2. Management Accounting | 1Introduction to Management AccountingIntroductionManagerial accounting may be regarded as a body of knowledge that isconcerned with concepts and decision-making tools that enable management tomake better decisions and to evaluate results. As a body of technical knowledge,management accounting primarily consists of certain decisionmaking techniques ortools drawn from financial and management theory and practice. A basic premise isthat the primary task of management is to make decisions and that this task is greatlyimproved by the knowledge and skills of the management accountant. A corollarypremise is that the management accountants ability to serve management is greatlyenhanced by a knowledge of management and, in particular, a sound knowledge ofthe fundamentals of marketing, production, and finance.This book is based on the assumption that the accountant in the role of advisorto management must understand basic management concepts, particularly thoseconcepts embedded in the function of decisionmaking. Only if the accountant hasa proper understanding of managements needs will he or she be able to furnishthe data and special analyzes that will enable management to make consistentlygood decisions. Conversely, this book assumes that management must understandaccounting and the type of information that the accountant can provide. Withoutan understanding of some accounting, the manager or decisionmaker may fail torequest information or seek help at a critical time. Therefore, this book is written fortwo groups of individuals: accountants and managers. The accountants, of course,are expected to acquire a higher degree of proficiency in the use of the planning andcontrol techniques presented. 3. 2 | CHAPTER ONE Introduction to Management AccountingDefinition of Management Accounting What is accounting? A very old but frequently used definition states: Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions, and events, which are, in part at least of a financial character, and interpreting the results thereof. (AIA Bulletin No. 1 Review and Resume) A more recent definition states: Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisionsin making reasoned choices among alternative courses of action. (APB Statement No. 4) This latter definition is more appropriate to managerial accounting because of its emphasis on decisionmaking. Management accounting may be simply defined as a body of accounting knowledge primarily consisting of concepts and techniques (tools) useful to management in making better decisions and evaluating performance. Most managerial accounting theorists and writers agree that the following concepts and tools represent the foundation of management accounting: Decision-making ToolsConcepts 1. Costvolumeprofit analysis1. Fixed and variable costs 2. Comprehensive budgeting2. Escapable and inescapable costs 3. Flexible budgeting 3. Relevant costs 4. Incremental analysis 4. Incremental costs 5. Return on investment 5. Sunk costs 6. Direct costing 6. Opportunity costs 7. Capital budgeting7. Common costs 8. Inventory models 8. Direct and indirect cost 9. Cost analysis for marketing9. Contribution margin production, and finance 10. Planning 10. Segmental income statements 11. Control 11. Financial statement ratio analysis12. Standards 13. Organization From the above listing, it is apparent that the subject matter of management accounting has little to do with transactions analysis and the preparation of statements from historical data. However, management accounting is not independent of financial accounting. Financial accounting is a foundation requirement for management accounting and a study of financial accounting must precede the study of management accounting. The basic carryover from the study of financial accounting is a solid understanding of financial statements. An understanding of how to analyze and record the effects of individual transactions of assets, liabilities, capital, and revenue is helpful but not essential.Management: The Focal Point of Management Accounting The term management accounting obviously consists of two words each of which represents highly developed areas of study. The term management accounting suggests an important relationship between management and accounting. 4. Management Accounting | 3Furthermore, there is implied an area of common interests. Management accountingis not merely the application of accounting to management; rather it is a study ofanalytical techniques that result from the combining of accounting fundamentals withthe fundamental concepts of management.The student that is planning a professional career in accounting must developan appreciation and understanding of management. It is management that guidesthe business and makes the decisions which determine the success or failure of abusiness. The accountant serves in a staff or advisory function under management.On the other hand, those students planning a professional career as managersneed to understand and appreciate that a knowledge of accounting is criticallyimportant. Although accountants use technical accounting expertise to preparefinancial statements, it is management that receives and uses financial statements.Management, not accountants, has the need and responsibility to read and understandfinancial statements. Financial