Management Accounting Definition
Management accounting also is known as managerial accounting and can be defined as a process of
providing financial information and resources to the managers in decision making. Management
accounting is only used by the internal team of the organization, and this is the only thing which
makes it different from financial accounting. In this process, financial information and reports such
as invoice, financial balance statement is shared by finance administration with the management
team of the company. Objective of management accounting is to use this statistical data and take a
better and accurate decision, controlling the enterprise, business activities, and development.
Financial accounting is the recording and presentation of information for the benefit of the various
stakeholders of an organization. Management accounting, on the other hand, is the presentation of
financial data and business activities for the internal management of the organization. In this article,
we will learn what is management accounting and its functions.
Introduction to Management Accounting
One of the definitions of Management accounting says that it is the application of professional skills
and knowledge in the preparation of financial and accounting information in a manner in which it
will assist the internal management in the formulation of policies, planning, and control of the
operations of the firm.
The basic function of management accounting is to help the management make decisions. There is
no fixed structure or format for it.
Financial accounting, costing, business analysis, economics, etc are some tools and techniques of
management accounting.
The only need for management accounting is that the data should serve its purpose, which is helping
the management take important business decisions.
Advantages and Objectives of Management Accounting
There are many objectives of but the prime objective is to assist the management team of an
organization in improving the quality of their decisions. Purpose of management accounting is to
help the managerial team with financial information so that they can execute business operations
and activities more efficiently. Following is the list of all benefits of management accounting –
1. Decision Making
2. Planning
3. Controlling business operations
4. Organizing
5. Understanding financial data
6. Identifying business problem areas
7. Strategic Management
Decision Making
This is the most important benefit of the process of management accounting. In fact, it is the main
purpose of it. In this form of accounting, we use techniques from all fields like costing, economics,
statistics, etc.
It provides us with charts, tables, forecasts and various such analysis that makes the process of
decision making easier and more justified.
Planning
Managerial accounting does not have any strict timelines like financial accounting. It is, in fact, a
continuous and ongoing process.
So financial and other information is presented to the management at regular intervals like weekly,
monthly or sometimes even daily.
Hence managers can use this analysis and data to plan the activities of the organization. For
example, if the recent data shows a dip in the sales for a certain region, then the sales manager can
advise his team and plan some action to rectify the situation.
Identifying Business Problem Areas
If some product is not performing well, or some department is running into unexpected losses, etc.
managerial accounting can help us identify the underlying cause.
Actually, if the management is diligent and their data and reports are frequent, they can identify the
problem very early on. This will allow the management to get ahead of the problem.
Strategic Management
Concept of management accounting is not mandatory by any law. So it can have its own structure
according to the company’s requirements. So if the company feels certain areas need more in-depth
analysis or investigation it can do so freely.
This allows them to focus on some core areas. The information presented to them allows them to
make strategic management decisions.
Like if the company wishes to launch a new product line, or discontinue an existing one,
management accounting will play a huge part in this strategy.
Limitations of Management Accounting
Data based on Financial accounting – Decisions taken by the management team are based
on the data provided by Financial Accounting
Less knowledge – Management has insufficient knowledge of economics, finance, statistics,
etc.
Outdated data – Management team receives historical data, which may change eventually
when management is taking the decisions.
Expensive – Setting up a management accounting system requires a lot of investment.
Difference between Management Accounting and Financial Accounting
Sr. Management Accounting Financial Accounting
No.
For external reporting to various
Only used for internal purposes of
1 stakeholders and mandatory by law in
the firm
most cases
Is not under the regulation of any Is governed by Standards, Laws,
2
law or regulations regulations, etc
The main purpose is to help internal Helps investors, creditors, etc. take
3
management take decisions investment decisions
Includes both financial and non- Is only concerned with financial
4
financial information information
Not subject to any audits or Financial records are audited as per the
5
investigation norms
13 Important principles of Management Accounting
1. Designing and Compiling
Accounting information, records, reports, statements and other evidence of past, present or
future results should be designed and compiled to meet the needs of the particular business
and/or specific problem.
It means that management accounting system is designed in such a way presenting the
relevant data. If so, a particular problem is to be solved. Moreover, accounting information
can be modified and adopted to meet the requirements of management.
2. Management by Exception
The principle of management by exception is followed when presenting information to
management. It means that budgetary control system and standard costing techniques are
followed in the management accounting system.
