Financial and Management Accounting - Assignment Example

Performance Management ‘’There are limitations, but financial and management accounting perform a fundamental role in the measurement of performance within an organization’’ Critically evaluate the statement. "Management accounting produces information for managers within an organization. It is the process of identifying, measuring, accumulating, analyzing, preparing, interpreting, and communicating information that helps managers fulfil organization objectives" (Horngren, Sundem, & Stratton, 2005, p. 5). It is monitoring internal costs of the company (Anthony 2003). This internal cost measurement is used to make long term and short term goals (Aranya 1990). Recent years have caused a change in the perspective of management accountants towards assisting management with the decision making process. Financial accounting on the other hand is the use of financial data within a company to analyse the performance of the company. Financial accounting encompasses the use of Generally Accepted Accounting Principles to produce financial statements that critically evaluate the financial performance of a given company over a certain period of time (usually a year). During the course of financial accounting, a record is kept for all the business transaction of a company and that record is formally produced in the form of formal statements. These financial statements are used by to facilitate external users such as the shareholders, lenders and suppliers of an organisation (Bushman et al, 2001). Both these methods of performance management and evaluation may seem identical as per their definitions but in reality they both are quite different from each other. Management accounting is basically information generated and used by the employees and the management of that company, the information and the data generated within the management accounting scope is future oriented and carries forecasting value to the management of the organisation. Financial accounting on the other hand involves the use of Accounting Standards (mainly IASs); which are a set of principle issued by different countries. Financial accounting information is generally used by many different people such as the lenders, shareholders, employees, etc. This information is easily available to everyone, in contrast, the managerial accounting information is not that easily available. The nature of management accounting is forward looking i.e. it tends to focus on future issues and the reports are generally produced whenever they are needed whilst the financial accounting nature is concerned with the past performance of the company and the reports involved are usually time bound i.e. they are usually produced yearly, half yearly, quarterly, etc. (Bacidore et al, 1999; Ittner et al, 2001) Both these methods of performance management have their respective drawbacks and limitations. Management accounting relies upon financial accounting and data. It analyses the past information to predict or forecast any future plans whilst if the original information i.e. the financial accounting would not be accurate, the results obtained by management accounting would be of inept. Financial accounting on the other hand uses many assumption/judgements and such judgments and calculation may be subjective to many arguments e.g. Depreciation, Provisions, etc. (All such judgements do not involve cash transactions hence it can easily be argued that they must not be deducted from the profit). Management accounting is a complex method and hence its application requires huge training of the staff. Financial accounting on the contrary, is not that complex but its application too requires competent staff. Besides the complexity, the cost involved in the implementation of management accounting systems are really high, hence it requires major financing to properly implement the system. Management accounting interpretation, on the other hand, requires judgement and technique to correctly interpret the data; hence it is at the user’s discretion as to how the data is interpreted. This interpretation is complex as the management accounting branch is in its introductory phase and this branch of accounting requires clever interpretation as the theory and standard of management accounting is not that clear. Many grudges and personal prejudices lead to a question mark over the objectivity of the decisions taken by the management (Canibano et al, 2000). Financial accounting hugely relies upon quantitative analysis. This leads to the omission of non-monetary data which in itself is a major indicator of the performance of a business e.g. if a call centre service is to be analysed on financial basis, it would be really difficult to do so until and unless the quantitative analysis is done. Both the accounting methods tend to focus on quantitative data and they lack the ability to focus upon on other qualitative factors which may be the Critical Success Factors (Sloan, 2001). This lack of attention towards the non monetary issues lead to the ignorance of many important aspects of performance, hence it leads to poor performance evaluation of a company. Both these accounting functions tend to be less effective when measuring the performance of Not-for-Profit organisations. The effect of this ignorance of quantitative data leads to managerial accounting defects as well. Secondly, financial accounting is deemed to be the analysis of past performance, hence it is assumed to be of little use when the future of a company is concerned (Ciancanelli, 2007). The process of management accounting requires major installation costs. Such heavy investments can only be tolerated by large organisations hence it seems difficult for smaller organisation to implement management accounting into their