statements, in one sense, are summary reports ofhow well management has performed (made decisions) for a given period of time.For management to have a negative attitude towards accounting is tantamount tobeing negative towards their own responsibilities and accomplishments.Certain concepts of management are essential to a study of managementaccounting. The following concepts will be employed throughout this text as importantin understanding the technical aspects of management accounting. Planning Control (performance evaluation) Organization Standards Decisionmaking Feedback Goals and objective StrategyThese terms will be explained in the chapters where they can be logicallyassociated to the management accounting tools that make them relevant.Accounting as an Organizational Function Management accounting techniques are useful in all types of businesses.Managers of service, merchandising, manufacturing, banks, insurance companies,etc. all can benefit from the use of management accounting. Management accountingis frequently associated with fairly large corporate businesses; however, it is equallyuseful to small businesses.When a business reaches a certain size, then the accounting activity is of such avolume that the accounting activity must be organized and managed. Consequently,accounting in larger businesses can be thought of as a departmentalized functionappearing on the organization chart as a staff function. While the term managementaccounting implies to individuals possessing specialized knowledge of managementand accounting, the term can also be applied to the accounting department as a whole.A simple model of the accounting function is shown in Figure 1.1. The managementtechniques presented in this book would primarily be used in the budgeting andrevenue and cost analysis section of the accounting department. 5. 4 | CHAPTER ONE Introduction to Management AccountingFrom a departmental viewpoint, all accounting activities are management in nature. The accounting department exists to serve the financial data needs of management. The controller or head of the accounting department in many companies is considered to be a part of the decisionmaking team. Therefore, from an organizational viewpoint, the distinction between financial accounting and managerial accounting is somewhat artificial. The controller, the chief executive officer of the accounting department, is always serving as an management accountant, regardless of what type of accounting is being done. However, the majority of accounting activities he or she supervises would from an academic viewpoint be classified as financial accounting as opposed to management accounting.Relationship of Financial and Managerial Accounting The study of accounting is normally divided into two broad categories: financial and managerial. This division is somewhat arbitrary in that the study of managerial accounting requires a strong foundation in financial accounting. However, there is a definite difference in orientation and methodology which needs to be understood. Accounting exists in a network of complex business relationships both internal and external. In management accounting, the focal point is the role of management within the organizational structure. Both the financial accountant and the managerial accountant need a knowledge of external factors and relationships as well as a conceptual knowledge of accounting principles and procedures. Accounting as a function within a business organization is service oriented. Accounting serves the financial information needs of many different types of groups including investors, governments, customers, employees, unions, and bankers. Most importantly, it serves the internal information needs of management. Figure 1.2 illustrates the environment in which management and the management accountant operate. FIGURE 1.1 Diagram of the Accounting Function Board of DirectorsPresident MarketingProduction FinanceDepartmentDepartmentDepartmentAccountingDepartment 6. Management Accounting | 5 In a broad sense, financial accounting, as a branch of accounting in general,serves all types of users. Management accounting, on the other hand, is intendedto serve primarily managements internal information needs; therefore, managerialaccounting is not governed by strictly defined and publicly promulgated principlesand standards. Financial accounting is concerned with the reporting of operationsto external parties; whereas, management accounting is internal in direction and isprimarily concerned with serving the decisionmaking needs of management.Management accounting as a body of technical knowledge is, in fact, a synthesisof various disciplines. Many of the techniques such as capital budgeting models andEOQ models have been borrowed from other disciplines. The conceptual frameworkof management accounting, then, has building blocks in its foundation from:1. Management theory ( planning, control, organization)2. Financial accounting (financial statements)3. Finance theory (capital budgeting, working capital)4. Economic theory (pricing, forecasting, supply, demand, cost behavior)5. Marketing theory (order getting, order processing, order delivery)6. Mathematics (algebra, calculus) Therefore, an understanding of management accounting is greatly enhanced, ifpreceded by a knowledge of the fundamentals of