Aim of Management Accounting - Coursework Example

Running Head: MANAGEMENT ACCOUNTING MANAGEMENT ACCOUNTING A REPORT & NO> SUBMITTED> Abstract Management accounting aims to help managers make well-informed and timely decisions, in order to eventually attain the firm’s goals. The use and misuse of this managerial tool has become the center of recent controversy, triggered by the Enron and WorldCom scandals. The backlash has been to tighten regulation, particularly for financial institutions, in a way that contributed to the deterioration of the present financial crisis. This report will explore management accounting as a field of endeavor, the sources of its data, and the aid it provides management decision-making, culminating in how untested accounting standards could work against management’s best interests. MANAGEMENT ACCOUNTING Introduction It is difficult to imagine such a conventional and subdued profession as accounting being embroiled in scandal and intrigue worthy of a spythriller. Not long ago, however, the word Enron was splashed across newspaper headlines, and instantly the word’s connotation transformed from a solid company name to a synonym for deceit. Enron was but the most publicized among a slew of several other cases – there were Tyco International, HealthSouth, Adelphia Communications, WorldCom, Global Crossing, Arthur Andersen and Rite Aid (Garrison, Noreen and Brewer, 2006, p. 20), which merited either monstrous fines or even imprisonment for the managers who were held responsible. The unethical accounting practices that fueled these scandals brought stark reality into focus, that naïve common trust was misplaced in the business world, and the supposedly iron clad regulations by the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) are but illusion. Overnight, the image of the insufferably straight-laced, soft-spoken, bespectacled accountant was forever shattered, supplanted by the notorious persona of the quintessential white-collar criminal. These series of scandals became the eye-opener to the need for a more vigilant approach to the proper practice of accounting. Managerial accounting in particular, being the vehicle by which managers make decisions, plays a pivotal role in ensuring that the requisite ethical standard be observed. The quality of management accounting reports will directly determine the quality of managerial decisions. It thus helps to understand management accounting. What is management accounting? Management accounting is defined as “the process of identifying, measuring, accumulating, analyzing, preparing, interpreting, and communicating information that helps managers fulfill organizational objectives.” (Horngren, Sundem and Stratton, 2002, p. 5). The importance of managerial accountants to the proper management of an enterprise cannot be overemphasized. Management accounting pursues five major objectives: “1. Providing information for decision making and planning, and proactively participating as part of the management team in the decision-making and planning processes; 2. Assisting managers in directing and controlling operational activities; 3. Motivating managers and other employees toward the organization’s goals; 4. Measuring the performance of activities, subunits, managers, and other employees within the organization; 5. Assessing the organization’s competitive position, and working with other managers to ensure the organization’s long-run competitiveness in its industry.” (Hilton, 2008, p. 6) In discussing the scope and functions of management accountancy, it is inevitably important to also discuss its distinction from its more public and better known counterpart, financial accounting. Because management accounting provides information for managers’ decision-making, it is essentially an internal system of reporting for use by persons within the organization. In contrast, financial accounting is intended to provide information to persons external to the organization, such as stockholders, creditors, bankers, and the government agencies such as the SEC and the IRS. While the information produced by management accounting is current and even forward-looking in order to aid decision-making, the information provided by financial accounting is a reflection of transacted activities and helps the outside stakeholders form an opinion about the company’s past financial performance. Also, financial management is subject to a strict set of conventions known as the Generally Accepted Accounting Principles (GAAP), as well as being regulated by the FASB and the SEC, and required by law to produce a standard set of reports for submission to the government and its external stakeholders. On the other hand, managerial accounting is essentially unrequired and unregulated, since its usefulness is confined to management’s purposes. To illustrate the effect of GAAP, consider the proposed relocation of a store and the subsequent sale of its vacated property, which includes the building and the land on which it stands. In deciding the impact of this alternative on the firm’s profitability, management would have to determine the net benefit (or loss) created by this move. Essential data would therefore include the incremental (or additional) costs and returns as a result of the move. The sale of the property would be stated as a return or cash inflow. The question is: what value should be ascribed to the sale? Were GAAP controlling in this instance, the land would be valued at its historical cost and the building at its depreciated