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Management accounting is the process of identifying, measuring, accumulating, analyzing, preparing, interpreting, and communicating information that helps managers fulfill organizational objectives. Financial accounting on the contrary is the field of accounting that develops information for external decision-makers such as stockholders, suppliers, banks, and government regulatory agencies.
These are the definitions of the two different fields of accounting according to Horngren, Sundem, and Stratton in their book “Introduction to Management Accounting” (1996). From the above mentioned definitions one can see a clearly different objective and a clear distinction between financial and management accounting. Historically, both disciplines have been used separately and were considered as an important tool for managers and for external decision-makers to take decisions. However, reading the business press regularly, it seems that articles on the field of financial accounting have become extremely important. Articles for example on the importance of shareholder value, the analysis of companies purely by their shares, the going-public of increasingly smaller companies seem to be dominating. Techniques of management accounting, such as detailed production cost analysis, cost allocations or efficiency analysis are treated obviously to a lesser extent. Regarding this trend, one might question the actual importance of management accounting.
Are techniques of financial accounting more important in decision-making than methods of management accounting?
In order to find evidence for or against this problem statement this paper, initially the question of whether there really is a dominance of financial accounting methods in practice is addressed. Then, an analysis is made on which arguments are used in the discussion as to which accounting method is more relevant? As the different points of view in this context concentrate mainly on three different fields - cost-benefits, timeliness and time pressure, and capabilities of management accounting methods - the actual discussion of the different opinions is also divided into those three different parts. In addition to the discussion in those three different parts, opinions on the future of management accounting and financial accounting methods are treated. Then, the author’s opinion follows. The paper ends with a conclusion that gives also answer to the main problem statement.
Management and financial accounting in practice
“ Despite the increasing availability of powerful, and steadily less costly, data processing systems, companies typically keep only one set of books. Management accounting practices therefore follow, and become subservient to, financial accounting practices. ” (Hopper, Kirkham, Scapens, Turley, 1992)
A number of people may agree with this statement by Johnson and Kaplan, but it is important to mention here that a lot of the information on accounting practices is anecdotal and sometimes lacks reliable evidence. This is why the above quoted scientists are also criticized. However, in the last few years there have been a number of surveys made on the topic to find out if the assumption that financial accounting dominates management accounting methods is actually true. A number of the surveys that have been made reveal that procedures and indicators that are used for external reporting are used for internal reporting as well. An important issue in management accounting is cost analysis. Colin Drury and Mike Tayles have found out in a survey distributed in 1991 in the United Kingdom that 79% of the companies responding to the survey used total costs as a tool for decision-making. (Drury & Tayles, 1994) 79% of the respondents used the same product cost information for internal decision-making that they used for external reporting. In the same survey, only 4% of the respondents indicated to make use of Activity-Based Costing (ABC), which is a very detailed and sometimes complicated tool in management accounting. Another example of the dominance of external financial accounting is also supported by the study of Drury and Tayles. This study demonstrated that 90% of the companies used historical cost asset valuations (a financial accounting method) in order to compute internal profitability of a division (Drury & Tayles, 1995). Rewarding systems for managers are increasingly connected to financial accounting measures, such as short-term profits and earnings per share. This trend is then supported through stock-option models, where managers can increase their income enormously if the share price rises. Although a number of textbooks stress the importance of evaluating managers on those costs and profits that are under direct control of them, 23% of the companies surveyed in the Drury study did not distinguish between controllable and non- controllable costs. The result of this is that managers themselves concentrate much more on financial accounting information as source of their own performance measure. Labor overhead recovery rates - as a simplistic cost allocation method were - according to the Drury and Tayles study - used by 68% of the automated production activities.
However, one should bear in mind while reading those results, that those results may indicate a trend in current accounting practice, but do not give clear evidence on the idea that management accounting is unimportant in relation to financial accounting methods. A survey that has been made by Nathan Joseph in 1996 among qualified management accountants in the United Kingdom showed a number of interesting results concerning the use of accounting methods. There is a mixed opinion on the influence of external reporting on management decisions. Another finding was that managers considered information on cash flow as most important in order to make decisions, whereas earnings were regarded as very essential for external decision-makers. This supports the idea that there is a need for different information for internal and external decision-makers. This survey also made clear that information, which is not part of external reports of a company, is still very important for internal decision-makers. However, it should also be mentioned here that the accountants who responded used integrated financial accounting systems and that the management reports are - according to Nathan Joseph -“characterized by means of financial accounting measures due to financial reporting requirements to head office” (Joseph, Turley, Burns, Lewis, Scapens & Southworth, 1996).
The above mentioned findings in various studies make clear that financial accounting methods play an important role, but there is not a clear dominance of such financial accounting methods, as it can also be proven that management accounting methods are not completely neglected.
