Financial Accounting vs Management Accounting

Differences Between Financial and Management Accounting

The key difference between financial accounting and management accounting is that financial accounting is the preparation of financial reports for the analysis by the external users interested in knowing the financial position of the company, whereas, management accounting is the preparation of the financial as well as non-financial information which helps managers in making policies and strategies of the company.

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 that 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 in the company or not.

Remember the “Satyam Scandal” where manipulation of accounts was on the forefront! Since management accounting helps to create reports for internal purposes, the risk is not always visible.

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What is Financial Accounting?

Financial accounting helps to classify, analyze, summarize, and record financial transactions of the company. The main objective is to showcase an accurate and fair picture of the financial affairs of the company. To understand it well, first, we should start with a double-entry system and debit & credit, and then gradually should understand journal, ledger, trial balance, and four financial statements.

Double-Entry System

This is the essence of financial accounting. Every financial transaction has two equal aspects. That means if cash is withdrawn from the bank, in the company’s book under the double-entry system, both cash and bank would be affected. Under the double-entry system, we call these two aspects debit and credit.

Debit and Credit

Understanding debit and creditUnderstanding Debit And CreditA debit is a left-hand accounting entry that increases an asset or expense account while decreasing a liability or equity account. Credit, on the other hand, is a right-hand accounting entry that decreases an asset or expense account while increasing a liability or equity account.read more 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 in the company in the form of cash. Under the 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 liability rises, we will credit the account.

In this example, both the asset and 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

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

Ledger Entry

Once you know the essence of the 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  

Trial Balance

From ledger, we can create a trial balance. Here are a snapshot and the format of a trial balanceFormat Of A Trial BalanceTrial Balance has a tabular format that shows details of all ledger's balances in one place. As every organization must analyze its financial condition over a specific period of time, it contains transactions done during the year as well as the opening and closing balances of ledgers.read more of the example we took above.

Trial Balance of MNC Co. for the year-end

ParticularsDebit (Amount in $)Credit (Amount in $)
Cash Account20,000
Capital Account20,000
Total20,00020,000

Financial Statements

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.

Income statement:

The purpose of the income statementPurpose Of The Income StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more 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 the income statement –

ParticularsAmount
Revenue*****
Cost of Goods SoldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.read more(*****)
Gross Margin****
Labour(**)
General & Administrative Expenses(**)
Operating Income (EBIT)***
Interest Expenses(**)
Profit Before Tax***
Tax Rate (% of Profit before tax)(**)
Net Income***
Balance Sheet:

Balance Sheet is based on the equationBalance Sheet Is Based On The EquationBalance Sheet Formula is a fundamental accounting equation which mentions that, for a business, the sum of its owner’s equity & the total liabilities equal to its total assets, i.e., Assets = Equity + Liabilitiesread more – “Assets = Liabilities + Shareholders’ Equity.” Here’s a simple snapshot of the balance sheetSnapshot Of The Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more so that you can understand how it is formatted.

Balance Sheet of ABC Company

 2016 (In US $)
Assets 
Cash45,000
Bank35,000
Prepaid Expenses25,000
Debtor40,000
Investments100,000
Equipment30,000
Plant & Machinery45,000
Total Assets320,000
Liabilities 
Outstanding expenses15,000
Creditor25,000
Long term debtTerm DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more50,000
Total Liabilities90,000
Stockholders’ Equity 
Shareholders’ equity210,000
Retained EarningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more20,000
Total Stockholders’ Equity230,000
Total liabilities & Stockholders’ Equity320,000
Shareholders’ equity statement:

Shareholders’ equity statement is a statement that includes shareholders’ equity, retained earnings, reserves, and many such items. Here’s a format of shareholders’ equity statement –

Shareholders’ Equity 
Paid-in Capital: 
Common Stock***
Preferred Stock***
Additional Paid-up Capital: 
Common Stock**
Preferred Stock**
Retained Earnings***
(-) Treasury Shares(**)
(-) Translation Reserve(**)
Cash flow statement:

The objective of the cash flow statementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities.read more 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 activitiesCash Flow From Operating ActivitiesCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more (which can be calculated using a direct and indirect method of cash flow), cash flow from financing activities, and cash flow from investing activitiesCash Flow From Investing ActivitiesCash flow from investing activities refer to the money acquired or spent on the purchase or disposal of the fixed assets (both tangible and intangible) for the business purpose. For instance, the purchase of land and joint venture investment is cash outflow, while equipment sale is a cash inflow.read more. All non-cash expenses (or losses) are added back, and all non-cash incomes (or profits) are deducted to get precisely 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 significant 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.

If you want to learn Cost AccountingCost AccountingCost accounting is a defined stream of managerial accounting used for ascertaining the overall cost of production. It measures, records and analyzes both fixed and variable costs for this purpose.read more professionally, then you may want to look at 14+ video hours of Cost Accounting Course.

Periodical Reports

The critical 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 that helps the management get a snapshot of what’s going on in the business and where they can go in the near future.

These reports are only created for internal purposes and not for 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 the 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 balanced 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 for 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 –

Functions

Management accounting has some crucial functions that are as follows –

Financial Accounting vs. Management Accounting Infographics

Let’s see the top differences between financial vs. management accounting.

Financial Accounting vs Management Accounting

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Key Differences

Financial vs. Management of Accounting Comparative Table

Basis for ComparisonFinancial AccountingManagement Accounting
Inherent meaningClassifies, analyses, records, and summarizes the financial affairs of the company.Management accounting helps management make effective decisions about the business.
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.
ScopeThe scope is pervasive, but not as much as the management accounting.The scope is much broader.
Measuring gridQuantitative.Quantitative and qualitative.
DependenceIt is not dependent on management accounting.It takes help from financial accounting to make the right decisions.
Basis of decision making Historical information is the basis of decision making.Historical and predictive information is the basis of decision making.
Statutory requirementIt is legally mandatory to prepare financial accounts of all companies.Management accounting has no statutory requirement.
FormatFinancial accounting has specific formats for presenting and recording information.There’s no set format for presenting information in management accounting.
Used forMainly for potential investors and all stakeholders.Only for management;
RulesFinancial accounting should be prepared as per the GAAPGAAPGenerally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors.read more or IFRS.Management accounting doesn’t follow any rule.
VerifiableThe information presented is verifiable.The information presented is predictive and not immediately verifiable.

Conclusion

  • Both accounting is a great tool for management to run the business well.
  • Management accounting is solely devoted to serving management decision making, but without financial accounting, its function would be limited and narrower.
  • Financial accounting, on the other hand, is mandatory as per the statutory requirement. It needs to be prepared because, legally, every company is bound to disclose right and accurate information to the potential & existing investors and governments.

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Comments

  1. Stella Raphael says

    Thankyou for the helpful information above…

    • Dheeraj Vaidya says

      Thanks for your kind words!