In this way, the actual performance is compared with pre-determined one for finding the
deviations. The unfavorable deviations alone are informed precisely to management as
what is going wrong. If so, the management has spent less time to read and study the
information and more time to take action.
3. Control at Source Accounting
Costs are best controlled at the points at which they are incurred – control at source
accounting. The performance of individual workers, details of materials issues and
utilization and usage of services such as machine, power, repairs and maintenance, vehicles
etc. are prepared in the form of quantitative and qualitative information. In this way, control
can be exercised over employees, materials and service providing devices.
4. Accounting for Inflation
A profit cannot be said to be earned unless capital is maintained intact in real terms. It
means that money value is not stable. Hence, it is necessary to assess the value of capital
contributed by the owners of the business concern in terms of real value of money through
revaluation accounting. In this way, rate of inflation is taken into account to judge the real
success of the business concern.
5. Use of Return on Investment
Return on investment is otherwise called as Return on Capital Employed. The rate of return
shows the efficiency of the business concern. For this purpose, the capital employed is
calculated in terms of real money value.
6. Utility
Management accounting systems and related forms should be used only as long as they
serve a useful purpose.
7. Integration
It means that all the required information of the management is integrated so that they can
be used effectively at the maximum and at the same time, the accounting service is provided
at minimum cost.
8. Absorption of Overhead Costs
Overhead costs are absorbed on anyone of the predetermined basis. The overhead costs are
the combination of indirect materials, indirect labour and indirect expenses. Hence, the
selected method or methods for the absorption of overheads should bring about the desired
results in the most equitable manner.
9. Utilization of Resources
The available resources should be effectively used. The reason is that some resources are
available in plenty only in reason and some other resources are available in scarcity
throughout the year. Hence, the management accounting system should be ensuring proper
utilization of available resources.
10. Controllable and Uncontrollable Costs
Based on controllability of costs, the costs are classified into two types i.e. controllable and
uncontrollable. There is no meaning of taking steps to control the uncontrollable costs.
Hence, the management accounting system can provide techniques to control the
controllable costs.
11. Forward Looking Approach
The management accounting system can guess the future problems through standard
costing techniques by means of fixing standard. In this way, the future problem may be
prevented to occur.
12. Appropriate Means
The most appropriate means of accumulating, recording and presenting the accounting
information should be selected. It means that proper mechanization of accounts is used in
every business organization.
In other words, an ordinary computer may be used in the small size business organization
and advanced technology computer with proper software can be used in the large size
business organization and multinational corporation.
13. Personal Contacts
Personal contact with departmental managers, foreman and others cannot be replaced entirely by
reports and statements. It means that direct personal contact avoids the misunderstanding between
the management and employees. Moreover, responsibility is very easily fixed and control is
exercised at required time.
Financial Statements Analysis
Financial statement analysis is a judgmental process which aims to estimate current and past
financial positions and the results of the operation of an enterprise, with primary objective of
determining the best possible estimates and predictions about the future conditions. It essentially
involves regrouping and analysis of information provided by financial statements to establish
relationships and throw light on the points of strengths and weaknesses of a business enterprise,
which can be useful in decision-making involving comparison with other firms (cross sectional
analysis) and with firms’ own performance, over a time period (time series analysis).
Financial analysis is the process of identifying the financial strengths and weaknesses of the firm
by properly establishing relationships between the various items of the balance sheet and the
statement of profit and loss. Financial analysis can be undertaken by management of the firm, or
by parties outside the firm, viz., owners, trade creditors, lenders, investors, labour unions,
analysts and others. The nature of analysis will differ depending on the purpose of the analyst. A
technique frequently used by an analyst need not necessarily serve the purpose of other analysts
because of the difference in the interests of the analysts. Financial analysis is useful and
significant to different users in the following ways:
1. Finance manager: Financial analysis focusses on the facts and relationships related to
managerial performance, corporate efficiency, financial strengths and weaknesses and
creditworthiness of the company. A finance manager must be well-equipped with the
different tools of analysis to make rational decisions for the firm. The tools for analysis
help in studying accounting data so as to determine the continuity of the operating
policies, investment value of the business, credit ratings and testing the efficiency of
operations. The techniques are equally important in the area of financial control, enabling
the finance manager to make constant reviews of the actual financial operations of the
firm to analyse the causes of major deviations, which may help in corrective action
wherever indicated.
