The Nature of Management Accounting

Introduction

In today’s fast paced world, Ethics have emerged as an integral part of every system. With the growing number of organizations worldwide and fierce competition, every firm wants a larger share of the pie. It is just a matter of time before businesses collapse and financial markets stumble on a worldwide scale. In order to avoid such a catastrophe, today’s accountants have been given more challenges to face and higher roles to play within their organizations. Managerial and financial accountants are required to operate with highest ethical standards.

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Accounting is more than a way to organize financial figures. The goals of a nation and the aspiration of a people influence the structure of an accounting system. There is divergence and variety in the world’s accounting systems because there is divergence and variety in the world’s cultures. A manager who fails to appreciate this point may assume that the financial statements of a company operating in another nation are in accordance with the accounting system that he or she is familiar with–a dangerous assumption. Without appreciating these differences, a manager might misinterpret the financial statements, and in so doing, distort his or her evaluation of an overseas operation.

The principal accounting systems found around the world are surveyed here in terms of historic development of companies and accounting systems, qualifications of practitioners, professional societies, procedures for changing accounting standards, major influences on setting accounting guidelines, and publishing financial reports including public attitudes on the role of business in society.

Managerial Accounting is the process of identifying, measuring, analyzing, interpreting and communicating information in order to achieve an organization’s goals (Thompson, 2006). Managerial Accounting is widely known as Cost Accounting all over the world. Management accounting is concentrated towards managers of organizations to assist them in management [Needs comma] making decisions and plan the company’s operations. It revolves around the inner management teams and usually is confidential in nature with increasing competition, both locally and globally, management accountants are now faced with more responsibility and their scope of accountancy has drastically widened. They focus more on the managerial activities at all levels within the organization. This is done to help the internal users to improve the effectiveness and efficiency of the organization by delivering better quality goods and services (Thompson, 2006). On the other hand, financial accountants are in charge of making financial statements for external decision makers. These decision makers include banks, suppliers, stockholders and government agencies that play a vital role in financing the company (Horngreen, Stratton, & Sundem, 2002).

Since external users have limited access to the company’s information, there own success depends on getting reliable and consistent external reports. These reports are general-purpose financial statements such as income statements, owner’s equity statements, cash flow statements and balance sheet. These financial statements report on the financial performance of the company and are an important indicator of the company’s progress. These reports help investors to understand the financial health of the company and invest into these companies (Larson & Jenson, 2002).

Background to Accounting

Accounting, as the word implies, is a reckoning of the financial results of an enterprise between those who control the employment of capital or assets and those who provide the capital or assets. Accounting responds to the needs of business and follows developments in commercial activity. The earliest records of business transactions, the essence of accounting, are over 5,500 years old. These are Egyptian and Sumarian records on agricultural production and tax collection. Other ancient records include both sides of a trade or barter and the amount of inventory in storehouses. The earliest extant records of depreciation, an expression of the idea of the wasting away of physical assets, go back to the days of the Greek and Roman record keepers. A wall, for example, would be depreciated over a period of eighty years, which one might construe as a measure of its useful life and the efficacy of ancient construction practices.

During the middle Ages, commerce became more reliant on arithmetic and writing, and on money as a medium of exchange. The advancement of accounting practices was evidenced by the discovery of accounting records in Genoa dating back to 1340. These records were in terms of money, one of the first instances where unlike material items were described in terms of a like medium. In addition to expressing accounts in terms of the common monetary unit of the day, these records made the earliest known distinction between capital and income.

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As the Renaissance dawned in Europe, there was a growing social acceptance of an individual accumulating private property and capital as something other than sinful. During this time, private property became sanctioned by society and protected by legal rights. There arose a practice of banking, where money was lent to those in commerce. The practice of lending money necessitated establishing some means of measuring performance – that is, the success or failure of business ventures – and some means of judging the creditworthiness of potential borrowers.

The first bankers were goldsmiths with whom those in commerce entrusted the safe keeping of their gold coins, which signified the rewards of success in commercial ventures. After a while, the goldsmiths began to notice that their depositors, in general, kept a sizable portion of their wealth in their safekeeping without withdrawing the coins. The gold coins lay “sterile” in the goldsmiths’ safes. The goldsmiths became bankers once they learned that they could make money by lending out a portion of the deposits entrusted to them to finance commerce and trade. That portion depended on the depositors remaining unconcerned with, or ignorant of, the fact that not all the gold deposited with the goldsmiths was physically in their possession. Such concerns could be allayed by paying the depositors interest as an inducement for them not to withdraw their funds. This permitted the bankers to lend a larger portion of these deposits to those in commerce. The final stage of the transformation from craftsmen to bankers occurred when they gave up making artefacts of gold, and spent their days borrowing from depositors at a lower rate of interest and lending the proceeds to borrowers at a higher rate of interest.

The Industrial Revolution again changed the nature of business activity, which necessitated changes in accounting practices. This time, change was fostered by the need to raise massive amounts of capital for first canal, and then railroad, construction. The accounting profession in the United Kingdom, the nation where the Industrial Revolution began, developed the idea of the purpose of accounting being to present a “true and fair” view of the financial results of the operations of a business entity.

Changes in accounting practices, such as the formalized distinction between income and capital and the definition and accounting treatment of fixed assets, inventory, depreciation, and allocation of overhead had to be agreed on in order to present a true and fair view of the financial results of an operation. The demand for a true and fair view of financial results from the merchant bankers was the incentive for the English and Scottish accounting firms to provide such information. They opened branch offices in the United States to obtain the necessary information. These branch offices became the major American accounting firms, thus forging a close link between accounting practices on both sides of the Atlantic. English and Scottish accounting practices form the foundation of accounting practices in many nations because Great Britain was the capital exporter for the development of industry and trade throughout its empire, upon which the sun never set.

During this time, accounting practices were adapted to conform with the change in business organizations from proprietorships and partnerships to limited liability stock companies. Limited liability stock companies were the legal vehicle selected for raising the enormous quantities of capital required for the building of industries first in England, then in the United States and elsewhere. The concept of limited liability was in response to individuals refusing to expose themselves to a loss that exceeded their investment. Limited liability stock companies contained the magnitude of losses to the amount of funds placed at risk in buying the securities of the companies. The liability associated with the failure of a limited liability stock company does not extend beyond the loss of value of its securities to include the personal wealth and property of the founders, officers, members of the board of directors, and other shareholders.

