Financial Management & Cost Accounting

Module 1. Introduction to Financial Management

Lesson 2
FINANCE AND ACCOUNTING

2.1 Shareholder's Wealth Maximization (SWM) Goal

It is accepted that the SWM goal is much superior to the profit maximization goal. It is based on the premise that financial decisions taken should aim to increase the ‘value’ of the firm. The value of the firm increases when the market price of the firm’s equity shares increases. And as the market price of the shares increases, the shareholders become wealthier. Hence all such financial decisions should be taken which increases the wealth of shareholders rather than that decisions/course of actions which erode their wealth. The decisions which can increase the wealth of shareholders are those which have a positive NPV (Net Present Value). NPV is defined as the Present value of benefits of a project minus the present value of costs of project.

NPV = Present value of benefits – Present value of costs

The present value is found by applying a suitable discount factor to the expected cash flows. As the NPV is based on “cash” instead of “accounting profits” it is superior to profit maximization because while ‘profit may be ambiguous the ‘cash flow during a period’ is unambiguous. Moreover the rate of discounting factor takes into account the time value of money as well as the risk associated with the cash flows of a given project or course of action.

2.2 Finance & Accounting

The finance and accounting functions are closely related and they fall in the domain of the chief financial officer of the organization as shown in the Figure below:

Table 2.1: Organization of Finance Functions of a Firm

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Chief finance officer
Treasurer	Controller
Cash manager	Financial accounting manager
Credit manager	Cost accounting manager
Fund raising manager	Tax manager
Capital budgeting manager	Internal auditor
Portfolio manager	Data processing manager

In popular perception, it is noted that Finance and Accounting are often considered indistinguishable and inseparable. However, it is important to know the differences between the two:

2.2.1 Record Keeping V/S Value Maximizing

Financial accounting is primarily related to the systematic recording, classifying, and summarizing of all financial transactions of a firm, and presenting them in various financial statements viz, balance sheet, profit and loss statement, funds flow statement and cash flow statement. Accounting function, thus, focuses primarily on recording what has happened. The role of finance manager is mainly involved in the decision making. He strives to take such financial decisions which will maximize the value of the firm, that is, maximize the market value of the equity shares of the firm, thereby maximizing the shareholders’ wealth. The role of the financial manager is different from the accountant, in the sense that, while making financial decisions, the financial manager uses the financial statements and data like balance sheet, P and L account, etc in raw form or use them in conjunction with appropriate mathematical or statistical techniques, such as capital budgeting, operations research techniques, etc to take an appropriate decision.

2.2.2 Accrual V/S Cash Flow

The accountant prepares the accounting reports on the basis of accrual method that is recognized when the sales are made (and not when cash is received, the sales may be a credit sale for which cash has not been received. The accountant records it as ‘sales’, irrespective of whether it is a cash or a credit sale or cash receipt or no cash receipt is there.) But, the finance manager primarily dwells in the financial activities which involve cash inflows or cash outflows. He has to take decisions with respect to the timing, the magnitude and risks associated with cash flows.

2.2.3 Past V/S the Future

It can also be said as uncertain v/s certainty. An accountant’s job is to record what has happened, hence, it is historic in nature and refers to the past, where as the financial manager’s job is to manage financial resources of the firm and take a financial decision. These financial decisions refer to the future and affect the future of the firm. Hence, the finance function is future oriented. Also, it can be seen that as the accountant is concerned more with the past, he deals with ‘certainty’ where as a finance manager who is more concerned with the future, which is uncertain, deals with uncertainty and risk.