Every business has three primary financial tasks that determine the success or failure of the enterprise and by which its managers are judged:
- Making profit— avoiding loss and achieving profit goals by making sales or earning other income and by controlling expenses
- Cash flow— generating cash from profit and securing cash from other sources and putting the cash inflow to good use
- Financial health— deciding on the financial structure for the entity and controlling its financial condition and solvency
Key Concept To continue in existence for any period of time, a business has to make profit, generate cash flow, and stay solvent.
Accomplishing these financial objectives depends on doing all the other management functions well. Business managers earn their keep by developing new products and services, expanding markets, improving productivity, anticipating changes, adapting to new technology, clarifying the business model, thinking out clear strategies, hiring and motivating people, making tough choices, solving problems, and arbitrat- ing conflicts of interests between different constituencies (e.g., customers who want lower prices versus employees who want higher wages). Managers should act ethically, comply with a myriad of laws, be responsible members of society, and not harm our natural environment—all the while making profit, generating cash flow, and avoiding insolvency.
ACCOUNTING INSIDE AND OUT Ask people to describe accounting and the most common answer you’ll get is that accounting involves a lot of record keeping and bookkeeping. Which is true. The account- ing system of a business is designed to capture and record all its transactions, operations, activities, and other develop- ments that have financial consequences. An accounting sys- tem generates many documents, forms, and reports. Even a small business has hundreds of accounts, which are needed to keep track of its sales and expenses, its assets and liabilities, and of course its cash flows. Accounting systems today are computer-based. The accounts of a business are kept on the hard disks of computers, which should be backed up frequently, of course.
The primary purpose of an accounting system is to accu- mulate a complete, accurate, and up-to-date base of data and information needed to perform essential functions for a busi- ness. Figure 1.1 presents a broad overview of the internal and external functions of business accounting. Note the Janus, or two-faced, nature of an accounting system that looks in two different directions—internal and external, or inside and outside the business.
In addition to facilitating day-to-day operating activities,the accounting department of a business has the responsibility of preparing two different kinds of internal reports— very detailed reports for management control and much more con-
densed reports for decision making. Likewise, the accounting department prepares two different kinds of external reports— financial reports for owners and lenders and tax returns for tax authorities. Accountants have a relatively free hand in
designing control and decision-making reports for managers. In sharp contrast, external reporting is compliance-driven.
External financial reports must comply with authoritative standards and established accounting rules. And, as I’m sure you know, tax returns must comply with tax laws.
INTERNAL FUNCTIONS OF ACCOUNTING In addition to the day-to-day operational demands (preparing payroll checks, paying bills on time, sending out invoices to customers, etc.), the other internal functions of accounting: the preparation of manage- ment control reports and reports for management decision making. Management control demands attention to a very large number of details; quite literally, thousands of things can go wrong. Management decision making, in contrast, focuses attention on relatively few key factors. Decision mak- ing looks at the forest, not the trees. For decision-making purposes, managers need accounting reports that are con- densed and global in nature—that present the big picture. These reports should resonate with the business model and should be structured according to the profit and cash flow models of the business.
In passing, I should mention that accounting information seldom comprises the whole set of information needed fordecision making and control. Managers use many, many other sources of information—competitors’ sales prices, delivery problems with suppliers, employee morale, and so on. Nonaccounting data comes from a wide diversity of sources, including shopping the competition, sales force reports, market research studies, personnel department records, and so on. For example, customer files are very important, and they usually include both accounting data (past sales history) and nonaccounting data (sales reps assigned to each customer).
EXTERNAL FUNCTIONS OF ACCOUNTINGAccountants have two primary external reporting responsibilities: the preparation of tax returns and external financial reports (see Figure 1.1 again). Exceedingly complex and constantly changing laws, rules, and forms govern state and federal income taxes, payroll taxes, property taxes, and sales taxes. Accountants have their hands full just keeping up with tax regulations and forms. Accountants also have to stay abreast of changing accounting standards to prepare external financial reports.
External Financial Reports In the next chapter I present an overview of external financial reports. Please bear in mind that this book does not examine in any great detail the external financial reports of business.* This book is mainly concerned with internal reports to man agers and how managers analyze the information in these reports for making decisions and for controlling the financial performance of the business. Only a few brief comments about external financial reporting of particular importance to managers are mentioned here.
The financial statements of a business that are the core of the external financial reports sent to its shareowners and lenders must conform with generally accepted accounting principles (GAAP). These are the authoritative guidelines, rules, and standards that govern external financial reporting to the outside investors and creditors of a business. The main purpose of having financial statements audited by an inde- pendent CPA firm is to test whether the statements have been prepared according to GAAP. If there are material departures from these ground rules of financial statement accounting and disclosure, the CPA auditor says so in the audit opinion on the financial statements.
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