Continental Europe lagged in the adoption of the Anglo view on accounting because the first steps toward industrialization, the building of the railroads, were financed with government (public) funds, not the private funds of individuals and banks. In England and the United States, first canals and railroads, then steel mills and communication systems, the backbone of an industrialized society, depended primarily on private sources of capital. Government involvement with the building of canals was in granting rights of way. To minimize public expenditures for the building of the railroads, the government made it attractive for private capital to invest in railroad construction by providing generous land grants along the railroad’s right of way and lucrative mail contracts.

Organization Affects Accounting

As companies became more complex organizations through the formation of subsidiaries and independent operating units, accounting practices took on a new assignment of being a mechanism for internal reporting and control. Accounting had to respond to the mergers of independent companies that took place late in the nineteenth century to form trusts and the break-up of the monopolistic trusts under Theodore Roosevelt early in the twentieth century. Later in the twentieth century, accounting had to accommodate the demand for a true and fair measure of the financial performance of companies in diverse fields (conglomerates) and to deal with growing government intervention and regulation of business. In addition, a new specialty, tax accounting, came into being.

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Codification of Accounting Principles

There are many influences at work that affect the nature of the accounting system. The codification of accounting up to the 1970s occurred exclusively within the borders of a nation. When companies were, for the most part, operating units within a national setting, the application of accounting principles, from the point of view of an individual company, was global–global in the sense that the generally accepted accounting practices were universally applied at each operating location of the company.

The application of accounting principles was global also from the perspective of a nation having colonies overseas. Historically, companies operating within the realm of the British Empire consistently applied British accounting standards no matter where their activities were located. The same was true for the colonial empires of France, Germany, Belgium, Spain, Portugal, and other European nations. One problem facing accounting today is the fracturing of the codification.

The Functions of Managerial Accounts

Managerial accounting provides special purpose reports created to meet the information needs of internal users. Usually internal reports would deal with the best marketing mix of products to maximize profits and minimize costs. “The Institute of Management Accountants (IMA) is the world’s leading organization dedicated to empowering management accounting and finance professionals to drive business performance.” (Institute of Management Accountants 1997, Para 1) Management accountants have an obligation towards their company, the general public as well as towards themselves to serve in the best interest with the highest standards of ethical conduct. The four main categories are Confidentiality, Competence, Integrity and Objectivity.

Objectives of Managerial Accounts

Management accountants are supposed to keep their company information confidential and must not leak out information to outside sources without the permission of the higher authorities. Further more they must ensure their subordinates realize the seriousness of the information passed down to them and must monitor them to ensure that the confidentiality matter is not leaked out. Passing out valuable information to an outside source like a competitor would be a violation of the confidentiality clause.

Management accountants are supposed to work inside the law and must respect all rules and obey the rules and regulations. The reports prepared must be clear and should provide relevant recommendations after a thorough analysis of the report prepared. Unable to provide clear reports though legal but not up to the standards set by the IMA could result in violating the competence clause. Management accountants are responsible to ensure that future potential conflicts are avoided and must advise or at times warn people of such conflicts from arising. They must refrain from activities that may jeopardize their ability to work ethically. If unable to maintain a reputation for integrity will result in a violation of the integrity clause.

Management accountants are required to fairly communicate information and disclose all relevant information that could be expected to influence an intended users understanding of the reports (Banis, 2000). Overall, financial and managerial accountings both are very important aspects of the business world. Most companies have some form of each type of accounting incorporated into their business operations. With huge failures like Enron Corp and Arthur Anderson, it is viable and safer to abide by following the appropriate standards of ethical conduct and the company will be able to successfully keep track of their financial standing for internal as well as external purposes.

“During the past decade many organization in both the manufacturing and services sectors have faced dramatic changes in their business environment.” (Colin, 3) These changes are having significant influence on management accounting system. Globalization is the main reason for the keen competition. The successful companies not only compete against domestic competitors, but also the companies over the world. World Trade Organization (WTO) provide more business opportunities, however, at the same time, it brings more global competitors into the domestic market. For example, after China entered into WTO, she opened her domestic market for the western in various industries, such as car manufacturing, manufacturing food and farm product and so on.

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Due to the economic development, customers in China have more choices on goods and services, the higher quality of goods and services are demanded. In order to compete in such competitive business environment, companies become more “customer-driven and make customer satisfaction an overriding priority.” (Colin, 21-29) The above situation not only faced by China, but all over the world. These changes are playing a significant influence on management accounting system. This is the reason why the traditional costing and budgeting approach as relevant management techniques for the use in planning and control has diminished in recent decades. Most companies, therefore, focus on total quality management to meet the customers’ satisfaction (TQM). TQM are helping many companies change and improve their performance. By customer oriented process of continuous improvement the product and services of consistent high quality in timely fashion. The management accounting needs to be modified to meet the current planning & budgeting needed on the ground that the world wide business environment facing keen competition caused by globalization and changes from time to time.

Cost Control and Managerial Accounting

Effective cost control would greatly attribute to the gross profit of companies and only cost is in companies’ control. An appropriate costing method is very important. “Traditional absorption costing was development when most organizations produced only a narrow range of product and when overhead costs were only a very small fraction of total costs, direct labour and direct material cost accounting for the largest proportion of the costs. Errors made in attributing overheads to products were not too significant.”(ICSA Practice & Revision Kit, 24)

An alternative way for costing is Activity Based Costing (ABC). Traditional costing is structure-oriented whereas ABC is process-oriented. Hence, we see that the traditional usage of fixed and variable costs is totally meaningless. In ABC, all costs are included. “In fact, ABC is possibly even more relevant to services industrial because, the absence of a direct materials element, a services business’s total costs are likely to be particularly heavily affected by overheads. There certainly is evidence that ABC has been adopted by some business which sells services rather than goods.” (Peter, 101-102)

Nowadays, overheads are likely to be far important within the cost structure of an organization and direct labour may account for as little as 5% of a product’s cost. For example, in the bank there has been an increase in non-volume related support activities such as computing, from processing and investigation work. These activities are vital to sales of a wide range of products and tend to vary in the long term according to the range and complex the products; the more support services will be required. For example, bank A which sells 1200 repayment mortgages, and bank B which sells 400 repayment mortgages, and bank B which sells 400 repayment mortgages, 400 fixed rate mortgages and 400 low start mortgages. Support activity cost in bank B are likely to be a far higher than in bank A although the banks sell the same number of mortgages. ABC provides more meaningful and accurate product costs. In a highly competitive environment, bank must be able to assess product profitability and have a clear understanding of what drives overhead costs. ABC gives a meaningful analysis of costs. Because ABC allows management to determine the costs ABC system can more accurately measure the resources consumed by cost objects. Traditional cost systems report less accurate cost because they use cost driver where no cause-and effect relationships exist to assign support costs to cost objects.

