Financial Accounting and Managerial Accounting
We start this series with a look at the difference between the two most basic types of accounting: financial and managerial. As we strive to better understand why and how we keep track of our money, we start by distinguishing different types and purposes of accounting.
There are many types of accounting, including:
- Financial Accounting
- Managerial Accounting
- Cost Accounting
- Tax Accounting
- Fiduciary Accounting
- Forensic Accounting
This paper will examine the first two types of accounting: financial accounting and managerial accounting. Understanding the difference between the two is helpful, but it’s perhaps more important to understand how the two go together and how they rely on each other. Neglecting one of these two types of accounting will make the other suffer in a downward spiral that is the source of much frustration for owners and managers.
One classic distinction between the two is that financial accounting is for users outside of a company and managerial accounting is for users inside of a company. For example, financial accounting produces financial statements that can be provided to external users such as banks, regulators, the IRS and shareholders.
Managerial accounting provides financial information to internal users such as owners and managers so that they can make better strategic decisions.
While this is true as far as it goes, this distinction fails to fully capture the interdependence of financial and managerial accounting. There is another distinction between the two types of accounting which makes the case for interdependence more forcefully: financial accounting looks backward in an effort to represent what happened. Managerial accounting uses the same information to look forward, basing future actions on the information provided by financial accounting to set strategy. Without a passion for one you will generally not have the other. An owner who is not concerned about receiving timely, accurate financials will not be able to manage from the numbers, and a manager who does not intend to manage from the numbers will not insist on receiving timely, accurate financial data.
Looked at this way, it is evident that you need the financial accounting of what happened yesterday to make good decisions for tomorrow. Owners and managers need a strong understanding of how to use financial statements in order to have a passion for producing them in the first place.
Now we will look closer at each type of accounting individually.
Financial accounting is what is most often thought about when we use the word “accounting.” This is the process of keeping track of all the economic activity that happens in a given period. It is usually accomplished by your bookkeeper. When we think of an accountant, we often think of a CPA who does your taxes, but before the CPA can do your taxes, he or she needs the hard data to work from. This most basic information about the economic activity of your company is the financial accounting done by your bookkeeper.
Components of Financial Accounting
The primary language of financial accounting is “credits and debits.” Suffice it to say that conducting business has two sides – spending money and making money. Financial accounting tracks all the money spent to conduct your business in a process often called “accounts payable.” It tracks the money made in a series of activities that can be lumped under the heading of “accounts receivable.” This information ends up on your income statement, also called the profit and loss (P&L) statement.
In addition to tracking the “ins and outs” of economic activity, financial accounting provides a picture of the impact that this activity has on the health of your business in terms of assets, liabilities and equity. Simply put, financial accounting keeps track of what you have, what you owe, and what you own. What you have equals what you owe plus what you own. This information is presented on your Balance Sheet under the classic equation ASSETS = LIABILITIES + EQUITY.
Finally, there is the question of cash. Because most business is a series of promises between parties, promises to pay and promises to deliver, cash does not always change hands at the moment the promise is made. Many of these obligations are accrued. For this reason, financial accounting is best done on an accrual basis as opposed to a cash basis. When that is done, there needs to be a way to track the movement of cash in and out of the business separate from accrued promises between parties, and this is done on the cash flow statement.
The results of all of this financial accounting is usually presented in chunks of time called accounting periods, usually one month, three months (one quarter) or annually. The financial package that reports the results of a period should contain all three of the above mentioned statements: the P&L, balance sheet, and statement of cash flows.
As stated above, these statements can be given to external users such as partners, stockholders, lenders, or consultants like us, and that’s why people talk about financial accounting being for those outside the business. However, in privately held companies, the most important audience for these documents should be the owner-operator. He or she can use these statements to set strategy and guide the company to greater profitability.
If running a business is both an art and a science, managerial accounting is where the science comes in. Just as the architect works from measurements and drawings, so the business owner works from numbers and data. There is a creative side to the sciences, but they all start with hard data.
