MG433,

Foundations in Management Michaelmas Term 2010 Summative Essay

Essay question: Is increased precision in accounting always desirable? Discuss this with reference to management accounting techniques such as either costing methods or performance measurement or both. Candidate number: 35998 Word count: 2,386 Please do not write your name on any of the pages 1

 IS INCREASED PRECISION IN ACCOUNTING ALWAYS DESIRABLE? The importance of management accounting in any organization is indubitable. It instills veracity in institutional processes, provides a comprehensive overview of the business by making activities visible, imparts new insights and instigates action (Swieringa and Weick, 1987). On completion of the action it also provides an elucidation of the outcome. This assists managers to plan further for the advancement of the company. A question then arises whether increased precision in accounting techniques is always required to realize this advancement. I will attempt to answer this question in the course of this article by concentrating on performance measurement techniques used in accounting. This essay consists of four perspectives. The first one describes the idea of what I think precision in management accounting means and through a historical account tries to explain how it has led to innovations and creation of different accounting techniques over the past century. The second is a theoretical perspective highlighting how modern academic theories try and guide practitioners to inculcate increased precision in performance measurement within their organizations. The next explains the negative aspects of increased precision in accounting to insert a skeptical view to the argument. Lastly through a futuristic perspective assumptions are made about the use of performance measures in the years ahead whilst taking a stand that increased precision in accounting is desirable but identification of processes and situations in which it can benefit the most is also equally necessary. It is my belief that precision within management accounting can be looked at in two different ways. Meticulousness in numbers and exactitude of calculations is one way while correctness of models employed to measure both financial and nonfinancial performance is another. The latter links management accounting techniques and organizational control and will be the focus of this essay. An integral part of todays organizational control system is performance measurement. By evaluating the expediency of people and processes in an organization it enables the achievement of predefined strategies and goals. In search of precision, performance measures have been evolving over time as 2

 businesses have tried to incorporate them with the organizational purpose. This has led to innovations in performance measurement techniques and an effort is made to highlight some that have ensued over the past century in order to stress on how precision leads to novelty. The use of performance measures is dated as early as 1920. It was employed by large corporations like Du Pont and General Motors because the then used system of measuring financial performance was unsuccessful in indicating the rate of return on capital invested (Kaplan, 1984). The Return on Investment (ROI as a product of profit and turnover) performance measure was also employed to indicate the competence of their many operating departments and managers since these organizations had become vertically integrated and decentralized while dealing with mass production and distribution. However it was found that detrimental actions like waning new investments to increase capital turnover by decentralized managers that were focusing excessively on short-term profit led to the decrease in the long-term value of the business (Kaplan and Atkinson, 1998). On realizing the confines of the ROI method, General Electric adopted a new measure called Residual Income method in 1950. Residual Income was calculated by subtracting the charge on capital from operating income. This was to encourage managers to make investments that would lead to long-term benefits thus aligning the interests of divisional managers and the enterprise (Christensen et al, 2002). This practice matured further by 1990 as a result of innovation of a more precise measurement system called Economic Value Added or EVA that was an extension of the RI method and used a financial economics framework to derive the charge on capital by considering the opportunity cost of the capital and thus portraying economic profits (Stern, Stewart and Chew, 1995). Young writes about frequently proposed adjustments that are made to EVA model to increase its precision as a performance measure (Young, 1999). Capitalizing research and development to prevent under investments by managers. Non-dismissal of intangibles like goodwill leading to increased motivation for management to earn returns on capital invested. Capitalizing

 costs of restructuring so as to demand returns. He predicts many such changes will be proposed to the EVA model in the future. Thus it is clear that being increasingly precise in identification of inadequacies of previous fiscal frameworks of performance measures and accurately creating new ones has led to the advance in performance-based management accounting techniques. However the competence of using only financial evaluations to accomplish proficiencies that organizations aim for in todays information age has been questioned. This has led to the incorporation of both financial and nonfinancial measures into an objective portrayal of the performance of organizations and its employees known as the Balanced Scorecard (Kaplan and Norton, 1992). The Balanced Scorecard makes available to managers the ability to collectively scrutinize issues within the customer, internal, innovative and financial perspectives that they think shape the organizations progress. It acts as a tool for planning, predicting and reviewing the processes to reach desired targets. In the past decade the precise use of the Balanced Scorecard has accelerated within businesses and has enabled them to move forward. An example is the transition made by the First Financial Corporation from a product oriented to a single banking service company comprised of ten different banks (Kaplan, 2005). Increased precision aided FCFC to tailor the design of the scorecard to its own needs and produce it for the board of directors, CEO, managers and the enterprise as a whole. This enabled them to attain their requirements of corporate governance. Over the years a steady transition between ROI, RI, EVA with the use of Balanced Scorecard has been a gradual process as a result of an endeavor to reduce fallacy and improve accuracy in management accounting. As new and better techniques of performance measurement evolve, their relation to two allied theories concerning precision in accounting must be mentioned. These are the paradoxical (Meyer and Gupta, 1994) and contextual theories (Chenhall, 2006). The paradoxical model emphasizes that there are diverse norms for measuring performance in any organization and they continually change over time. The change occurs on running down of measures due to factors like improved 4

