In this article, we're going to learn about the differences between management accounting and financial accounting.
Some of you might already be familiar with the differences between financial and management accounting if you are already working in the accounting profession. But just to give you a very simple and brief overview, financial accounting is more concerned with putting together statutory reports that are required for external use. When we say statutory reports, we mean reports that are required by law. So, a report that might be required by law, depending on the jurisdiction that you live in, could be a tax return that's required each year or a statement of profit or loss if you're in the UK. These are all reports that a financial accountant would put together. And when we say financial reports are primarily for external use, we mean parties like auditors, government authorities, tax authorities; if you're in the UK, that could be the HMRC. A further defining feature of financial accounting is that it is concerned with using mostly past financial information. Financial accounting is also governed by rules and regulations. The rules in this case could be the IFRS (International Financial Reporting Standards) standards that are applied in certain jurisdictions. There's also GAAP (generally accepted accounting principles) which is mostly used in the United States. These are frameworks that institutions use to put their accounts together within a regulatory framework. Financial accounting is mostly concerned with putting together mandatory reports, so reports that we have to produce, either by law or for shareholders, or different authorities. Finally, financial accounting is mostly based on financial information. So, the clue is in the name, it's mostly concerned with just finance. There's much less of a focus on non-financial information in the financial accounting world.
This is quite different to management accounting which, at its simplest form, is very much concerned with reporting in such a way that helps management to make decisions. So, reports are for internal use e.g. for directors, where the management accountant would produce reports for directors to help them plan and control and make good decisions for the business. Management accounting is very much focused on both past and future information. An example of a management accounting report would be a budget, which is forward-facing. It looks into the future and offers projections to see how the business is going to do in maybe one to five years time. Very often, the budget is based on figures from prior years, the idea being that the business is unlikely to deviate hugely from past figures. In that way, a budget looks at both future information as well as the past. In management accounting, the reports that are produced are very much used to aid decision making by helping management to make good decisions. Those types of decisions might be pricing decisions or how many units of a product to produce, what types of products to produce etc. With those kinds of decisions, management accounting really helps to drive and optimise the decision-making process. Management accounting is not governed by rules or regulations, so it's very much ad hoc in nature, and management accounting reports can vary between different organisations. It's not governed by IFRS or GAAP. There is no standard authority that oversees management accounting and it's not mandatory for an organisation to produce management accounts. Finally, management accounting is a mix of financial and non-financial information. So, it's not just limited to financial information, there's lots of different pieces of non-financial information used. An example of that might be customer complaints, or machine hours. These would be very much considered in the management accounting world.
Let's See an Example
We're going to look at an example to clarify what we've just seen above.
Looking at the question, there are some clues and they're highlighted already for you, but let's break the question down into smaller pieces. So, Leon works in the finance department and his job involves preparing budgets. You might remember that a budget is very much a management accounting type of report and the reason for that is that a budget looks into the future, and it's not necessarily based on just financial information alone. These are two criteria that would suggest that Leon is working in the management accounting remit rather than the financial accounting remit. We also notice that Leon is responsible for putting together weekly sales reports. These seem like they're ad hoc reports just for Paris PLC. They're not necessarily statutory reports that Paris PLC has to produce for their shareholders or a government authority. So, that's going to help management make decisions about what sort of products they should focus on and maybe where they want to expand or invest money in. So, these reports that Leon has put together, they're helping management to make decisions. Again, we have another clue that suggests that this is a management accounting remit that Leon is working on. Finally, the monthly financial reports that Leon is putting together show how actual expenditure is comparing against budgeted expenditure. This type of reporting is known as variance analysis and it's very much something that we would associate with management accounting, and the reason for that is that variance analysis is a way of controlling costs and looking at optimising costs in certain areas. All of this leads us to believe that Leon is working in management accounting. In essence, Leon is working on reports that inform the internal management of Paris PLC. He’s not tasked with putting together a monthly profit and loss statement for the local tax authority that Paris PLC reports to. He's not putting together any mandatory reports. He's very much focused on informing management on making better decisions.
Three Components of Management Accounting
Planning is all about setting the objectives of the organisation. When we say objectives, we're talking about what the company aspires to do. These objectives can be broken up into three different levels or three different tiers:
If you can imagine a hierarchy, at the very top of the planning section, there is strategic planning, which is the highest level of planning in an organisation. It's normally done by the board of directors or the senior leadership team in the organisation. Strategic planning is all about planning for large decisions that have a large impact on the business. Often, strategic planning is concerned with ambiguous decisions, or another way to phrase that might be, decisions where there are a lot of unknown quantities. An example of that would be a company looking to expand into a new region e.g. a retailer looking to expand into a brand new region. They might not have the experience or all the information required to make that decision, and this would be a strategic planning decision.
Underneath strategic planning is tactical planning, which tends to be done by department managers, and it's very much focused on supporting the strategic plan. Taking that same retailer that's looking to expand into a new region, tactical planning might be concerned with planning the logistics of how to get all the products into this new region. It's supporting the plan that the senior management team has put together.
Then underneath tactical planning, at the lowest level of the planning hierarchy, is operational planning. This is very much based on the day to day actions that support the tactical plan, which in turn supports the strategic plan. So, it's very much a pyramid with strategic sitting on the top, tactical sitting in the middle, and operational at the very bottom. Using the same example of the retailer, operational planning might be something like rostering to ensure that the expansion into the new region is successful. Rostering is where we place employees at different shifts during the day; that would be an example of a day to day task that supports the tactical planning measures that have been drafted by the middle level tier of management.
The next component of management accounting is control, and control is all about controlling costs and making sure that costs are within plans. At the start of a year, an organisation might draft a budget, and the budget has a goal at the end of it e.g. a budget might include a 2% increase in revenue, and the budget sets out how that organisation is going to achieve that goal. Within the controlled remit of management accounting, we're making sure that the goal is achieved. Normally, companies do this by setting a budget and looking at results each period and evaluating performance versus that budget. Think back to the example with Leon, where he's looking in every period at how actual expenditure or actual sales compare to budgeted figures. So, in each period, a management accountant is very much focused on looking at performance and evaluating versus a budget, and that also helps identify inefficiencies. So, if we see that there's constant overspending in certain areas, that's going to really help the company understand where they're inefficient, where they're perhaps not performing as expected. And that's going to drive that goal, at the end of the year, that 2% revenue increase is only going to be made possible by constantly evaluating performance and rectifying any inefficiencies.
3. Decision Making
The final component of management accounting is decision making, and that's very much focused on supporting the decision making of business managers and the overall business itself. Management accounting is focused on producing information that helps management decide things like what prices to charge, how many units to produce, what types of units to produce etc. These are all decisions that a management accountant would help the business make.
Hugh Martin is the Managing Director of the Lankill Group. A former CIMA prizewinning student, he teaches VIVA's P1 Management Accounting course. For full access to the P1 course and all of our other CIMA courses, check out our 365-day All Access membership.