management, finance, production,marketing, economics, and mathematics.Environmental Structure of AccountingAccounting is a complex body of knowledge and procedures that has evolvedover the last few hundred years. The complexity of accounting in the last fifty yearshas greatly accelerated as more complex financial transactions have been developedand regulatory agencies, both private and non private, have come into existence.Voluminous rules and regulations, (for example, Financial Accounting Standards)have been written and put into practice. Also, the rapid development of personalcomputers and very powerful accounting and systems software has had its impactin accelerating the complexity of accounting. Within accounting, there are highlydeveloped specialized areas such as the following: Tax accountingAccounting Information Systems Financial auditingInternal auditing Management accounting Financial accounting Not-for-profit accounting Governmental accountingAccounting as a profession employs hundreds of thousands of individuals whoserve both in public accounting and private accounting. As of 2006, there wereapproximately 650,000 CPAs in the USA. Accounting is needed in every type ofbusiness and organizations including state and federal governments, banks, not-for-profit businesses, manufacturing and retail businesses of all types, and labor unions.The professional accountant needs to have an awareness and knowledge of howthe financial and economic environment has an impact on business. Also, an acuteawareness of the many different types of organizations that a business interacts withis crucial to being a successful management accountant. 7. 6 | CHAPTER ONE Introduction to Management Accounting Comparison to Financial Accounting The differences between financial and managerial accounting can be effectivelyillustrated by using (1) an input and output approach and (2) a financial statementapproach. Both approaches will be illustrated. Input/output Approach - Although narrower in scope of users, managementaccounting, nevertheless, is broader in scope in the type of data used in the modelsthrough which data is processed and analyzed. The input and output diagramsillustrated in Figures 1.3 and 1.4 reveal the differences in the nature of inputs and themode of processing between financial and management accounting.The input/output diagram shown in Figure 1.4 reveal that management accountingdeals with a wider range of inputs and outputs. Also, the methodology of processingdata involves numerous types of mathematical model. The inputting, processing, andoutputting of data in management accounting is not limited to a prescribed set ofrules dealing only with historical data as is the case in financial accounting. Financial Statement ApproachBoth financial accounting and management accounting are concerned with financialstatements. The financial accountant is concerned with analyzing and recording thehistorical transactions (past decisions) of the business. A primary objective of thefinancial accountant is to fairly present financial statements based on past events (seeFigure 1.3). The management accountant is primarily concerned with desired future Figure 1.2 Accounting EnvironmentORGANIZATIONSGovernments FinancialBusinessBusiness Firms Labor UnionsConsumersInvestors(States & Federal)Instiltutions Professions PresidentFinancial Accounting Accounting SystemMarketing ProductionFinanceBalanceIncome Cash FlowGeneral LedgerJourlnals SheetStatement Statement AccountingSpecial Journals Auditing SystemsPayrollGeneralCost AccountingBudgeting AccountingAccounting Theory and Methodlogy Theory AssumptionsStandards and Recording Rules Statistical and Mathematical Techniques 8. Management Accounting | 7events. Future events will be the results of decisions to be made by management.The management accountant, then, is also concerned with financial statements(e.g. budgeted financial statements) that reflect the anticipated consequences ofplanned decisions (planned transactions). For example, the financial accountant isconcerned with questions such as: What is the amount of cash on hand? What is thecost of inventory on hand? The management accountant, however, is concerned withquestions such as: What amount of cash should be on hand? What is the desiredlevel of inventory? Figure 1.5 summarizes the differences in viewpoint for each itemon the balance sheet and income statement. Figure 1.3 Financial AccountingInputsAccounting Transactions (Historical Data)Accounting Department Accounting transactions are processed by means of journals, accounts and ledgers. Now doneprimarily by use of accounting software and computers.OutputsIncome StatementBalance SheetStatement of Cash Flows Other types of financial reports Figure 1.4 Managerial AccountingInputs Planned data, Statistical data, Future costs.Standards, Historical accounting data, if relevantAccounting Department Data for decision-making and performanceevaluation are processed by means of budget models, forecasting models, cost analysis techniques, etc. OutputsOperating budgetsCapital budgetsFlexible budgetsSpecial reports (graphic, tables)Summaries and Schedules Segmental income statement 9. 