Costs and benefits as decision variables
There are quite a number of economists who try to explain the different findings treated in the section before. An important part of the discussion on the question whether financial accounting methods are more important than management accounting methods and what method should be used in managerial decision-making, is based on a cost- benefit analysis. Horngren stated in 1986, that managers consider the establishment of a new, more elaborate accounting system as an investment that is analyzed in a cost-benefit relation (Johnson & Kaplan, 1987). Johnson and Kaplan - actually two supporters of management accounting - argued in 1987 that the reason why financial accounting methods play such an important role in decision-making is that managers do not want to spend money on more than one account (Drury & Tayles, 1995). Instead, the financial accounting methods with rather simplistic stock valuation for financial reporting purposes are preferred. The choice to use only one type of accounting method or system is clearly determined by a cost-benefit relationship. It is considered to be too expensive to operate two different accounting systems (one for financial reporting and one for internal decision-making). Drury and Tayles claim that most managers simply do not see the possible benefits that exceed the costs of setting up and maintaining a separate management accounting system (Drury & Tayles, 1994). They gave an additional explanation for the preference of financial accounting methods. Managers in companies do not believe that a new separate system for internal decision-making would bring much different information (Drury & Tayles, 1994) than that for financial reporting. So the actual sense or use of management accounting systems is doubted.
In contrast to the above mentioned economists, one strong supporter of the clear distinction between financial and management use of accounting data is William Vatter. In his point of view management accounting methods are essential for an “efficient and smooth performance of regular operating activities” (Johnson & Kaplan, 1987). He argues that extra management accounting information can support management decisions and improve the success of a company. Detailed information on costs and allocated overhead costs can lead to more successful managerial decisions. In fact, inefficiencies of services that are performed in-house can be detected and - if appropriate - can be outsourced (Zimmerman, 1997). A thorough allocation of service department costs can thus lead to important information and lead to essential benefits for a company. Maurice Clark, an economist from the University of Chicago, determined a number of different functions of cost accounting, such as testing the efficiency of processes and departments, detecting losses, wastes, and pilfering, determining the profitability of products. In his opinion, the only way to meet these functions lies ultimately in the development of accounting methods that are separated from financial accounting methods, as financial accounting requirements are not as detailed as necessary (Johnson & Kaplan, 1987). His view is supported by other economists from the London School of Economics and Political Science (LSE) that occupied themselves with cost accounting and its important role in management accounting. They argue that there are more benefits than costs in an additional management accounting system. They enforced the idea that - in cost accounting - information should be relevant for a particular decision and argued against the idea of gathering information from the basis of financial statements (Johnson & Kaplan, 1987). Other scientists also underline the importance of elaborated cost accounting systems. Kaplan argues that product cost information should differ for different purposes. Accurate cost information is necessary for decision-making in order to be able to distinguish between profitable and unprofitable products. If there is only one method of costing in a system, there is a danger that managers are going to drop products that are actually profitable (Drury & Tayles, 1994). To avoid such wrong decisions, management accounting systems can contribute to better decisions.
It comes clear from the above mentioned different point of views, that whereas some economists stress arguments that refer mostly to the costs of establishing a management accounting system, others see benefits like cost-detecting and profitability analysis in management accounting methods. Hence, regarding the discussion from a cost-benefit view, the most important question that managers ask is whether an investment in a management accounting system pays off the cost connected to it. However, this question is very difficult to answer as the actual benefits usually appear after the introduction of management accounting methods.
Time as decision variable
Besides arguments on a cost-benefit relationship, other arguments that refer to the factor time are often brought into this discussion. William Vatter, actually a strong supporter of management accounting methods once said that timely information is more important than the completeness of it (Johnson & Kaplan, 1987). Many managers obviously share this attitude. This is another reason why rather simple methods in cost allocation - as used in financial accounting - are used more often than elaborated management accounting systems. Speed of information is often preferred over accuracy of information. Often managers can not wait on all the detailed information to be ready before taking action. Very detailed management accounting systems may fail to provide managers with relevant information, and the link to reality in companies is - according to a number of managers - sometimes very difficult to see (Johnson & Kaplan, 1987).
Another reason why companies often make use of only financial accounting methods refers to time in a different way. In this case it is not timeliness of information, but the time accountants in companies actually have available. It has been discovered by a study of Drury and Tayles in 1991 that 97% of the respondents prepared monthly profit statements (Drury & Tayles, 1997). This means, that a lot of time of the companies’ accountants is needed for those monthly statements. With such a time pressure, accountants do not have the time to track and analyze all the costs that might be important for internal decision-making. As a consequence, the focus lies on financial accounting methods as there are monthly financial reports to be made.