The identification of the cost of quality and the process-orientation in ABC open up for a very powerful link to Total Quality Management (TQM) where both ABC and TQM can realize their fullest potential. Standard costing is another alternative way for costing which are predetermined costs to use as a standard against which actual costs can be compared. Since it is set in advance, they are likely to be different from the actual. Therefore, the variances between them are worth investigating. Similar to ABC, it can also be applied in services industries such as the bank, the output of the bank are the number of cheques and number of loan application processed, and there are also input and output relationship. Although standard costing question the relevance of traditional variance analysis for cost control and performance appraisal in the competitive business environment, it can provide better quality management information, than the traditional costing for large volume, complex but stable manufacturing situations. For example, the detail tracking of costs is unnecessary for decision-making purpose. Product cost for decision making should be extracted from data base of standard costs reviewed periodically.

Costing plays a great role for control in companies where budgeting for planning of resources and so on. After a corporate set its objective and strategy, budgeting helps it for planning, motivating, controlling and evaluating. (Kircher, 43-52)

Organizations, both profit-making and non-profit making, are facing “tight budget”, such as the companies in Hong Kong, most of them are trying to cut their costs as low as possible, even the Government in Hong Kong suffers from the deficit budget. She tries to cut even education and welfare expenditures. With adopting the appropriate costing and budgeting method, in certain extent, helps to planning and costing the “money” and finance within an organization. For example, the welfare department may try to use ABC for controlling the cost; educational division, not only the formal education, but also some tutorial school may try incremental budgeting. Traditional costing and budgeting, in some way, still be very useful in different areas. Old methods do not mean that it is not meaningless to every areas whereas some new and innovation methods may not match all type of activities, such as educational may try incremental budgeting but not the ZBB.

Decision Making, Cost analysis and Managerial Accounting

An organization needs resources and people to carry out the activities. The management team of the organization must achieve the goals with the resources, people and activities. The four important roles of a management team is decision making, planning, directing operational activities, and controlling. These four activities are impossible without the information from the managerial accountant analysis. The information that a managerial accountant analysis provides can be used in making day to day decisions or long term decision making. Most of the data provided is financial but some organizations are also using substantial non-financial data(Hilton, 4).

What’s the difference between Financial Accounting and Managerial Accounting? Unlike Financial Accounting, Managerial Accounting focuses on the managers within the organizations, rather than interested parties outside the organization. Financial Accounting is the use of accounting information for reporting to interested parties outside the organization. The outside parties are people like stockholders, lenders, investment analysts, unions, consumer groups, and government agencies. Financial Accounting and Managerial Accounting have some similarities despite their differences. They both gather data from the organizations basic accounting system(Hilton, 4).

They are different cost for different purposes. The meaning of cost can change when it is used in different context. Cost can be defined as the sacrifice made, usually measured by the resource given up, to achieve a particular purpose. The activity that causes cost to be incurred is called cost drivers. Activity refers to the measure of the organization’s output of products or services. The most important classification of cost involves the way cost changes in relation to the change of activities within the organization (Hilton, 8).

Variable Costs and Fixed Cost are the most common Classification of cost. They are found in financial data from local farmer bookkeeping records to an accounting system of multimillion-dollar corporations listed on the Dow Jones. Variable cost is the change in total in direct proportion to a change in the level of activity (or cost driver). The increase of cost drivers will increase variable cost. For example, if there is an increase in the orders of sandwiches that contain chicken at Jack in the Box by 3% then the variable cost will increase by three percent. Fixed cost as you guessed, it stays unchanged in total as the level of activity (or cost drivers) varies. If activity level goes up in the organization then the fixed cost will still stay the same. Examples of fixed cost are Property tax, depreciation of Plant and equipment, and the salary of employees (Hilton, 30).

Cost Drivers is a characteristic of an activity or event that causes cost to be incurred by that activity or event. For example, in a manufacturing firm the cost of assembly labour would be driven by the quantity of products, machine setup labour would be driven by the number of production runs. Accountants have to be careful to separate different types of cost drivers for each cost pool. They should realize that the cost pool varies with the cost driver. The higher the relationship of the cost between the cost drivers, the more accurate will be the resulting understanding of cost behaviour.

Controlling cost is one of the most important roles in managerial accounting today. To assist managers the cost is traced from the department or the work centre it came from. This is recognized as responsibility accounting. A cost that can be traced to a particular department is a direct cost. For example, the paint used to paint corn stoves on the assembly line at Nesco Inc. is a direct cost for the assembly line. Now if you did not guess it, a non-traceable cost to a particular department is an indirect cost. For Example, at Nesco the maintenance tool room supplies benefits every department and therefore is an indirect cost.

Now cost can qualify under both direct and indirect cost. For example, depending on which department you have under consideration now if it was maintenance they would consider it to be direct cost. If you had said the assembly department they would consider the tools they use from the tool room mentioned earlier to be indirect cost. It is best to link cost to as many direct cost as possible. This is called activity accounting. This process will aid in the deletion of non added value cost. This way it will not interfere with product quality, performance, or perceived value. Direct and indirect costs that can be controlled are called controllable cost. Incontrollable cost is cost that cannot be influenced by the manager. Incontrollable costs are more common because every cost is not totally controllable. Cost are most commonly always can’t be controlled over a short period of time. Most Controllable cost must be controlled over a long period of time (Hilton, 32).

Manufacturing Accounts and Managerial Accounts

Manufacturing Accountants classify costs by the functional area of the organization to which costs relates. Some examples of functional areas of manufacturing service production, merchandise, marketing, administration, and research and development. Three categories which a manufacturing firm classifies cost are direct material, direct labour, and manufacturing overhead. Direct material is raw material that is introduced in the manufacturing process and is physically incorporated into the finished product. It is considered raw materials before it enters production and direct materials when it enters production. The cost of salaries, wages, and fringe benefits for personnel who work directly on the manufactured products are classified as direct-labour cost.

