Why anyone keeps score¶
Every business, from a lemonade stand to a warehouse chain with hundreds of stores, has to answer the same question: what actually happened to our money this year? Investors want to know before they hand over their savings. Banks want to know before they lend a dime. Managers want to know so they can fix what isn't working. Financial accounting is the system that answers that question, in numbers other people can trust and compare.
The $65 question¶
Costco Wholesale collects roughly $5 billion a year in membership fees, paid up front for a year of shopping. A new member walks up to the counter, hands over $65, and walks out with a card good for twelve months of shopping at Costco's prices. Has Costco earned that $65 the moment the cash hits the register, or does it still owe the member eleven more months of access before the money is really Costco's?
That question isn't a technicality. Answering it honestly, and telling the answer to people who weren't standing at the counter, is the whole job of financial accounting. It has two jobs: measure what a business actually did, in dollars, and communicate that measurement to people outside the business who can't watch the register themselves. Stockholders, banks, and regulators all rely on that measurement instead of their own eyes.
Costco is a corporation: a company owned by stockholders, who buy shares of stock in exchange for a claim on whatever the company earns. We'll build every company in this course as a corporation, real or invented, because that's the ownership structure financial accounting's rules are written for.
Not every report inside a company has to follow those rules. If a Costco regional manager wants a report on which stores are overstaffed this week, for her own use, that's managerial accounting: built for one internal decision, on whatever schedule and format she needs. Financial accounting is stricter, because it goes to people outside the company who have no other way to check the numbers.
Financial or managerial?
Costco's warehouse managers get a weekly memo ranking which stores sell the most rotisserie chicken per employee-hour. That memo never leaves the company and follows no outside rulebook, so it's managerial accounting. The annual report Costco mails to stockholders follows a strict set of rules so every reader can trust and compare the numbers. That's financial accounting.
Where the money moves¶
Everything a business does with money sorts into one of three buckets: raising it, spending it on things that will last, or running the day-to-day. Accountants call these financing, investing, and operating activities, and the split matters because each one tells outsiders something different about how a company is doing.
Take Cobalt Tutoring, a small tutoring company three friends started in June. Priya Natarajan and two partners put in $9,000 cash and take shares of stock in return. That's financing: money coming into the company from its owners, not money it earned by tutoring anyone yet. A week later, the company borrows $3,000 more from a bank, signing a note due in two years. That's financing too; a loan is just money raised from a lender instead of an owner.
With that cash, Cobalt buys laptops and a whiteboard for $5,000. That's investing: spending cash on things the company will use for years, not use up in a month. Once the office is set up, the operating activities start. Cobalt pays $600 cash for June's rent, and by the end of the month it has collected $3,200 cash from students for tutoring sessions. Rent and tutoring fees are both operating, because they're part of running the tutoring business itself, month after month.
| Cobalt Tutoring's first month | Category |
|---|---|
| Founders put in $9,000 cash for shares of stock | Financing |
| Borrow $3,000 from a bank, due in two years | Financing |
| Buy $5,000 of laptops and a whiteboard | Investing |
| Pay $600 cash for June's rent | Operating |
| Collect $3,200 cash from students for tutoring | Operating |
Common mistake: counting the founders' cash as something Cobalt earned
The $9,000 the founders put in looks like money coming into the business, so it's tempting to lump it in with the $3,200 collected from students. It isn't the same thing. The $9,000 came from the owners in exchange for stock; the company didn't do anything to earn it. The $3,200 came from students paying for a service Cobalt actually delivered. One is financing, the other is operating, even though both show up as cash in the bank.
Before you go on¶
- Financial accounting measures what a business did and communicates it to people outside the business; managerial accounting serves internal decisions and skips the external rulebook.
- We treat every company in this course, real or invented, as a corporation owned by stockholders.
- Financing activities raise money from owners and lenders; investing activities buy things the company will use for years; operating activities run the day-to-day business.
- Cash from owners is financing, not something the company earned by serving a customer.
Next, we'll look at where all this measuring actually shows up: the documents a corporation hands its stockholders once a year.