However, other economists argue that one should not use timeliness of management accounting information and time pressure of internal accountants as a reason for a dominance of financial accounting methods. One of their argument against the above mentioned view is that modern information technology makes it possible to gather information in time anyway, so that the argument that management accounting systems are not timely is probably a myth. Another argument used in this context is also to see more the benefits of the installation of a management accounting system. It is argued that a modern management accounting system can serve as a two-way communication system between senior management and subordinate managers.
Subordinate managers get information on the company’s objectives as soon as the objectives are clear and senior managers receive regular information - which is not only relevant for financial reports - on performance in the different parts of the organization. A regular two-way flow of information can also be a motivating factor, as employees feel better informed about “their” company. From this point of view, a management accounting system plays - as a source of communication, control, and motivation - an important part in the strategy of the organization. This means that a good management accounting system contributes strongly to a sustainable competitive advantage (Johnson & Kaplan, 1987).
Hence, from the above mentioned arguments one can see that the arguments referring to timeliness and time pressure are very practical in nature. On the one hand some economists use doubts regarding the timeliness of management accounting information and the time pressure of internal accountants as an argument against management accounting methods. On the other hand, modern information technology is regarded as a solution and benefits of management information systems are used as counter arguments.
Capabilities of management accounting systems
Another problem that is often connected to the use of management accounting systems is the capability of such systems to gather management information. Most examples of more sophisticated management accounting methods in theory refer to companies that produce between one and five different products (Johnson & Kaplan, 1987). Most companies in the survey by Drury and Tayles produced more products, some produced more than 1000 different products. Johnson and Kaplan state, that cost allocation and control often becomes difficult in practice with conventional accounting methods. This difficulty in allocating costs adequately is another explanation for the dominance of financial accounting methods, as there are much less detailed requirements for financial reporting for external decision-makers. In a more complex case often one cost driver (very often labor costs) is allocated in a two-step method. The two-step involves firstly an allocation of overhead costs on various cost centers, and after that in a second step a further allocation on different products. A diverse range of products is thus a reason why companies often use a single cost driver as a simple way to allocate costs. Johnson and Kaplan state furthermore, that a dominance of financial accounting methods as simplistic cost allocation can be explained historically. By the year 1925, basically all methods of management accounting had been developed. In that period, most companies did not produce such a high diversity of products as they do today. The accounting systems of that time were an important tool in decision-making. However, those systems did not develop any further as companies and production processes developed with increased complexity (Johnson & Kaplan, 1987).
This can be quite a strong argument, as production processes in companies actually tend to become more complex. However, one can again use as a counter argument information technology. Such technology is a tool for state-of-the-art systems that keeps pace with progress in complexities. The more frequent use of so-called management information systems (MIS) can probably help to eliminate problems with complex production processes. The rapid pace of progress in information technology questions therefore the relevance of the arguments of people who consider management accounting information to be incapable of providing relevant information for internal decisions (Laudon & Laudon, 1998).
From the above discussed points of view one can see again that the arguments of those people favoring the use of financial accounting methods are more practical ones. Those people in favor of management accounting information bring in modern information technology as a counter argument in the discussion, which can - at least to some extent - make the argumentation against management information systems irrelevant.
The future of accounting methods
After having discussed the arguments on the different accounting methods, one can also see very different views on the role of management accounting methods in the future. One argument - that could serve more as an explanation for a dominance of financial accounting - is a historical one. At the beginning of the century, when managers usually had a technological background, they knew exactly what products and processes they managed. This has changed, however, and today’s managers very often spend most of their working career in accounting, finance, marketing or legal functions. The lack of profound knowledge about technological processes in companies has thus contributed to the importance of financial accounting methods and to a trend “to manage a company by numbers” based on short-term financial reports.
Some people stress that information for external investors, for example, becomes most important in the future in order to finance business ventures. No doubt, capital markets are very important, and more and more small and medium-sized companies have discovered those markets as an important source of finance. This is why credibility and consistency in information is another important argument for a focus on financial accounting methods. Consistency between information directed towards external decision-makers and internal information is regarded to be a source of credibility in financial markets and thus a reason why executives prefer one type of accounting information for both - internal and external decisions. This attitude is supported in a survey by Hopper, where six companies in the United Kingdom were studied. Hopper found out that most executives are more concerned about financial accounting information as that information has a strong influence on how capital markets evaluate the performance of the company (Hopper, Kirkham, Scapens & Turley, 1992).
