: McGraw Hill.
You will see later how different procedures can produce numbers which have very different meanings. This will be one of the key takeaways of this course: do not trust numbers when you do not know how they were computed!↩︎