Management accounting

Ethical conduct in management accounting

July 2016

Tim Fipps

MANAGEMENT ACCOUNTING

TABLE OF CONTENT
1. Introduction .................................................................................................................... 2
2. Definition of management accounting ........................................................................... 2
3. Ethical conduct standards for management accountants ................................................ 5
4. Review on ethical misconduct cases ............................................................................ 11
5. How management accountants can reduce ethical misconduct .................................... 14
6. Summary and conclusion ............................................................................................. 15
References ........................................................................................................................ 16

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1. Introduction

This paper reviews the ethical standards and rules of conduct imposed on management
accountants. Cases found in finance and accounting literature are referred.

2. Definition of management accounting

Management accounting is an area within accounting.

Accounting checks the financial health of a business, akin to medicine checking the health of
a person, and communicates this financial information to users such as shareholders and
managers [Elliott & Elliott, 2011, page 3].

2.1. Management accounting defined

The probably most important professional association of management accountants in the
U.S., the Institute of Management Accountants (IMA, 2008a), defines:
"Management accounting is a profession that involves partnering in management decision
making, devising planning and performance management systems, and providing expertise in
financial reporting and control to assist management in the formulation and implementation
of an organization's strategy".

2.2. Context and differentiation of management accounting

The field of accounting consists of three main areas: financial accounting, management
accounting, and auditing. [Horngren, Sundem & Stratton, 2002; Larson, Wild & Chiappetta,
2006; Zimmerman, 2000]
This classification is user-oriented.
Financial accounting is concerned with communicating accounting information to external
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parties.
Management accounting is concerned with generating accounting information for managers
inside the organization, to assist them in their decision-making and planning on operational
and strategic matters.
Auditing refers to examining the authenticity, usefulness and compliance of accounting
information.
Other areas of accounting include tax, treasury and controlling.
Management accounting information differs from financial accounting information in several
ways:
- Stockholders, creditors, and public authorities use financial accounting information which is
publicly reported.
- Only managers within the organization use management accounting information which is
privy to them.
- Financial accounting information is prepared and presented by reference to general financial
accounting standards, but management accounting information is put together based on the
specific requirements and purposes of managers.
- Financial accounting focuses on the organization as a whole (aggregated), but management
accounting provides information mainly at a disaggregated organization level, about
individual sub-units and activities such as the organization's divisions, operations, projects,
products and plants.
- Financial accounting information is historical, management accounting information is
primarily forward looking, on things that will affect the future of the organization.

2.3. What management accountants do

The management accounting process includes identifying, measuring, analyzing, interpreting
and communicating information.
Management accountants assist the organization's management in their decision-making, i.e.
in the formulation of policies and strategies and in the planning and control of the operations.
By way of
- measuring, calculating and reporting about economic activities within the organization,
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- including information relating to the costs and returns of products or services purchased and
produced by the organization as well as intended projects,
- using accounting information and techniques, i.p. financial and other decision oriented
information,
- compiled in investment appraisals, budgets, and costing reports,
management accountants inform the relevant business operation metrics to the management
which enable the latter to make their operational and strategic decisions.
Planning, costing, performance appraisal and operational control are the main areas of
management accounting activities:
- Planning and budgeting: deciding what products to make, where and when to make them,
determining the resources such as machinery, labor, materials required (a budget is the
quantitative expression of the business plan of operation)
- Costing and performance evaluation: evaluating the costs and profitability of individual
products and product lines, determining the relative contribution of different parts of the
organization such as "overheads"
- Operational control: knowing the relationships between outputs and inputs of production
and delivery, the amounts and completion stages of work-in-process on the factory floor,
ensuring a smooth flow of production, identifying bottlenecks
The main tasks and activities of management accountants include capital budgeting, margin
analysis, product costing/valuation, constraint analysis, and trend analysis / forecasting.
[Horngren, Sundem & Stratton, 2002; Larson, Wild & Chiappetta, 2006; Zimmerman, 2000]
Capital budgeting:
- determine the economic benefits and financing optimization for capital expenditure
decisions using metrics such as net present value and internal rate of return
Margin analysis:
- compute the profit or cash flow generated by the sale from a specific product, customer,
store or region
- compute the incremental benefit obtained by increasing sales based on breakeven analysis
Constraint analysis:
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- identify where constraints (bottlenecks) occur within the supply chain, production or sales
process, and ascertain the impact of these constraints on revenue, profit and cash flow
Product costing/valuation:
- establish the actual ("true") costs of products or services, including direct costs, and allocate
overhead charges
Trend analysis and forecasting:
- measure and analyze trendlines for costs, and investigate variances or deviations, using also
historical records for making projections

3. Ethical conduct standards for management accountants

Ethics are moral principles that govern human behavior, and this includes accountants as
much.

