Accounting for Management Control is a managerial activity concerned with planning and controlling of the corporations financial resources to generate returns on its invested funds. The raising and using of capital for generating funds and paying returns to the suppliers of capital is the finance function of a company. Thus the funds raised by the company will be invested in the best investment opportunities, with an expectation of future benefits. As every business activity either directly or indirectly involves the acquisition and use of funds, there is an inseparable relationship between the finance and other functions like production, marketing etc.
The raising of funds and using of money may not necessarily limit the general running of the business. A firm in a tight financial position will give more priority to financial considerations to devise its marketing and production strategies in tune with its financial constraints. On the contrary, management of a business company, with plentiful supply of funds, will be more flexible in formulating its production and marketing policies. In fact, the financial policies will be devised to fit the production and marketing decisions under such a situation. It may be difficult to separate the finance function from the other functions of the business, the finance function can be broadly discussed as
- Managerial functions
- Routine functions
The managerial functions require greater planning, control and execution of financial activities. Whereas, the routine functions need a greater managerial talent to carry them out. The routine functions are mainly incidental to the effective handling of the managerial functions. Some of the important routine functions are:
- Supervision of cash receipts and payments and safeguarding of cash;
ii Custody and safeguarding of securities, insurance policies and other valuable papers;
iii. Taking care of the methodological procedures of new outside financing;
- Preparation of the reports and keeping of the records.
These routine functions are carried out by the people at the supervisory levels.
SCOPE OF ACCOUNTING FOR MANAGEMENT CONTROL
The scope and functions of accounting of management control are divided into two broad categories:
- Traditional approach
- Modern approach
The traditional approach to the scope of management accounting refers to its subject matter in the initial stages study. According to this approach, the scope of management accounting is confined to the raising of funds. Hence, the scope of finance was treated by the traditional approach in the narrow sense of procurement of funds by corporate enterprise to meet their financial needs. Since the main emphasis of finance function at that period was on the procurement of funds, the subject was called corporation finance till the rnid-1950’s and covered discussion on the financial instruments, institutions and practices through which funds are obtained.
As the problem of raising funds is more intensely felt at certain episodic events such as merger, liquidation, consolidation, and reorganization and so on. These are the broad features of the subject matter of corporation finance which has no concern with the decisions of allocating firm’s funds. The limitations of this approach fall into the following categories. (Kenon, Arthur J, Foundation of Finance: The Logic and practice of Financial Management)
- i) The emphasis in the traditional approach is on the procurement of funds by the corporate enterprises which was woven around the viewpoint of the suppliers of funds such as investors, financial institutions, investment bankers, etc, i.e. outsiders. It implies that the traditional approach was the outsider-looking-in approach.
ii). The second criticism levelled against this traditional approach was that the scope of accounting management was confined only to the episodic events such as mergers, acquisitions, reorganizations, consolation, etc. The scope of finance function in this approach was confined to a description of these infrequent happenings in the life of an enterprise. Thus, it places over emphasis on the topics of securities and its markets, without paying any attention on the day to day financial aspects.
iii). Another serious lacuna in the traditional approach was that the focus was on the long-term financial problems thus ignoring the importance of the working capital management. This approach has failed to consider the routine managerial problems relating to finance of the firm. (Kenon, Arthur J, Foundation of Finance: The Logic and practice of Financial Management)
During the initial stages of development, management accounting was dominated by the traditional approach as is observed from the finance books of early days. Its over emphasized long-term financing lacked in analytical content and placed heavy emphasis on descriptive material. The traditional approach omits the discussion on the important aspects like cost of the capital, optimum capital structure, valuation of firm, etc. In the absence of these crucial aspects in the finance function, the traditional approach implied a very narrow scope of financial management. The modern or new approach provides a solution to all these aspects of financial management. (Chandra. Prasanna, Managers’ Guide to Finance and Accounting)
Recently, a number of economic and environmental factors, such as the technological innovations, industrialization, intense competition, interference of government, growth of population, necessitated efficient and effective utilization of financial resources. The optimum allocation of the firm’s resources is the order of the day to the management. Then the emphasis shifted from episodic financing to the managerial financial problems, from raising of funds to efficient and effective use of funds.