Some companies don’t consider fringe benefits as direct-labour cost, but observe it as cost overhead. If you have been wondering where all the other cost goes in the manufacturing firm well, it is classified under manufacturing overhead. They are three different types of manufacturing overhead, which are indirect material, indirect labour, and other manufacturing cost. Indirect material is material that is required in the production process, but do not become part of the integral finished product. (DeMaris, 47-53) For example, end-mills that are used in machine shops to machine raw material into a finished product. The end-mill is not at all part of the product, but aided in the completion of the final product. Usually, indirect materials are like glue or paint may be so inexpensive there is no reason to trace it to a direct cost. Indirect labour is the cost of the personnel who do not work directly on the product, but whose ser-vices are necessary for the manufacturing process. Production supervisors, custodial employees, and security guards are examples of indirect labour (Hilton, 36).

Production cost is different in service industry and nonprofit organizations compared to manufacturing firms. A service industry is consumed as the products produced, whereas a manufactured product can be stored in inventory. Hotels, banks, airlines, professional sports franchises, and automotive repair shops are examples of business of producing services. Another form of service industry is non-profit organizations such as the Red Cross for an example. The same cost classification for a manufacturing industry can be used in service firms, though this is not commonly used. Recording and classifying cost is important in service and nonprofit organizations for the same reasons as in manufacturing firms. The timing with which the costs of acquiring assets or services are recognized as expense is important to both managerial and financial accounting. The cost that is incurred when an asset is used up or sold for the purpose of generating revenue is an expense. Product cost and period cost are use to describe the timing with which various expenses are recognized (Firmin, 75-82).

A product cost assigned to goods that were either purchased or manufactured for resale. It is used to value the inventory of manufactured goods or merchandise until the goods are sold. In the period of the sale, the product cost is recognized as an expense called cost of goods sold. The product cost of merchandise inventory acquired by a retailer or wholesaler for resale consists of the purchase cost of the plus any shipping charges. The product cost of manufactured inventory consists of direct material, direct labour, and manufacturing overhead. For example, the labour cost of a production employee at Dupont is included as a product cost of the paint manufactured (Hilton, 37).

Another term for product cost is inventorial cost, since a product cost is stored as the cost of inventory until the goods are sold. In addition to retailers, wholesalers, and manufacturers, the concept of product cost is significant to other producers of inventorial goods. Mining Companies, lumber companies, and agricultural firms are examples of non-manufacturers that produce inventorial goods. Apples, timber, coal, and other such goods are inventoried at their product cost until the time period during which they are sold. All cost that are not product costs are called period costs. (Lander, 264-280) A period cost is identified with the period of time in which they are incurred rather that with units of purchased or produced goods. Period costs are recognized as expenses during the time period in which they are incurred. All research and development, selling, administrative costs are treated as period costs. This is true in manufacturing, retail, and service industry firms.

Components of Managerial Accounting

Direct material, direct labour, and manufacturing overhead are the three types of production costs incurred by manufacturers. These costs are product costs because they are stored in inventory until the time period when the manufacturer’s products are sold. Manufacturers have product-costing systems to keep track of the flow of these costs from the time production begins until finished products are sold. As direct material is consumed in production, its cost is added to work-in-process inventory. Similarly, the costs of direct labour and manufacturing overhead are accumulated in work in process. When products are finished, their costs are transferred from work-in-process. When Products are finished, their costs are transferred from work-in-process inventory to finished goods inventory (Deakin, 380-83). The costs then are stored in finished goods until the time period when the products are sold. During this period, the product costs are transferred from finished goods to cost of goods sold, which is an expense of the period when the sale is made (Hilton, 39).

Manufacturers generally prepare a schedule of cost of goods manufactured and a schedule of cost of goods sold to summarize the flow of manufacturing costs during an accounting period. These schedules are intended for internal use by management and are generally not made available to the public. (Hilton, 44) Opportunity costs arise in many business decisions. Opportunity cost is defined as the benefit that is sacrificed when the choice of one action precludes taking an alternative course of action. If a Corvette and Cavalier are the choices of cars available, the opportunity cost of driving a Cavalier forgone pleasure associated with driving a Corvette. Opportunity costs arise in many business decisions. Opportunity cost can also pop up in personal decisions. The opportunity cost of a student’s college education includes the salary that is forgone as result of not taking a full-time job during the student’s years in college. From the economic perspective, a dollar of opportunity cost associated with an action should be treated as equivalent to a dollar of out-of-pocket costs are those that require the payment of cash or other assets as a result of their incurrence(Crossman, 222-27).  Before management makes decisions they should consider opportunity cost and out-of-pocket cost.

Sunk costs are costs that have been incurred in the past. These sunk costs affect future cost and cannot be changed by any current or future action. For example such cost includes the acquisition cost of equipment previously purchased and the manufacturing cost includes cost of inventory on hand. Regardless of the current effectiveness of the equipment or the inventory, the costs of acquiring them cannot be changed by any forthcoming action. These costs are irrelevant to future decisions (Hilton, 46).

Differential cost is the amount by which cost differs under two alternative actions. Pretend that a country government is considering tow competing sites for a new landfill. If the northern site is chosen the annual cost of transporting refuse to the site is projected at $250,000. If the southern site is selected, annual transportation charges are expected to be $150,000. The annual differential cost of transporting refuse is annual cost of transporting refuse to northern site subtracted by the annual differential cost of transporting refuse to southern site equals an annual differential cost of $100,000. The site should be moved to the southern site. Differential cost like the example above, also none as incremental costs, are found in variety of economic decisions (Hilton, 47).

Marginal Costs and Managerial Accounting

A special case in differential-cost concepts is the marginal cost, which is the extra cost incurred when one additional unit is produced. Marginal costs and average costs arise in a variety of economic situations. The cost incurred by Nesco Inc. When one additional green corn stove made is the marginal cost of manufacturing corn stoves. Marginal cost can change over different production quantities. This is because the efficiency changes of the production process. The marginal cost of producing a corn stove, like we talked about above, declines as output increases. It is more efficient for a company to produce two hundred stoves instead of just one (Hilton, 48).

