1.2 Who Uses Accounting Information?

The accounting system generates output in the form of financial reports. As shown in Figure 1.4, there are two major categories of reports: internal and external. Internal reports are used by those who direct the day-to-day operations of a business enterprise. These individuals are collectively referred to as “management,” and the related area of accounting is called managerial accounting, or management accounting. Managerial accounting focuses on the information needed for planning, implementing plans, and controlling costs. Managers and executives who work inside a company have access to specialized managerial accounting information that is not available to outsiders. For example, the management of McDonald’s Corporation has detailed managerial accounting data on exactly how much it costs to produce each food and drink item on the menu. Further, if Burger King or Wendy’s starts a local burger price war in, say, Missouri, McDonald’s managers can request daily sales summaries for each store in the area to measure the impact.

Other examples of decisions made using managerial accounting information are whether to produce a product internally or purchase it from an outside supplier, what prices to charge, and which costs seem excessive. Consider companies that produce computers. Most computers are shipped with an operating system already installed. More than 75% of computers have Microsoft’s Windows preinstalled. The computer makers must decide whether to develop their own operating system or pay Microsoft a licensing fee to use Windows. Most computer manufacturers have determined it is cost-effective to license from Microsoft. Companies like Costco often use products produced by outside suppliers rather than manufacture the products themselves. The products are then labeled with brand names like “Kirkland Signature” and sold to customers. These are just two examples of decisions that must be made by management given available financial information.

External financial reports, included in the firm’s annual report, are used by individuals and organizations that have an economic interest in the business but are not part of its management. Information is provided to these “external users” in the form of general-purpose financial statements and special reports required by government agencies. The general-purpose information provided by financial accounting is summarized in three primary financial statements: balance sheet, income statement, and statement of cash flows (discussed in Topic 2).

• The balance sheet. Reports the resources of a company (the assets), the company’s obligations (the liabilities), and the owners’ equity, which represents the difference between what is owned (assets) and what is owed (liabilities).

• The income statement. Reports the amount of net income earned by a company during a period.

• The statement of cash flows. Reports the amount of cash collected and paid out by a company in the following three types of activities: operating, investing, and financing.

Examples of external users of the information contained in these three financial statements, along with other available information, are described in the following paragraphs.

Lenders

Lenders (creditors) are interested in one thing—being repaid, with interest. If you were to approach a bank for a large loan, the bank would ask you for the following types of information in order to evaluate whether you would be able to repay the loan:

• A listing of your assets and liabilities

• Payroll stubs, tax returns, and other evidence of your income

• Details about any monthly payments (car, rent, credit cards, etc.) you are obligated to make

• Copies of recent bank statements to document the flow of cash into and out of your account

In essence, the bank would be asking you for a balance sheet, an income statement, and a statement of cash flows. Similarly, banks use companies’ financial statements in making decisions about commercial loans. The financial statements are useful because they help the lender predict the future ability of the borrower to repay the loan.

In the case of Walmart, for example, a review of its balance sheet indicates that the company has several formal lenders. In addition, Walmart reports a balance in its Accounts Payable account. This amount represents amounts owed to vendors from whom Walmart has purchased on credit. Considering Walmart’s reputation, this “lending” is very low risk.

Investors

Investors want information to help them estimate how much cash they can expect to receive in the future if they invest in a business now. Financial statements, coupled with knowledge of business plans, market forecasts, and the character of management, can aid investors in assessing future cash flows. Many companies have broad ownership with a few individuals owning a large portion of the company’s stock. Examples include Walmart with members of the Walton family owning a significant number of shares and Mark Zuckerberg owning a large number of shares of Facebook.

Obviously, millions of Americans invest in McDonald’s, Walmart, General Electric, and other public companies without ever seeing the financial statements of these companies. Investors can feel justifiably safe in doing this because large companies are followed by armies of financial analysts who would quickly blow the whistle if they found information suggesting that investors in these companies were at serious risk. But what about investing in a smaller company, one that the financial press doesn’t follow, or in a local family business that is seeking outside investors for the first time? In such cases, investing without looking at the financial statements is like jumping off the high dive without looking first to see if there is any water in the pool.

Management

In addition to using managerial accounting information available only to those within the firm, managers of a company can use the general financial accounting information that is also made available to outsiders. Company goals are often stated in terms of financial accounting numbers, such as a target of sales growth in excess of 5%. Also, reported “net income” is frequently used in calculating management bonuses. Finally, managers of a company can analyze the general-purpose financial statements (using techniques introduced in Topic 6 and discussed in detail in Topic 14) in order to pinpoint areas of weakness about which more detailed managerial accounting information can be sought.

Other Users of Financial Information

There are many other external users of financial information, including suppliers, customers, employees, competitors, government agencies, and the press. These are described below.

Suppliers and Customers

In some settings, suppliers and customers are interested in the staying power of a company. On the supplier side, if Boeing receives an order from an airline for 30 new 747s over the next 10 years, Boeing wants to know whether the airline will be around in the future to take delivery of and pay for the planes. On the customer side, a homeowner who has foundation repair work done wants to know whether the company making the repairs will be around long enough to honor its 50-year guarantee. Financial statements provide information that suppliers and customers can use to assess the long-run prospects of a company.

Employees

Employees are interested in financial accounting information for a variety of reasons. As mentioned earlier, financial statement data are used in determining employee bonuses. In addition, financial accounting information can help an employee evaluate the likelihood that the employer will be able to fulfill its long-run promises, such as pensions and retiree health care benefits. Financial statements are also important in contract negotiations between labor unions and management.

Competitors

If you were a manager at PepsiCo, would you be interested in knowing the relative profitability of Coca-Cola’s operations in the United States, Brazil, Japan, and France? Of course you would, because that information could help you identify strategic opportunities for marketing efforts where potential profits are high or where your competitor is weak. Similarly, Walmart can use information in financial statements to track its competitors and identify new opportunities to grow and use its market share in retail to increase its revenues in other ventures.

Government Agencies

Federal and state government agencies use financial accounting information frequently. For example, to make sure that investors have sufficient information to make informed investment decisions, the Securities and Exchange Commission monitors the financial accounting disclosures of companies (both U.S. and foreign) whose stocks trade on U.S. stock exchanges. The International Trade Commission uses financial accounting information to determine whether the importation of Ecuadorian roses or Chinese textiles is harming U.S. companies through unfair trade practices. The Justice Department uses financial statement data to evaluate whether companies are earning excessive monopolistic profits.

The Press

Financial statements are a great place for a reporter to find background information to flesh out a story about a company. For example, a story about Walmart can be enhanced by using the sales data shown in its annual report. In addition, a surprising accounting announcement, such as a large drop in reported profits, is a trigger for an investigative reporter to write about what is going on in a company.

In summary, who uses financial accounting information? Everyone does, or at least everyone should. External financial reports come within the area of accounting referred to as financial accounting. Most of the data needed to prepare both internal and external reports are provided by the same accounting system. A major difference between managerial and financial accounting is the types of financial reports prepared. Internal reports are tailored to meet the needs of management and may vary considerably among businesses. General-purpose financial statements and other external reports, however, follow certain standards or guidelines and are thus more uniform among companies.

Questions Practice Exercises