The broader view of the modern approach of the finance function is the wise use of funds. Since the financial decisions have a great impact on all other business activities, the financial manager should be concerned about determining the size and nature of the technology, setting the direction and growth of the business, shaping the profitability, amount of risk taking, selecting the asset mix, determination of optimum capital structure, etc..
According to the new approach, the accounting management is concerned with the solution of the major areas relating to the financial operations of a firm, viz., investment, financing and dividend decisions. The modern financial manager has to take financial decisions in the most rational way. These decisions have to be made in such a way that the funds of the firm are used optimally. These managerial finance functions require special care with extraordinary administrative ability, management skills and decision – making techniques.
Finance functions can be divided into three major decisions, which the firm must make, namely the investment decision, the finance decision, and the dividend decision. Each of these decisions must be considered in relation to the objective of the firm: an optimal combination of the three decisions will maximize the value of the share to its shareholders. Since, these decisions are interrelated; their joint impact on the market price of the company’s stock must be considered.
- Investment Decision
The investment decision is the most important one among the three decisions. It relates to the selection of assets in which funds are invested by the firm. The assets which can be acquired fall into two broad groups:
- Long-term assets which will yield a return over a period of time in future,
- Short-term / current assets which are convertible into cash in the normal course of business usually within a year.
Accordingly, the asset selection decision of a firm is of two types. The first of these involving the first category of assets is popularly known as capital budgeting. The other one which refers to short-term assets is designated as liquidity decision.
- Capital Budgeting Decision
It is the most crucial financial decision of a firm which relates to the selection of an investment proposal whose benefits are likely to arise in future over the life-time of the corporation. The first aspect of the capital budgeting decision is the choice of the investment out of the available alternatives. The selection will be always based on the relative benefits and returns associated with it. Another aspect of the capital budgeting decision is the analysis of risk and uncertainty.
As, the benefits from the proposed investment relate to the future period, their accrual is uncertain. An element of risk in the sense of uncertainty of future benefits is involved in this exercise. Therefore, the return from the proposed investment should be evaluated in relation to the risk associated with it. Finally, this return should be judged with a certain norm which is referred by several names such as cut-off rate, required rate, hurdle rate, minimum rate of return, etc. (Brigham Houston. J.F, Fundamentals of Financial Management)
- Liquidity Decision
The liquidity decision is concerned with the management of the current assets which is a pre-requisite to long-term success of any business firm. The main objective of the current assets management is the trade – off between profitability and liquidity. There is a conflict between these two concepts. If a firm does not have adequate working capital, it may become illiquid and consequently fail to meet its current obligations thus inviting the risk of bankruptcy. On the contrary, if the current assets are too large, the profitability is adversely affected.
Hence, the key strategy and the main consideration in ensuring a trade-off between profitability and liquidity is the major objective of the liquidity decision. The funds should be invested optimally in the individual current assets to avoid inadequacy or excessive locking up of funds in these assets. The liquidity decision should obtain the basic two ingredients, i.e. overview of working capital management and the efficient allocation of funds on the individual current assets.
- Financing Decision
The second major decision of the firm is the financing decision for determining the best financing mix of the corporation.
After determining the asset-mix, the company must decide the mode of raising the funds to meet the firm’s investment requirements. The major issue in this decision is to determine the proportion of equity and debt capital. Since the involvement of debt capital affects the return and risk of shareholders, the company should get the optimal capital structure to maximize the shareholders’ return with minimum risk, in other words the cost of capital is the lowest and the market value of the share is the highest at that combination of debt and equity. Thus, the financing decision covers two inter-related aspects: (i) capital structure theory, and (ii) capital structure decision. (Horngren Charles T, Introduction to Management Accounting)
- Dividend Decision
The third important decision of a firm is its dividend policy. The financial manager must decide whether the firm should distribute all profits or retain it in the firm or distribute part and retain the balance. The dividend decision should be taken in terms of its impact on the shareholders’ wealth. The optimum dividend policy is one which maximizes the market value of share. If the shareholders are not indifferent to the firms dividend policy, the financial manager must determine the optimum dividend-payout ratio.