 performance, perverse learning, selection of efficient managers, suppression of continual discrepancies in performances and external changes. This frequently creates instability within organizations. The managers in such cases must be increasingly precise in identifying new performance indicators that are not correlated and are orthogonal to the earlier ones to prevent repeated use of run down measures. This facilitates the company to move from completion of one strategy to the vision of another one motivating and empowering employees along the way thus augmenting organizational performance. The contextual theory states that performance measures have to be set by companies based on external environment, strategy, technology, organizational structure and size of the organization. An example is a business that deals with complex technologies involved in manufacturing highly specialized products using advanced methods like just in time and total quality management. The performance measures in this case must be flexible and perceptive to mutual dependence across elements of the production process (Chenhall, 2006). The advantages of such a measurement system are not guaranteed unless the organization is successful in setting them precisely furnished to its own system and functions. In this way both paradoxical and contextual theories stress the need for managers to be increasingly precise in identification of new performance indicators and situations where they should be employed in order to shape the success of their business. An analogous framework emphasizing the notion of situated functionality has also been adopted (Ahrens and Chapman, 2007). The writers articulate the use of accounting techniques for creating general awareness thereby instilling activity to achieve specific purposes within individual organizations calling it situated functionality of accounting. These measures may not be the constant within different businesses but are exercised as a resource for action depending on the composition and strategy of the organization. Thus the theoretical perspective indicates that academics also place a high value on precision within accounting techniques. Every action has an equal and opposite reaction and it is the same in the case of response towards the use of increased precision in management accounting. 5

 Even though it incentivizes innovation and is supported by academic theories there is a skeptical view towards it under certain circumstances. A mention of some of these views is warranted to shed light on both sides of the coin. A major concern in todays business environment is whether managers can deal with the extreme pressures that are an adjunct to their work. Weick shares this trepidation and illustrates that as the need to enhance efficiency in corporations grows and as economic pressures intensify the measures employed to monitor performance increase. Increased search of precision in both goal setting and organizational control leads to excessive stress within employees (Weick, 1983). In the case of setting goals when the difficulty of tasks is set as per perceived abilities of the workers, it creates maximum ambiguity that might cause stress. Deciding to cut the workforce or to reduce operating costs so as to tighten organizational control increases both quantitative and qualitative workload. Managers end up monitoring too many events and actions. This leads to increased stress levels and severely affects utility as absenteeism increases, medical restrictions escalate and problem solving using innovation takes a back seat. In physical expenses the costs incurred can even go up to 20 billion dollars per year (Weick, 1983). However stress is a part of everyday life and appropriate time management along with actions such as meditation and yoga can help control it. Weick also writes that a lot of stress related problems depend on the personality of the individuals. So in order to reduce tribulations, selection of candidates for positions that demand a heavy workload should be rigorous and based largely on how they can handle stressful situations. Sometimes increased precision leads to the transfer of all decision-making powers to top-level managers leading to absolute organizational control within a few administrators and lack of innovation in lower tiers of the organization. This shortcoming of increased precision via the top down hierarchical model of organizational control is well explained by Norreklit using a critical view of the balanced scorecard (Hanne Norreklit, 2000). When the top levels of management formulate the balanced scorecard to accurately align the goals of individual workers with company strategy the lower tier perceive it as a basis of reaction rather than action. In such cases the 6