8 | CHAPTER ONE Introduction to Management Accounting Figure 1.5 Summary of Financial And Managerial Accounting Points of ViewFinancial Accounting ViewpointManagerial Accounting Viewpoint1. CASH1. CASH What is the balance?How much cash should be on hand? Emphasis is on: Emphasis is on: General journal entries,Cash budgeting, cash flow, alternative bank reconciliations, petty cash. uses of cash.2. ACCOUNTS RECEIVABLE 3. ACCOUNTS RECEIVABLE What is the amount that is collectible? What should the credit terms be? Emphasis is on: Emphasis is on: Estimation of bad debts, factoring, Effect of different credit terms, bad debt recording of collections. factors, analysis of credit revenue and expenses.3. INVENTORY 3. INVENTORY What is the historical dollar amount that What is the optimum level of inventory? should be assigned to inventory?Emphasis is on: Emphasis is on: EOQ models, safety stock, quantity Inventory cost methods, methods ofdiscounts. estimating inventory.4. FIXED ASSETS4. FIXED ASSETS What is the unamortized amount? How much plant and equipment is Emphasis is on: needed? Depreciation methods, journal entries orEmphasis is on: trades and retirements. Capacity requirements, capital budgeting, replacement of equipment.5. SHORT-TERM DEBT 5. SHORT-TERM DEBT What amount is owed?How much short-term debt is needed? Emphasis is on? Emphasis is on: Recording accrued liabilities and interestCost of capital, debt/equity ratios, cash expense.budgeting, and risk.6. LONG-TERM DEBT6. LONG-TERM DEBT What amount is owed?How much long-term debt should be Emphasis is on: issued? Amortization of bond premium andEmphasis is on: discount, accrued interest, and bond Cost of capital, debt/equity ratio, cash refunding. budgeting, issuance of different typesof securities. 10. Management Accounting | 9 7. STOCKHOLDERS EQUITY 7. STOCKHOLDERS EQUITYWhat is the amount of stock issued?How much stock should be issued?How should different types of stockWhat kind of stock security should betransactions be recorded?issued?Emphasis is on:Emphasis is on: Recording different types of stock Cost of capital, debt/equity ratio, cash transactions, recording of different types flow, and amount of dividends. of dividends. 8. SALES8. SALESHow much were sales? What will the amount of sales be?Emphasis is on:Emphasis is on:Recording of sales and purchases Sales forecasting, pricing, cashtransactions.budgeting, methods of increasing sales. 9. EXPENSES 9. EXPENSESHow much were expenses?What should the amount expenses be?Emphasis is on:Emphasis is on:Journal entries, accrued expenses, Budgeting, flexible budgeting cost-depreciation, bad debts. volume-profit analysis.The Management Accountant The management accountant is a professional accountant just like the CPA. He or she is likely to possess a degree in accounting. However, unlike the CPA, the management accountant is more likely to work for an industrial firm rather than an accounting firm. In a manner similar to the CPA, he or she may even be certified. The Institute of Management Accountants which is the professional organization of management accountants has over 70,000 members. The IMA gives twice a year a comprehensive three day exam over the knowledge expected of the management accountant. Individuals passing all parts of the exam are awarded a Certificate in Management Accounting (CMA). CMAs are governed by a set of ethical rules and are also required to accumulate a certain number of CPE hours each year. The exam is a difficult test with less than 20% of those taking the exam passing in one setting. The exam is given in five parts covering the following subject areas: (1) managerial economics and business finance, (2) organization and behavior, (3) public reporting standards, auditing and taxes, (4) periodic reporting for internal and external purposes, and (5) decision analysis, including modeling and information systems. If you are interested in learning more about the IMA, visit their web site, IMA.COM.Management Accounting Conceptual FrameworkThe real business world is extremely complex. The environment in which the accountant and manager operates has myriads of components which are highly 11. 10 | CHAPTER ONE Introduction to Management Accounting interrelated. A successful approach in dealing with complexity is to develop a model which contains the components of reality that need to be studied and understood. Most management accounting books have some underlying model; unfortunately, these authors use of the model is seldom welldefined or clearly presented. This book is based on a well defined model, somewhat traditional in nature, but different in approach in that it is explicitly defined and consistently used throughout the book. Furthermore, a comprehensive management accounting simulation based on the same model accompanies the book. This management accounting model will facilitate the understanding of how accounting and management are interrelated and how they have a mutual dependency upon each other. Furthermore, this model clarifies the relationship of financial and managerial accounting. This conceptual management accounting framework is presented in chapter 2. Summary Management accounting consists of a body of knowledge that consists of tools capable of helping management make better decisions. The tools require special types of information not normally found in the traditional records of the accounting system. In management accounting, the accounting function is required to provide a much broader range