Part I - Micro Business Publicationsmicrobuspub.com/pdfs/chapter1.pdf · Flexible budgeting 3....

Part IFoundations of

Management Accounting

Chapter 1 • Introduction to Management Accounting

Chapter 2 • Management Accounting and Decision-making

Chapter 3 • Financial Statements for Manufacturing Businesses

Chapter 4 • Classification of Manufacturing Costs and Expenses

Chapter 5 • Management Accounting Theory of Cost Behavior

Chapter 6 • Direct Costing Financial Statements

Management Accounting | 1

Introduction to Management AccountingIntroduction

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 AccountingThe 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.


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 FunctionManagement 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.


President

Board ofDirectors

MarketingDepartment

ProductionDepartment

FinanceDepartment

AccountingDepartment

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 AccountingThe 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


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 AccountingAccounting 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-for-profit 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.


Comparison to Financial AccountingThe 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 ApproachBoth 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)

FinancialInstiltutions Business Firms Labor Unions Consumers Investors Business

Professions

Financial Accounting

BalanceSheet

IncomeStatement

Cash FlowStatement

President

Marketing Production Finance

Accounting

Accounting System

Jourlnals General Ledger

Special Journals

Auditing Cost Accounting Systems Budgeting Payroll GeneralAccounting

Accounting Theory and Methodlogy

Theory Assumptions Standards and Recording Rules Statistical and Mathematical Techniques


events. 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 of planned decisions (planned transactions). For example, the financial accountant is concerned with questions such as: What is the amount of cash on hand? What is the cost of inventory on hand? The management accountant, however, is concerned with questions such as: What amount of cash should be on hand? What is the desired level of inventory? Figure 1.5 summarizes the differences in viewpoint for each item on the balance sheet and income statement.

Figure 1.4 • Managerial Accounting

Figure 1.3 • Financial Accounting

InputsPlanned data, Statistical data, Future costs.

Standards, Historical accounting data, if relevant

Accounting DepartmentData for decision-making and performance

evaluation are processed by means of budgetmodels, forecasting models, cost analysis

techniques, etc.

OutputsOperating budgets

Capital budgetsFlexible budgets

Special reports (graphic, tables)Summaries and Schedules

Segmental income statement

InputsAccounting Transactions

(Historical Data)

Accounting DepartmentAccounting transactions are processed by means

of journals, accounts and ledgers. Now doneprimarily by use of accounting software and computers.

OutputsIncome Statement

Balance SheetStatement of Cash Flows

Other types of financial reports


Figure 1.5

Summary of Financial And Managerial Accounting Points of View

Financial Accounting Viewpoint Managerial Accounting Viewpoint

1. CASHWhat is the balance?Emphasis is on:

General journal entries,bank reconciliations, petty cash.

1. CASHHow much cash should be on hand?Emphasis is on:

Cash budgeting, cash flow, alternative uses of cash.

2. ACCOUNTS RECEIVABLEWhat is the amount that is collectible?Emphasis is on:

Estimation of bad debts, factoring, recording of collections.

3. ACCOUNTS RECEIVABLEWhat should the credit terms be?Emphasis is on:

Effect of different credit terms, bad debt factors, analysis of credit revenue and expenses.

3. INVENTORYWhat is the historical dollar amount that should be assigned to inventory?Emphasis is on:

Inventory cost methods, methods of estimating inventory.

3. INVENTORYWhat is the optimum level of inventory?Emphasis is on:

EOQ models, safety stock, quantity discounts.

4. FIXED ASSETSWhat is the unamortized amount?Emphasis is on:

Depreciation methods, journal entries or trades and retirements.

4. FIXED ASSETSHow much plant and equipment is needed?Emphasis is on:

Capacity requirements, capital budgeting, replacement of equipment.

5. SHORT-TERM DEBTWhat amount is owed?Emphasis is on?

Recording accrued liabilities and interest expense.

5. SHORT-TERM DEBTHow much short-term debt is needed?Emphasis is on:

Cost of capital, debt/equity ratios, cash budgeting, and risk.

6. LONG-TERM DEBTWhat amount is owed?Emphasis is on:

Amortization of bond premium and discount, accrued interest, and bond refunding.

