Finance and accounting are terms often used interchangeably. While both are related to the administration and management of an organization’s assets, each has a different scope and focus.
To help you elevate your business fluency, here’s a look at the key differences between the two disciplines.
1. Scope and Focus
Finance and accounting operate on different levels of the asset management spectrum. Whereas accounting provides a snapshot of an organization’s financial situation using past and present transactional data, finance is inherently forward-looking; all value comes from the future.
In accounting, insight into a firm’s financial situation is gained through what is known as the “accounting equation,” which is: Assets = Liabilities + Owners’ Equity.
This formula looks at what a company owns (its assets), what it owes (its liabilities), and the residual that belongs to shareholders (owner’s equity). And it must balance out—the assets on the left should equal the claims against those assets on the other side. It’s a fundamental means for determining whether a company’s financial records accurately reflect the transactions carried out over a period of time.
When assessing performance through the lens of finance, cash is king. Unlike accounting’s reliance on transactional data, finance looks at how effectively an organization generates and uses cash through the use of several measurements.
Free cash flows is arguably the most important one, which examines how much money a company has to distribute to investors, or reinvest, after all expenses have been covered. It’s a strong indicator of profitability, and can be used to make present-day investment decisions based on an expectation of future payoff.
2. Measuring Financial Performance
This difference in scope underscores a contrast between the underlying principles of accounting and finance.
The accrual method of accounting, which is followed by most organizations, records transactions as they are agreed upon, as opposed to when they are completed. It allows for transactions to be made with credit or deferred payments, and operates under the idea that revenues and costs will smooth out over time to more accurately depict economic reality. This makes it possible to compare year-on-year growth of a company’s revenues, costs, and profits without factoring in one-off events, as well as seasonal and cyclical changes.
Finance rejects that idea, instead believing that the best way to measure economic returns from a company is to calculate the cash it’s able to produce and leverage, which is dependent on when that cash is exchanged—rather than just agreed upon.
3. Assessing Value
Another point of difference between the disciplines is their approach to value. In accounting, a conservatism principle is often applied, which suggests that companies should record lower projected values of their assets and higher estimates of their liabilities. Under this doctrine, if you don’t know the value of something precisely, you count it as zero.
This is handled much differently in finance, which employs an analytical process, known as valuation, to determine the worth of a company, project, or asset. The gold standard is discounted cash flow analysis, which is applied to a series of cash flows over a period of time. The discount rate (represented as a percentage) accounts for opportunity cost, inflation, and risk, and brings the value of a future stream of cash to its present value.
LEVERAGING YOUR FINANCIAL KNOW-HOW
Both finance and accounting are highly valuable for assessing a company’s position and performance. By understanding the underlying principles of the two disciplines and how they contrast, you can develop greater financial intuition and make better business decisions.
ABOUT THE AUTHOR:
Imtiaz Ahmad is a qualified finance professional from ICAEW & ACCA with 15+ years of experience; worked for a diversified range of industries in Pakistan and Middle East. He is a seasoned Coach, Mentor, Counselor and Trainer in Accountancy and Finance profession too. He has 500+ students who got qualified ACCA, CA and CMA to his credit, in different countries around the globe.