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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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Chapter 1 provides an introduction to accounting, and an overview of accounting history as well as describing how the role of accounting has changed, including the influence that this changed role has had on non-financial managers. Chapter 2 describes the context in which management accounting operates: the capital market emphasis on shareholder value, and the strategic necessity of organizing complex businesses through divisions.

Chapter 3 describes how transactions are recorded by accounting systems and the limitations that are imposed by these methods. Chapter 4 covers the traditional theoretical approach to management accounting and control, while Chapter 5 offers alternative perspectives on accounting. The theoretical framework in Chapters 4 and 5 is important to support the interpretive analysis and critical perspective taken by this book.

Chapter 6 shows how the most important financial reports are constructed.

This introduction to financial accounting is an important building block for an understanding of management accounting.

Introduction to Accounting

This chapter introduces accounting and provides a short history of management accounting. It describes the early role of the management accountant and recent developments that have influenced the role of non-financial managers in relation to the use of financial information. The chapter concludes with a critical perspective on accounting history.

Accounting, accountability and the account Businesses exist to provide goods or services to customers in exchange for a financial reward. Public-sector and not-for-profit organizations also provide services, although their funding comes not from customers but from government or charitable donations. While this book is primarily concerned with profitoriented businesses, most of the principles are equally applicable to the public and not-for-profit sectors. Business is not about accounting. It is about markets, people and operations (the delivery of products or services), although accounting is implicated in all of these decisions because it is the financial representation of business activity.

The American Accounting Association defined accounting in 1966 as:

The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information.

This is an important definition because:

ž it recognizes that accounting is a process: that process is concerned with capturing business events, recording their financial effect, summarizing and reporting the result of those effects, and interpreting those results (we cover this in Chapter 3);

ž it is concerned with economic information: while this is predominantly financial, it also allows for non-financial information (which is covered in Chapter 4);

ž its purpose is to support ‘informed judgements and decisions’ by users: this emphasizes the decision usefulness of accounting information and the broad spectrum of ‘users’ of that information. While the primary concern of this book is the use of accounting information for decision-making, the book takes a


stakeholder perspective that users of accounting information include all those

who may have an interest in the survival, profitability and growth of a business:

shareholders, employees, customers, suppliers, financiers, government and society as a whole.

The notion of accounting for a narrow (shareholders and financiers) or a broad (societal) group of users is an important philosophical debate to which we will

return throughout this book. This debate derives from questions of accountability:

to whom is the business accountable and for what, and what is the role of accounting in that accountability?

Boland and Schultze (1996) defined accountability as:

The capacity and willingness to give explanations for conduct, stating how one has discharged one’s responsibilities, an explaining of conduct with a credible story of what happened, and a calculation and balancing of competing obligations, including moral ones. (p. 62)

Hoskin (1996) suggested that accountability is:

more total and insistent... [it] ranges more freely over space and time, focusing as much on future potential as past accomplishment. (p. 265) Boland and Schultze argued that accountability entails both a narration of what transpired and a reckoning of money, both meanings deriving from the original meanings of the word account.

Accounting is a collection of systems and processes used to record, report and interpret business transactions. Accounting provides an account – an explanation or report in financial terms – about the transactions of an organization. It enables managers to satisfy the stakeholders in the organization (owners, government, financiers, suppliers, customers, employees etc.) that they have acted in the best interests of stakeholders rather than themselves. This is the notion of accountability to others, a result of the stewardship function of managers that takes place through the process of accounting. Stewardship is an important concept because in all but very small businesses, the owners of businesses are not the same as the managers.

This separation of ownership from control makes accounting particularly influential due to the emphasis given to increasing shareholder wealth (or shareholder value). Accountability results in the production of financial statements, primarily for those interested parties who are external to the business. This function is called financial accounting.

Accounting is traditionally seen as fulfilling three functions:

ž Scorekeeping: capturing, recording, summarizing and reporting financial performance.

ž Attention-directing: drawing the attention of managers to, and assisting in the interpretation of, business performance, particularly in terms of the comparison between actual and planned performance.

ž Problem-solving: identifying the best choice from a range of alternative actions.


In this book, we acknowledge the role of the scorekeeping function in Chapters 6 and 7, while emphasizing attention-directing and problem-solving as taking place through three inter-related functions, all part of the role of functional as well as financial managers:

ž Planning: establishing goals and strategies to achieve those goals.

ž Decision-making: using financial information to make decisions consistent with those goals and strategies.

ž Control: using financial information to maintain performance as close as possible to plan, or using the information to modify the plan itself.

Planning, decision-making and control are particularly relevant as increasingly businesses have been decentralized into many business units, where much of the planning, decision-making and control is focused. Managers need financial and non-financial information to develop and implement strategy by planning for the future (budgeting); making decisions about products, services, prices and what costs to incur (decision-making using cost information); and ensuring that plans are put into action and are achieved (control). This function is called management accounting.

This book is primarily concerned with the planning, decision-making and control aspects, i.e. management accounting. However, it begins by setting the role of the manager and the use of accounting information in the context of financial accounting.

