Lecture notes management Accounting

what is management accounting and its functions and what is management accounting information system. what are modern management accounting techniques
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COURSE: MANAGEMENT ACCOUNTING COURSE CODE: MC-105 AUTHOR: Dr. N. S. MALIK LESSON: 01 VETTER: Prof. M S Turan MANAGEMENT ACCOUNTING: NATURE AND SCOPE Objective: The present lesson explains the meaning, nature, scope and limitations of accounting. Further, it discusses the activities covered under management accounting and its difference with financial accounting. LESSON STRUCTURE 1.1 Introduction 1.2 Definitions of Management Accounting 1.3 Nature of Management Accounting 1.4 Functions of Management Accounting 1.5 Scope of Management Accounting 1.6 The Management Accountant 1.7 Management Accounting and Financial Accounting 1.8 Cost Accounting and Management Accounting 1.9 Limitations of Management Accounting 1.10 Self-Test Questions 1.11 Suggested Readings 1.1 INTRODUCTION Management accounting can be viewed as Management-oriented Accounting. Basically it is the study of managerial aspect of financial accounting, "accounting in relation to management function". It shows how the accounting function can be re-oriented so as to fit it within the framework of management activity. The primary task of management accounting is, therefore, to redesign the entire accounting system so that it may serve the operational 1needs of the firm. If furnishes definite accounting information, past, present or future, which may be used as a basis for management action. The financial data are so devised and systematically development that they become a unique tool for management decision. 1.2 DEFINITIONS OF MANAGEMENT ACCOUNTING The term “Management Accounting”, observe, Broad and Carmichael, covers all those services by which the accounting department can assist the top management and other departments in the formation of policy, control of execution and appreciation of effectiveness. This definition points out that management is entrusted with the primary task of planning, execution and control of the operating activities of an enterprise. It constantly needs accounting information on which to base its decision. A decision based on data is usually correct and the risk of erring is minimized. The position of the management in respect of its functions can be compared to that of an army general who wants to wage a successful battle. A general can hardly fight successfully unless he gets full information about the surrounding situation and the extent of effectiveness of each of his battalions and, to the extend possible, even the enemy's intentions. Like a general a successful management too strives to outstrip other competitors in the field by streamlining its operating efficiency. It needs a thorough knowledge of the situation and the circumstances in which the firm operates. Such knowledge can only be gained through the processed financial data rendered by the accounting department on the basis of which it can take policy decision regarding execution, control, etc. It is here that the role of management accounting comes in. It supplies all sorts of accounting information in the 2form of such statements as may be needed by the management. Therefore, management accounting is concerned with the accumulation, classification and interpretation of information that assists individual executives to fulfill organizational objectives. The Report of the Anglo-American Council of Productivity (1950) has also given a definition of management accounting, which has been widely accepted. According to it, "Management accounting is the presentation of accounting information in such a way as to assist the management in creation of policy and the day to day operation of an undertaking". The reasoning added to this statement was, "the technique of accounting is of extreme importance because it works in the most nearly universal medium available for the expression of facts, so that facts of great diversity can be represented in the same picture. It is not the production of these pictures that is a function of management but the use of them." An analysis of the above definition shows that management needs information for better decision-making and effectiveness. The collection and presentation of such information come within the area of management accounting. Thus, accounting information should be recorded and presented in the form of reports at such frequent intervals, as the management may want. These reports present a systematic review of past events as well as an analytical survey of current economic trends. Such reports are mainly suggestive in approach and the data contained in them are quite up to date. The accounting data so supplied thus provide the informational basis of action. The quality of information so supplied depends upon its usefulness to management in decision-making. The usual approach is that, first of all, a thorough analysis of the whole 3managerial process is made, then the information required for each area is explored, and finally, all the information, after analysis in terms of alternatives, is taken into consideration before arriving at a management decision. It is to be understood here that the accounting information has no end in itself; it is a means to an end. As its basic idea is to serve the management, its form and frequency are all decided by managerial needs. Therefore, accounting aids the management by providing quantitative information on the economic well being of the enterprise. It would be appropriate if we called management accounting an Enterprise Economics. Its scope extends to the use of certain modern sophisticated managerial techniques in analyzing and interpreting operative data and to the establishment of a communication network for financial reporting at all managerial levels of an organization. 