Don’t get confused between marginal cost and average cost. Going back to the stove example, the marginal cost of the second stove is $1,900. However, the average cost per unit when two stoves are manufactured is $3,900 divided b 2, or $1,950. Similarly, the marginal cost of the eleventh stoves is $1,690, but the average cost per unit when 11stoves are produced is $1,790 (calculated by dividing $19,690 by 11). To understand the marginal cost of production is the extra cost incurred when one or more units are produced. The average cost per unit is the total cost. For whatever quantity is manufactured, divided by the number of units manufactured (Hilton, 47) .A product-costing system accumulates the costs incurred in a productive process and assigns those costs to the organizations final products. Products costs are needed for a variety of purposes in both financial accounting and managerial accounting (Hilton, 47).

Financial Accounting and Managerial Accounting

In Financial accounting, product costs are needed to value inventory on the balance sheet and to compute cost-of-goods-sold expense on the income statement. Under generally accepted accounting principles, inventory is valued at its cost until it is sold. Then the cost of the inventory becomes an expense of the period which it is sold. (Hilton, 48) In manager accounting, product cost are needed for the planning, for cost control, and to provide managers with data for decision making. Decisions about product prices, the mix of products to be produced, and the quantity of output to be manufactured are among those for which product cost information is needed. (Hilton, 66)

Manufacturing cost consist of direct material, direct labour, and manufacturing overhead. The product-costing systems used by manufacturing firms employ several manufacturing accounts. As production takes place, all manufacturing costs are added to the work-in-process inventory account. Work in process is partially completed inventory. A debit to the account increases the cost-based valuation of the assets represented by the unfinished products. As soon as products are completed, their product costs are transferred from work-in-process inventory to finished-goods inventory. This is accomplished with a credit to work in process and a debit to finished goods. During the time period when products are sold, the product cost the inventory sold is removed from finished goods and added cost of goods sold, which is an expense of the period in which the sale occurred. (William, 179-82) A credit to finished goods and a debit to cost of goods sold completes this step. Cost of goods sold is closed into the Income Summary account at the end of the accounting period, along with all other expenses and revenues of the period (Hilton, 66).

Job-order-costing is used by companies where goods are produced batches and there are significant differences among the batches. Job-order-costing can be found in business such as aircraft manufactures, printers, custom furniture manufactures, and custom machining firms. In job-order-costing, each different batch of production is called a job or job order. The cost-accounting procedures are designed to assign costs to each job to obtain an average cost per unit(Hilton, 67).

Process costing is used by companies that produce large numbers of identical units. Firms that produce chemicals, microchips, gasoline, beer, fertilizer, textiles, processed food, electricity, are among those using process costing. In these firms, there is no need to trace cost to precise batches of production, because the products in the dissimilar batches are identical(Hilton, 68).  A process-costing system gathers all the production costs for a huge number of units of output, and then these costs are averaged over all of the units.

The distinction between job-order and process costing hinges on the type of production process involved. Job-order costing systems assign costs to distinct production jobs that are notably different. Then an average cost is computed for each unit of product in each job. Process-costing systems average costs over a large number of similar units of product (Hilton, 68).

In a job-order costing system, costs of direct material, direct labour, and manufacturing overhead are assigned to each production job. These costs compromise the inputs of the product-costing system. As costs are incurred, they are added to the work-in-process inventory account in the ledger. To keep track of the manufacturing costs as-signed to each job, a subsidiary ledger is maintained. The subsidiary ledger account as-signed to each job is a document called a job cost sheet. (Hilton, 69) Process costing is used in production processes where relatively large numbers of nearly identical products are manufactured. The purpose of a process-costing system is the same as that of a job-order costing system-to accumulate costs and assign these costs to units of product. Product costs are needed for planning, cost control, decision making, and reporting to various outside organizations (Hilton, 70).

The flow of costs in process-costing systems

The flow of costs in process-costing systems and job-order costing systems is the same. Costs of direct material, direct labour, and manufacturing overhead are added to a Work-in-Process Inventory account. Direct labour and manufacturing overhead are often combined into a single cost category termed conversion costs. When products are completed, the costs assigned to them are transferred either to Finished-Goods Inventory or to the next production department’s Work-in-Process Inventory account. In sequential production processes, the cost of the goods transferred from one production department to another is called transferred-in cost (Hilton, 70).

There are some important distinction between job-order and process-costing systems. Head among these is that job-order costing systems accumulate production costs by job or batch, whereas process-costing systems build up costs by department. Another main difference is the focus on equivalent unit in process costing. An on equivalent unit is a measure of the amount of productive input that has been applied to a fully or partially completed unit of product. In process costing, production costs per on equivalent unit are calculated for direct-material and conversion costs (Hilton, 70).

The key document in a process-costing system is the departmental production report, rather than the job-cost sheet used in job-order costing. There are four steps in preparing a departmental production report analyze the physical flow of units, calculate the on equivalent unit, compute the cost per on equivalent unit and analyze the total costs of the department. (Hilton, 70) In the weighted-average method of process costing, the cost per on the same unit, for each cost category, is a weighted average of the costs due to the beginning work-in-process inventory and the costs incurred during the current period. Job-order and process costing represent the polar extremes of product-costing systems. Operation costing is a crossbreed of these two methods. It is planned for production processes in which the direct material differs significantly among product lines but the con-version activities are essentially the same. Direct-material costs are gathered by batches of products using job-order costing methods (Anthony, 1-20). Conversion costs are accumulated by production departments and are assigned to product units by process-costing methods.

Costs play a very important part in Managerial accounting. Actually it could make or break a business large or small. Costs and expenses need to have a close watch on them at all times. As we saw many companies in the year 2002 go through bankruptcy, we can only wonder maybe this was from poor managerial accounting systems. Companies like Enron can be an example for our own companies to keep a check on our cost and expenses.

The Organizational Foundations of Managerial Accounting

Management accounting is built on organizational foundations. First, elements of organizational structure shape its techniques, approaches, and role in the firm. Second, it is a function of the theories of organization to describe and explain organizational behaviour. Hector was among the first authors to point to the problem of adapting accounting to organization theory and vice versa:

… It seems appropriate that organization theory receive considerable attention by members of the accounting profession, which is presently in the throes of rethinking its scope and methods. For an inappropriate organization structure can frustrate the most worthy of intentions and, in any case, any fundamental changes in accountancy will require changes in the traditional theory of organization (Hector, 293).