value. This would be completely misleading as a basis for proper management decision, because the land and building will be selling at their market value, not their historical or accounting value. GAAP as a rule ignores market valuation, which on the other hand is vital information for management accounting. Thus, GAAP may be important because the existence of common ground rules make financial data comparable among companies or industries, and seek to prevent fraud and misrepresentation. GAAP should not be required for internal purposes, however, because data for management must be flexible, timely, meaningful and tailored to the needs of management, something not capable of being achieved under GAAP conventions. What are the sources of data, and how are they used to make management decisions? Despite the strategic differences between management and financial accounting, there are many similarities also that exist between them. Mainly, they both draw upon data generated and supplied by the company’s accounting system, most especially their cost accounting system. This is one part of the accounting system that accumulates cost information concerning the company’s operations. This well of financial information provides important information that, crafted to present the financial picture in different ways, constitutes the basis for both financial and management accounting. As far as financial accounting is concerned, this is the only source of information. However, other than the company’s basic accounting system, management accounting, unlike financial accounting, draws data from other sources as well. It is not unusual for information about the market, such as the market values of certain company assets and the taste and preferences of the company’s customers to be included in management accounting reports. Unlike financial accounting reports which are required to adhere to the GAAP and to comply with government and professional regulators’ reportorial requirements, management accounting abides only and is dictated upon by the needs of management. It is thus the needs of management that determine how detailed or general the data should be, how and from where it should be sourced, and in what form it should be presented. Understandably, it is to management’s interest to try to minimize the cost of acquiring information, since data accumulation does not come cheap. The more intricate the data required, the more expensive the company’s investment in information technology and research capability. Where this type of research may not yield useful results or aid in making decisions, management may as well forego such type of data sourcing. On the other hand, management decisions may require a more creative way of looking at data. This would influence the need for a certain type of data, or for a certain manner of collating this data. One other aspect where financial and management accounting differ is the degree to which accuracy and precision are required in their data. Financial accounting necessarily must produce results which are precisely determined and accurately rendered pursuant to the GAAP. Management accounting, on the other hand, does not need the kind of precision and accuracy financial accounting necessitates. For instance, sales figures in the hundreds of millions of dollars may be conveniently rounded off to the nearest million dollars. This apparent leniency is for the purpose of making sufficiently reliable data available at the time management decisions are to be made. The timeliness of data production is traded off slightly in the degree of accuracy, but usually a ballpark figure formed from educated estimation is many times more useful to management than an accurately derived figure that comes too late. At this point it is useful to determine the reason for the kinds of reports management accountants prepare. Unlike financial accounting reports which are standard, management reports are varied. There are some reports which deal on how well management has met its strategic plans. This usually entails some comparison of company’s performance indicators with those of their closest competitor or the industry standard. There are other reports that give periodic information and updates on measures of ongoing activity such as number of orders received, backlog on production output or delivery of merchandise, capacity utilization, collection and sales. Current or cumulative data would often be compared against targets and budgets, to get an idea if the company was performing as expected, or to troubleshoot problem areas as they develop. Management accountant may target performance of segments of the company such as its business units, functional departments, area or customer divisions. Data may also be gathered on performance discrepancies, such as problems in the decline of profitability of certain product lines, requiring information on how costs may be distributed and aligned, or how prices are set. This points to another important aspect of how financial accounting and management accounting differ. While financial management deals with the company as a single entity, management accounting is capable of segmenting the data into useful parts or categories. In fact, segments reporting is the primary attention of management accounting, since it is the way information is make specific to particular aspect of the business that aids in effective decision making. Still other reports may provide insight into possible business opportunities the company