1.3 NATURE OF MANAGEMENT ACCOUNTING The term management accounting is composed of 'management' and 'accounting'. The word 'management' here does not signify only the top management but the entire personnel charged with the authority and responsibility of operating an enterprise. The task of management accounting involves furnishing accounting information to the management, which may base its decisions on it. It is through management accounting that the management gets the tools for an analysis of its administrative action and can lay suitable stress on the possible alternatives in terms of costs, prices and profits, etc. but it should be understood that the accounting information supplied to management is not the sole basis for managerial decisions. Along with the accounting information, management takes into consideration or weighs other factors concerning actual execution. For reaching a final 4decision, management has to apply its common sense, foresight, knowledge and experience of operating an enterprise, in addition to the information that is already has. The word 'accounting' used in this phrase should not lead us to believe that it is restricted to a mere record of business transactions i.e., book keeping only. It has indeed a 'macro-economic approach'. As it draws its raw material from several other disciplines like costing, statistics, mathematics, financial accounting, etc., it can be called an interdisciplinary subject, the scope of which is not clearly demarcated. Other fields of study, which can be covered by management accounting, are political science, sociology, psychology, management, economics, statistics, law, etc. A knowledge of political science helps to understand authority relationship and responsibility identification in an organization. A study of sociology helps to understand the behaviour of man in groups. Psychology enables us to know the mental make-up of employers and employees. A knowledge of these subjects helps to increase motivation, and to control the actions of the people who are ultimately responsible for costs. This builds a better employer-employee relationship and a sound morale. The subject of management reveals the processes involved in the art of managing, a knowledge of economics assists in the determination of optimum output in the forecasting of sales and production, etc., and also makes it possible to analyze management action in terms of cost revenues, profits, growth, etc. It is with the help of statistics that this information is presented to the management in a form that can be assimilated. The subject of management accounting also encompasses the subject of law, knowledge 5of which is necessary to find out if the management action is ultra-vires or not. It is, therefore, a wide and diverse subject. Management accounting has no set principles such as the double entry system of bookkeeping. In place of generally accepted accounting principles, the philosophy of cost benefit analysis is the core guide of this discipline. It says that no accounting system is good or bad but is can be considered desirable so long as it brings incremental benefits in excess of its incremental costs. Applying management accounting principles to financial matters can arrive at no single perfect solution. It is, therefore, an inexact science, which uses its own conventions rather than standardized principles. The facts to be studied here can be interpreted in different ways and the precision of the inferences depends upon the skill, judgement and common sense of different management accountants. It occupies a middle position between a fully matured and an infant subject. Since management accounting is managerially oriented, its data is selective in nature. It focuses on potential opportunities rather than opportunities lost. The data is operative in nature catering to the operational needs of a firm. It details events, monetary and non-monetary. The nature of data, the form of presentation and its duration are mainly determined by managerial needs. It is quite frequently reported as it is meant for internal uses and managerial control. An accountant should look at his enterprise from the management's point of view. Whenever he fails to do that he ceases to be a management accountant. Management accounting is highly sensitive to management needs. However, it assists the management and does not replace it. It represents a service 6phase of management rather than a service to management from management accountant. It is rather highly personalized service. Finally, it can be said that the management accounting serves as a management information system and so enables the management to manage better. 