Thus, management accounting requires a good grasp of the elements of organizational structure and theories of organization. Identifying the elements of an organization structure most prevalent and essential to a proper functioning of a management accounting system allows the tailoring of the internal reporting system to that structure or the suggestion of a more appropriate organization structure. Similarly, the theories of organization point to significant elements that approximate the patterning and order inherent in organizations. Determination of these characteristics guides management accounting to more effective ways of providing its services. This part of the paper will introduce elements of organizational structure and theories of organization most relevant to a proper functioning of management accounting.

The accounting foundations include basic and secondary objectives, qualitative characteristics, and concepts as an accounting framework within which techniques may be evaluated. Management accounting techniques will be judged in terms of their conformity to this “emerging management accounting theoretical structure.” (Hector, 293) The problem and decisional foundations include the frameworks for determining the types of problems, the needed information, the types of decisions taken and decision centres, and defining the role of management accounting in decision making.

The organizational foundations include the elements of organizational structure most prevalent and essential to a proper functioning of a management accounting system and the theories of organization essential to an identification of the significant elements that approximate the patterning and order in organizations. They define the role and scope of management accounting in the organization and the techniques, approaches, and philosophies it may espouse in order to provide adequate services to the organization (Homgren, 56-60).

The behavioural foundations include various concepts–namely, the objective function in management accounting, motivation theories, models of decision making, and heuristics, which identify factors and situations that influence individual behaviour and performance and suggest avenues for management accounting to adapt its services.

The strategic foundations show congruence between the strategic process, types, and decision making, and the conduct of management accounting in general and strategic management accounting in particular.

These foundations point to the possibility of formulating a model of the nature, elements, and determinants of the conceptual foundations of management accounting. Such a model would represent a first step toward the development of a combinatorial theory of management accounting. More explicitly, the scope and conduct of management accounting in a given organization rests on the five conceptual foundations discussed above. Management accounting systems will differ from one another on the basis of the extent of appreciation and the incorporation of these foundations, their determinants, and their elements in the design of the system.

Analysis of Managerial Accounting Foun dations

Each of these foundations may be characterized by appropriate determinants. Hence, the accounting foundations are determined by the extent to which management accounting techniques are derived from an accounting conceptual framework. The problem and decisional foundations are determined by the problem formulation process and the information and decision systems frameworks. The organizational foundations are determined by the theories of organization and the elements of organizational structure. The behavioural foundations are determined by the objective function, the motivation theories, the heuristics, and the models of decision making. The strategic foundations are determined by the strategic process and the strategic archetypes. Each of the determinants of the conceptual foundations depends on the set of variables or elements of the foundations, which will characterize by their implementation the resulting management accounting system.

Financial Versus Management Accounting

Financial accounting deals with reporting information that pertains to the financial position, performance, and conduct of a firm for a given period to a set of users and the market in general. Management accounting is more oriented toward internal decision making and purposively channels relevant and timely information to internal managers. Both are production processes of different accounting data for different problem-solving situations.

Financial accounting is the result of applying generally accepted accounting principles (GAAP) to the recording of transactions between different entities. As such, financial accounting statements conform to a set of rules established by the profession. Management accounting, however, reflects the use of techniques from different disciplines, including accounting, for internal problem solving. Therefore, management accounting techniques may differ from GAAP techniques and from one firm to another. They do not conform to any set of prescribed rules, and much may be left to the decision-maker’s philosophies.

In short, the frame of reference used in management accounting is much broader than that used in financial accounting. Vergil Boyd and Date Taylor considered the specific difference to be the following: The managerial approach places the student in the role of a user of financial data in decision making. The conventional approach assigns the student the role of preparer of financial statements for use by others (Vergil, 210.)

The student of managerial accounting is called upon to use his or her entire knowledge of the business world in making business decisions based upon accounting data. Conventional accounting limits itself to accounting techniques, principles, and practices, and rarely deals with decisions other than those required in the preparation of financial statements. An attempt is made to consider the external and internal business environment in managerial accounting. Conventional accounting usually ignores these conditions.

The arrangement and emphasis of topical material differs under the two methods because of the differences in objectives. The purpose of managerial accounting is to make a decision related to a business problem. Conventional accounting has as its end the ability to prepare adequate financial statements (Vergil, 210). To this list of differences, it may be also added that financial accounting data are required to be objective and verifiable, while management accounting emphasizes relevance and flexibility.

Management versus Cost Accounting

Although the relationship between cost accounting and management accounting has not been explicitly clarified, it is usually believed that it is one point of emphasis. Cost accounting deals mainly with cost accumulation, inventory valuation, and product costing. It emphasizes the cost side. The objective function is implicitly perceived to be cost minimization. Similarly, management accounting deals with the efficient allocation of resources. The objective function may be perceived to be profit maximization. It is also believed that the cost accountant and the management accountant are performing different activities; cost control is in the domain of the cost accountant, while cost reduction is in the domain of the management accountant (Bassett, 386) .A cursory examination of accounting textbooks shows that, in general, those labelled cost accounting emphasize cost control while those labelled management accounting or managerial accounting emphasize planning, which may have reinforced the belief in a difference between both areas (James, 299).

It is advisable, however, not to stress those differences, but rather to conceive of management accounting as an attempt to bring techniques from other disciplines into the area of cost accounting. In fact, in recent years, the scope of cost accounting has been enlarged in various ways.

  • It emphasizes not only the explanatory but also the predictive ability of accounting data.
  • It develops normative models to be applied in the accounting context with an emphasis on mathematical, statistical, and operations research techniques. It stresses the behavioural impact of accounting information on the users.
  • It uses non-accounting information–economic, environmental, and qualitative–to improve the relevance of management accounting data.
  • It merges economic and social goals and consequently draws the accountant into program budgets and “performance” auditing in not-for-profit organizations.
  • It relies on more frequent and heavier use of computers, leading to a centralization of information and the expected candidature of the management accountant for the job of the “information manager” having overall responsibility of this resource.

