The Science of Meaningful Financial Decision Making | A Story of Numbers

Relevant, accurate and timely financial information is what all stakeholders need to make good financial decisions. The financial information that users need to make meaningful decisions depends on the sorts of decisions they make. There are two broad users of financial information: internal and external.

Managerial accounting is the discipline that concerns itself with providing internal reports to help users make decisions about their companies. Examples include: financial comparisons of operating alternatives, revenue and sales forecasts as well as cash requirements.

Managerial accounting as a discipline emerged during the Industrial Revolution when large-scale manufacturing required a more complex and nuanced accounting system than what was previously available or even necessary. Prior to the Industrial Revolution, accounting as a discipline was largely cash-based.

Due to the large and long-term risks that needed to be undertaken for multinational, sizeable and long-term projects; managerial accounting was conceptualised to allow internal stakeholders to both calculate the costs associated with a particular project as well as forecast their future requirements.

On the other hand, external users of financial information include: investors and creditors. Investors use accounting information to decide whether to buy, hold or sell the shares of a company. Creditors, on the other hand–such as suppliers and bankers–use publicly available accounting information to evaluate the risks of granting credit or lending money. This generally pertains to how similar companies compare in size and profitability; as well as an enterprise’s ability to pay its debts as it becomes due.

For external users and stakeholders, it is the information in the financial statements that informs their decision-making criteria. In addition to investors and creditors, other external users include: tax authorities, regulatory agencies, customers, labour unions and the like.

GAAP

The Generally Accepted Accounting Principles (GAAP) are standards that indicate how to report economic events. Each country has its own primary standard-setting body which develops accounting standards that public companies must follow.

In our globalised business world, interested stakeholders usually compare the information that is derived from the different accounting standards. Convergence becomes a major issue when assessing the results that ensue from the use of different standards–especially when it comes to MNCs.

Firstly, the historical cost vs fair value principles are used in determining how companies will record the value of their assets. When using the historical cost principle, asset value is recorded at the purchase price–regardless of the fluctuations in its value (appreciation and depreciation) that have transpired during the course of the accounting year.

On the other hand, the fair value principle is used when assets and liabilities are reported at a fair value: the price received or paid to sell an asset or settle a liability. Fair value calculations are more more useful in situations where assets are actively traded; such as securities, commodities and the like.

The economic entity assumption underlies the need to keep separate and distinct the economic activities of the owner from the business. For all businesses, the economic activities of the business must be kept separate from the personal activities of the owners.

When it comes to corporations, however, the status of the business as a separate legal entity and the legal liability limitations of the owners; requires yearly external audits by independent accountants (among other obligations). Companies that do not issue stock– i.e, without external investors–are not required to adhere to this particular standard.

The Key Criteria

Long story short, depending on the status on the stakeholder–different information is interpreted and required to make meaningful financial decisions. The ability to interpret the mathematical calculations is based not only upon the numbers themselves; but also requires the expertise to understand the numbers based on other similar firms in the industry. For instance, comparing a tech firm to a hotel would be inappropriate. Similarly, comparing a small tech firm to a tech giant would also be inappropriate.

At the same time, the many nuances of the numbers themselves–based on taxation and financing requirements would lead to a wholly different outcome; even amongst companies that have similar operational activities.

In conclusion, despite the scientific process which underlies the standardisation of the process; significant idiosyncratic and industry-specific information is required to make meaningful decisions that will benefit the organisation as well as all its stakeholders.

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