Accounting can be used to accomplish a lot of things. The trick is knowing what those things are, and how best to use accounting for each of them.
There are three main types of accounting:
- Financial accounting
- Management accounting
- Tax accounting.
Each has its own purpose.
Financial accounting is about creating a clear picture of a company’s financial position. Financial accounting helps people outside the company understand what it is worth and whether they should entrust their money to it or buy shares in it or lend it money. To do this, financial statements have to be consistent so that investors can compare one firm with another, and audited so that everyone knows they have been checked for errors.
Management accounting is about helping managers make decisions. Management accounting helps managers run their businesses more efficiently. It does this by providing information on how well each part of the business contributes to profits, as opposed to just giving a snapshot of how profitable the whole thing was last year. Management accountants calculate measures such as contribution margin and return on investment that show which parts of the business are profitable and which aren’t. They also calculate measures such as inventory turnover and accounts receivable turnover that tell managers how well they are keeping up with demand.
Tax accounting is about compliance with the tax code.
Accounting has two jobs.
- One job is to keep track of the money that comes in and out of a business.
- The other job is to provide a measure of how well the business is doing.
It helps to have a clear understanding of what each of these jobs entails, because they’re quite different.
The job of keeping track of the money that comes into and out of a business is a bit like being a receptionist at a hotel. You need to know who’s coming in, when they’re leaving, what room they’re going to, whether they paid cash or used a credit card, and so on.
In order to do this job it’s essential for you to have all kinds of information about them: name, address, phone number, credit card number. You need this information even though you don’t really care very much about what happens to them after they check out; all you care about is handling the transaction while it’s happening.
Most people think of accounting as one thing, but in fact it is several different things. The most fundamental differences are between financial accounting and managerial accounting.
Financial accounting focuses on measuring the value of a company to investors. This includes keeping track of how much money you have, what rights to take money out of the company you have, and so on. It also includes financial statements like profit-and-loss statements and balance sheets.
Financial accounting can be useful — but it tends to focus on the short term. If you take money out of your company to buy a boat, that will reduce profit this quarter also probably cost you value in the long term.
Financial accounting tells you how much money you made this quarter; managerial accounting helps you figure out whether that was a good idea or not.
Management accounting is focused on helping managers make good decisions — which means not just decisions that maximize short-term profits, but any decision that has a cost and an effect on the future of the company. It is for measuring stuff like inventory control or cash flow or marketing effectiveness or new product development or even simple tasks like keeping track of how many pencils you have left in the break room.
Accountants are often thought of as boring, but that’s because most people don’t understand accounting.
A personal financial statement is a snapshot of your net worth at one point in time. It tells you how rich you are, not how you got that way.
A business financial statement is a movie, telling the story of how the business got to where it is today.
Companies make money by doing things that other people want. When they make more money than they spend, the excess is called profit. Businesses can make money in several ways: they can charge more for their products than it cost to make them; they can charge less for their products than it costs to make them, but then sell enough volume to cover their costs; or they can do something that other people want done so much that they will pay for it even though it costs more to do it than the money they bring in.
Accounting is about making the numbers tell stories about the past and predict the future.
Accounting is a way of designing incentives. That doesn’t mean it is a bad thing. But it does mean you have to be careful about how you use it.
One of the most basic ways to use accounting is to pay people more for better performance. But if you do that, you also need to make sure they know what good performance is. You can’t just say “be more productive.” You have to define productivity in some objective way, and then measure how productive each employee has been.
You could define productivity as revenue minus cost – how much money did we make? – but that would not be very useful unless the employees’ incentives lined up with your company’s goals. If your company makes lawnmowers, then paying an employee more if he sells more lawnmowers might work; but if your company makes missiles, you probably don’t want employees trying to cut costs by building cheaper missiles.
There are, broadly speaking, two different ways to do accounting. One is called Generally Accepted Accounting Principles (GAAP). The other is what accountants sneeringly refer to as “creative accounting.”
As a general rule, the stricter rules you follow, the more honest your accounting. If you make something up, no one can check whether you’re telling the truth. But if you try to follow the rules exactly and consistently, everyone can see whether you’re following them or not.
Which system is better? It depends. If you’re a publicly traded company, GAAP is the law. Creative accounting will be discovered sooner or later and could land you in jail. As long as your business is unimportant enough that no one cares if it’s solvent or not, then creative accounting might be an OK thing to do: You’ll know what’s true and what isn’t true, and so will your customers and suppliers.
There’s an old joke about bookkeeping: The criminally inclined start by robbing banks; next they rob their customers; and finally they rob their shareholders. The punchline is supposed to be “next they rob their own employees.” But there’s another punchline: “First they hire an accountant.”
The way we conceptualize our finances reflects the way we conceptualize our lives.
At the broadest level, there are two ways to think about one’s finances: as a lifetime income stream, or as a set of financial assets and liabilities. The first is an accountant’s approach; the second is a banker’s approach. Each has its uses; together, they form a more complete picture of your finances than either can alone.
The accountant sees your life as an income stream because that is the only thing that matters to him, and it is all he can see. The banker sees your life as a portfolio of financial assets and liabilities because that is what she deals with every day, and it is all she knows how to talk about. But each view has blind spots.