The nature and importance of financial accounts are very familiar to anyone who runs a limited company. Financial accounting refers to the statutory accounts filed each year that show your company’s revenue, expenses and profits.
Management accounting, on the other hand, isn’t a statutory requirement, but it is best practice. Many companies rely on management accounts to support their business strategy and operations. In this article, we will explain the key differences between management accounting and financial accounting, and how each of these accounts can help your business.
Management accounting vs. financial accounting
Financial accounts and management accounts are generated via different processes, for different purposes, explains Rachael Marshall, founder of financial consulting firm Magic Digits. “Financial accounting is a legal requirement, and the resulting accounts are used by people outside the company to assess your performance,” she says. “Management accounts are not a requirement, but they’re created to be used by people inside the company to help understand how your business is performing, and to support decision making.”
Management accounting vs financial accounting: when to use them
As a small or medium business owner, you can choose to produce financial accounts only, or both financial and management accounts. You cannot only produce management accounts.
If you are considering adopting management accounting, then it’s important to consider what information those accounts should capture, and how frequently they should be created. “If you aren’t already, then I recommend moving to management accounting and financial accounting once you have profits of £1 million or more,” says Marshall. “But if you have the resource and the skills available, they’re incredibly helpful at any point.”
What is management accounting?
Management accounting involves creating a bespoke set of accounting data that includes financial data based on current and future performance. Management accounts are often tailored to specific businesses so they can be used to inform a particular decision or address an ongoing challenge, explains Marshall. “We might provide management accounts that split out sales by product or service, or look at labour costs as a ratio of total costs versus sales,” she says. “Those details won’t be found in financial accounts, but they might be important in deciding whether you need to recruit more people or address a shortfall in sales in a particular area.”
Management accounting in practice
Creating management accounts can be complex, and it’s usually outsourced to specialist accounting firms, says Marshall. “In many small and medium businesses, there is a bookkeeper or finance assistant, but I recommend working with a specialist to set up management accounts, to ensure you are capturing the right information, and sharing it in a way that helps people make decisions. Not everyone needs to see all the underlying data,” she says.
Marshall advises clients on what data should be captured, and with what frequency. Typically, clients will need to link applications into their central accounting platform, and from there, the management accountant can pull data into management accounts. For example, a business might connect payment terminals, invoices and sales records, payroll, and banking systems into their accounting platform.
This is the approach taken by Hawthorn International, a company that manufactures custom branded clothing for retailers, sports teams, and businesses. The in-house finance team uses a central accounting platform that is linked to finance and production systems. This allows an external accountant to pull data that is used to create annual financial accounts alongside weekly management accounts.
Hawthorn used management accounting data to help evaluate a new potential business launch. The company is hoping to launch an eCommerce site that will allow companies to buy smaller quantities of clothing online and pay via credit card. To support the business, Hawthorn would need to add a new production line and invest in additional equipment. It was essential that the company understood how this investment could be funded, and what the potential return on investment would be.
“We wanted to increase our production line from three to four lines, to launch the new business line. We had the space, but we needed to know how much that extra production line would cost, versus what it would bring into the business,” says Rob Williams, a director at the firm. “Our management accounts were essential in showing what we needed to spend on equipment and resources, and how long it would take us to recoup that investment based on a 20% increase in revenue.”
What is financial accounting?
Financial accounting refers to the area of accounting concerned with gathering and reporting all business transactions through financial statements. This can include, but is not limited to, income statements, balance sheets and a cash flow statement.
Financial accounting in practice
Financial accounts that track a company’s assets and liabilities are a legal requirement but can also be helpful when making business decisions based on past performance and current data. These accounts can also be important when discussing financial agreements with potential investors, partners, and suppliers.
These accounts are essential in understanding the overall position of the business, and can help provide an overview of current assets, liabilities, and cash at hand. “When we could see the price of fuel was about to go up, we knew that our shipping and raw material costs would increase,” says Williams. “We looked at our financial accounts and could see the cash was available for us to pre-buy six months’ worth of material before the price went higher. That was only possible because I could see that we had available funds to complete that transaction.”
Key similarities between management accounting and financial accounting
- Both management accounts and financial accounts will include key financial metrics such as assets, liabilities, revenue and expenses.
- Both management accounts and financial accounts can be used to provide an understanding of your company’s financial performance.
Key differences between management accounting and financial accounting
- All limited companies are required to file annual financial accounts to Companies House. Management accounts are completely optional.
- Financial accounts report on past performance and will compare data with the prior year. Management accounts focus on current performance and will include comparison with previous years and forecasting future performance.
- Financial accounts follow the same format and layout, based on GAAP (generally accepted accounting principles). Management accounts can be tailored to each company, and can include dashboards, charts and a changing design.
- Financial accounts are usually produced annually or quarterly. Management accounts are produced more frequently, which could be monthly, or even weekly.
