ADVANCED MANAGEMENT ACCOUNTING

LESSON 1: INTRODUCTION TO MANAGEMENT ACCOUNTING

Learning objectives After studying this chapter you should be able to
Explain terms such as management accounting, cost accounting, and

financial accounting
Explain the main features of management accounting Differentiate between management accounting and financial accounting

involved in strategic planning, e.g. the setting of objectives and the formulation of policy. The forecasting process will involve accounting for uncertainty (risk) via statistical techniques, such as probability, etc. 4. Communications: If the management accounting system is to be really effective it is essential that it goes hand in hand with a good, sound, reliable and efficient communication system. Such a system should communicate clearly by providing information in a form, which the user, i.e. managers and their subordinates, can easily understand (reports, statements, tabulations, graphs and charts). However, great care should be taken to ensure that managers do not suffer from information overload, i.e. having too much information much of which they could well do without. 5. Systems: The management accounting department/section will also be actively involved with the design of cost control systems and financial reporting systems. 6. Flexibility: Management accounting should be flexible enough to respond quickly to changes in the environment in which the company/organization operates. Where necessary information/ systems should be amended/modified. Thus, there is a need for the management accounting section/ department to be involved with the monitoring of the environment on a continuing basis. 7. An appreciation of other business functions: Those who provide management accounting information need to understand the role played by the other business functions. In addition to communi-cating effectively with other business functions, they also need to secure their cooperation and coordination, e.g. the budget preparation process relies on the existence of good communica-tions, cooperation and coordination.

Introduction
Managers use management accounting information to choose strategy to communicate it and to determine how best to implement it. They use management accounting information to coordinate their decisions about designing, producing and marketing a product or service What is Management Accounting? Management accounting is very closely linked to cost accounting; so closely, in fact, that it is difficult to say where cost accounting ends and where management accounting begins. Cost accounting simply aims to measure the performance of departments, goods and services. However, management accounting is much, much more and involves: 1 The provision or information for management: Indeed, the role of the management accountant could well be described as that of an information manager. The information generated should be designed to assist management, to control business operations and to help management with decision-making. In fulfilling this role the management accounting department/section must consult with the users of the information, i.e. management, to assess its needs in terms of precisely what information is required and when, etc. The aim is, to provide management with a flow of relevant information, e.g. reports, statements, spreadsheets, etc. as and when required. A frequent flow of information (weekly or monthly) should enable management to respond to emerging problems/situations as soon as possible. The early detection of problems means earlier solutions & early action. 2. Advising management: A key part of management accounting is to advise management about the economic consequences and implications of its (proposed) decisions and alternative course of action. In particular, this advice should answer a frequently overlooked question: What happens if things go wrong? (If interest rates go up? Or if the sales target is not achieved?) 3. Forecasting, planning and control: A lot of management account-ing is concerned with the future and predetermined systems such as budgetary control and standard costing. Such systems investi-gate the differences (i.e. variances) which arise as a result of actual performance being different from planned performance in terms of budgets or standards. In addition, the management accountant should also be
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External environment

Figure 1.1 8. Staff Education: The management accounting department/ section needs to ensure that all the users of the information it provides, e.g. managers and their subordinates, are educated about the techniques used, their purpose and their benefits, etc.

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9. Gate keeping: The management accounting department/ section sits at a very important information junction (see Figure 1.1). This gate keeping position places the management accounting section in a position of power; it has access to (can send information to and from) management and subordinates, and communicates with and receives a certain amount of information from the external environment. Its power arises because it can control the flow of information upwards to management - or downwards to subor-dinates. 10.Limitations: Although management accounting can, and does, provide a lot of useful information, it must be stressed that management accounting is not an exact science. A vast amount of the information generated depends upon subjective judgment, e.g. the assessment of qualitative factors or assumptions about the business environment. Management accounting is not the be all and end all of decision-making, it is just one of the tools which can help management to make more informed decisions. 11.Being the servant: Finally, having established that management accounting is a tool, it must be emphasized that it is there to serve the needs of management.

stores information in a way that allows managers to access the information that each needs. Management accounting and financial accounting have different goals. Management accounting measures and reports financial and non-financial information that helps man-agers make decisions to fulfill the goals of an organization. Managers use management accounting information to choose, communicate, and implement strategy. They also use management accounting information to coordinate product design, production, and marketing decisions. Management accounting focuses on internal reporting. Financial accounting focuses on reposing to external parties. It measures and records business transactions and provides financial statements that are based on gener-ally accepted accounting principles (GAAP). Managers are responsible for the financial statements issued to investors, government regulators, and other parties outside the orga-nization. Executive compensation is often directly affected by the numbers in these finan-cial statements. It is not difficult to see that managers are interested in both management accounting and financial accounting. Cost accounting provides information for management accounting and financial accounting. Cost accounting measures and reports financial and no financial informa-tion relating to the cost of acquiring or utilizing resources in an organization. Cost accounting includes those parts of both management accounting and financial accounting in which cost information is collected or analyzed. The internal reporting-external reporting distinction just mentioned is only one of several significant differences between-management accounting and financial accounting. Other distinctions include management accountings emphasis on the future-thats bud-geting-and management accountings emphasis on influencing the behavior of man-agers and employees. Another distinction is that management accounting is not nearly as restricted by GAAP as is financial accounting. For example, managers may charge interest on owners capital to help judge a divisions performance, even though such a charge is not allowable under GAAP. Reports such as balance sheets, income statements, and statements of cash flow are common to both management accounting and financial accounting. Most companies adhere to, or only mildly depart from, GAAP for their basic internal financial statements. Why? Because accrual accounting provides a uniform way to measure an organizations financial performance for internal and external purposes. However, management accounting is more wide-ranging than financial accountings emphasis on financial state-ments. Management accounting embraces more extensively such topics as the develop-ment and implementation of strategies and policies, budgeting, special studies and forecasts, influence on employee behavior, and nonfinancial as well as financial information.