1.4 FUNCTIONS OF MANAGEMENT ACCOUNTING The basic function of management accounting is to assist the management in performing its functions effectively. The functions of the management are planning, organizing, directing and controlling. Management accounting helps in the performance of each of these functions in the following ways: (i) Provides data: Management accounting serves as a vital source of data for management planning. The accounts and documents are a repository of a vast quantity of data about the past progress of the enterprise, which are a must for making forecasts for the future. (ii) Modifies data: The accounting data required for managerial decisions is properly compiled and classified. For example, purchase figures for different months may be classified to know total purchases made during each period product-wise, supplier-wise and territory-wise. (iii) Analyses and interprets data: The accounting data is analyzed meaningfully for effective planning and decision-making. For this purpose the data is presented in a comparative form. Ratios are calculated and likely trends are projected. (iv) Serves as a means of communicating: Management accounting provides a means of communicating management plans upward, downward and outward through the organization. Initially, it means identifying the feasibility and consistency of the various segments of 7the plan. At later stages it keeps all parties informed about the plans that have been agreed upon and their roles in these plans. (v) Facilitates control: Management accounting helps in translating given objectives and strategy into specified goals for attainment by a specified time and secures effective accomplishment of these goals in an efficient manner. All this is made possible through budgetary control and standard costing which is an integral part of management accounting. (vi) Uses also qualitative information: Management accounting does not restrict itself to financial data for helping the management in decision making but also uses such information which may not be capable of being measured in monetary terms. Such information may be collected form special surveys, statistical compilations, engineering records, etc. 1.5 SCOPE OF MANAGEMENT ACCOUNTING Management accounting is concerned with presentation of accounting information in the most useful way for the management. Its scope is, therefore, quite vast and includes within its fold almost all aspects of business operations. However, the following areas can rightly be identified as falling within the ambit of management accounting: (i) Financial Accounting: Management accounting is mainly concerned with the rearrangement of the information provided by financial accounting. Hence, management cannot obtain full control and coordination of operations without a properly designed financial accounting system. 8(ii) Cost Accounting: Standard costing, marginal costing, opportunity cost analysis, differential costing and other cost techniques play a useful role in operation and control of the business undertaking. (iii) Revaluation Accounting: This is concerned with ensuring that capital is maintained intact in real terms and profit is calculated with this fact in mind. (iv) Budgetary Control: This includes framing of budgets, comparison of actual performance with the budgeted performance, computation of variances, finding of their causes, etc. (v) Inventory Control: It includes control over inventory from the time it is acquired till its final disposal. (vi) Statistical Methods: Graphs, charts, pictorial presentation, index numbers and other statistical methods make the information more impressive and intelligible. (vii) Interim Reporting: This includes preparation of monthly, quarterly, half-yearly income statements and the related reports, cash flow and funds flow statements, scrap reports, etc. (viii) Taxation: This includes computation of income in accordance with the tax laws, filing of returns and making tax payments. (ix) Office Services: This includes maintenance of proper data processing and other office management services, reporting on best use of mechanical and electronic devices. (x) Internal Audit: Development of a suitable internal audit system for internal control. (xi) 91.6 THE MANAGEMENT ACCOUNTANT Management Accounting provides significant economic and financial data to the management and the Management Accountant is the channel through which this information efficiently and effectively flows to the management. The Management Accountant has a very significant role to perform in the installation, development and functioning of an efficient and effective management information system. He designs the framework of the financial and cost control reports that provide each management level with the most useful data at the most appropriate time. He educates executives in the need for control information and ways of using it. This is because his position is unique with respect to information about the organization. Apart from top management no one in the organization perhaps knows more about the various functions of the organization than him. He is, therefore, sometimes described as the Chief Intelligence Officer of the top management. He gathers information, breaks it down, sifts it out and organizes it into meaningful categories. He separates relevant and irrelevant information and then ranks relevant information in an intelligible form to the management and sometimes also to those who