Many small medium business are confused over the difference between these accounting principles. Unless you have some formal training in accounting, it may be a little confusing. Most prefer to just leave it to the accounts person, but as owners, we really should take more care.
At first let us understand what accounting is. Accounting may be defined as a system of collecting, summerising, analyzing, and reporting in financial terms, information about a business organization. The business accounting as understood today, comprises of, financial accounting, and management accounting. These two parts of the business system have something in common and there are differences as well.
As a part of the accounting system of business enterprises, these two differ from each other in many respects. The first difference is in its structure or formats of its presentation of information. Financial accounting has a single unified structure of presentation, which means, that the information relating to enterprise business system is presented more or less on a uniform basis. The end products of linancial accounting are its three basic financial statements, and these are:
- The balance sheet.
- The profit and loss account/income statement.
- The statement of changes in financial position.
The balance sheet presents the financial position of an organization at any point of time. The profit anil loss statement would contain the organization’s financial performance over a specified period of time, which is usually one year. The inflow and outflow of financial resources of an organization during a period of time is reported in the statement of changes. The financial statements prepared are based upon an equation or model, which implies, that all organizations present their linancial statements on basis of a uniform structure. This would mean that financial accounting has a unified structure.
Primarily, financial statements are usually meant for people outside the organization, such as shareholders, creditors, government, the general public, and like others. These people also get such reports from other organizations, and to maintain uniformity in these statements, financial accounting system uses a unified structure system.
On the other hand, management accounting is mainly concerned with the in-house management. Since the accounting statements are used internally, it varies in structure from organization to organization, depending upon the circumstances and requirements of individual use. Therefore, management accounting is tailored to meet the needs ot the management of the particular organization.
The next difference is in the generally accepted accounting principles. Financial accounting is prepared in accordance with the Generally Accepted Accounting Principles, which in short is known as GAAP. Preparation of financial statements following GAAP ensures that the account presentations have been prepared on basis of a norm, as per the general guidelines issued by law.
On the other hand, management accounting is an in-house requirement, and is for the exclusive use of the management of the organization. These management accounting statements are never made available to the outsiders, and hence could be formulated in the manner as wanted by the in-house management.
The third difference between financial accounting and management accounting is the statutory requirement of preparation of accounts. As discussed above, financial statements are prepared solely for the people outside the organization, who have interests in the business operation of the organization. There are shareholders, who would use the information contained in the linancial statements, to decide whether or not to invest in the organization. By law it is mandatory to prepare such statements, and it is a statutory obligation. In fact, the company law not only makes it mandatory to prepare such accounts, it also has laid down the structures, based on which such financial statements need to be prepared.
The fourth difference is the reflection of historical accounts. As mentioned above. there are three types of financial accounting statements that are prepared. Within these three, while the balance sheet and the profit and loss account, report the financial position on a particular date, and the results of operation of the organization during a specific period of time respectively, the statement of changes of the financial position reports the inflow and outflow of resources during a particular period of time. Therefore, financial statements record historical data. On the other hand, management accounting does not record any financial history of the organization.
The fourth difference relates to segment reporting. Financial accounting pertains to the business as a whole, though some organizations segment such accounting for its different operating centres. But as and when the financial statements are presented, it shows the business as a whole. Contrary to this, the management accounting system may present statements in segmented fashion.
Finally, the financial accounting and management accounting differs in respect of their ultimate objectives. Financial accounting is prepared specifically for external reporting, where-as. management accounts are solely for in-house use.
COST ACCOUNTING
Then came Ihe third term that can be found in many account and management books. What is cost accounting? Some say that cost accounting is a subset of management accounting. Some define cost accounting as a manufacturer’s financial accounting.
Cost accounting can be described as the process of accumulating, measuring, analyzing, interpreting and reporting cosl information that is both useful and relevant to Ihe inleraal and external stakeholders of a business entity. External slaveholders are those who have a vested financial interest in a business or company. For example banks (loans), financial houses (mortgages), investors (investments), etc. Internal stakeholders are the business or company directors, managers, division heads, etc.
One of the many benefits of cost accounting is that it turns data into information, knowledge and wisdom about a business entity’s operations that is useful for:
- measuring performance
- reducing or managing costs
- determining the fees or prices for goods and services
- deciding to authorize, modify or discontinue a program or acltivity
Another benefit is that information on the costs programs and activities may be used as a basis to estimate future costs in preparing and reviewing budget requests. Once budgets are approved and executed, cost information serves as a useful feedback on performance.
Moreover, costs may he compared lo known or assumed benefits to identify value-added and non-value added activities. Reliable information on the cost of programs and activities is crucial for the effective management of a business entity’s operations. Cost accounting is especially important for fulfilling the objective of assessing operational performance. The objective is to improve the efficiency and effectiveness of operations by furnishing program managers and others with timely and relevant cost-based performance information to allow for continuous improvement in delivering outputs and outcomes to stakeholders. Cost accounting has been with us since early times to help managers understand the costs of running a business. Modern cost accounting originated during the industrial revolution, when the complexities of running a large scale business led to the development of systems for recording and tracking costs to help business owners and managers make decisions.
In the early industrial age, most of the costs incurred by a business were what modern accountants call “variable costs” because they varied directly with the amount of production. Money was spent on labour, raw materials, power to run a factory, etc. in direci proportion to production. Managers could simply total the variable costs for a product and use this as a rough guide for decision-making.
Some costs tend to remain the same even during busy periods, unlike variable costs which rise and fall with volume of work. Overtime, the importance of these “fixed costs” has become more important to managers. Examples of fixed costs include the depreciation of plant and equipment, and the cost of departments such as maintenance, tooling, production control, purchasing, quality control, storage and handling, plant supervision and engineering. In the early twentieth century, these costs were of little importance to most businesses. However, in the twenty-first century, these costs are often more important than the variable cost of a product, and allocating them to a broad range of products can lead to bad decision making.
In modern accounting, costs are measured in accordance with Generally Accepted Accounting Principles (GAAP). In accordance to GAAP the principle is to record historical events and assign a monetary value to each event that has taken place. Costs are measured in units of currency by convention. Cost accounting could also be defined as a kind of management accounting thai translates the Supply Chain (the series of events in the production process that, in concert, result in a product! into financial values.
In conclusion, for any business entity-from the smallest business enterprise to the largest multinational corporation -to be successful requires the use of financial, cost and management accounting concepts and practices. It provides key data to managers for planning and controlling, as well as costing products, services, and customers. The central focus is how it could help managers make better decisions.