2. Top management: The importance of financial analysis is not limited to the finance
manager alone. It has a broad scope which includes top management in general and other
functional managers. Management of the firm would be interested in every aspect of the
financial analysis. It is their overall responsibility to see that the resources of the firm are
used most efficiently and that the firm’s financial condition is sound. Financial analysis
helps the management in measuring the success of the company’s operations, appraising
the individual’s performance and evaluating the system of internal control.
3. Trade payables: Trade payables, through an analysis of financial statements, appraises
not only the ability of the company to meet its short-term obligations, but also judges the
probability of its continued ability to meet all its financial obligations in future. Trade
payables are particularly interested in the firm’s ability to meet their claims over a very
short period of time. Their analysis will, therefore, evaluate the firm’s liquidity position.
4. Lenders: Suppliers of long-term debt are concerned with the firm’s longterm solvency
and survival. They analyse the firm’s profitability over a period of time, its ability to
generate cash, to be able to pay interest and repay the principal and the relationship
between various sources of funds (capital structure relationships). Long-term lenders
analyse the historical financial statements to assess its future solvency and profitability.
5. Investors: Investors, who have invested their money in the firm’s shares, are interested
about the firm’s earnings. As such, they concentrate on the analysis of the firm’s present
and future profitability. They are also interested in the firm’s capital structure to ascertain
its influences on firm’s earning and risk. They also evaluate the efficiency of the
management and determine whether a change is needed or not. However, in some large
companies, the shareholders’ interest is limited to decide whether to buy, sell or hold the
shares.
6. Labour unions: Labour unions analyse the financial statements to assess whether it can
presently afford a wage increase and whether it can absorb a wage increase through
increased productivity or by raising the prices.
7. Others: The economists, researchers, etc., analyse the financial statements to study the
present business and economic conditions. The government agencies need it for price
regulations, taxation and other similar purposes.
Objectives of Analysis of Financial Statements
Analysis of financial statements reveals important facts concerning managerial performance and
the efficiency of the firm. Broadly speaking, the objectives of the analysis are to apprehend the
information contained in financial statements with a view to know the weaknesses and strengths
of the firm and to make a forecast about the future prospects of the firm thereby, enabling the
analysts to take decisions regarding the operation of, and further investment in the firm. To be
more specific, the analysis is undertaken to serve the following purposes (objectives):
to assess the current profitability and operational efficiency of the firm as a whole as well
as its different departments so as to judge the financial health of the firm.
to ascertain the relative importance of different components of the financial position of
the firm.
to identify the reasons for change in the profitability/financial position of the firm.
to judge the ability of the firm to repay its debt and assessing the short-term as well as the
long-term liquidity position of the firm.
Through the analysis of financial statements of various firms, an economist can judge the extent
of concentration of economic power and pitfalls in the financial policies pursued. The analysis
also provides the basis for many governmental actions relating to licensing, controls, fixing of
prices, ceiling on profits, dividend freeze, tax subsidy and other concessions to the corporate
sector.
Tools or Techniques of Financial Statement Analysis
1. Comparative Statement or Comparative Financial and Operating Statements.
2. Common Size Statements.
3. Trend Ratios or Trend Analysis.
4. Average Analysis.
5. Statement of Changes in Working Capital.
6. Fund Flow Analysis.
7. Cash Flow Analysis.
8. Ratio Analysis.
9. Cost Volume Profit Analysis
A brief explanation of the tools or techniques of financial statement analysis presented below.
1. Comparative Statements
Comparative statements deal with the comparison of different items of the Profit and Loss Account
and Balance Sheets of two or more periods. Separate comparative statements are prepared for
Profit and Loss Account as Comparative Income Statement and for Balance Sheets.
As a rule, any financial statement can be presented in the form of comparative statement such as
comparative balance sheet, comparative profit and loss account, comparative cost of production
statement, comparative statement of working capital and the like.
1.1 Comparative Income Statement
Three important information are obtained from the Comparative Income Statement. They
are Gross Profit, Operating Profit and Net Profit. The changes or the improvement in the
profitability of the business concern is find out over a period of time. If the changes or
improvement is not satisfactory, the management can find out the reasons for it and some
corrective action can be taken.