accounting system. Besides the costs, management accounting may not be accepted by many organisations because of the differing organisational structure and culture. This is because of the fact that the management accounting process requires major changes in the organisations structure and hence it may lead many personnel to react to such changes by not accepting the accounting system overall. This rigid response of the employees may lead to an inefficient installation of management accounting system at a very heavy cost. Although with all such limitations, Financial and managerial accounting is widely used around the globe as major source for analysing and evaluating the performance of an organisation. Both the financial and the managerial accounting evaluation methods are deemed to present the past performance of the company and are considered historical but such historical facts and figures can be used to improve the performance of a company in the future. There are different methods of performance evaluation used within financial and managerial accounting. Methods such as Ratio Analysis are common tools used to analyse of company’s performance. These ratios use the data provided by the financial accounting system and use that data to compare the company’s current year performance with prior years to give a better understanding of the performance of the company. Except the prior year results, these ratios are compared with the ratios of other similar organizations to analyse any discrepancies and such discrepancies are focused upon after their identification. This comparison really helps the organisation to identify those areas which are excelled by their competitors and such excellence is followed as a result (Barton et al, 2002). All these Ratio analysis are done through the use of the financial statements prepared by an organisation. Such techniques can help in enhancing the criteria of performance evaluation through the use of better comparisons against competitors and prior results. These comparisons between the organisations and its competitors may sometimes not be meaningful when there may be changes between the accounting policies followed by two organisations whose ratios are compared between themselves. Such changes in the accounting policies, technological changes and price changes make it difficult to analyse an organisation’s performance through ratio analysis. If all these matters are taken into consideration and an identical organisation is selected for comparison, ratio analysis would prove to be a very useful tool of measuring a company’s performance. Besides the ratio analysis, other techniques such as analysing the relevant costs methods assess all the relevant costs faced by a company. These relevant costs e.g. opportunity cost are all focused upon and all irrelevant costs are ignored to determine the actual costs tolerated by a company. This method helps in properly identifying all the actual costs that are to be tolerated by the company and finally is helps the company to decide whether to continue with any particular venture or not. Budgets and forecasts also help a company to compare the actual performance of the company with the budgets prepared. (Kaplan, 2002) These budgets can be performed using historical data, competitor performance, etc. Such budgets are prepared after inclusion of many elements that may affect the economic position of a company in the future e.g. inflation. Forecasting on the other hand help in identifying risks that a company may face and such risks can be addresses using different measures. These risks can be mitigated through the use of financial management techniques and methods (Collier et al, 2002; Cagwin et al, 2002). Hedging is one basic technique that is used to mitigate the financial risks faced by a company. (Hernandez, 2004) Other non financial risks are identified through proper market analysis and proper research (techniques such as PESTEL analysis are used to analyse the different types of risk faced by a company (Vaivio, 1999; Bhimani et al, 2007). Segmental Reporting is another way to measure the performance of a company and that too with respect to the revenue and the cost centres. Segmental Reporting helps in identifying costs, revenues and profits pertaining to different sectors, divisions, subsidiaries, etc. Segmental Reporting has its limitation. Its major limitation is that it is a complex method of ascertaining the performance of different segments and besides that only the 10 largest segments of any given company can be reported in the annual report of that company. This limitation does not overlap the benefit of segmental reporting which helps in identification of low performing divisions/sectors of a company. This identification helps in deciding the future of that division i.e. any loss making division may either be shut down or measures would be taken to improve the division’s performance in the future. There are other methods that help in evaluating the performance of a company. The popular methods used are: Return On Investment (ROI); ROI is a performance measuring tool. It assesses the return of any given project with respect to the capital injected in that project. The main limitation of ROI is that if a departmental manager’s performance is measured on the basis of ROI; the manager may tend to avoid all those opportunities that would have a negative impact on his own department’s performance (Although that investment opportunity would have a positive NPV and good return for the company as a whole). Except this issue, ROI may work exceptionally well in any business environment for measuring the performance of a company. ROI is a good performance measure as it clearly indicates about the return that would be achieved by a department. This further helps in aligning