The distinction between financial and management accounting


Executive summary

By definition, management accounting covers that involve identifying, measuring, accumulating, analyzing, interpreting and communicating information that enables the management to make effective decisions as regards planning, evaluation and control of an entity's resources. Some entities such as Apple Plc use the traditional management accounting practices instead of innovative skills and practices that have been and are being developed by the professional accounting institutes. This distinction in the two practices is basically illustrated by the cost control techniques applied. Sometimes this is influenced by poor understanding of the managers and directors in regard to the role and nature of management accounting. This limits the perceived ability to enhance sound strategic decisions that can improve the entity's performance. It's indispensable to understand that financial accounts alone do not give a complete view of entity's affairs and in most cases are meant for compliance with the statutory regulations. According to Anthony (2003), financial accounts may only be satisfactory in small business that is owner-managed. Management accounting plays a major role in giving a broad aspect to all the company's activities and this enables the managers and directors to make informed decisions that can improve the entity's economy, efficiency as well as success of operations.

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Another challenge that limits the managers and directors ability to innovatively play their role in management accounting is the poor performance evaluation system that is adopted by the entity. This is one of the major sources of dissatisfaction among staff. Where the performance of directors, managers at departmental and divisional levels are evaluated based on profit margins arising from their departments and divisions, cost allocation may really be an issue particularly where the cost allocation to the cost centre is done using absorption costing system. This can raise conflictions among managers of the various divisions since each of them want to optimize his division's profit margin (Anthony, 2003).

Findings and Discussion

Role & nature of management accounting

From the findings, one of the limiting factors in enhancing effective and strategic decisions by the directors and managers at Apple plc is premised on the perceived narrow or little understanding of the nature of management accounting and its role in the company. In promoting a better understanding that would certainly help the staff and the managers in the decision making I would like to first shed some light on the distinction between the financial accounting and management accounting. According to Anthony (2003), management accounting is actually designed to be used by managers within an entity as compared to financial accounts whose design is mainly customized for shareholders, creditors, employees and even the government's needs. Another distinguishing factor is that management accounting is forward looking as compared to financial accounting which is historical. Therefore, a good understanding of management accounting and its role plays a key part in an entity's future activities.

I would like to inform the directors that management accounting plays a vital role in providing operational and financial information that is decision based. This information can guide the managers and directors in managing the work team. Management accountants therefore play a dual role of preparing this information and reporting the relationships drawn and necessary steps to the corporation's managers and directors. According to Horngren et al (1999) in preparing management accounts the management accountants' activities should include planning, forecasting, variance analysis and costs control. These tasks play a key role in management accounting and the dual accountability is imperative especially when a company is designing a new product. In most cases financial accounting act as a stepping stone in management accounting.

Another key role played by management accounts is value creation whereby management accountants assist in driving the business success. For instance IT costs form uncontrollable spending in financial institutions and publishing companies as well as telecommunication corporations that derive their profit from information's economy. Management accounting in such entities work hand in hand with IT department in controlling costs through cost transparency and thereby driving the entities business. The board of directors also ought to look at management accounting as a management control mechanism used by managers as an internal business structure overview. According to Horngren et al (1999), the procedure helps managers to facilitate control functions in an organization.

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Some of the key processes in management accounting include analysis, this involves data collection on past, present and the planned activities and the role played by the management accountants should be to design appropriate mechanisms of capturing this operational data in a manner that is cost effective. The management can then use the data to produce appropriate information and present such information to the management. Such data may involve efficiency in methods and processes employed in production and the production costs (Merchant, 1998).

It's imperative to understand that management accountants do not make decisions in their function rather they identify a problem, and precisely defines a solution's objectives. The defined solution is then picked by the managers and directors to make decisions that will improve efficiency and reduce costs. The accountants also search for alternative course of action in production methods, specification and distribution channels. After evaluation they choose the appropriate courses of action e.g. cost volume profit analysis, discounted cash flow etc. Such choices are given to management and with their approval the company takes the course of action that is chosen (Horngren et al, 1999).

According to Merchant (1998), planning is also a key feature in management accounting. Management accounting supports managers planning by ensuring that all activities are coordinated into a master plan whose objectives are quantified, and therefore possibly draw a budget that can guide Apple Inc. In comparing the targets of the planned activities with actual performance management accounting guides the accountants and the managers to exercise the appropriate level of control in relation to potential benefits. It is imperative to appreciate that management accounting looks at the past to plan for the future. It also entails detailed information necessary for overall planning and effective control of operations. Appreciating the time horizon and the level of detail involved are key to the understanding the nature of management accounting. I would advise the management to establish a management accounting function to undertake the various roles involved. The management should also ensure that the function does not work with the exclusion of financial accounting reports since such reports will guide the management accountants in drawing areas that need dire attention.

Performance evaluation system

Performance evaluation system adopted by the management should be carefully chosen, they can strain the relationships between director and managers, supervisors and the staff. This ruins trust where there is misunderstanding and miscommunication. In the context of Apple Inc, the adopted system has majorly contributed to managers' dissatisfaction. The company's performance evaluation system is based on division's profit margin where a percentage is set for meeting the minimum required profit margin as well as exceeding the target. An effective performance evaluation system should be based on the managers' responsibilities and their contributions to the company, staff motivation as well as valid input in the company's personnel decisions. According Zimmerman (2002), evaluating the managers performance basing on division's profit margin only, is ineffective and frustrating for mangers who have carried out their responsibilities since profit margin may not necessarily be tagged to the managers' individual performance.