1.2 Comparative Balance Sheet
The financial condition of the business concern can be find out by preparing comparative
balance sheet. The various items of Balance sheet for two different periods are used. The
assets are classified as current assets and fixed assets for comparison. Likewise, the
liabilities are classified as current liabilities, long term liabilities and shareholders’ net
worth. The term shareholders’ net worth includes Equity Share Capital, Preference Share
Capital, Reserves and Surplus and the like.
2 Common Size Statements
A vertical presentation of financial information is followed for preparing common-size statements.
Besides, the rupee value of financial statement contents are not taken into consideration. But, only
percentage is considered for preparing common size statement.
The total assets or total liabilities or sales is taken as 100 and the balance items are compared to
the total assets, total liabilities or sales in terms of percentage. Thus, a common size statement
shows the relation of each component to the whole. Separate common size statement is prepared
for profit and loss account as Common Size Income Statement and for balance sheet as Common
Size Balance Sheet.
Common-Size Statement: Meaning and Types| Method of Financial Analysis
The common-size statements, balance sheet and income statement are shown in analytical
percentages. The figures are shown as percentages of total assets, total liabilities and total sales.
The total assets are taken as 100 and different assets are expressed as a percentage of the total.
Similarly, various liabilities are taken as a part of total liabilities.
These statements are also known as component percentage or 100 per cent statements because
every individual item is stated as a percentage of the total 100. The short comings in comparative
statements and trend percentages where changes in items could not be compared with the totals
have been covered up. The analyst can assess the figures in relation to total values.
The common-size statements may be prepared in the following way:
(1) The totals of assets or liabilities are taken as 100.
(2) The individual assets are expressed as a percentage of total assets, i.e., 100 and different
liabilities are calculated in relation to total liabilities. For example, if total assets are Rs 5 lakhs
and inventory value is Rs 50,000, then it will be 10% of total assets (50,000×100/5,00,000)
Types of Common-Size Statements:
Balance Sheet Common Size Analysis
The balance sheet common size analysis mostly uses the total assets value as the base value. On
the balance sheet, the total assets value equals the value of total liabilities and shareholders’
equity. A financial manager or investor uses the common size analysis to see how a firm’s
capital structure compares to rivals. They can make important observations by analyzing specific
line items in relation to the total assets.
For example, if the value of long-term debts in relation to the total assets value is too high, it
shows that the company’s debt levels are too high. Similarly, looking at the retained earnings in
relation to the total assets as the base value can reveal how much of the annual profits are
retained on the balance sheet.
Let’s take the example of ABC Company whose balance sheet for 2017 is as follows:
From the table above, we can deduce that cash represents 14.5% of the total assets while
inventory represents 12% of the total assets. In the liabilities section, we can deduce that
accounts payable represent 15%, salaries 10%, long-term debt 30%, and shareholder’s equity
40% of the total liabilities and stockholder’s equity.
Income Statement Common Size Analysis
The base item in the income statement is usually the total sales or total revenues. Common size
analysis is used to calculate net profit margin, as well as gross and operating margins. The ratios
tell investors and finance managers how the company is doing in terms of revenues, and they can
make predictions of the future revenues. Companies can also use this tool to analyze competitors
to know the proportion of revenues that goes to advertising, research and development and other
essential expenses.
We can compute common size income statement analysis for ABC Company for 2017.
By looking at this income statement, we can see that in 2017, the amount of money that the
company invested in research and development (10%) and advertising (3%). The company also
pays interest to the shareholders, which is 2% of the total revenue for the year. The net operating
income or earnings after interest and taxes represent 10% of the total revenues, and it shows the
health of the business’s core operating areas. The net income can be compared to the previous
year’s net income to see how the company’s performance year-on-year.
Importance of Common Size Analysis
One of the benefits of using common size analysis is that it allows investors to identify drastic
changes in a company’s financial statement. It mainly applies when the financials are compared
over a period of two or three years. Any significant movements in the financials across several
years can help investors decide whether to invest in the company. For example, large drops in the
company’s profits in two or more consecutive years may indicate that the company is going
through financial distress. Similarly, considerable increases in the value of assets may mean that
the company is implementing an expansion or acquisition strategy, making the company
attractive to investors.
Common size analysis is also an excellent tool to compare companies of different sizes but in the
same industry. Looking at their financial data can reveal their strategy and their largest expenses
that give them a competitive edge over other comparable companies. For example, some
companies may sacrifice margins to gain a large market share, which increases revenues at the
expense of profit margins. Such a strategy allows the company to grow faster than comparable
companies because they are more preferred by investors.
