The primary purpose of financial accounting is to provide investors (for example, shareholders) or creditors (for example, banks) information regarding company and management performance. The financial data prepared for this purpose are governed by generally accepted accounting principles (GAAP) in the United States and international financial reporting standards (IFRS) in many other countries.
GAAP and IFRS provide consistency in the accounting data used for reporting purposes from one company to another. It implies that the cost accounting information used to compute the cost of goods sold, inventory values, and other financial accounting information used for external reporting must be prepared in accordance with GAAP or IFRS. Although GAAP and IFRS are converging, differences remain. For the reasons discussed in the next paragraph, these differences are not important for our discussion, but you should remain aware of them.
In contrast to cost data for financial reporting to shareholders, cost data for managerial use (that is, within the organization) need not comply with GAAP or IFRS. Management is free to set its own definitions for cost information. Indeed, the accounting data used for external reporting are often entirely inappropriate for managerial decision making. For example, managerial decisions deal with the future, so estimates of future costs are more valuable for decision making than are the historical and current costs that are reported externally. Unless we state otherwise, we assume that the cost information is being developed for internal use by managers and does not have to comply with GAAP or IFRS.
This does not mean there is no “right” or “wrong” way to account for costs. It does mean that the best, or correct, accounting for costs is the method that provides relevant information to the decision-maker so that he or she can make the best decision.