3.1. Ethics in decision-making and conduct

Ethics deals with human behavior in relation to what is morally considered good or bad, right
or wrong. To determine whether a decision is good or bad, the decision-maker must compare
his/her options with some standard of perfection the values and norms. However, the
decision-maker is required to assess the specific situation, the circumstances, and the parties
affected by the decision, as often such standard of perfection is not a statement of static
position. The decision-maker must then estimate the outcome of the decision and will be
responsible for its results.

3.2. Ethical standards and rules of conduct

As ethical behavior means human conduct guided by some standard of perfection in the form
of values and norms, responsible communities in the society have defined such standards, and
also have outlined rules of conduct.
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These communities recognize that living and working together, including doing business,
requires the understanding, the assimilation and the practice of such standards and rules, for
the society and its constituencies to function and to blossom. This includes the activities in
economy and business and their actors, among them the managers and all breeds of the world
of finance and money, hence also accountants. For the good of human society, they all shall
"play by the rules".

3.3. Why rules of conduct for accountants

Accountants serve the interests of many stakeholders in society, such as consumers,
investors, taxpayers, lenders, and the general public.
According to the International Federation of Accountants (IFAC), this requires two things
from accountants, concerning result and process: checking for net benefits, i.e. whether
benefits outweigh costs, and performing evaluations according to standards such as
competence, accountability, objectivity, and transparency [Verschoor, 2016].

3.4. and why rules of conduct for management accountants

Management accountants form a species of the accounting family which are employed to
serve the requirements of the organization they are attached to. They focus on providing
information to internal users and decision-makers. Business owners and decision-makers
require this information when reviewing business operations and making decisions, hence
this information is privileged and sensitive to the organization.
Someone my ask: Given that their addressees are internal to the organization, and their
reports are purpose-made, on the behest and on the specific requirements of the organization's
management, why do management accountants require rules of conduct? Shouldn't they just
follow the orders of their management? After all, management are the ones commissioning
the assignments and receiving their results.
Though the law provides a higher degree of freedom for the organization and presentation of
management accounting information, as compared to financial accounting, the management
accountants do not act in moral-free space.
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Management accounting's function is to provide information that facilitates and influences