may explore. Internal audit reports are capable of highlighting not only company weaknesses but specific strengths that give the company strategic advantage or competency in particular areas of its operations. This may point to business opportunities best served by this competence. For instance, Walt Disney Company has a sterling reputation in the area of animation, theme parks, feature films and television broadcasting. The success of its theme parks and the derived cost efficiencies and skills competence it has developed in the area of property management has enabled Disney to penetrate the hotel and resort management business, not one of its traditional areas of business. (Hilton, 2008, p. 3) Application: From Enron and WorldCom to the 2008 credit crunch Despite the legal tussles and imprisonment sentences being handed down, the story is not yet over. A fairly recent article released by the Agence France-Presse, remarking on what happens to be the top (business and otherwise) news of the season, says that the Enron backlash is responsible for global financial crisis. Because of the need to rebuild confidence in the flailing financial reportorial system, new accounting standards were put in place in order to ensure that Enron, WorldCom, and similar cases do not happen again. The new rule required banks to recognize losses sooner than what had formerly been the practice, which had been to hold the assets and await their recovery. In compliance, banks were compelled to quickly recognize the “fair value” of their quickly devaluing assets. The problem is obvious. In a volatile market, disequilibria often creates market inefficiencies that abnormally price assets at extreme (i.e., either extremely low or extremely high) levels. Speculators know this market well; however, factoring it into the books and making decisions on the basis of these abnormal valuations magnifies the error of the situation rather than stabilizes it. The rule in question, known as the FAS 157, requires assets to be valued at fair-market prices. This would be fine under the theory of market efficiency. However, market efficiency is a myth, because not all market participants know of all the pertinent information concerning the asset at any point in time. Oftentimes, the market moves on rumors, innuendoes, fear and greed. Short-term market movements are emotional and erratic. Basing management action on such a foundation is like building one’s house on shifting sand. Many critics have attributed to FAS 157 the weakening of financial firms. These institutions were required by the new regulations to raise capital in order to offset financial losses at the first sign of asset value declines – the Agence France-Presse called it a “death spiral” – in the event of tightening liquidity due to scarcity of cash. Now that the crisis has begun to take its toll on the financial system, Edward Yingling, president of the American Bankers Association, was reported by the article to call the SEC’s attention to the fact that “there is not a true ‘fair value’ that can be assigned to troubled assets.” (Agence Free-Presse, 2008). Another observation on the absence of a validly functioning market was made by Brian Wesbury of First Trust Portfolios, who attributes Merrill Lynch’s problems to its forced sell-off of USD 30.6 billion of illiquid mortgage-backed securities at only one-fifth of its original value, because they were required to make mark-to-market calls by the new standard. The mark-to-market rule is an example of a standard that, while regulated, is intended to form the basis of managerial actions by financial institutions. It is a good rule during times of market normality, when valuations are arrived at in the course of regular market action. However, when markets are stressed and volatile, this rule is destabilizing because it requires managers to react in ways that exacerbate the abnormality, whereas the better option would have been to hold the assets to maturity, or at least until the markets have calmed down. As it is, the write-offs force massive sale of assets, triggering a further drop in prices. Conclusion Like a double-edged sword, management accounting can be both tool for proper governance, or instrument of deception, as in the original Enron scandal. While the case could always be made that the manager is the real criminal because he provided the inducement, the accountant cannot escape responsibility for his professional acts. Even so, as in the present financial crisis, ill-considered management decisions based on accounting indicators may create havoc even when ill intent is absent. As Robert Eisenbeis, formerly of the Federal Reserve and now economic analyst at Cumberland Advisory said, “The accounting serves as a canary in the mineshaft, pointing out where the problems are.” (Agence France-Presse, 2008). The management accountant’s actions must at all times be cogent and above reproach, in order that it may continue to adequately fulfill this mandate. 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(2008) Managerial Accounting: Creating Value in a Dynamic Business Environment, 7th ed.. McGraw-Hill. Horngren, C.T., Sundem, G.L. & Stratton, W.O. (2002) Introduction to Management Accounting, 12th ed. Prentice-Hall International. Hoskin, R.E. (1997) Financial Accounting: A User Perspective, 2nd ed. John Wiley & Sons., Inc., New York, N.Y. Warren, C.S., Reeve, J.M. & Fess, P.E. (1999) Financial and Managerial Accounting. South-Western College Publishing, Cincinnati, Ohio. Read More