Differences Between Financial Accounting and Management Accounting
Financial accounting and management accounting are like the two legs of the same human. The function of both of them is to ensure that the management progresses toward a better future.
But management accounting is much broader than financial accounting in helping management since the subject “management accounting” is created to serve the management (yes, only the management).
Financial accounting, on the other hand, is a niche subject which helps management see how a company is doing financially. Though financial accounting is created for stakeholders and potential investors who can look at the books of financial accounts and decide for themselves whether they would invest into the company or not.
That means the risk of financial accounting is much more visible than management accounting. Remember the “Satyam Scandal” where manipulation of accounts was on forefront! Since management accounting helps to create reports for internal purpose, the risk is not always visible.
We discuss differences between Financial Accounting vs Management Accounting in the sequence below –
- Financial Accounting vs Management Accounting Infographics
- What is Financial Accounting?
- What is Management Accounting?
- Financial Accounting vs Management Accounting – Key differences
- Financial Accounting vs Management Accounting (Comparison Table)
Financial Accounting vs Management Accounting Infographics
There are a lot of differences between financial accounting vs management accounting. Let’s have a look –
Now let us understand Financial Accounting and Management Accounting in detail.
What is Financial Accounting?
Financial accounting helps to classify, analyze, summarize, and record financial transactions of the company. The main objective of financial accounting is to showcase an accurate and fair picture of financial affairs of the company.
To understand financial accounting well, first, we should start with double entry system and debit & credit, and then gradually should understand journal, ledger, trial balance, and four financial statements.
Let’s start with the double entry system.
Double entry system
This is the essence of financial accounting.
In financial accounting, every financial transaction has two equal aspects. That means if cash is withdrawn from bank, in the company’s book under double entry system, both cash and bank would be affected.
Under double entry system, we call these two aspects debit and credit.
Debit and credit
Understanding debit and credit is easy. You need to remember two rules –
- Debit the increase of assets and expenses and the decrease of liabilities and incomes.
- Credit the increase of liabilities and incomes and the decrease of assets and expenses.
Here’s an example to illustrate debit and credit –
Let’s say that around $20,000 worth of capital is being invested into the company in the form of cash.
Under double entry system, there are two accounts here – cash and capital.
Here cash is an asset and capital is a liability.
According to the rule of debit and credit, when an asset increases, we will debit the account and when a liability will increase, we will credit the account.
In this example, both the asset and the liability are increasing.
So, we will debit the cash since it is an asset and we will credit the capital since it is a liability.
Journal entry is based on the debit and the credit of the accounts. Taking the previous example into account, here’s how a journal entry will look like –
|Cash A/c ………………….Debit||$20,000||–|
|To Capital A/c…………………………….Credit||–||$20,000|
Once you know the essence of double entry system, journal, and ledger, we need to look at ledger entry.
A ledger entry is an extension of the journal entry. Taking the journal entry from above, we can create a T-format for ledger entry.
Debit Cash Account Credit
|To Capital Account||$20,000|
|By balance c/f||$20,000|
Debit Capital Account Credit
|By Cash Account||$20,000|
|To balance c/f||$20,000|
From ledger, we can create a trial balance. Here’s a snapshot and the format of a trial balance of the example we took above.
Trial Balance of MNC Co. for the year end
|Particulars||Debit (Amount in $)||Credit (Amount in $)|
There are four financial statements that every company prepares and every investor should look at –
- Income Statement
- Balance Sheet
- Shareholders’ Equity Statement
- Cash Flow Statement
Let’s understand each of them briefly.
The purpose of the income statement is to find out the net income of the company for the year. We take into account all the financial transactions (including non-cash ones) and do a “revenue – expense” analysis to find out the profit for the year. Here’s the format of income statement –
|Cost of Goods Sold||(*****)|
|General & Administrative Expenses||(**)|
|Operating Income (EBIT)||***|
|Profit Before Tax||***|
|Tax Rate (% of Profit before tax)||(**)|
Balance Sheet is based on the equation – “Assets = Liabilities + Shareholders’ Equity”. Here’s simple snapshot of balance sheet so that you can understand how it is formatted.
Balance Sheet of ABC Company
|2016 (In US $)|
|Plant & Machinery||45,000|
|Long term debt||50,000|
|Total Stockholders’ Equity||230,000|
|Total liabilities & Stockholders’ Equity||320,000|
Shareholders’ equity statement:
Shareholders’ equity statement is a statement which includes shareholders’ equity, retained earnings, reserves, and many such items. Here’s a format of shareholders’ equity statement –
|Additional Paid-up Capital:|
|(-) Treasury Shares||(**)|
|(-) Translation Reserve||(**)|
Cash flow statement:
The objective of cash flow statement is to find out the net cash inflow/outflow of the company. The cash flow statement is a combination of three statements – cash flow from operating activities (which can be computed using a direct and indirect method of cash flow), cash flow from financing activities, and cash flow from investing activities. All non-cash expenses (or losses) are added back and all non-cash incomes (or profits) are deducted to get exactly the net cash inflow (total cash inflow – total cash outflow) for the year.
What is Management Accounting?
Management Accounting collects, analyses, and understands the financial, qualitative, and statistical information to help the management make effective decisions about the business.
Management accounting is much pervasive in scope since the entire business is moved by a single decision made by the top management. The strategy is a big component of it. It also focuses on predicting future scenarios so that the business gets ready to face new challenges and to reach new milestones.
