The Difference between Finance and Accounting — and Why it Matters
A number of years ago a friend, an MBA from an Ivy League business school, asked me what the difference between finance and accounting was. Up to that point I had not thought about it myself since my career had me in both worlds. We talked about it for a little bit, and afterwards made a mental note that, if someone with her credentials asked the question, it must be important to explain.
I started out by explaining that one difference between accounting and finance was the time perspective — accounting looks at where money has come and gone in the past, whereas finance is concerned with what will happen in the future. Regardless the type of accountant — tax preparer, forensic accountant working at the FBI, staff accountant at a business — the focus is on what happened to the money in the past. And likewise, regardless of the type of finance practitioner — Wall Street investor, art collector, serial entrepreneur — the focus is on what is available now and how to make more money.
But more importantly, finance is concerned with making money, whereas accounting’s focus is about record-keeping. Often people hear finance and think of trading stocks and bonds, hedge funds, and real estate investing. But, simply put, it is about what we have now and how to use it to make money in the future.
By way of example, let’s say that a $100,000 deposit was made in to the bank. Accounting will look at that money and ask what it was for. Was it a draw from the line of credit? Did a customer make a payment on an outstanding receivable? Was it a prepayment from a customer? Meanwhile, finance will ask how that money should best be used. Should it be used to build financial reserves? Can it be used to fund a new project? Are there liabilities that need to be paid?
And this is where the two converge — because both accounting and finance need each other in order to fully function. If we think about the example and the questions each ask, then we would see that, without connecting, finance might end up paying back the loan that accounting said was just drawn down. Or finance might put all of a customer’s prepayment in to a new project, when half of that money was needed to pay suppliers for the customer’s project. And if finance doesn’t do its job to reinvest profits, then the company won’t grow. So it’s not an either / or equation, it’s a both / and condition.*
That leads us to our final question, which is how to practically apply this understanding to our business. After all, having a solid accounting platform in a failing business doesn’t do any good, and a financially successful business with poor accounting opens the door to fraud, waste, and potential tax issues. The key is to make sure that the accounting platform informs financial decisions. That is, after all, the relationship. Here are three questions to ask that will help you get started with this understanding:
- Is my business’s money system set up so that accounting reports tell me information that will help me make money? Just getting a profit and loss report isn’t enough — QuickBooks offers additional reports that help gauge profitability so we can see how things are going.
- Is the business’s focus more concerned with tax avoidance, or one of profit? While acknowledging the importance of tax compliance and paying fewer taxes, I think it’s fair to point out that the ultimate way to not pay taxes is to not make a profit. And sadly, I have seen businesses where the tax avoidance efforts have cost the business opportunity to think about growth and profit.
- Since the focus should be on making financial decisions, and less on accounting, is there a way to make the business’s accounting faster and more efficient? With more and more applications tying banks, credit cards, inventory management, payroll, online sales, and many other business processes to accounting software, the answer is most likely yes and worthy of considering for a 2016 business infrastructure improvement.
Speaking of 2016, I’m gearing up for another year of financial columns for Smart Hustle and planning articles. I’d love to hear your questions about finance, accounting, and how you can make your business more profitable! So please e-mail me at email@example.com and let me know what you’d me to cover next year.
* Sometimes I’ve wondered why business schools have separate accounting and finance classes. Why not have one class called Money and then teach both financial disciplines together so that students can see the whole picture?