The financial management involves the solution of the three decisions of the firm according to the modern approach. The traditional approach with a very narrow perception was devoid of an integrated conceptual and analytical framework. In contrast the modern approach has broadened the scope of financial management to ensure the optimum decisions by fulfilling the objectives of the business firm. (McAlpine, T.S, The Basic Arts of Accounting)
OBJECTIVES OF THE CORPORATION
The modern approach to financial management is to give answers for three questions: where to invest and in what amounts how to raise and in what amount, and when to pay dividends. These aspects relate to the firm’s investment, financing and dividend policies. In order to meet them rationally, the company must have an objective. It is generally agreed that the financial objective of the firm should be the maximization of owners’ economic welfare. There is a disagreement as to how the economic welfare of the owners can be maximized. The two well known and widely discussed criteria in this respect are:
- Profit maximization, and
- Wealth maximization.
- Profit Maximization
According to this concept, actions that increase the firm’s profit are undertaken while those that decrease profit are avoided. The profit can be maximized either by increasing output for a given set of scarce input or by reducing the cost of production for a given output. The profit maximization is nothing but a criterion for economic efficiency as profits provide a yardstick by which economic performances can be judged under condition of perfect competition.
Under perfect competition, profit maximization behavior by firms leads to an efficient allocation of resources with maximum social welfare. As the capital is a scarce material, the financial manager should use these capital funds in the most efficient manner for achieving the profit maximization. Profitability maximization should serve as the basic criterion for the ultimate financial management decisions.
The profit maximization criterion has been and criticized on the following grounds:
- its vagueness
- it ignores the timing of benefits
iii. it ignores risk
One practical difficulty with profit maximization criterion is that the term profit is vague and ambiguous as it is amenable to different interpretations, like, profit before tax or after tax, total profit or rate of return, etc. If profit maximization is taken to be the objective, the problem arises, which of these variants of profit to be maximized. A vague concept of profit cannot form the basis of operation for financial management.
A more important technical objection to profit maximization is that it ignores the differences in the time pattern of the cash inflows from investment proposals. In other words, it does not recognize the distinction between the returns in different periods of time and treat them at a par which is not true in real world as the benefits in earlier years should be valued more than the benefits received in the subsequent years.
Another limitation of profit maximization as an operational objective is that it ignores the quality aspect of benefits associated with a financial course of action. As a matter of fact, the more certain the expected return, the higher the quality of the benefits. Conversely, the more uncertain the expected returns, the lower the quality of benefits which implies risk to the investors.
Generally, the investors want to avoid or at least to minimize the risk. Hence, the concept of profit maximization is unsuitable as an operational criterion for financial management, as it only considers the size of benefits but gives no weight to the degree of uncertainty of future benefits. (Horngren, C.T, Accounting: A Managerial Emphasis)
Therefore the profit maximization concept is inappropriate to a company from the point of view of financial decisions, i.e. investment, finance and dividend policies. It is not only vague and ambiguous but also it does not recognize the two basic aspects, i.e. risk and time value of money. The most appropriate operational decision criteria should consist of the following aspects:
- it must be precise and exact;
- it should consider both quality and quantity dimension of the receipts;
iii. it should be based on the bigger the better principle; and
- it should recognize the time value of money.
An alternative to profit maximization, which solves these issues, is the wealth maximization objective.
- Wealth Maximization
The most widely accepted objective of the firm is to maximize the value of the firm for its owners. The wealth maximization goal states that the management should seek to maximize the present value of the expected returns of the firm. The present value of future benefits is calculated by using its discount rate that reflects both time and risk. The discount rate i.e., capitalisation rate that is applied is, therefore, the rate that reflects the time and risk preferences of the suppliers of capital. (Moor, Carl L, Managerial Accounting)
The next feature of wealth maximization criterion is that it takes both the quantity and quality dimensions of benefits along with the time value of money. Other things being equal, income with certainty are valued more than the uncertain ones Thus, the objective of wealth maximization has a number of distinct merits.
