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Introduction to Management Accounting

Introduction

Managerial accounting may be regarded as a body of knowledge that is

concerned with concepts and decision-making tools that enable management to

make better decisions and to evaluate results. As a body of technical knowledge,

management accounting primarily consists of certain decision‑making techniques or

tools drawn from financial and management theory and practice. A basic premise is

that the primary task of management is to make decisions and that this task is greatly

improved by the knowledge and skills of the management accountant. A corollary

premise is that the management accountant’s ability to serve management is greatly

enhanced by a knowledge of management and, in particular, a sound knowledge of

the fundamentals of marketing, production, and finance.

This book is based on the assumption that the accountant in the role of advisor

to management must understand basic management concepts, particularly those

concepts embedded in the function of decision‑making. Only if the accountant has

a proper understanding of management’s needs will he or she be able to furnish

the data and special analyzes that will enable management to make consistently

good decisions. Conversely, this book assumes that management must understand

accounting and the type of information that the accountant can provide. Without

an understanding of some accounting, the manager or decision-maker may fail to

request information or seek help at a critical time. Therefore, this book is written for

two 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 and

control techniques presented.

2 | CHAPTER ONE • Introduction to Management Accounting


Definition 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 decisions–in 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

decision-making.

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 Tools Concepts

1. Cost‑volume‑profit analysis 1. Fixed and variable costs

2. Comprehensive budgeting 2. 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 budgeting 7. Common costs

8. Inventory models 8. Direct and indirect cost


9. Cost analysis for marketing 9. Contribution margin

production, and finance 10. Planning

10. Segmental income statements 11. Control

11. Financial statement ratio analysis 12. 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.

Management Accounting | 3

Furthermore, there is implied an area of common interests. Management accounting

is not merely the application of accounting to management; rather it is a study of

analytical techniques that result from the combining of accounting fundamentals with

the fundamental concepts of management.

The student that is planning a professional career in accounting must develop

an appreciation and understanding of management. It is management that guides


the business and makes the decisions which determine the success or failure of a

business. The accountant serves in a staff or advisory function under management.

On the other hand, those students planning a professional career as managers

need to understand and appreciate that a knowledge of accounting is critically

important. Although accountants use technical accounting expertise to prepare

financial statements, it is management that receives and uses financial statements.

Management, not accountants, has the need and responsibility to read and understand

financial statements. Financial statements, in one sense, are summary reports of

how well management has performed (made decisions) for a given period of time.

For management to have a negative attitude towards accounting is tantamount to

being negative towards their own responsibilities and accomplishments.

Certain concepts of management are essential to a study of management

accounting. The following concepts will be employed throughout this text as important

in understanding the technical aspects of management accounting.

Planning

Control (performance evaluation)

Organization

Standards

Decision-making

Feedback

Goals and objective

Strategy

These terms will be explained in the chapters where they can be logically

associated 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 accounting

is frequently associated with fairly large corporate businesses; however, it is equally

useful to small businesses.

When a business reaches a certain size, then the accounting activity is of such a

volume that the accounting activity must be organized and managed. Consequently,

accounting in larger businesses can be thought of as a departmentalized function

appearing on the organization chart as a staff function. While the term management

accounting implies to individuals possessing specialized knowledge of management

and 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 management

techniques presented in this book would primarily be used in the budgeting and

revenue and cost analysis section of the accounting department.

4 | CHAPTER ONE • Introduction to Management Accounting

President

Board of

Directors

Marketing

Department

Production

Department

Finance

Department

Accounting
Department

From 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 decision‑making 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

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 intended

to serve primarily management’s internal information needs; therefore, managerial

accounting is not governed by strictly defined and publicly promulgated principles

and standards. Financial accounting is concerned with the reporting of operations

to external parties; whereas, management accounting is internal in direction and is

primarily concerned with serving the decision‑making needs of management.

Management accounting as a body of technical knowledge is, in fact, a synthesis

of various disciplines. Many of the techniques such as capital budgeting models and

EOQ models have been borrowed from other disciplines. The conceptual framework

of 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, if

preceded by a knowledge of the fundamentals of management, finance, production,

marketing, economics, and mathematics.

Environmental Structure of Accounting

Accounting is a complex body of knowledge and procedures that has evolved


over the last few hundred years. The complexity of accounting in the last fifty years

has greatly accelerated as more complex financial transactions have been developed

and 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 personal

computers and very powerful accounting and systems software has had its impact

in accelerating the complexity of accounting. Within accounting, there are highly

developed specialized areas such as the following:

Tax accounting Accounting Information Systems

Financial auditing Internal auditing

Management accounting Financial accounting

Not-for-profit accounting Governmental accounting

Accounting as a profession employs hundreds of thousands of individuals who

serve both in public accounting and private accounting. As of 2006, there were

approximately 650,000 CPAs in the USA. Accounting is needed in every type of

business and organizations including state and federal governments, banks, not-forprofit businesses,
manufacturing and retail businesses of all types, and labor unions.

The professional accountant needs to have an awareness and knowledge of how

the financial and economic environment has an impact on business. Also, an acute

awareness of the many different types of organizations that a business interacts with

is crucial to being a successful management accountant.

6 | CHAPTER ONE • Introduction to Management Accounting

Comparison to Financial Accounting

The differences between financial and managerial accounting can be effectively

illustrated by using (1) an input and output approach and (2) a financial statement

approach. Both approaches will be illustrated.


Input/output Approach - Although narrower in scope of users, management

accounting, nevertheless, is broader in scope in the type of data used in the models

through which data is processed and analyzed. The input and output diagrams

illustrated in Figures 1.3 and 1.4 reveal the differences in the nature of inputs and the

mode of processing between financial and management accounting.

The input/output diagram shown in Figure 1.4 reveal that management accounting

deals with a wider range of inputs and outputs. Also, the methodology of processing

data involves numerous types of mathematical model. The inputting, processing, and

outputting of data in management accounting is not limited to a prescribed set of

rules dealing only with historical data as is the case in financial accounting.

Financial Statement Approach

Both financial accounting and management accounting are concerned with financial

statements. The financial accountant is concerned with analyzing and recording the

historical transactions (past decisions) of the business. A primary objective of the

financial accountant is to fairly present financial statements based on past events (see

Figure 1.3). The management accountant is primarily concerned with desired future

Figure 1.2 • Accounting Environment

ORGANIZATIONS

Governments

(States & Federal)

Financial

Instiltutions Business Firms Labor Unions Consumers Investors Business

Professions

Financial Accounting

Balance
Sheet

Income

Statement

Cash Flow

Statement

President

Marketing

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