The sheer number of managerial accounting topics that can be used for strategic calculations is overwhelming. These topics can include understanding cost behavior and cost-volume-process analysis, operational budgeting and capital budgeting, standard costing and variance analysis, activity-based costing, pricing of individual products and services, and the analysis of the profitability of product lines, customers, territories, job order costing, product vs. period costing, process costing, allocation of manufacturing overhead, costing of joint products, etc.
Managerial Accounting for Small Businesses
As with so much of what we read about business, the majority of these topics apply more to the corporate world than to the small enterprise. So what does managerial accounting for the small business owner look like?
First, it starts with timely accurate financials. This means having the three financial statements produced every month by your bookkeeper and/or controller. Then, they have to be reviewed. This most basic step of producing and reviewing financial statements for your business every 30 days will do more to stabilize and ensure the longevity of your enterprise than perhaps any other activity.
But what does it mean to review your financial statements? One description of the process has come to be called an MD&A. Wikipedia defines it in this way:
“Management discussion and analysis or MD&A is an integrated part of a company's annual financial statements. The purpose of the MD&A is to provide a narrative explanation, through the eyes of management, of how an entity has performed in the past, its financial condition, and its future prospects.”
The Power of a Narrative
Again, as with most business commentary, this definition applies mainly to large companies who are reporting out to their shareholders. But even a single small business owner can conduct an MD&A with a spouse or a trusted manager. And instead of doing so only annually (as even the smallest S-Corp is required to do) they need to do it monthly. There is a magic in this ancient measure of time. As the plaque on the wall of one of our clients office reads: “Your success lies in the phrase, ‘Every 30 days.’” The month is quintessential business period, then the quarter, then the year. The sailor measures in fathoms and knots, and the business owner in months, quarters and fiscal years.
The Wikipedia definition above is helpful in that it points to the fact that an MD&A “provides a narrative.” The act of studying your financials should lead to an articulation of the results of your economic activity. Storytelling is a powerful exercise and allows the author to shape the events being told in a way that is meaningful and inspirational to their audience, even if that audience is themselves.
But the owner-operator suffers from the problem of not really having anyone else to tell the story to. Sometimes the bank may want to know how you did, but generally, if the owner-operator prepares a narrative of their business activity, it’s generally for themselves. Some have tried to form boards, but there’s an artificial nature to a board that has no ownership and no real skin in the game. Peer roundtables, consultants and coaches are generally the audience for small business owners looking for someone to tell their narrative to. We will explore this question of small-business boards in another paper in this series.
The other helpful part of this definition is that it touches on the past, the current financial conditions and the future. This is the essence of managerial accounting: the study of the past, how it has created the present, and to use that information to plan for the future.
In this paper we have only explored the idea of using the three basic financial statements in managerial accounting. Business analytics can track, measure and report on almost any type of data. Like baseball statisticians, curious business owners and managers can find meaning in even the most mundane statistics. But the three basic financial statements are the right place to start. There are countless ways to better understand and steer your business using these statements when they are produced in a timely and accurate fashion. We will explore many of those ways in future papers in this series.
Managerial and financial accounting are the two main types of accounting, and they are both essential for running your business well. Once you embrace one with a passion, you will almost certainly end up embracing the other because of their interdependence and their tremendous value to the small enterprise owner or manager.
Questions for Consideration:
- Which of the two types of accounting is stronger in your business or enterprise?
- Do you feel that you devote too much or too little time producing and reviewing your financial statements?
- What’s your narrative for your company’s financial performance of the last fiscal year?
Articles for Further Reading
“Financial Accounting vs. Managerial Accounting” by Jeffery Glen.
This article provides a detailed comparison of financial and managerial accounting, explaining the difference between the two.
“Financial Accounting (Explanation)” by Harold Averkamp.
This article explains an overview of what financial accounting is. The author goes into detail and breaks down financial accounting into its principles, financial statements, and reporting methods.
“What is Managerial Accounting?” by Harold Averkamp.
This article explains what managerial accounting is and what it can be used for. This article emphasizes managerial accounting’s use in a manufacturing company.