Profit margin is reached at by dividing the net income with net sales. Individual divisions' arrangements in operations and financing vary so much that different divisions are bound to reach different expenditure levels. Comparing the profit margins of different divisions may therefore have little meaning. The profit margin can be used to rate the managers capacity to lead his team towards effective cost control but should not be used as the only base for evaluation of the managers performance. One of the key aspects of performance evaluation is technical competence of the staff. To enhance an effective performance evaluation system for managers, technical competence should be ranked the highest in performance evaluation since it's the most important input as long as performance evaluation is the bases for promotion and compensation decisions. Other factors that should be considered include ability to gain a new business and interpersonal skills. Performance evaluation may differ based on individual's position in the company i.e. lower middle and upper management. However individual's position should not weigh more than other factors (Anthony, 2003).

Accounting data allows easy collation of appropriate benchmarks and comparison, performance is usually computed in financial terms. Use of profit margins may influence managers to act in the company's interest. Cost control is a hierarchical exercise but it's impractical for the top individual to make all the necessary decisions. The organization should split the structure into responsibility centers with managers whose objectives are set while at the same time given discretion in the best way to achieve. The extent to which the manager has achieved the objective depending on center's circumstances and priorities can be used as the centre's performance measure (Zimmerman, 2002).

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The responsibility centers may include cost centers, profit centers and investment centers. The cost centers may be allocating the same budgets to achieve the best intended results. If we take for instance the mixing department, the manager of the center has some autonomy in the division's operations or processes' decisions. According to Horngren et al, (1999), costs can be contained by reducing quality and such a center will eventually report profits. It's worth noting that, there is no financial performance metrics that can identify quality reduction.

The same way the profit center manager has some autonomy in the decisions concerning the inputs and outputs and the main objective in a profit center is to optimize profits or hit the profit target. The manager is given discretion to make decisions regarding the employed resources and achieved outputs. According to Anthony (2003), use of profits centers in performance measurement does not allow for reduction in quality since such procedures induce a drop in sale. In this case, such centers end-up inducing performance behavior that meet organizations interest such as unit costs minimization through long and continuous production runs. However, this may involve internal competition, for instance where IT department is organized as a profit centre it may invoice other departments for services rendered.

According to Merchant (1998), profit center manager may raise profits through selling products on credit terms that are extended. Such credit sale involve capital engagement in form of company debtors and the cost of such capital is not attributed to the profit center and this makes use of profit centers ineffective in performance measurement since the encourage wastage of resources.

Absorption Vs Variable costing

According to Horngren et al (1999), absorption costing is one of the managerial cots accounting method and it refers to the tracing of variable costs and the fixed costs of production. This involves the costs which are identifiable from the products and the estimated expenses incurred in the period of production. In absorption costing direct materials purchased are recorded as assets and as they go through production the cost incurred is recorded in wok in progress (asset). The direct labor incurred is recorded in labor account as an expense. The overhead costs like electricity, depreciation are recorded as individual expenses, and when production is complete the costs are transferred to the finished units and the cost of goods sold accordingly. The cost of manufacturing will never equal the cost of good sold such that some costs associated with production will not go to the income statement but will remain as assets in the inventory accounts.

Apple plc manufactures a wide variety of products like chews, candy bars and other sweets which are produced in batches through automated processes. The mentioned process; mixing, cooking and product packaging involve various costs. In the production process as the produced unit passes from one process to another the costs incurred in one stage are transferred to the other and when the product is fully processed the costs incurred as expenses are transferred to the units of production for each division, this means that some departments like the service departments may not be allocated to costs since all the manufacturing costs will always be absorbed by the produced units and they are do not produce on their own but are rather supportive. According to Anthony (2003), in this case the manager of such a division is likely to report the required profit margin or even more as compared to other divisional managers.

Absorption costing is normally contrasted with direct or variable costing. When using the direct or variable costing, the fixed overhead costs are not assigned to manufactured products. I would recommend use of variable costing for Apple as long as it concerns performance evaluation for managers. According Anthony (2003), variable costing is always useful in management accounting when it comes to decision making for instance the decisions to do with performance analysis. Variable Costing involves tracing of only the production costs that are variable to the product while the fixed production costs are taken as period expenses. It's good to note that absorption costing is relevant in external financial reporting as well as reporting on income tax.

Conclusion and Recommendations

I would encourage the board of directors to work hand in had with the finance and accounting division manager to establish an effective management accounting function in the company so that the function can undertake the various roles of management accounting. The manager in the division should be responsible in ensuring that the management accountant perform the dual role of management accounting roles and reporting in order to enable the manager have his inputs regarding costs control. The management should also hold a meeting with the divisional managers to allow them to freely discuss their dissatisfaction with the system of performance evaluation used. I would advise the management to use performance evaluation system that enlists technical competence as a key aspect in promotion and compensation decisions for managers and then the bonuses given to managers can be based on profit margin targets. To fairly use the profit margin as a base for performance evaluation I would urge the management to use variable costing.