LEARNING OBJECTIVE 1 Identify the major differences and similarities between financial and managerial accounting.

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/free/0072834943/0072834943_001_00004.jpg','popWin', 'width=99,height=126,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a> 1–1

Financial accounting reports are prepared for external parties such as shareholders and creditors, whereas managerial accounting reports are prepared for managers inside the organization. This contrast in orientation results in a number of major differences between financial and managerial accounting, even though both disciplines often rely on the same underlying financial data. These differences are summarized in Exhibit 1–2.

EXHIBIT 1–2 Comparison of Financial and Managerial Accounting <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/free/0072834943/0072834943_001_00006.jpg','popWin', 'width=525,height=604,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

As shown in Exhibit 1–2, financial and managerial accounting differ not only in their user orientation but also in their emphasis on the past and the future, in the type of data provided to users, and in several other ways. These differences are discussed in the following paragraphs.

Emphasis on the Future

Since planning is such an important part of the manager’s job, managerial accounting has a strong future orientation. In contrast, financial accounting primarily provides summaries of past financial transactions. These summaries may be useful in planning, but only to a point. The future is not simply a reflection of what has happened in the past. Changes are constantly taking place in economic conditions, customer needs and desires, competitive conditions, and so on. All of these changes demand that the manager’s planning be based in large part on estimates of what will happen rather than on summaries of what has already happened.

Relevance of Data

Financial accounting data are expected to be objective and verifiable. However, for internal uses the manager wants information that is relevant even if it is not completely objective or verifiable. By relevant, we mean appropriate for the problem at hand. For example, it is difficult to verify estimated sales volumes for a proposed new store at Good Vibrations, but this is exactly the type of information that is most useful to managers in their decision making. The managerial accounting information system should be flexible enough to provide whatever data are relevant for a particular decision.

Less Emphasis on Precision

Making sure that dollar amounts are accurate down to the last dollar or penny takes time and effort. While that kind of accuracy is required for external reports, most managers would rather have a good estimate immediately than wait for a more precise answer later. For this reason, managerial accountants often place less emphasis on precision than financial accountants do. In fact, one authoritative source recommends that, as a general rule, no one needs more than three significant digits in the data that are used in decision-making.¹ For example, in a decision involving hundreds of millions of dollars, estimates that are rounded off to the nearest million dollars are probably good enough. In addition to placing less emphasis on precision than financial accounting, managerial accounting places much more weight on nonmonetary data. For example, data about customer satisfaction may be routinely used in managerial accounting reports.

Segments of an Organization

Financial accounting is primarily concerned with reporting for the company as a whole. By contrast, managerial accounting focuses much more on the parts, or segments Any part of an organization that can be evaluated independently of other parts and about which the manager seeks financial data. Examples include a product line, a sales territory, a division, or a department., of a company. These segments may be product lines, sales territories, divisions, departments, or any other categorization of the company’s activities that management finds useful. Financial accounting does require some breakdowns of revenues and costs by major segments in external reports, but this is a secondary emphasis. In managerial accounting, segment reporting is the primary emphasis.

Generally Accepted Accounting Principles ( GAAP )

Financial accounting statements prepared for external users must be prepared in accordance with generally accepted accounting principles (GAAP). External users must have some assurance that the reports have been prepared in accordance with some common set of ground rules. These common ground rules enhance comparability and help reduce fraud and misrepresentation, but they do not necessarily lead to the type of reports that would be most useful in internal decision making. For example, GAAP requires that land be stated at its historical cost on financial reports. However, if management is considering moving a store to a new location and then selling the land that the store currently sits on, management would like to know the current market value of the land—a vital piece of information that is ignored under GAAP.

Managerial accounting is not bound by GAAP. Managers set their own rules concerning the content and form of internal reports. The only constraint is that the expected benefits from using the information should outweigh the costs of collecting, analyzing, and summarizing the data. Nevertheless, as we shall see in subsequent chapters, it is undeniably true that financial reporting requirements have heavily influenced management accounting practice.

Managerial Accounting—Not Mandatory

Financial accounting is mandatory; that is, it must be done. Various outside parties such as the Securities and Exchange Commission (SEC) and the tax authorities require periodic financial statements. Managerial accounting, on the other hand, is not mandatory. A company is completely free to do as much or as little as it wishes. No regulatory bodies or other outside agencies specify what is to be done, or, for that matter, whether anything is to be done at all. Since managerial accounting is completely optional, the important question is always, “Is the information useful?” rather than, “Is the information required?”