the interest of the shareholders with that of the managers. Economic Value Added (EVA); EVA is the estimation of a company’s economic profit. Economic profit is considered to be that profit which get unaffected by accounting issues. Economic profit does not include issues such as depreciation, amortisation and all such factors that are usually based upon accounting principles. Economic profit is considered to be value created in excess of the required return demanded by the shareholders of the organisation (SHANE JOHNSON, 2007; Lovata et al, 2002) EVA is calculated as follows: NOPAT = Net Operating Profit after Tax r = Capital Employed C = Weighted Average Cost of Capital EVA is based upon historical accounts and the calculation involves the use of cost of capital which is derived using the Capital Asset Pricing Model (CAPM); the CAPM in itself uses many assumptions which have their own drawbacks as well. The benefits of using EVA clearly overweigh its limitations. EVA is based on cash flow and is not affected due to the distortions brought in by the accounting policies chosen. EVA makes Responsibility Accounting to be done easily in any organisation by making managers accountable for their respective result. This helps in identifying and taking corrective actions against those managers or departments that are performing below par. Residual Income; Residual Income is a method to analyse the managerial performance in an organisation. The method measures an investment centre’s performance. The basic method involves the assessment of the net operating income that an investment centre earns above the required return of the assets in operation within that particular division/department. Financial accounting and managerial accounting as a whole give better insight into the performance of any particular company. Such an insight is deemed to be really useful as it can raise alarm when any given organisation performs adversely. Management of a company use financial and managerial accounting techniques to correct all errors committed in the past by using all the different methodologies used in financial and managerial appraisal. Such an appraisal is really helpful as it helps in changing prior years adverse results to favourable results in the future (Jiambalvo, 2001; Institute of Management Accountants, 1999). If performance evaluation is to be done without the use of both these methods, it would be incomplete as proper performance evaluation would require both financial and non-financial performance appraisal. FA usually focuses on financial issues whilst MA focuses on costing issues which are usually addressed to the management of the company. Hence the basic idea would be to use both FA and MA along with other qualitative analysis techniques. Except this, a company should adopt better control procedures to avoid any wastage so that the end product offered to the customer should be highly appreciated by them. (Vincent, 2000) Despite the fact that all the performance evaluation methods and techniques have their own drawbacks and limitations, they have very good advantages too and without the use of Management and Financial accounting, there is no way that a company’s/division’s performance can be assessed. All these methods have their own drawbacks but they produce satisfying results when assessing the performance of a company. Management and financial accounting hence play a vital role in the success of any organization. They help in giving an insight to the managers about the problem areas, risk factors and performance determinants which can be controlled by managerial decisions and processes (CIMA, 2000; Longenecker et al, 2007; Fletcher, 2001). These risk factors can be assessed thorough many different techniques. Risk in any business environment can be assessed through both qualitative and quantitative techniques. Qualitative technique include the use of scoring techniques where the negative aspects of a business decision are ranked according to their incidence and impact whilst the quantitative techniques include the use of simulation techniques. Monte Carlo technique is by the far the most common and the most popular risk assessing technique used by many businesses around the globe. Finally, it can be said that financial and management accounting techniques do have their limitations but those limitations are not that strong to affect organisations from using these techniques/measures for performance evaluation. Financial and Management accounting techniques are widely used around the globe and they have vast credibility and popularity. The use of such techniques ensures that the company are following proper methods of appraisal and hence as a result it satisfies the shareholders and the lenders of those companies about the progress of the company. Auditing is another aspect that keeps both the lenders and the shareholders assured about the company’s normal course of business and any advancement opportunities and these auditing techniques cannot be fulfilled directly if financial and management accounting techniques are not pursued by a company. Hence it can be said that financial and management accounting techniques form the basis of any business organisation. References ANTHONY, N 2003, ‘Management accounting: a personal history, Journal of Management accounting Research, Vol.15 N0.3 pp.249-253 ARANYA, N 1990,’ Budget instrumentality participation and organizational effectiveness,’ Journal of Management Accounting Research, vol 2, no 4, pp. 67-77 BACIDORE, J.M., BOQUIST, J.A., MILBOURN, T.T., & THAKOR, A. V. The Search for the Best Financial Performance Measure. Financial analyst journal, Vol 55, 14-16.April 1999 http://www.jstor.org/stable/4480163 BARTON, S. D., & WOODBURY, D. (2002). 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