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.
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 That means if cash is withdrawn from the bank, in the company’s book under the double-entry system, both cash and bank would be affected.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 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 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 balance of the example we took above.
Trial Balance of MNC Co. for the year-end
| Particulars | Debit (Amount in $) | Credit (Amount in $) |
| Cash Account | 20,000 | – |
| Capital Account | – | 20,000 |
| Total | 20,000 | 20,000 |
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 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 the income statement –
| Particulars | Amount |
| Revenue | ***** |
| Cost of Goods Sold | (*****) |
| 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 equation – “Assets = Liabilities + Shareholders’ Equity.” Here’s a simple snapshot of the balance sheet so that you can understand how it is formatted.
Balance Sheet of ABC Company
| 2016 (In US $) | |
| Assets | |
| Cash | 45,000 |
| Bank | 35,000 |
| Prepaid Expenses | 25,000 |
| Debtor | 40,000 |
| Investments | 100,000 |
| Equipment | 30,000 |
| Plant & Machinery | 45,000 |
| Total Assets | 320,000 |
| Liabilities | |
| Outstanding expenses | 15,000 |
| Creditor | 25,000 |
| Long term debt | 50,000 |
| Total Liabilities | 90,000 |
| Stockholders’ Equity | |
| Shareholders’ equity | 210,000 |
| Retained Earnings | 20,000 |
| Total Stockholders’ Equity | 230,000 |
| Total liabilities & Stockholders’ Equity | 320,000 |
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 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 calculated 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 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 Accounting 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 –
- Simulations
- Financial modeling Forecasts
- Financial Ratios
- Game theory
- Management Information System
- Key Performance Indicators
- Key Result Areas
- Balance Scorecards etc.
Functions
Management accounting has some crucial functions that are as follows –
- Forecast cash flow: Management accounting forecasts the essential 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 performance 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 Infographics
Let’s see the top differences between financial vs. management accounting.
Key Differences
- 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 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 vs. Management of Accounting Comparative Table
| Basis for Comparison | Financial Accounting | Management Accounting |
| Inherent meaning | Classifies, 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. |
| Scope | The scope is pervasive, but not as much as the management accounting. | The scope is much broader. |
| Measuring grid | Quantitative. | Quantitative and qualitative. |
| Dependence | It 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 requirement | It is legally mandatory to prepare financial accounts of all companies. | Management accounting has no statutory requirement. |
| Format | Financial accounting has specific formats for presenting and recording information. | There’s no set format for presenting information in management accounting. |
| Used for | Mainly for potential investors and all stakeholders. | Only for management; |
| Rules | Financial accounting should be prepared as per the GAAP or IFRS. | Management accounting doesn’t follow any rule. |
| Verifiable | The 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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