of information. Also, in management accounting, the role of the accountant is perceived to be much broader. Consequently, the accountant is expected to have a much better understanding of marketing, production, and finance fundamentals. Management accounting is a subject that should be understood by both management and accountants. Q.1.1List six examples of tools that the management accountant could use to help management to make decisions. Q.1.2List several features of management accounting that make it different from financial accounting. Q.1.3What types of activities both financial and managerial does the accounting department within a business provide? Q.1.4In terms of financial statements and from a management accounting point of view, what kinds of questions does the management accountant ask? Q.1.5In the study of management accounting, what kind of concepts would you be likely to encounter that are more important than in financial accounting? Exercise 1.1 Financial and Management Accounting Compared For each item or statement listed below, indicate (4) whether this item or statement pertains more to financial accounting or to management accounting. 12. Management Accounting | 11 FinancialManagement Statement/item Accounting Accounting Information is made available to management to make a1 purchase decision.2Use of the sales journal to record sales on credit. Accounting is the art of recording, classifying, and3 summarizing transactions and event Use of fixed and variable costs to develop standards for4 evaluating performance.5Accounting is a service activity Preparation of a segmental contribution income6 statement.7Installation of a payroll accounting system.8Installation of a profit planning system. Installation of a cost system for material, labor, and9 overhead. A body of knowledge that uses concepts and techniques10 from management, marketing, and financial theory and also uses techniques from economics and mathematics. More likely to ask the question, what is the correct cash11 balance? More likely to ask the question, what is correct cost12 amount to assign to inventory? More likely to ask the question, what amount of inventory13 should be on hand? More likely to ask the question, how much plant capacity14 is needed? Concerned with the procedures for recording issue of15 stocks and bonds. Concerned with determining whether to issue stocks or16 bonds. The body of knowledge that must be learned to become17 a CPA. The body of knowledge that must be learned to become18 a CMA. More likely to be concerned with future events and also19 with the internal events of a company. More likely to be concerned with historical external20 events such as transactions already completed. 13. 12 | CHAPTER ONE Introduction to Management Accounting Exercise 1.2 Financial and Management Accounting Compared For each item or statement listed below, indicate (4) whether this item or statement pertains more to financial accounting or to management accounting.FinancialManagementStatement/itemAccounting AccountingThe IRS has requested certain invoices and documents 1to support certain expenses deducted for tax purposes.The vice president of marketing has requested certain 2cost estimates concerning a new proposed product.A customer returned a defective product purchased the 3previous day. An entry to his account was made.A significant increase in advertising has been made and 4a request has been made concerning by how much salesmuch increase to offset the increase in advertising.An income statement showing segmental contribution 5and segmental net income has been requested.An analysis of operating expenses in terms of fixed and 6variable expenses has been requested.A physical inventory of raw materials has been made and 7the count compared to perpetual inventory records.A new sales people compensation plan has been 8proposed and an analysis of the effect on sales and totalsales people compensation has been requested.Two supplier have made a proposal concerning the sale 9and installation of new production equipment. Only oneproposal will be accepted.10A new computerized accounting system was installed. 14. Management Accounting | 13Exercise 1.3 Financial and Management Accounting ComparedFor each item or statement listed below, indicate (4) whether this item or statementpertains more to financial accounting or to management accounting.FinancialManagement Statement/itemAccounting Accounting1General Ledger2Cost-volume-profit tool3Accounts4Comprehensive business budgeting5Inventory costing using FIFO6Recordings sales in the sales journal7Making end-of-year adjusting entries8Preparing segmental income statements9Comparing actual results against standards 10Preparing income tax forms 11Preparing manufacturing overhead rates 12Subsidiary ledgers 13Use of ratios to evaluate performance 14Recording materials issued in a materials used summary Preparing financial statements from an adjusted trial 15 balance Using incremental analysis to evaluate which equipment 16 to purchase 17Recording labor incurred in a labor cost summary Installing a perpetual inventory system to control raw 18 materials 19Preparing a cost of goods manufactured statement 20Sending the annual report to stockholders 15. 14 | CHAPTER ONE Introduction to Management Accounting
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