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1.1 Financial Accounting & Cost Accounting

Users of Financial Reports

  • Investors – To decide if they should invest.
  • Lenders – To judge if they should give a loan.
  • Tax authorities – To calculate taxes.
  • Suppliers – To decide if they should extend credit.
  • Customers – To assess company reliability (sometimes).

These people are called external users of financial information.

Managers as Internal Users

Managers are the biggest users of accounting info. They use it for:

  1. Planning
  2. Decision Making
  3. Controlling

Two Main Types of Accounting Systems

Type of Accounting Purpose
Financial Accounting Records transactions between the company and external parties and prepares 3 financial statements.
Cost Accounting Tracks internal costs and inventory for internal use.
  • Simplicity vs. Complexity:
    • For small, simple organizations, preparing these statements (B/S, Income Statement and Cash Flow statement) is straightforward as transactions are clear.
    • For large, complex organizations, it becomes much harder because the financial accountant doesn't have all the necessary internal details.

Why Cost Accounting emerged?

Alpha Company's example to understand why cost accounting emerged:

  • Alpha Company (Small & Simple):

    • Initially, Alpha produces a few engineering components on a "made-to-order" basis.
    • The financial accountant easily tracks material purchases, wages, other expenses, and sales.
    • An income statement showing profit can be prepared simply by subtracting total costs from total sales (e.g., Sales 8,00,000 - Material 5,00,000 - Other Expenses 2,00,000 = Profit 1,00,000).

  • Alpha Company (Growing & Complex):

    • Over time, Alpha grows:
      • Increased production volume.
      • Added more products and customers.
      • Started producing complex items, sometimes using imported materials.
      • Began stocking standard products (no longer just made-to-order).
      • Started holding inventory (e.g., 10 days' worth of material due to supply uncertainty).
    • The Challenge for the Financial Accountant: Now, the financial accountant can't simply subtract total purchases from total sales to find profit because:-
      • Not all purchased materials are consumed
      • Not all products started are completed
      • Not all completed products are sold
    • If the financial accountant incorrectly matches total purchases and production expenses to only the units sold, it would show a huge loss! They need to know the cost of sales

Role of the Cost Accountant

Tracks:

  • Material issued to production.
  • Movement of semi-finished and finished goods.
  • Provides the closing inventory value (materials, work-in-process, finished goods).

Helps the financial accountant:

Profit = Sales – Expenses – Closing Stock

Birth and Growth of Cost Accounting

  1. Developed as a sub-system of financial accounting.
  2. Needed to value closing stock accurately.
  3. Now used for more than just stock valuation:
  • Helps in managerial decisions
  • Used for pricing, cost control, efficiency.

Modern Use of Accounting Information

Companies now use accounting info for:

  • Studying competitors
  • Understanding customers
  • Analyzing suppliers

Example:

  • A software company identifies firms with high inventory values.
  • Then pitches inventory management software to them.
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