are interested in the information in the information outside the company. He also compares the actual performance with the planned one and reports and interprets the results of operations to all levels of management and to the owners of the business. Thus, in brief, management accountant or controller is the person who designs the management information system for the organization, operates it by means of interlocked budgets, computes variances and exhorts others to institute 10corrective measures. Mr. P.L. Tandon has explained beautifully the position of the management accountant in the following words. "The management accountant is exactly like the spokes in a wheel, connecting the rim of the wheel and the hub receiving the information. He processes the information and then returns the processed information back to 1 where it came from" . 2 Dr. Don barker sees a very bright future for the management accountants. According to him, "Management Accountants will be presented with many opportunities for innovative actions in the global economic environment. In addition to their role of providing accurate, timely and relevant information, management accountants will be expected to participate as business consultants and partners with management in the strategic planning process". Thus, there are tremendous possibilities for management accountants to shine as a professional group in the years to come. To fit in this role, it is necessary that the management accountants develop effective communication abilities, adopt a structured approach, a flexible accommodation and keep themselves aware with the latest evolving technologies in the profession. FUNCTIONS OF MANAGEMENT ACCOUNTANT It is the duty of the management accountant to keep all levels of management informed of their real position. He has, therefore, varied functions to perform. His important functions can be summarized as follows: 1 Tandon, P.L.: "The Role of Management Accountants in General Management”. 4th All India Seminar on Management Accounting, Lucknow, Feb. 1963. 2. President (1991-92), The Institute of Management Accountants, USA. 11(i) Planning: He has to establish, coordinate and administer as an integral part of management, an adequate plan for the control of the operations. Such a plan would include profit planning, programmes of capital investment and financing, sales forecasts, expenses budgets and cost standards. (ii) Controlling: He has to compare actual performance with operating plans and standards and to report and interpret the results of operations to all levels of management and the owners of the business. This id done through the compilation of appropriate accounting and statistical records and reports. (iii) Coordinating: He consults all segments of management responsible for policy or action. Such consultation might concern any phase of the operation of the business having to do with attainment of objectives and the effectiveness of the organizational structures and policies. (iv) Other functions: ¾ He administers tax policies and procedures. ¾ He supervises and coordinated the preparation of reports to governmental agencies. ¾ He ensures fiscal protection for the assets of the business through adequate internal control and proper insurance coverage. ¾ He carries out continuous appraisal economic and social forces and the government influences, and interprets their effect on the business. It should be noted that the functions of a Management Accountant are more of those of a 'staff official'. He, in addition to processing historical 12data, supplies a good deal of information concerning the future operations in line with the management's needs. Besides serving top management with information concerning the company as a whole, he supplies detailed information to the line officers regarding alternative plans and their profitability, which help them in decision-making. As a matter of fact the Management Accountant should not bother himself regarding the decision taken by the line officials after tendering advice unless he has reasonable grounds to believe that such a decision is going to affect the interests of corporation adversely. In such an event also he should report it to the concerned level of management with tact, firmness combined with politeness. 1.7 MANAGEMENT ACCOUNTING AND FINANCIAL ACCOUNTING Financial accounting and management accounting are closely interrelated since management accounting is to a large extent rearrangement of the data provided by financial accounting. Moreover, all accounting is financial in the sense that all accounting systems are in monetary terms and management is responsible for the contents of the financial accounting statements. In spite of such a close relationship between the two, there are certain fundamental differences. These differences can be laid down as follows: (i) Objectives: Financial accounting is designed to supply information in the form of profit and loss account and balance sheet to external parties like shareholders, creditors, banks, investors and Government. Information is supplied periodically and is usually of such type in which management is not much interested. Management Accounting is designed principally for providing accounting information for internal 13use of the management. Thus, financial accounting is primarily an external reporting process