A short history of accounting

The history of accounting is intertwined with the development of trade between tribes and there are records of commercial transactions on stone tablets dating back to 3600 BC (Stone, 1969). The early accountants were ‘scribes’ who also practised

law. Stone (1969) noted:

In ancient Egypt in the pharaoh’s central finance department... scribes prepared records of receipts and disbursements of silver, corn and other commodities. One recorded on papyrus the amount brought to the warehouse and another checked the emptying of the containers on the roof as it was poured into the storage building. Audit was performed by a third scribe who compared these two records. (p. 284) However, accounting as we know it today began in the fourteenth century in the Italian city-states of Florence, Genoa and Venice as a result of the growth of maritime trade and banking institutions. The first bank with customer facilities opened in Venice in 1149. The Lombards were Italian merchants who were established as moneylenders in England at the end of the twelfth century.

Balance sheets were evident from around 1400 and the Medici family (who were Lombards) had accounting records of ‘cloth manufactured and sold’. The first treatise on accounting (although it was contained within a book on mathematics)


was the work of a monk, Luca Pacioli, in 1494. The first professional accounting body was formed in Venice in 1581.

Much of the language of accounting is derived from Latin roots. ‘Debtor’ comes from the Latin debitum, something that is owed; ‘assets’ from the Latin ad + satis, to enough, i.e. to pay obligations; ‘liability’ from ligare, to bind; ‘capital’ from caput, a head (of wealth). Even ‘account’ derives initially from the Latin computare, to count, while ‘profit’ comes from profectus, advance or progress. ‘Sterling’ and ‘shilling’ came from the Italian sterlino and scellino, while the pre-decimal currency abbreviation ‘LSD’ (pounds, shillings and pence) stood for lire, soldi, denarii.

Chandler (1990) traced the development of the modern industrial enterprise from its agricultural and commercial roots as a result of the Industrial Revolution in the last half of the nineteenth century. By 1870, the leading industrial nations – the United States, Great Britain and Germany – accounted for two-thirds of the world’s industrial output. One of the consequences of growth was the separation of ownership from management. Although the corporation, as distinct from its owners, had been in existence in Britain since 1650, the separation of ownership and control was enabled by the first British Companies Act, which formalized the law in relation to ‘joint stock companies’ and introduced the limited liability of shareholders during the 1850s. The London Stock Exchange had been formed earlier in 1773 by stockbrokers, who had previously worked from coffee houses.

The second consequence of growth was the creation of new organizational forms. Based on his extensive historical analysis, Chandler (1962) found that in large firms structure followed strategy and strategic growth and diversification led to the creation of decentralized, multidivisional corporations like General Motors, where remotely located managers made decisions on behalf of absent owners and central head office functions. Ansoff (1988) emphasized that success in the first 30 years of the mass-production era went to firms that had the lowest prices.

However, in the 1930s General Motors ‘triggered a shift from production to a market focus’ (p. 11).

In large firms such as General Motors, budgets were developed to co-ordinate diverse activities. In the first decades of the twentieth century, the DuPont company developed a model to measure the return on investment (ROI). ROI (see Chapters 7, 12 and 13) was used to make capital investment decisions and to evaluate the performance of business units, including the managerial responsibility to use capital efficiently.

The role of management accounting

The advent of mechanized production following the Industrial Revolution increased the size and complexity of production processes, which employed more people and required larger sums of capital to finance machinery. Accounting historians suggest that the increase in the number of limited companies that led to the separation of ownership from control caused the attention of cost accounting to shift from determining cost to exercising control by absent owners over their managers.


The predecessor of management accounting, ‘cost accounting’, was reflected in the earlier title of management accountants as cost or works accountants. Typically situated in factories, these accountants tended to know the business and advise non-financial managers in relation to operational decisions. Cost accounting was concerned with determining the cost of an object, whether a product, an activity, a division of the organization or market segment. The first book on cost accounting is believed to be Garcke and Fell’s Factory Accounts, which was published in 1897.

Historians have argued that the new corporate structures that were developed in the twentieth century – multidivisional organizations, conglomerates and multinationals – placed increased demands on accounting. These demands included divisional performance evaluation and budgeting. It has also been suggested that developments in cost accounting were driven by government demands for cost information during both World Wars. It appears that ‘management accounting’ is a term used only after the Second World War.

In their acclaimed book Relevance Lost, Johnson and Kaplan (1987) traced the development of management accounting from its origins in the Industrial Revolution supporting process-type industries such as textile and steel conversion, transportation and distribution. These systems were concerned with evaluating the efficiency of internal processes, rather than measuring organizational profitability.

Financial reports were produced using a separate transactions-based system that reported financial performance. Johnson and Kaplan (1987) argued that by 1925 ‘virtually all management accounting practices used today had been developed’ (p. 12).

They also described how the early manufacturing firms attempted to improve performance via economies of scale by reducing unit cost through increasing the volume of output. This led to a concern with measuring the efficiency of the production process. Calculating the cost of different products was unnecessary because the product range was homogeneous.

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