decision-making in companies. The related relationships and dependencies and their
implications potentially involve a wide range of ethical issues, including objectivity and
honesty in conduct and reporting, confidentiality in disclosure and information utilization,
dysfunctional effects of incentive and performance appraisal systems, and questions of
corporate governance.
Since decisions depend on the information provided by management accountants, their
conduct has obviously an ethical dimension. [Nsor-Ambala & Onumah, 2015]
But ethical conduct is not easy
Threats to ethical conduct may arise from situations involving self-interest, self-review,
advocacy, familiarity, and intimidation [CCAB, 2011].
The commitment to the profession as well as to the employer can land management
accountants in situations subject to personal judgment, preferences, biases, discrepancies,
malpractices and conflicts [Ghose, 2015].
"Conicts of interest result when individuals reap inappropriate personal benets from their
acts in an ofcial capacity" [Larsen, 2005].
Studies have shown that management accountants have engaged in budget "slacking" and/or
"padding" [Hopwood, 1972], leading to managerial failures and other corporate failures,
blamed on "unforeseen or uncontrollable events", also using technical jargon to confuse
stakeholders [Nsor-Ambala & Onumah, 2015].
Exxon, WorldCom, and Global Crossing are examples of failing ethics and resulting failure
[Hunter, 2010].
Their professional pledge requires management accountants to report in full and without bias,
whether the information is positive or negative, and it requires them to abstain from
disclosing or using such internal information for personal gain. Failure to do so can
immediately destroy trust and can even have serious legal implications.
The loss of trust may not affect the implicated individuals, but also their colleagues, seniors,
employers, the whole profession (accountants, auditors, managers, ...), a whole industry
(financial services, ...), or a whole nation (please spare me from providing examples ...).
Accountants, including management accountants, command an art and science and a
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"language" that are cryptic to most normal human beings, bordering to appearing or indeed
being occult. Yet, these people juggle and deal with the very essence and lifeblood of the
economic beings, whether in the shape of the homo economicus, the corporation, the nation,
or even the world.
The results of their (accountants) exertions decide whether a product, a project, a division, or
indeed a whole organization will be created or built, will be continued and maintained, and
about financing and investment (spurring interest and action of individuals, corporations and
whole nations and even beyond).
These implications of the management accountants' activities and reports, their apparent
obscurity due to their intricacy, and the secrecy due to their privacy in addressee compel the
bodies representing them -- professional associations and educational institutions -- to devise,
disseminate and impose rules of conduct on their members, representatives and fellows.
The conduct rules serve to provide guidance on do's and don'ts to the practitioners, reminding
them on the implications and consequences of their activity, while they also serve the
professional community to repudiate or bar anyone violating them.
They also shall help their bit to provide a level playing field for the actors in the market,
which is supposed to be governed by fair competition.
Ethical standards in management accounting help managers and owners make business
decisions that are "by the rules". They help these actors and their organizations to abide by
the commonly established and accepted rules and to be "good citizens". They are part of
achieving commendable governance.

3.5. Standards & rules promulgated by professional associations

Professional associations of management accountants such as the Institute of Management
Accountants (IMA) in the U.S. issue codes of professional ethics for management
accountants. These are mandatory for their members. When joining the association or
renewing membership, IMA (Institute of Management Accountants) obliges its members to
behave ethically, according to the IMA Statement of Ethical Professional Practice (the
Statement).
Such code imposes responsibilities and duties on the management accountants towards the
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organizations for which they work for as well as towards the public. The code provides
explicit guidance on how management accountants should respond to questionable or clearly
improper financial or regulatory reporting practices in their organizations.
The Institute of Management Accountants, established in 1919 as resource for U.S.
accounting professionals, includes a commitment to maintaining Highest Standards of
Integrity and Trust as one of its core values [IMA, 2005]:
"Members of IMA shall behave ethically. A commitment to ethical professional practice
includes overarching principles that express our values, and standards that guide our conduct.
IMA's overarching ethical principles include: honesty, fairness, objectivity, and
responsibility. Members shall act in accordance with these principles and shall encourage
others within their organizations to adhere to them. A member's failure to comply with the
following standards may result in disciplinary action."
While rules require compliance in specific situations, values influence behavior in all
situations. Therefore, IMA ask their members to apply its standards as "personal values", for
all situations in work and life, and not only as rules that can be "comfortably" bent. [IMA,
2008b; Butler, 2003, in Greer & Lampe, 2008]
Other accounting associations demand similar conduct from their members, defining
principles and giving also many prescriptive rules.
"The Financial Executives International (FEI) Code of Ethics contains obligations for its
members that are very similar to those in the IMA Statement. These include honesty and
integrity, completeness of information, compliance with laws, action in good faith and due
care, and confidentiality." [Verschoor, 2016]
The Code of Ethics for Professional Accountants issued by International Federation of
Accountants (IFAC) defines the accountants duty "to act in the public interest" [IFAC,
2005].
The International Ethics Standards Board for Accountants (IESBA), a part of the
International Federation of Accountants (IFAC):
"The IESBA Handbook contains five fundamental ethical principles with which all
professional accountants are expected to comply, including those employed in business. The
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principles are integrity, objectivity, professional competence and due care, confidentiality,
and professional behavior." [Verschoor, 2016]

