Accounting deals with the provision of information about the economic activities of various accounting entities, the largest of which is the whole economy, for which national accounts are prepared. However, the traditional province of the accountant is the smaller unit, typically a business firm. Here, a distinction is often made between financial accounting and management accounting.
Financial accounting deals with the provision of information to providers of finance (shareholders and creditors) and other interested parties who do not participate in the management of the firm (such as trade unions and consumer groups). This usually takes the form of a balance sheet (a statement of assets and claims thereon at a point in time), and a profit and loss account (a statement of revenue, expenses and profit over a period of time), supplemented by various other statements and notes. The form of financial accounting by companies is, in most countries, laid down by statute, and the contents are usually checked and certified independently by auditors. In some countries, there are also accounting standards laid down by the accounting profession or by the independent bodies which it supports, such as the United States Financial Accounting Standards Board, which determine the form and content of financial accounts. The auditing and regulation of financial accounts is a natural response to the potential moral hazard problem arising from the information asymmetry which exists between managers and providers of finance. In the absence of such quality assurance, users of accounts would have little confidence in the honesty and accuracy of statements that could be distorted by management to represent its performance in the most favourable light.
Management accounting is concerned with the provision of information to management, to assist with planning, decision making and control within the business. Because planning and decision making are inevitably directed to the future, management accounting often involves making future projections, usually called budgets. Important applications of this are capital budgeting, which deals with the appraisal of investments, and cash budgeting, which deals with the projection of future cash inflows and outflows and the consequent financial requirements of the entity. Management accounting is also concerned with controlling and appraising the outcome of past plans, for example, by analysing costs, and with assessing the economic performance of particular divisions or activities of the entity. Because the demand for management accounting information varies according to the activities, size and management structure of the entity, and because the supply of such information is not subject to statutory regulation or audit, there is a much greater variety both of techniques and of practice in management accounting than in financial accounting. Management has, of course, direct control over the information system of the business, so that formal regulation of the management accounting system is less important. However, within large organizations, there are information asymmetries and potential moral hazard problems between different groups (e.g. between branch managers and head office), and such organizations typically have internal auditing systems to reduce such problems.
Both management accounts and financial accounts derive from an accounting system which records the basic data relating to the transactions of the entity. The degree to which management accounting and financial accounting information can both derive from a common set of records depends on the circumstances of the individual accounting entity and, in particular, on the form of its management accounting. However, all accounting systems have a common root in double-entry bookkeeping, a self-balancing system, based on the principle that all assets of the entity (‘debits’) can be attributed to an owner (a claim on the entity by a creditor or the owners’ ‘equity’ interest in the residual assets of the entity, both of which are ‘credits’). This system owes its origin to Italian merchants of the fifteenth century, but it is still fundamental to accounting systems, although records are now often kept on computers, so that debits and credits take the form of different axes of a matrix, rather than different sides of the page in a handwritten ledger. The design of accounting systems to avoid fraud and error is an important aspect of the work of the accountant.
The traditional orientation of accounting was to record transactions at their historical cost, that is, in terms of the monetary units in which transactions took place. Thus, an asset would be recorded at the amount originally paid for it. Inflation and changing prices in recent years have called into question the relevance of historical cost, and inflation accounting has become an important subject. It has been proposed at various times and in different countries that accounts should show current values, that is, the specific current prices of individual assets, or that they should be adjusted by a general price level index to reflect the impact of inflation on the value of the monetary unit, or that a combination of both types of adjustment should be employed. Intervention by standard-setting bodies on this subject has been specifically directed at financial accounting, but it has been hoped that the change of method would also affect management accounting.
Financial accounting has also been affected, in recent years, by an increased public demand for information about business activities often supported by governments. Associated with this has been demand for information outside the scope of traditional profit-oriented accounts, resulting in research and experimentation in such areas as human asset accounting, environmental (or ‘green’) accounting and corporate social reporting. There has also been more interest in accounting for public-sector activities and not-for-profit organizations. Recent developments in management accounting, facilitated by the increased use of computers, include the greater employment of the mathematical and statistical methods of operational research and greater power to simulate the outcomes of alternative decisions. This development has, however, been matched by a growing interest in behavioural aspects of accounting, for example, studies of the human response to budgets and other targets set by management accountants. The whole area of accounting is currently one of rapid change, both in research and in practice.
Geoffrey Whittington
University of Cambridge
Further reading
Arnold, J. and Hope, A. (1990) Accounting for Management Decisions, 2nd edn, Englewood Cliffs, NJ.
Arnold, J., Hope, A., Southworth, A. and Kirkham, L. (1994) Financial Accounting, 2nd edn, Englewood Cliffs, NJ.
Ashton, D., Hopper, T. and Scapens, R. (eds) (1990) Issues in Management Accounting, Englewood Cliffs, NJ.
Kellas, J. and Nobes, C. (1990) Accounting Explained. Harmondsworth.
Parket, R.H. (1988) Understanding Company Financial Statements, 3rd edn, Harmondsworth.
Whittington, G. (1992) The Elements of Accounting: An Introduction, Cambridge, UK.