while management accounting is primarily an internal reporting process. (ii) Analyzing performance: Financial accounting portrays the position of business as a whole. The financial statements like income statement and balance sheet report on overall performance or statues of the business. On the other hand, management accounting directs its attention to the various divisions, departments of the business and reports about the profitability, performance, etc., of each of them. Financial accounting deals with the aggregates and, therefore, cannot reveal what part of the management action is going wrong and why. Management accounting provides detailed analytical data for these purposes. (iii) Data used: Financial accounting is concerned with the monetary record of past events. It is a post-mortem analysis of past activity and, therefore, out the date for management action. Management accounting is accounting for future and, therefore, it supplies data both for present and future duly analyzed in detail in the 'management language' so that it becomes a base for management action. (iv) Monetary measurement: In financial accounting only such economic events find place, which can be described in money. However, the management is equally interested in non-monetary economic events, viz., technical innovations, personnel in the organization, changes in the value of money, etc. These events affect management's decision and, therefore, management accounting cannot afford to ignore them. 14For example, change in the value of money may not find a place in financial accounting on account of "going concern concept". But while affecting an insurance policy on an asset or providing for replacement of an asset, the management will have to take into account this factor. (v) Periodicity of reporting: The period of reporting is much longer in financial accounting as compared to management accounting. The Income Statement and the Balance Sheet are usually prepared yearly or in some cases half-yearly. Management requires information at frequent intervals and, therefore, financial accounting fails to cater to the needs of the management. In management accounting there is more emphasis on furnishing information quickly and at comparatively short intervals as per the requirements of the management. (vi) Precision: There is less emphasis on precision in case of management accounting as compared to financial accounting since the information is meant for internal consumption. (vii) Nature: Financial accounting is more objective while management accounting is more subjective. This is because management accounting is fundamentally based on judgement rather than on measurement. (viii) Legal compulsion: Financial accounting has more or less become compulsory for every business on account of the legal provisions of one or the other Act. However, a business is free to install or not to install system of management accounting. The above points of difference between Financial Accounting and Management Accounting prove that Management Accounting has flexible 15approach as compared to rigid approach in the case of Financial Accounting. In brief, financial accounting simply shows how the business has moved in the past while management accounting shows how the business has to move in the future. An attempt may now be made to compare and study the two types of accounting on basis of the characteristics of the data used. It is presented through the box- 1.1, given below. Box 1.1 Features of data Provided by Financial Provided by Accounting Management accounting 1. Period After a stated period At frequent intervals 2. Time Historical data Current and future data 3. Unit of expression Money only Any statistical unit 4. Nature Actual data Projected data 5. Specificity Aggregates Detailed analysis 6. Description Money consequences Events 7. Reality Objective Subjective 8. Precision Pie to Pie accuracy May be guess-work 9. Principles Double entry system Cost benefit analysis 10. Legality Obligatory Optional 11. Purpose Overview of entire Analytical details of such Business activity activities as call for decisions 1.8 COST ACCOUNTING AND MANAGEMENT ACCOUNTING Cost accounting is the process of accounting for costs. It embraces the accounting procedures relating to recording of all income and expenditure and the preparation of periodical statements and reports with the object of ascertaining and controlling costs. It is, thus, the formal mechanism by means of which the costs of products or services are ascertained and controlled. On the other hand, management accounting involves collecting, analyzing, interpreting and presenting all accounting information, which is useful to the management. It is closely associated with management control, which comprises planning, executing, measuring and evaluating the 16performance of an organization. Thus, management accounting draws heavily on cost data and other information derived from cost accounting. Today cost accounting is generally indistinguishable from the so-called management accounting or internal accounting because it serves multiple purposes. However, management accounting can be distinguished from cost accounting in one important respect. Management accounting has a wider scope as compared to cost accounting. Cost accounting deals primarily with cost data while management accounting