3.6. Four ethical conduct standards for management accountants

IMA (2005) defines four standards of ethical conduct to be used by management accountants:
competence, confidentiality, integrity, and credibility.
In addition, a second section of the code outlines procedures for dealing with instances of
ethical misconduct.
Competence
- Acquire professional expertise and continuously develop knowledge and skills.
- Use relevant and reliable information for analysis.
- Comply with laws, regulations, technical standards.
- Prepare reports and recommendations that are accurate, clear, concise and timely.
Confidentiality
- Refrain from disclosing confidential information except when authorized or legally
obligated to do so.
- Refrain from using (or even appearing to use) confidential information for unethical or
illegal advantage.
Integrity
- Address conflicts of interest, advise stakeholders about them, mitigate them, and avoid them
as much as possible.
- Avoid activities that would prejudice executing tasks in ethical manner.
- Be honest and "recognize and communicate professional limitations or other constraints that
would preclude responsible judgment or successful performance of an activity".
- Provide relevant information whether "good" or "bad", if any.
Credibility
- Communicate information fairly and objectively.
- Disclose fully all relevant information that could reasonably be expected to influence an
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intended user's understanding of the reports, comments, and recommendations presented.
- Disclose delays or deficiencies in information, timeliness, processing, or internal controls in
conformance with organization policy and/or applicable law.

4. Review on ethical misconduct cases

Many ethical misconduct cases are reported in the literature. Below four cases are reviewed,
and each case is discussed in terms of IMA's four ethical standards competence,
confidentiality, integrity, and credibility.

4.1. Case 1: Changing cost structure

when one manager wants to change the cost allocation system "on the fly".
Source: "All you have to do is rearrange the numbers" [Joseph, Pergola & Butler, 2010]
A firm is manufacturing and selling one product. Fearing the budgeted sales targets are not
attainable, the firm's head of sales is asking the accountant to shift the costs for maintenance
and quality control from variable to fixed, by changing operational practice from volumebased to time-based. The change would allow to maintain the contribution margin for the sold
product, while otherwise sales price would be too high and the sales volume could not be
achieved. He suggests the accountant to re-arrange the cost allocation structure while
maintaining the budgets as had been agreed, which the CEO would be "pleasantly surprised
... with the great results" at year-end.
Integrity: The case indicates that the head of sales wants to press ahead to enable him and his
department to achieve their objectives. The proposal is motivated by self-interest that might
lead to sub-optimization, to the detriment of the greater good.
Competence: The change in operations and costing might disregard cause and effect of
production quality.
Credibility: Shifting cost contributions may not be a fair and objective reflection of the costs.
Understanding and reviewing the operational processes and their adequate reflection in
costing and budgeting, and how objectives are set and meant to be achieved.
Competence & credibility: Recognizing his limits of knowledge (competence) and the
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complexity of the issue (credibility), changing the costing structure requires a fair and
objective review, with the involvement and contribution of all relevant parties (integrity), in
this case at least from sales, production, maintenance, quality, and the CEO.

4.2. Case 2: Cost allocation system

and how the choice of a cost allocation system can lead to over-production to increase
operating income.
A firm uses absorption costing for measuring the divisions' performance. The performance
review revealed that finished goods inventories have ballooned over the year, due to excess
productions. This has resulted in lower unit costs of goods and hence higher operating
income. The latter has been a performance indicator for division managers.
Competence: Cost allocation method and performance appraisal show some misalignment.
Unlike variable costing, the absorption costing method (i.e. full costing) allocates also the
fixed overheads into the product cost. Therefore, unit costs can be decreased just by
increasing current production, i.e. by over-producing, hence building finished goods
inventories if sales are constant [Horngren, Sundem & Stratton, 2002, p. 609; Kaplan &
Atkinson, 1998, p. 504; Zimmerman, 2000, p. 496]. The lower costs of goods yield a higher
operating income.
Integrity: The costing method allowed division managers to "game" the production volumes
to augment their performance review, at the expense of increased (and probably useless)
inventories.
Credibility: For the economic health of the firm, the weakness in performance appraisal
system within the firm has to be addressed, and the system has to be adapted, to delete
incentives to game the system and to attain results that objectively improve the firm's
performance.