ADVANCED MANAGEMENT ACCOUNTING

Managent Accounting, Financial Accounting, and Cost Accounting

Accounting systems take economic events and transitions that have occurred and process the data in those transactions into information that is helpful to managers and other users, such as sales representatives and production supervisors. Processing any economic transaction entails collecting, categorizing, summarizing, and analyzing. For example, costs are collected by cost categories (materials, labor, and shipping); summa-rized to determine total costs by month, quarter, or year; and analyzed to evaluate how, costs have changed relative to revenues, say, from one period to the next. Accounting systems provide information such as financial statements (the income statement, bal-ance sheet, and statement of cash flows) and performance reports (such as the cost of operating a plant or providing a service). Managers use accounting information (a) to administer each of the activity or functional areas for which they are responsible and (b) to coordinate those activities or functions within the framework of the organization as a whole. Individual managers often require the information in an accounting system to be presented or reported differently. Consider, for example, sales order information. A sales manager may be interested in the total dollar amount of sales to determine the commissions to be paid. A distribution manager may be interested in the sales order quantities by geographic region and customer-requested delivery dates to ensure timely deliveries. A manufacturing manager may be interested in the quantities of various products and their desired delivery dates to schedule production. An ideal database-sometimes called a data warehouse or inform -consists of small, detailed bits of information that can be used for multiple purposes. For example, the sales order database will contain detailed, information about product, quantity ordered, selling price, and delivery details (place and date) for each sales order. The data warehouse

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Cost Management and Accounting Systems The term cost management is widely used in businesses today. Unfortunately, there is no uniform definition. We use cost management to describe the approaches and activities of managers in short-run and long run planning and control decisions that increase value for customers and lower costs of products and services. For example, managers make deci-sions regarding the amount and kind of material being used, changes of plant processes, and changes in product designs. Information from accounting systems helps managers make such decisions, but the information and the accounting systems themselves are not cost management. Cost management has a broad focus. For example, it includesbut is not confined to-the continuous reduction of costs. The planning and control of costs is usually inex-tricably linked with revenue and profit planning. For instance, to enhance revenues and profits, managers often deliberately incur additional costs for advertising and product modifications. Cost management is not practiced in isolation. Its an integral part of general man-agement strategies and their implementation. Examples include programs that enhance customer satisfaction and quality, as well as programs that promote blockbuster new- product development. Distinction Between Management Accounting and Financial Accounting The 12 principal differences between management and financial ac-counting are described here. 1. Necessity- Financial accounting must be done. Enough effort must be expended to collect data in acceptable form and with an acceptable degree of accuracy to meet the requirements of the Financial Accounting Standards Board (FASB) and other outside parties, whether or not the management regards this information as useful. Management accounting, by contrast, is entirely optional, no outside agencies specify what must be done or indeed that anything need be done. Because it is optional, there is no point in collect-ing a piece of ( management accounting information unless its value to managements believed to exceed the cost of collecting it. 2. Purpose- The purpose of financial accounting is to produce finan-cial statements for outside users. When the statements have been pro-duced, this purpose has been accomplished. Management accounting in-formation, on the other hand, is only a- means to an end, the end being the planning, implementing, and controlling functions of management. 3. Users- The users of financial accounting information (other than management itself) are essentially a faceless group. The managements of most companies do not personally know many of the shareholders, creditors, or others who use the information in the financial statements. Moreover, the information needs of most of these external users must be presumed; most external users do not individually request the informa-tion they would like to receive. By contrast, the users of management accounting information are known managers plus the people who help these managers-ana1yze the information. Internal users