Although some people might see good reason in an increasing importance of financial accounting systems, there is also an increasing number of economists who are of the opposite opinion. Increasing training demands, shorter product life cycles, and longer research and development periods in the future decrease the fraction of the costs that one can allocate directly to the products. This development will lead (and leads already today) to a renaissance of management accounting systems as more detailed cost allocation methods become more relevant in decision-making (Johnson & Kaplan, 1987). According to a study by Drury and Tayles in the United Kingdom in 1991, already 13% of the respondents used or intended to introduce Activity-Based Costing (ABC) methods as a better way to allocate costs and make better decisions (Drury & Tayles, 1994). In addition, the increasingly important stock of knowledge and other intangible assets in companies makes it impossible to obtain an appropriate measure of short-term profits, as a lot of the know-how is paying off in the long-term and in a more sustainable manner. Johnson and Kaplan support this view. They also stress the rising importance of non- financial indicators as information on competitive advantage. Examples are companies, that intend to become a quality producer, where indicators such as defect rates, customer complaints, or warranty expenses become very important. Manufacturing companies that intend to become a low-cost producer may use productivity rates as indicators. Highly innovative companies may be interested in measures, such as total product launch time or achievement of product milestones. This has as a consequence a new definition of the value of non-financial indicators and a different opinion on the use of those indicators. A rising importance of more non-financial indicators supports the need for a sound management information system in order to be able to quantify the required measures better in the future (Johnson & Kaplan, 1987).
To conclude this part, one can see from the discussion above that the different opinions in this part reveal one important feature. Financial accounting methods are very important and will remain very important in the future. However, the trend to use more non-financial indicators for decision-making strongly supports the use of management accounting methods at the same time. One can see from the above mentioned facts that management accounting methods have increased in importance and that such methods are more and more regarded as part of a strategic and sustainable competitive advantage.
The author’s opinion
The future trend of an increasing importance of indicators other than those for financial reporting mentioned above also supports my own opinion. I believe that management accounting becomes much more involved in internal decision-making than it has been in the past. One can see a shift in the focus from purely financial accounting information to more management accounting information. It is of crucial importance to understand that the future success lies not only in the hands of external investors, but increasingly in the hands of the company’s customers. This results in a more intensive need for more detailed measures on accurate costs, but also on measures that may be difficult to quantify at first. However, management accounting systems can provide internal decision-makers with relevant information. The opinion that the use of management accounting systems as a tool of strategy and competitive advantage is supported by the introduction of balanced scorecard methods in more and more companies. In fact, when I researched on the Internet I found a huge number of consulting companies that are often specialized and occupied with the introduction of the balanced scorecard method in companies. This fact supports my view (www.bma.com.au).
The trend towards a separation of financial and management accounting for external and internal decision-making respectively is, in my opinion, better particularly for companies that are active in a highly competitive environment. Slowly, the trend that management accounting information may play a more important role is accepted.
This paper demonstrates that opinion on the question whether financial accounting methods are more important than management accounting methods are fairly different. First of all, the findings from the various surveys make clear that financial accounting methods are actually used very often (sometimes integrated into management accounting methods), and that they are obviously used more often than other accounting methods. A number of economists, especially Drury and Tayles, give reasons for the dominance of financial accounting methods for decision-making. One important reason is the assumed poor cost-benefit relationship. The costs for the introduction of a separate management accounting system are perceived to be too high. In addition, possible benefits or the actual sense of a separate system are doubted. Practical problems, such as timeliness and capabilities of separate management accounting systems are also mentioned as a reason for financial accounting methods for internal decision-making.
However, the use of financial accounting information for decision-making is strongly criticized by economists, such as Johnson, Kaplan and Vatter. They consider management accounting systems to have more benefits than costs. Furthermore, practical problems, such as the timeliness of information, time pressure on accountants, and incapabilities of management accounting systems can easily be resolved through the use of modern information technology. However, one of the most important reasons for separate management accounting methods is the use of information as a competitive advantage. I think that this is the strongest argument in this discussion and the development of a competitive advantage through better information in production processes makes clear, that it is absolutely necessary to separate financial accounting information from management accounting. Non-financial information increases in importance. It is thus almost impossible to make good decisions without detailed information on costs (through ABC, for instance), quality or other indicators.
These findings then also give answer to the actual problem statement of this paper. Financial accounting information may be used more often for practical reasons, but that does not mean that it is more important. In fact, one can regard management accounting as even more important for internal decision-making, which could also explain, why more and more companies make more frequently use of management accounting methods for internal decision-making.
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3. C. Drury, M. Tayles, Product Costing in UK Manufacturing Organisations, European Accounting Review, 3, 1994
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5. H. Johnson, R. Kaplan, Relevance Lost: The Rise and Fall of Management Accounting, Harvard School Business Press, Cambridge, 1987
6. J.L. Zimmerman, Accounting for Decision Management and Control, 2nd edition, chapters 1,7,8,11, Irwin, Chicago, 1997
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8. N. Joseph, S. Turley, J. Burns, L. Lewis, R. Scapens, A. Southworth, External Financial Reporting and Management Information: a Survey of UK Management Accountants, Management Accounting Research, 7, 1996
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10. www.bma.com.au (1999)
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- Alexander Brüggen (Autor), 1999, Management information: Are methods of financial accounting more relevant?, München, GRIN Verlag, https://www.grin.com/document/103678