The wealth maximization is superior to the profit maximization objective. The wealth maximization objective involves a comparison of present value of future benefits to the cash outflow. If the activity results in positive net present value, i.e. the present value of future stream of cash flows exceeds the present value of outflows, reflecting both time and risk, it can be said to create wealth and such actions should be undertaken. Conversely, actions with value less than its cost reduce the wealth of the firm and should be rejected. In case of mutually exclusive projects, when only one is to be chosen, the alternative with the greatest net present value should be selected.
The wealth maximization criterion recognizes the time value of money and also tackles the risk which is ascertained by the uncertainty of the expected benefits. That is why, it is rightly said that maximization of wealth is more useful than minimization of profits as a statement of the objective of most business firms.
The financial decisions of the firm are interrelated as they jointly affect the market value of the shares by influencing return and risk. This relationship between return and risk can be expressed as:
Return = Risk—free rate + Risk premium
Here the risk free rate is a compensation for time and risk premium for risk coverage. In order to maximize the market value of the firm’s shares, a proper balance between return and risk should be maintained. Such a balance is termed as risk-return trade-off and it is the overview of the functions of financial management.
CONFLICT OF GOALS: MANAGEMENT VS OWNERS
In the joint stock company form of corporations, the decision making lies in the hands of its management. While taking the decisions, the management need not necessarily act in the best interest of the shareholders and may pursue their own personal welfare, job security, etc. In other words, there may be a divergence between the shareholders’ wealth maximization goal and the actual goals pursued by the management of the business firm. The survival of the management will be threatened if their objectives remain unfulfilled.
The wealth maximization criterion may be generally in accordance with the interests of the patties who are related to the company. Situations arise where a conflict may occur between the shareholders’ and managements goals, that is the management may play safe and create satisfactory wealth for the shareholders which may not be the maximum one. Such type of attitude of management towards the shareholders goal will frustrate the objective of shareholders wealth maximization. (Van Home, C. James, Financial Management and Policy)
FINANCIAL GOALS AND CORPORATIONS STRATEGY
In the shareholders’ wealth maximization criterion a specific point may arise whether wealth maximization is the objective of the firm. Whether a company exists with the sole objective of serving the interests of owners. The business firms do not exist with the main objective of maximizing the welfare of shareholders. The survival and the future growth of the firm always depends on how it satisfies its customers through the quality of goods and services. Further, the firms in practice set their vision or mission concerned with technology, leadership, market share, image, welfare of employees, etc.
Hence, the firm designs its strategy around such basic objectives in the areas of technology, production, purchase, marketing, finance, etc Therefore, the wealth maximization objective is the second level criterion which ensures to meet the minimum standard of the economic performance. As a matter of fact, the management is not only the agent of owners but also trustee for the owners. Hence, it is the responsibility of the management to harmonies the interests of owners with that of creditors, employees, government, society, etc.
- Van Horne, James C. (2002, Financial Management Policy, 12th edition, Prentice- Hall : New York
- Kenon, Arthur J. (2002), Foundation of Finance: The Logic and practice of Financial Management, Macmillan Publishing House USA.
- Khan, M.Y. (1995). Financial Managenient, McGraw-Hill: New York.
- Horngren Charles T, (2000), Introduction to Management Accounting, Irwin McGraw Hill : New York
- McAlpine, T.S. (1996). The Basic Arts of Accounting, Business Books, London
- Moor, Carl L. (1996). Managerial Accounting, South Western Publishing Co., Los Angeles.
- Prasanna, (1995). Managers’ Guide to Finance and Accounting, Harper and Row, New York
- Van Home, C. James, (2002). Financial Management and Policy, Wiley Publications, Santa Carla.
- Horngren, C.T., (2002). Accounting: A Managerial Emphasis, Prentice-Hall : New York
- Brigham Houston. J.F (1999). Fundamentals of Financial Management, Dryden Press: Florida.