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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 out-
side 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.


Accounting System

Facilitating operations External financial reports
Main examples include: Main features:
• Payroll • Three primary financial state-
• Purchasing ments, as well as footnotes
• Billing and cash collections and other disclosures
• Cash disbursements • Prepared according to gener-
• Property records ally accepted accounting prin-
ciples (GAAP)
• May be audited by CPA
Management control
• Financial reporting by publicly
reports owned corporations also gov-
Main features: erned by federal securities
• Comparison of actual per- laws
formance and results
against plans, goals, and
• Very detail oriented
Tax returns
• Problems and out-of-control
Main types are:
areas highlighted
• Federal and state in-
come taxes
Management decision- • Property taxes
making reports • Sales taxes
Main features: • Payroll taxes
• Based on profit and cash
flow models
• Designed for decision-
making analysis by man-
• Global focus on primary
factors that drive profit,
cash flow, and financial

FIGURE 1.1 Primary 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.), Figure 1.1 reveals two 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 for
decision 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).

Accountants 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.
External financial reports include footnotes that are an
integral addendum to the financial statements. Footnotes are
needed because the external financial report is directed to
outside investors and creditors of the business who are not
directly involved in the day-to-day affairs of the business.
Managers should already know most of the information dis-
closed in footnotes. If managers prefer to have certain foot-
notes included in their internal accounting reports, the
footnotes should be included”probably in much more detail
and covering more sensitive matters than footnotes presented
in external financial reports.
An external financial report includes three primary finan-
cial statements: One summarizes the profit-making activities
of the business for the period; one summarizes the cash
inflows and outflows for the same period; and one summa-
rizes the assets of the business at the end of the period that
are balanced by the claims against, and sources of, the assets.

*Without too much modesty, I can recommend my book, How to Read a
Financial Report, 5th ed. (New York: John Wiley & Sons, 1999).


The three primary financial statements do not come with
built-in analysis. Rather, the financial statements provide an
organized source of information. It™s up to the users to extract
the vital signals and messages from the statements. As I
explain later, managers need much more information than are
reported in the external financial statements.
For example, suppose you™re about ready to lower sales
prices 10 percent because you think sales volume will
increase more than enough to make this a smart move. You™d
better know which profit and cash flow analysis tools to use to
test the impact of this decision on your business. The external
profit report does not provide the information you need.
Rather, you need the type of internal profit report explained in
Chapter 3 to analyze just how much sales volume would have
to increase in order to increase profit. You might be surprised
by how much sales volume would have to increase. If you
think sales volume would have to increase by only 10 percent,
you are dead wrong!

GAAP have been developed to standardize accounting meth-
ods for measuring net income (bottom-line profit), for present-
ing financial condition and cash flow information, and to
provide financial disclosure standards for reporting to exter-
nal investors and lenders to business. Over the years GAAP
have come a long way, but have not yet resulted in complete
uniformity and consistency from one business to the next, or
even among companies in the same industry. Businesses can
choose from among different but equally acceptable account-
ing methods, which can cause a material difference in the
profit (net income) reported for the year and in the values of
certain assets, liabilities, and owners™ equity accounts
reported in the financial statements of a business.
Profit depends on how it™s measured”in particular, on
which accounting methods have been selected and how the
methods are applied in practice. I™m reminded of the old base-
ball joke here: There™s an argument between the batter and the
catcher about whether the pitch was a ball or a strike. Back
and forth the two go, until finally the umpire settles it by saying
“It ain™t nothing until I call it.” Likewise, someone has to decide
how to “call” profit for the period; profit depends on how the


“strike zone” is determined, and this depends heavily on which
particular accounting methods are selected to measure profit.
External financial reports are the primary means of com-
munication to fulfill the stewardship fiduciary function of
management”that is, to render a periodic accounting of what
has been done with the capital entrusted to management. The
creditors and shareowners of a business are the sources of, as
well as having claims on, the assets of the business. There-
fore, they are entitled to a periodic accounting by their stew-
ards (agents is the more popular term these days).
Please keep in mind that managers have a fiduciary respon-
sibility to the outside world. They are responsible for the
fairness and truthfulness of the financial statements. There™s
no doubt that top management has the primary responsibility
for the business™s financial statements”this cannot be shifted
or “outsourced” to the CPA auditor of its financial statements.
Nor can legal counsel to the business be blamed if top manage-
ment issues misleading financial statements, unless they were a
party to a conspiracy to commit fraud.
Because external financial reports are public in nature, dis-
closure is limited, especially in the profit performance report
of a business. Disclosure standards permit the business to
withhold information that creditors and external investors
probably would like to know. The theory of this, I believe, is
that such disclosure would reveal too much information and
cause the business to lose some of its competitive advantages.
The internal accounting profit report presented in the next
chapter contains confidential information that the business
wouldn™t want to reveal in its external financial report to the
outside world.
Publicly owned corporations are required to include a man-
agement discussion and analysis (MD&A) section in their
annual financial reports to stockholders, which deals with the
broad factors and main reasons for the company™s profit per-
formance. Generally speaking, these sections are not too spe-
cific and deal with broad issues and developments over the

The book analyzes how to make profit. So it seems a good
idea in conclusion to say a few words in defense of the profit


motive. Profit stimulates innovation; it™s the reward for taking
risks; it™s the return on capital invested in business; it™s com-
pensation for hard work and long hours; it motivates effi-
ciency; it weeds out products and services no longer in
demand; it keeps pressure on companies to maintain their
quality of customer service and products.
In short, the profit system delivers the highest standard of


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