information needs are relatively well known because the controllers office solicits these needs in designing or revising the management accounting system. 4. Underlying Structure- Financial accounting is built around one fundamental equation: Assets= Liabilities + Owners Equity. In manage-ment accounting, there are three types of accounting, each with its own set of principles. 5. Source of Principles- Financial accounting information must be reported in accordance with generally accepted accounting principles (GAAP). Outside users need assurance that the financial statements are prepared in accordance with a mutually understood set of ground rules; otherwise, they cannot understand what the numbers mean. GAAP pro-vide these common ground rules. An organizations management, by contrast, can employ whatever accounting rules it finds most useful for its own purposes. Thus, in manage-ment accounting, there may be information on unfilled sales orders, even though these are not financial accounting transactions; fixed assets may be stated at current values rather than historical cost; certain production overhead costs may be omitted from inventories; or revenues may be recorded before they are realized-even though each of these concepts is inconsistent with GAAP. Rather than asking whether it conforms to GAAP, the basic question in management accounting is the pragmatic one: Is the information useful? 6. Time Orientation- Financial accounting records and reports the financial history of an organization. Entries are made in the accounts only after transactions have occurred. Although financial accounting informa-tion is used as a basis, for making future plans, the information itself is historical. Management accounting includes, in its formal structure, numbers that represent estimates and plans for the future as well as informa-tion about the past. The objective of financial accounting is to tell it like it was, not like it will be. 7. Information Content- The financial statements that are the end product of financial accounting include primarily monetary information. Management accounting reports deal with no monetary as well as mone-tary information. These reports show quantities of material as well as its monetary cost, number of employees and hours worked as well as labour costs, units of products sold as well as rupee amounts of revenue, and so on. 8. Information Precision- Management needs information rapidly and is often willing to sacrifice some precision in order to gain speed in reporting. Thus, in management accounting approximations are often as useful as, or even more useful than, numbers that are more precise. Al-though financial accounting cannot be absolutely precise either, the approximations used in management accounting are broader than those in financial accounting. 9. Report Frequency- Corporations issue detailed, financial state-ments only annually and less detailed interim reports quarterly by con-trast, fairly detailed management accounting reports are issued monthly in most larger organizations; and

ADVANCED MANAGEMENT ACCOUNTING

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reports on certain activities may be prepared weekly, daily, orin a few instances in real time. 10.Report Timeliness- Because of the needs for precision and a review by outside auditors, plus the time requirements of typesetting, finan-cial accounting reports are distributed several weeks after the close of the ending December 31 generally are not received by shareholders until March or April. By contrast, because management accounting reports may contain information on which management needs to take prompt action, these reports are usually issued within a few days of the end of a month. 11. Report Entity- Financial statements describe the organization as a whole. Although companies that do business in several industries are required to report revenues and income for each industry, these are large segments of the whole enterprise. Management accounting, by contrast focuses, mainly on relatively small parts of the entity that is, on individ-ual products, individual activities, or individual divisions, departments and other responsibility centers. As we shall see, the necessity for divid-ing the total costs of an organization among these individual parts creates important problems in management accounting that do not exist in finan-cial accounting. 12.Liability Potential- Although it happens infrequently, a company may be sued by its shareholders or creditors for allegedly reporting mis-leading financial information in its annual report. By contrast, as previously stated, management accounting reports need not be in accord with GAAP and are not public documents. Although a man-ager may be held liable for some inappropriate action and management accounting information conceivably may have played some role in has or her taking that action, it is the action itself, not the management account-ing documents, that gives rise to the liability.

In terms of importance, management accountants ranked the abilities and skills needed to succed as follows: 1. Communication skills 2. Ability to work on a team 3. Analytical/problem solving skill 4. Solid understanding of accounting 5. Understanding of how a business functions 6. Computer skills What changes in work activities are projected in the future for management accountants? Projected to become more important are.
Internal consulting Process improvement Long-term strategic planning Performing financial and accounting analysis Computer system and operation

ADVANCED MANAGEMENT ACCOUNTING

Projected to become less important are Accounting systems and financial reporting
Consolidation Managing the accounting/finance function Accounting policy Short term budgeting Project accounting

The increasing use of information technology in the future was seen from the survey as helping management accountants spend a lower percentage of their time on data collection and financial statement preparation and a higher percentage on financial analysis. The survey indicates a clear shift away from activities we traditionally think of as the core of the controllers responsibilities- managing the function, ensuring business controls, and planning and reporting- toward activities we think of as business partnering- strategic planning, business leadership, analyzing and interpreting information, decision making, process improvements, and performance evaluation. The following question-answer format summarizes the chapters learning objectives. 1. What information does cost accounting provide? Cost accounting measures and reports financial information and other information related to the acquisition or consumption of an organizations resources. Cost accounting provides information to both management accounting and financial accounting. 2. How do management accountants support strategic decisions? Management accountants contribute to strategic decisions by providing information about the source of competitive advantage and by helping managers identify and build a companys resources and capabilities 3. What role do management accountants perform?

Surveys of Company Practice

A Day in the Life of a Management Accountant What do management accountants do? The following table, based on a survey of CMAs, shows the percentage of respondents who namd a particular work activity as in the top five work activity interms of time devoted to the activity. Accounting system and financial reporting Managing the accounting function Internal consulting Short-term budgeting Long-term strategic planning Financial and economic analysis Computer system and operations Process improvement Performance evaluation Tax compliance Accounting policy Project accounting Consolidations 62% 42% 42% 37% 25% 24% 21% 20% 17% 14% 13% 11% 11%

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In most organizations, management accountants perform multiple roles: problem solving (comparative analyses for decision making), scorekeeping (accumulating data and reporting reliable results), and attention directing (helping managers properly focus their attention).

ADVANCED MANAGEMENT ACCOUNTING

Notes

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