This enlargement of the scope of cost accounting into management accounting leads to the problem of the modern education of management accountants, which can be resolved by an exposure of students to either a proliferation of courses in the computer, quantitative, and behavioural sciences, or to an integrated multidisciplinary approach. Following the same line of reasoning, the 1972 AAA Committee on Courses in Managerial Accounting made the following appropriate assumptions:

  • The role of managerial accounting encompasses the entire formalized information function of an organization.
  • The accountant is the best candidate for a manager of this information system.
  • Managerial accounting should be developed around a framework for the information wide perspective in the analysis and design of the information function.
  • Managerial accounting should integrate material from the computer, the quantitative, and the behavioural sciences areas.
  • Management accounting should continue the traditional emphasis on problems while using more sophisticated approaches to problem solving. (AAA Committee on Courses in Managerial Accounting, p.2)

In brief, management accounting should go beyond cost accounting and integrate various materials from organization theory, behavioural sciences, information theory, and so on, in a multidisciplinary approach aimed at facilitating the production of information for internal decision making. In spite of these diversifications in the background of management accountants, they remain professionals, as evidenced by the growing popularity of the Certificate in Management Accounting program of the National Association of Accountants (NAA; also NA). The following excerpt from a brochure issued by the NAA highlights the new scope of the management accountant’s activities:

More and more people–inside the business world and out–realize the significant changes which have been taking place for years in accounting and the role of the accountant in business. No longer is he simply a recorder of business history. He now plays a dynamic role in making business decisions, in future planning and in almost every aspect of business operations. This new accountant is called a Management Accountant and he sits with top management because his responsibility is developing, producing and analyzing information to help management make sound decisions. Many management accountants make their way to top management positions. In response to the needs of business and at the request of many in the academic community, the National Association of Accountants has established a program to recognize professional competence in this field–a program leading to the Certificate in Management Accounting [CMA].

The CMA program requires candidates to pass a series of uniform examinations and meet specific educational and professional standards to qualify for and maintain the Certificate in Management Accounting. NA has established the Institute of Management Accounting to administer the program, conduct the examinations and grant certificates to those who qualify. The objectives of the program are threefold:

  • to establish management accounting as a recognized profession by identifying the role of the management accountant and the underlying body of knowledge, and by outlining a course of study by which such knowledge, can be acquired;
  • to foster higher educational standards in the field of management;
  • to assist employers, educators and students by establishing objective measurement of an individual’s knowledge and competence in field of management accounting.

Those management accountants are to occupy important positions in organizations and therefore have to abide by high ethical standards.

Accordingly the NAA has promulgated the following ethical standards for management accountants: Competence Management accountants have a responsibility to:

  • Maintain an appropriate level of professional competence by ongoing development of their knowledge and skills.
  • Perform their professional duties in accordance with relevant laws, regulations, and technical standards.
  • Prepare complete and clear reports and recommendations after appropriate analyses of relevant and reliable information.

Confidentiality Management accountants have a responsibility to:

  • Refrain from disclosing confidential information acquired in the course of their work except when authorized, unless legally obligated to do so.
  • Inform subordinates as appropriate regarding the confidentiality of information acquired in the course of their work and monitor their activities to assure the maintenance of the confidentiality.
  • Refrain from using or appearing to use confidential information acquired in the course of their work for unethical or illegal advantage either personally or through third parties.
  • Integrity

Management accountants have a responsibility to:

  • Avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict.
  • Refrain from engaging in any activity that would prejudice their ability to carry out their duties ethically.
  • Refuse any gift, favour, or hospitality that would influence or would appear to influence their actions.
  • Refrain from either actively or passively subverting the attainment of the organization’s legitimate and ethical objectives.
  • Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity.
  • Communicate unfavourable as well as favourable information and professional judgments or opinions.
  • Refrain from engaging in or supporting any activity that would discredit the profession.
  • Objectivity Management accountants have a responsibility to:
  • Communicate information fairly and objectively.
  • Disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, comments, and recommendations presented. (National Association of Accountants, 1-2 )

Management Accounting Theory

Management accounting is generally understood as a process or as referring to the use of techniques. For example, the 1958 Committee on Management Accounting defines it as “the application of appropriate techniques and concepts in processing the historical and projected economic data of an entity to assist management in establishing a plan for reasonable economic objectives, and in the making of rational decisions with a view towards achieving these objectives.” Similarly the emergent conceptual framework of management accounting started by the National Association of Accountants defines it as the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of financial information used by management to plan, evaluate, and control within an organization and to assure appropriate use of and accountability for its resources. Management accounting also comprises the preparation of financial reports for non-management groups such as shareholders, creditors, regulatory agencies, and tax authorities. (Pollard, 212)

Those techniques are further explicated as follows:

  • Identification – the recognition and evaluation of business transactions and other economic events for appropriate accounting action.
  • Measurement – the quantification, including estimates, of business transactions or other economic events that have occurred or may occur.
  • Accumulation – the disciplined and consistent approach to recording and classifying appropriate business transactions and other economic events.
  • Analysis – the determination of the reasons for, and the relationships of, the reported activity with other economic events and circumstances.
  • Preparation and Interpretation – the meaningful coordination of accounting and/or planning data to satisfy a need for information, presented in a logical format, and, if appropriate, including the conclusions drawn from those data.
  • Communication – the reporting of pertinent information to management and others for internal and external uses.
  • Plan – to gain an understanding of expected business transactions and other economic events and their impact on the organization.
  • Evaluate – to judge the implications of various past and/or future events.
  • Control – to ensure the integrity of financial information concerning an organization’s activities or its resources.
  • Assure accountability – to implement the system of reporting that is closely aligned to organizational responsibilities and that contributes to the effective measurement of management performance (Pollard, 212).

A generally accepted definition of a theory, as it could apply to management accounting, is that a theory represents the coherent set of hypothetical, conceptual, and pragmatic principles for a field of inquiry. Accordingly, management accounting theory may be defined as a frame of reference in the form of a set of postulates and/or principles from different disciplines by which management accounting techniques are evaluated. The task of justifying the existence of a management accounting theory lies in the definition of appropriate postulates and principles. Given the differences in the objectives between management accounting and financial accounting, the postulates of financial accounting, with some exceptions, do not hold true for management accounting. In fact, the 1961 AAA Management Accounting Committee, charged with determining the relevance of financial accounting concepts to management accounting, concluded that

  • the concepts underlying internal reporting differ in several important respects from those of external public reporting;
  • these differences are due to differences in the objectives of both areas; and
  • it is justified to develop a separate body of concepts applicable to internal reporting (Richard, 49).