6. LONG-TERM DEBTHow much long-term debt should be issued?Emphasis is on:

Cost of capital, debt/equity ratio, cash budgeting, issuance of different types of securities.


7. STOCKHOLDERS’ EQUITYWhat is the amount of stock issued?How should different types of stock transactions be recorded?Emphasis is on:

Recording different types of stock transactions, recording of different types of dividends.

7. STOCKHOLDERS’ EQUITYHow much stock should be issued?What kind of stock security should be issued?Emphasis is on:

Cost of capital, debt/equity ratio, cash flow, and amount of dividends.

8. SALESHow much were sales?Emphasis is on:

Recording of sales and purchases transactions.

8. SALESWhat will the amount of sales be?Emphasis is on:

Sales forecasting, pricing, cash budgeting, methods of increasing sales.

9. EXPENSESHow much were expenses?Emphasis is on:

Journal entries, accrued expenses, depreciation, bad debts.

9. EXPENSESWhat should the amount expenses be?Emphasis is on:

Budgeting, flexible budgeting cost-volume-profit analysis.

The Management AccountantThe 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). CMA’s 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


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 well-defined 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.

SummaryManagement 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.1.1 List six examples of tools that the management accountant could use to help management to make decisions.

Q.1.2 List several features of management accounting that make it different from financial accounting.

Q.1.3 What types of activities both financial and managerial does the accounting department within a business provide?

Q.1.4 In terms of financial statements and from a management accounting point of view, what kinds of questions does the management accountant ask?

Q.1.5 In 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.


Statement/item Financial Accounting

ManagementAccounting

1 Information is made available to management to make a purchase decision.

2 Use of the sales journal to record sales on credit.

3 “Accounting is the art of recording, classifying, and summarizing transactions and event…”

4 Use of fixed and variable costs to develop standards for evaluating performance.

5 “Accounting is a service activity…”

6 Preparation of a segmental contribution income statement.

7 Installation of a payroll accounting system.

8 Installation of a profit planning system.

9 Installation of a cost system for material, labor, and overhead.

10A body of knowledge that uses concepts and techniques from management, marketing, and financial theory and also uses techniques from economics and mathematics.

11 More likely to ask the question, what is the correct cash balance?

12 More likely to ask the question, what is correct cost amount to assign to inventory?

13 More likely to ask the question, what amount of inventory should be on hand?

14 More likely to ask the question, how much plant capacity is needed?

15 Concerned with the procedures for recording issue of stocks and bonds.

16 Concerned with determining whether to issue stocks or bonds.

17 The body of knowledge that must be learned to become a CPA.

18 The body of knowledge that must be learned to become a CMA.

19 More likely to be concerned with future events and also with the internal events of a company.

20 More likely to be concerned with historical external events such as transactions already completed.






1 The IRS has requested certain invoices and documents to support certain expenses deducted for tax purposes.

2 The vice president of marketing has requested certain cost estimates concerning a new proposed product.

3 A customer returned a defective product purchased the previous day. An entry to his account was made.

4A significant increase in advertising has been made and a request has been made concerning by how much sales much increase to offset the increase in advertising.

5 An income statement showing segmental contribution and segmental net income has been requested.

6 An analysis of operating expenses in terms of fixed and variable expenses has been requested.

7 A physical inventory of raw materials has been made and the count compared to perpetual inventory records.

8A new sales people compensation plan has been proposed and an analysis of the effect on sales and total sales people compensation has been requested.

9Two supplier have made a proposal concerning the sale and installation of new production equipment. Only one proposal will be accepted.

10 A new computerized accounting system was installed.






1 General Ledger

2 Cost-volume-profit tool

3 Accounts

4 Comprehensive business budgeting

5 Inventory costing using FIFO

6 Recordings sales in the sales journal

7 Making end-of-year adjusting entries

8 Preparing segmental income statements

9 Comparing actual results against standards

10 Preparing income tax forms

11 Preparing manufacturing overhead rates

12 Subsidiary ledgers

13 Use of ratios to evaluate performance

14 Recording materials issued in a materials used summary

15Preparing financial statements from an adjusted trial balance

16Using incremental analysis to evaluate which equipment to purchase

17 Recording labor incurred in a labor cost summary

18Installing a perpetual inventory system to control raw materials

19 Preparing a cost of goods manufactured statement

20 Sending the annual report to stockholders

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