However, management accounting can’t exist without financial accounting, cost accounting, and statistics. Management accountants gather data from financial accounting and evaluate the performance of the financial affairs of the company so that they can predict better targets and can improve the performance in the next year.
The key function of management accounting is to create periodical reports which help the top management make the right and the most effective decisions for the future of business.
These reports don’t have any structured format, but they do provide valuable information which helps the management get a snapshot of what’s going on in the business and where they can go in near future.
These reports are only created for the internal purpose and not for the external stakeholders.
These are the key features of these periodical reports –
- Trends: These reports talks about the current trend and the possible future trend. The graphs, the data points, and the actual results help the management look deep into the challenges the business has been facing and they can find best alternatives for the same. Management accounting doesn’t only talk about the business trend; it also talks about the controllable and uncontrollable factors, the key areas that need the attention of management, and how the company is being viewed by the investors.
- The culmination of quantitative and qualitative data points: The management accounting reports don’t only concentrate on quantitative data points, but also on qualitative data points. Management accounting takes help from cost accounting and financial accounting, but it also uses tools like balance scorecards and other charts to measure the qualitative aspects of the business.
- Informal and prepared for internal use: These management reports have no structure. They are prepared informally and there are no statutory requirements of producing structured reports under management accounting. And these reports are not shown to the investors or potential shareholders. These are prepared just for management only on the basis of which they make effective decisions.
- Predictive statements: As mentioned earlier, management accounting is all about predicting the future. These reports include a good number of predictive statements. These predictive statements are indicators of what might happen in the future and they are based on both future forecasts and historical information.
Tools used in management accounting
There are many tools used in management accounting. Following are top-most which are frequently used –
- Financial modeling Forecasts
- Financial Ratios
- Game theory
- Management Information System
- Key Performance Indicators
- Key Result Areas
- Balance Scorecards etc.
Functions of management accounting
Management accounting has some key functions that are as follows –
- Forecast cash flow: Management accounting forecasts the most important thing in business – cash flow. On the basis of the prediction of incoming cash flow, management decides to take corrective measures to increase the cash flow or to accelerate the growth.
- Forecast the future: Management accounting helps forecast the future of the company, the industry, and the social, political, economic, and technological changes (if any); because all of these factors affect a business or an organization.
- Return on investments: Management accounting analyses and synthesizes all the information gathered. The most important of them is how much the company got back (in terms of money, reputation, growth, and market share) on the time, effort, money, and resources they used.
- Understanding performance variances: The difference between the estimated and the actual performance creates the variance. Management accounting helps the management understand the performances variances and shows measures to correct them.
- Create or outsource decision: Management accounting helps the organization figure out whether to create an infrastructure or to simply outsource the function. For example, management accounting helps an organization decide whether to create an infrastructure to produce the raw materials of the products they produce or simply to outsource the entire function.
Financial Accounting vs Management Accounting – Key differences
Here are the most important differences between financial accounting and management accounting –
- The scope of financial accounting is narrower than management accounting. The scope of management accounting is more pervasive.
- The purpose of financial accounting is to showcase an accurate and fair picture of the financial affairs of the company to potential investors, government, and existing shareholders. The purpose of management accounting, on the other hand, is to facilitate the management in making effective decisions on the behalf of the shareholders.
- Financial accounting is independent of management accounting. Management accounting gathers data and information from financial accounting.
- Financial accounting only talks about quantitative data, and management accounting deals with both quantitative and qualitative data.
- Financial accounting needs to be reported by maintaining certain formats. Management accounting is represented via informal formats or structures.
- Financial accounting is based on historical information. Management accounting, on the other hand, is based on both historical and predictive information.
Financial Accounting vs Management Accounting (Comparison Table)
|Basis for Comparison – Financial Accounting vs Management Accounting||Financial Accounting||Management Accounting|
|1. Inherent meaning||Classifies, analyses, records, and summarizes the financial affairs of the company.||Management accounting helps management make effective decisions about the business.|
|2. Application||Financial accounting is prepared to show forth the accuracy and fair picture of financial affairs.||Management accounting helps management to take meaningful steps and strategize.|
|3. Scope||Scope is pervasive, but not as much as management accounting.||Scope is much broader.|
|4. Measuring grid||Quantitative.||Quantitative and qualitative both.|
|5. Dependence||Financial accounting is not dependent on management accounting.||Management accounting takes help from financial accounting to make right decisions.|
|6. Basis of decision making||Historic information is basis of decision making.||Historic and predictive information is basis of decision making.|
|7. Statutory requirement||It is legally mandatory to prepare financial accounts of all companies.||Management accounting has no statutory requirement.|
|8. Format||Financial accounting has specific formats for presenting and recording information.||There’s no set format for presenting information in management accounting.|
|9. Used for||Mainly for potential investors and all stakeholders.||Only for management.|
|10. Rules||Financial accounting should be prepared as per the GAAP or IFRS.||Management accounting doesn’t follow any rule.|
|11. Verifiable||The information presented is verifiable.||The information presented is predictive and not immediately verifiable.|
Conclusion – Financial Accounting vs Management Accounting
Even if there are many differences between financial accounting vs management accounting, both are great tools for management to run the business well.
Management accounting is solely devoted to serving the management decision making; but without financial accounting, the function of management accounting would be limited and narrower.
Financial accounting, on the other hand, is mandatory as per the statutory requirement. Financial accounting needs to be prepared because legally every company is bound to disclose right and accurate information to the potential & existing investors and governments.