 aspirations of workers are negatively affected leading to a diminishing motivation. The language barrier may also create problems because terminologies in the scorecard to signify strategies could have different meanings in diverse social and cultural groups. The solution could be to create performance measures interactively with lower level managers and workers to take into account the outlook of the entire organization. There will always be a few problems arising due to increased precision but as mentioned above by identifying these problems and employing techniques to counter them, they can be solved or prevented. The famous American poet Mark Strand said, The future is always beginning now and it holds true in the case of management accounting techniques making it vital that most modern developments in it are not overlooked. The prospect of accounting and performance measurement within it looks bright as the ambition to achieve precision and accuracy is never ending. Some old academic theories can be revisited while several contemporary ones will be formed. Frameworks about organizational control like the belief, boundary, diagnostic and interactive systems can be re-examined and applied (Simon, 1995) resulting in the combination of elements of control and empowerment via performance measures and encouraging active debate between senior and operational managers. This facilitates formulation of tactics to counter strategic uncertainties and to solve the problem of hierarchical setting of performance measures posed by the balance scorecard. Academics such as Meyer have constantly asked questions of how performance measurement can be enhanced for the future. He has suggested an original method known as Activity based profitability analysis or ABPA that uses economics, sociology and organization theory to suggest individual financial rewards for managers depending on their performances (Meyer, 2002). We can hope that by trying to increase precision within its framework ABPA could be the next stepping-stone after the balanced scorecard for newer and improved performance measures to develop. Through this essay I have made an attempt to communicate that increased precision in accounting is always desirable. To counter the debate that practitioners and academics share different views on management issues I have 7

 used both their standpoints to demonstrate that they are comparable in the case of precision in accounting so as to boost my argument. This essay has stressed, how by means of search and application of increased precision, administrators in businesses have transformed accounting techniques over the past century leading to substantial expansion in the industrial and information age. Examples of Du Pont, General Motors, General Electric and First Financial Corporation have been stated to illustrate this. Within academics, Kaplan, Gupta, Chenhall, Ahrens and Chapman have played a major role in devising theories that support the views of managers while making a point that it is necessary to identify situations where increased precision is most effective for the functionality of the organization depending on the scenario in which the business operates. A negative view point is used by certain academics to show that increased precision leads to stress among managers and can also de-motivate workers in the lower tier of the organization as the decision making and innovation become hierarchical in nature. But this can be counteracted by newer, more precise methods like the ABPA that may be the future. On the whole I think that increased precision in accounting is vital because of the three Is that are its consequence. These are identification, innovation and implementation. Identification of weaknesses in the preceding accounting frameworks paves the way for innovation within organizations leading to the implementation of more accurate techniques in management accounting. On the basis of my argument I can state that businesses cannot function without accuracy while management accounting and especially performance measurement that form an integral part of any business will always welcome increased precision. Bibliography Ahrens, T and Chapman, C. (2007). Management accounting as practice. Accounting, Organizations and Society. 32, 1-27. Christensen, P, Feltham, G and Wu, M. (2002). "Cost of Capital" in Residual Income for Performance Evaluation. The Accounting Review. 77 (1), 1-23. 8

 Kaplan and Atkinson, A (1998). Advanced Management Accounting. 3rd Ed. New Jersey: Prentice Hall International. 499-590. Kaplan, R. (1984). The Evolution of Management Accounting. The Accounting Review. LIX (3), 390-418. Kaplan, R. (2005). First Commonwealth Financial Corporation. Harvard Business Review. 1-30. Kaplan, R and Norton, D. (1992). The Balanced Scorecard - Measures That Drive Performance. Harvard Business Review. 71-79 Meyer, M and Gupta, V. (1993). The Performance Paradox Research in Organizational Behavior. 16, 309-369. Meyer, M. (2003). Rethinking Performance Measurement: Beyond the Balanced Scorecard. Pennsylvania: Cambridge University Press. 1-19. Nrreklit, H. (2000) The balance on the Balanced Scorecard- a critical analysis of some of its assumptions. Management Accounting Research. 11, 65-88. Stern, J.M., Stewart, G.B. and Chew, D.H. (1995). The EVA financial management system. Journal of Applied Corporate Finance. 8(2), 3246. Swieringa, R and Weick, K. (1987). Management Accounting and Action. Accounting, Organizations and Society. 12 (3), 293-308. Simons, R. (1995). Levers of Control. Harvard Business School Press. Weick, K. (1983). Stress in Accounting Systems. The Accounting Review. LVIII (2), 350-369. Young, S.D., (1999). Some reflections on accounting adjustments and economic value added. Journal of Financial Statement Analysis. 4(2), 713. 9