involves the considerations of both cost and revenue. Management accounting is an all inclusive accounting information system, which covers financial accounting, cost accounting, and all aspects of financial management. But it is not a substitute for other accounting functions. It involves a continuous process of reporting cost, financial and other relevant data in an analytical and informative way to management. We should not be very much concerned with boundaries of cost accounting and management accounting since they are complementary in nature. In the absence of a suitable system of cost accounting, management accountant will not be in a position to have detailed cost information and his function is bound to lose significance. On the other hand, the management accountant cannot effectively use the cost data unless it has been reported to him in a meaningful and informative form. 1.9 LIMITATIONS OF MANAGEMENT ACCOUNTING Management accounting, being comparatively a new discipline, suffers from certain limitations, which limit its effectiveness. These limitations are as follows: 171. Limitations of basic records: Management accounting derives its information from financial accounting, cost accounting and other records. The strength and weakness of the management accounting, therefore, depends upon the strength and weakness of these basic records. In other words, their limitations are also the limitations of management accounting. 2. Persistent efforts. The conclusions draws by the management accountant are not executed automatically. He has to convince people at all levels. In other words, he must be an efficient salesman in selling his ideas. 3. Management accounting is only a tool: Management accounting cannot replace the management. Management accountant is only an adviser to the management. The decision regarding implementing his advice is to be taken by the management. There is always a temptation to take an easy course of arriving at decision by intuition rather than going by the advice of the management accountant. 4. Wide scope: Management accounting has a very wide scope incorporating many disciplines. It considers both monetary as well as non-monetary factors. This all brings inexactness and subjectivity in the conclusions obtained through it. 5. Top-heavy structure: The installation of management accounting system requires heavy costs on account of an elaborate organization and numerous rules and regulations. It can, therefore, be adopted only by big concerns. 186. Opposition to change: Management accounting demands a break away from traditional accounting practices. It calls for a rearrangement of the personnel and their activities, which is generally not like by the people involved. 7. Evolutionary stage: Management accounting is still in its initial stage. It has, therefore, the same impediments as a new discipline will have, e.g., fluidity of concepts, raw techniques and imperfect analytical tools. This all creates doubt about the very utility of management accounting. 1.10 SELF-TEST QUESTIONS 1. What do you mean by management accounting? Explain giving examples. 2. What are the functions of a management accountant? Elaborate each one of them. 3. Explain the benefits of management accounting in the business sector and service sector. 4. Distinguish management accounting from financial accounting and cost accounting. 5. Explain the limitations of management accounting. 1.11 SUGGESTED READINGS 1. Ashish K. Bhattacharya, Principles and Practices of Cost Accounting rd (3 .), New Delhi: Prentice Hall of India Private Limited, 2004. 2. Charles T. Horngren, Cost Accounting, A Managerial Emphasis, Prentice Hall Inc., 1973. 3. D. T. Decoster and E. L. Schafer, Management Accounting, New York: John Willey and Sons, 1979. 4. John G. Blocker and Wettmer W. Keith, Cost Accounting, New Delhi: Tata Mc Grw Publishing Co. Ltd., 1976. 5. R. K. Sharma and Shashi K. Gupta, Management Accounting- th Principles and Practice (7 .), New Delhi: Kalyani Publishers, 1996. 19COURSE: MANAGEMENT ACCOUNTING COURSE CODE: MC-105 AUTHOR: DR. N. S. MALIK LESSON: 02 VETTER: Dr. Karam Pal FINANCIAL STATEMENT ANALYSIS Objective: The present lesson explains the discrepancy between accounting income and economic income; identify the devices used in practice to exploit the use of the bottom line; the use of a firm's financial statements to calculate standard financial ratios; decompose the return on equity into its key determinants; carry out comparative analysis; and highlights the uses of financial statement analysis for different purposes. LESSON STRUCTURE 2.1 Introduction 2.2 Financial Statements 2.3 Financial Statement Analysis 2.4 Methodical Presentation of Financial Statement Analysis 2.5 Techniques /Tools of Financial Statement Analysis 2.6 Self-Test Questions 2.7 Suggested Readings 2.1 INTRODUCTION Financial statements are an important source of information for evaluating the performance and prospects of a firm. If properly analyzed and interpreted, financial statements can provide valuable insights into a firm's performance. Analysis of financial statements is of interest to lenders (short term as well as long term), investors, security analysts, managers, and others. Financial statement analysis may be done for a variety of purposes, which may range 20

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