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General Accepted Accounting Principles
The differences between financial and management accounting are widespread. Some of these differences include accuracy, mandatory external reports, and emphasis on the financial implications of past activities. These characteristics describe financial accounting. Financial accounting is a way of measuring economic performance. This type of accounting summarizes data to prepare balance sheets and income statements for a business. The particular difference we discuss in this piece will be the difference in Generally Accepted Accounting Principles (GAAP). Financial accounting must follow GAAP while managerial accounting does not have to follow GAAP.
Generally accepted accounting principles help guide companies in recording business transactions. GAAP are not rules, but guidelines that a company must follow when recording. The principles determine the minimum level of correctness of statements. Compliance with GAAP has many positives. Principles maintain credibility because they communicate to outside companies that this GAAP-using company is accurately represented. Shareholders and analysts can read the report if they know it complies with accounting principles.
There are many principles to discuss for GAAP. The six principles we will discuss in this article are the economic entity assumption, accrual accounting, revenue recognition principle, relevance, reliability and consistency principle, materiality principle and cost principle. An economic entity includes any organization in the economy. Examples may include schools, hospitals, governments, and churches. Each event must be recorded by a specific entity. Another part of this principle is that the records should not contain any personal assets or liabilities related to the owners. The second principle is the accrual accounting principle. Accrual accounting captures the financial aspect of each event in the period of occurrence. Revenue is recognized when the business receives cash. Expenses are recognized when the company pays with cash. Further, the principle of revenue recognition is when the revenue is earned after the completion of the product or service, but without considering the timing of the cash flow. The final principle in the discussion of GAAP is relevance, reliability, and consistency. The information must be useful. For this information to be useful in accounting, it must be relevant, reliable and in a consistent manner.
Adequate information will help to correctly understand the choice of decision by studying the past performance of companies and the future situation. Internal users need accurate data to assess the value of the company. Reliable information must be confirmed. Otherwise, this information cannot be used or relied upon in the preparation of financial statements. Finally, the information must be consistent. This means that the methods must be the same for each accounting period. They can be compared between accounting periods if they are consistent. Consistency will help the company evaluate accounting period methods. The materiality principle states that the requirements of any principle can be ignored if and only if there are no consequences for users of financial information. An example of this principle would be tracking individual staples used in an office department. There is no definitive criterion for calculating the clamps used. This dollar judgment is not a significant entity for a large corporation, but it may be for small, privately owned businesses. It will depend on the size of the company. The cost principle deals with the recording of the company’s assets. Assets are equal to the exchange value at the time of their acquisition. Assets consisting of land or buildings are valued over time. Land and buildings do not need to be assessed for reporting.
So what’s the difference why management accounting doesn’t have to follow GAAP but financial accounting has to follow the principles? Managerial and financial accounting are two separate types of accounting, so each requires a specific method of financial reporting that helps that type of business. Management accounting is not bound by Generally Accepted Accounting Principles. In managerial accounting, managers set their own rules for financial reporting methods. The application of generally accepted accounting principles establishes a common basis on which external users can rely when evaluating a company. GAAP helps reduce fraud and detect misstatements in financial reports. Management accounting prepares reports for the manager’s internal use only. This information helps in making decisions about the future of the company. There are no specific reports required, only reports that the manager deems appropriate to assist in decision making. Reports are usually focused on departments of the organization rather than the whole. Financial accounting relies on reports for an organization’s perspective. It focuses on specific information because it is used outside the company. Therefore, financial accounting for external reports must follow GAAP.
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