There is a need, then, for the accounting profession to develop a conceptual framework in management accounting to guide the development and use of techniques. Similar to financial accounting, such a framework would include the following elements:

  • The objectives of management accounting as the first and important step for the development of the elements of the conceptual framework for management accounting.
  • Qualitative characteristics to be met as essential attributes of management accounting information.
  • Management accounting concepts as the foundation for the body of knowledge contained within the conceptual framework.
  • Management accounting techniques and procedures that constitute the internal accounting systems.

Although these elements and the total integrated framework have not yet been formalized through a deductive reasoning process, they do exist in the literature as separate attempts to resolve these issues. Each of the proposed elements of management accounting will be examined next. The objectives of management accounting are the first and essential step to the formulation of a management accounting theory. Then, the management accounting concepts will be true because they will be based on accepted objectives. In spite of the importance of management accounting objectives, there has never been a formal attempt by the profession to accomplish such a task. One noticeable exception, which may serve as de facto objectives of management accounting, was provided by the 1972 AAA Committee on Courses in Managerial Accounting. Four objectives were presented:

Management accounting should be related to the planning functions of the managers. This involves:

  • Goal identification.
  • Planning for optimal resource flows and their measurement.
  • Management accounting should be related to organizational problem areas.

This includes:

  • Relating the structure of the firm to its goals.
  • Installing and maintaining an effective communication and reporting system.
  • Measuring existing resource uses, discovering exceptional performance, and identifying causal factors of such exceptions.

Management accounting should be related to the management control function. This includes:

  • Determining economic characteristics of appropriate performance areas that are significant in terms of overall goals.
  • Aiding to motivate desirable individual performances through a realistic communication of performance information in relation to goals.
  • Highlighting performance measures indicating goal incongruity within identifiable performance and responsibility areas.

Management accounting should be related to operating systems management, by function, product, project, or other segmentation of operations. This involves:

  • Measurement of relevant cost input and/or revenue or statistical measures of outputs.
  • Communication of appropriate data, of essentially economic character, to critical personnel on a timely basis. (AAA Committee on Courses in Managerial Accounting, 6-7)

The NA’s emerging conceptual framework defines the objectives of management accounting as well as management accountants in terms of providing information and participating in the management process. More specifically the true objectives are defined as follows:

Providing Information Management accountants select and provide, to all levels of management, information needed for:

  • planning, evaluating, and controlling operations;
  • safeguarding the organization’s assets; and
  • communicating with interested parties outside the organization, such as shareholders and regulatory bodies.

Participating in the Management Process

Management accountants at appropriate levels are involved actively in the process of managing the entity. This process includes making strategic, tactical, and operating decisions and helping to coordinate the efforts of the entire organization. The management accountant participates, as part of management, in assuring that the organization operates as a unified whole in its long-run, intermediate, and short-run best interests. (National Association of Accountants, p.2) While these objectives reflect some of the priorities facing management accounting, they do not necessarily represent all the facets of the environment of management accounting. A formal study for the objectives of accounting is a definite must for the profession (Porter, 58-62).

Qualitative Characteristics of Management Accounting Information

Management accounting information should have certain desirable properties so that benefits are achievable. The 1969 AAA Committee on Managerial Decision Models explored the application to internal reporting of the standards of relevance, verifiability, freedom from bias, and quantifiability. (AAA Committee on Managerial Decision Models, 47-58) These standards for accounting information were suggested in the AAA Statement of Basic Accounting Theory. (AAA Committee on Managerial Decision Models, 51-55) This effort was pursued by the 1974 AAA Committee on Concepts and Standards–Internal Planning and Control. The Committee offered the following closely related properties as representatives of the benefits information or information systems:

  • Relevance/mutuality of objectives
  • Accuracy/precision/reliability
  • Consistency/comparability/uniformity
  • Verifiability/objectivity/neutrality/traceability
  • Aggregation
  • Flexibility/adaptability
  • Timeliness
  • Understandability/acceptability/motivation/fairness. (AAA Committee on Concepts and Standards, 83)

Conclusion

In conclusion, the revolution in management accounting is journey, not a destination. The journey embraces three streams of wisdom – finance and accounting, total quality management, and managerial economics. Managerial accounting has addressed itself mainly to the problems of sub-optimization, and has largely worked outside the scheme of the “continuous data gathering” system. It is rather obvious that this has been due largely to the fact that present accounting systems do not provide adequate structure to enable the gathering of enough pertinent managerial data from routine accounting records.

This lack of adequate structure is mainly due to the failure to recognize the conceptual foundations of management accounting as a guide for the development and evaluation of management accounting techniques. Management accounting rests on accounting, problem and decisional, organizational, behavioural, and strategic foundations. The incorporation of these five foundations in management accounting will provide the adequate structure that will enable the gathering of enough pertinent managerial data for internal problem solving.

One driving force to develop a global accounting system is the desire to underwrite securities in any, or all, of the world’s capital markets using a single set of financial statements. A positive incentive for a capital market to support a global accounting system is the enhancement of its volume of business by being able to participate in underwritings in other capital markets. Reinforcing the positive incentive is the realization that a capital market, which ignores the development of a global accounting system, may find itself with a unique set of accounting standards while the rest of the world relies on a common set of accounting standards. This would lead to an irretrievable loss of business. The desire for potential gain in business by participating, and the fear of a potential loss of business by not participating, encourage support of the concept of a global accounting system regardless of how officials of capital markets may feel about the matter. Opponents to a global accounting system certainly can delay the process, but they may not be able to prevent its eventual success.

The globalization of corporate activity, coupled with economic and political integration of large groupings of nations, is engines of change in accounting practices. Indeed, one might say that change is being pushed on the accounting profession by commercial interests, which find it difficult to accept the necessity of adopting a different set of accounting standards as business activities cross national borders. Two complementary approaches are being taken to tear down the Tower of Babel of Accounting Practices. One is standardization of accounting practices, whereby all nations agree to a common set of standards. The other is harmonization of accounting principles, which attempts to eliminate disparities and narrow differences between accounting systems.

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