4.3. Case 3: Cost allocation practice

when firms execute fixed-price contracts as well as cost-plus contracts.
Project contractors, especially those with public, government-financed customers, might
engage concurrently in several contracts. Such contracts can be fixed-price contracts or costplus contracts.
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The sales and project managements have the task to allocate the indirect costs (the overheads)
to the various projects.
Horngren, Datar & Foster (2003, p. 535) report a case of an airplane maker that builds
standard equipment for commercial clients under fixed-price contracts, and special equipment
for the air force under cost-plus contracts.
The allocation of overhead costs involves charging accounts of the various contracts,
knowing that shifting "indirect costs away from (fixed-price) commercial customers and to
the cost-plus contracts" would increase the firm's revenues and profit.
If management asks the accountants, would the latter arbitrarily re-arrange a cost allocation
procedure that is based on logical causality to one that is more arbitrary in order to increase
earnings by way of larger cost-based revenues?
The allocation of direct labour and overhead to costs of products and projects is often subject
to biased views and interests [Rogerson, 1992; Joseph, Pergola & Butler, 2010].
Competence: Accountants should understand the logical relationships between operations and
used resources, their costs, and how they contribute to the various projects and products.
Confidentiality: Contracts with public institutions might require the contractor to disclose
also information that would remain confidential in commercial business cases, such as how
costs are charged, which costs, etc, including the reasoning behind. The accountant would
have to stick to the logic of fair and objective allocation.
Integrity: Arbitrary cost allocation without or even against logical sense would be a
malpractice that discredits the honesty of the individuals involved and of the contractor, and
may even affect the customer who will have pains to justify the choice made for the contract.
Credibility: Inappropriate charging and communicating accordingly to the customer destroys
the credibility of the individuals involved and the whole organisation.
Management accountants must seek to design and implement costing and budgeting systems
that allocate costs, including indirect costs, to products in a fair, objective and logical manner.

4.4. Case 4: Valuation of inventory

when the senior manager is instructing the valuation of inventory.
The division manager of a firm asks the accountant to record the physical inventory. Some of
the items in the inventory are obviously obsolescent or have deteriorated due to long storage.
But the manager instructs the accountant to record all items at their original costs.
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Competence: Provide description of items that accurately reflects their status and should
affect their value. Obtain information in regards of usability and worth of the items in the
inventory.
Integrity: If unsure about the advised valuation, elaborate how the valuation has been arrived
and declare a limitation in judgement in regards of determining the technical and commercial
value of the items in the inventory. Advise the parties involved of the potential conflict of
interests.
Credibility: Address and communicate the information on the potentially differing valuation
fairly and objectively.

5. How management accountants can reduce ethical misconduct

Management accountants can reduce ethical misconduct. Four recommendations are given.

5.1. Recommendation 1: "climate of open house"

Cost allocation system and costing practice should reflect the logic of goods production and
service delivery. To enable all divisions, functions, etc to explain their operations, objectives
and planning, the management accountant should seek to create an open discussion with the
stakeholders, so that all relevant aspects can be considered in the costing.

5.2. Recommendation 2: Alignment of costing and incentives

To enable the various divisions and functions within the organization to aim for the same
overall objectives of the organization, the cost allocation system and costing practice should
be aligned with the incentive and performance appraisal system.

5.3. Recommendation 3: Independent review of self-appraisal

Studies on budgeting have shown how "budgetary slack" results when a subordinate him/herself furnishes the information for his/her performance evaluation, due to "information
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asymmetry" based on the subordinate's incentive to misrepresent production capabilities and
resource requirements [Chow, Cooper & Waller, 1988; Nouri, 1994; Stevens, 2002; Waller,
1988; Young, 1985].
Therefore, inputs from subordinates, as much as they are welcome from the perspective of
employee motivation, should be reviewed from an independent viewpoint.

5.4. Recommendation 4: Inventory

Amount of items in inventory as well as their valuation has to be regularly reviewed, to avoid
using it as "slack" and to avoid stacking unproductive assets.

6. Summary and conclusion

Management accounting information is privy (not public), purpose-made (not standard), on

individual tasks (dedicated for specific use, not only on the whole organization), and forward
looking (not only historical).
But management accountants have to act in ethical manner, due to the implications of their
information.
Accounting associations have commissioned ethical standards and rules of conduct.
Ethical standards in management accounting help accountants, managers and owners to make
business decisions that are "by the rules". They help these actors and their organizations to to
achieve commendable governance.

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