INTERNAL ACCOUNTING ENGINEERING

Table of Contents

1. What is Internal Accounting?

2. What are the differences between Financial and Internal Accounting?

3. What is the Manager's role, and what benefits are obtained from using an Internal Accounting System.

4. Why do some companies still use a General Accounting system for Cost Accounting

5. Certainly many companies today try to do some kind of internal accounting or reporting to measure how well certain departments or products are doing.  How is this method different from how these companies are doing cost accounting?

6. What do academic professionals have to say about Dr. Schwarz research work?

7. What is the difference between Cost Accounting and Internal Accounting?

8. Where can one learn more about Internal Accounting?

What is Internal Accounting?

General Accounting is strictly for Financial and External analysis - and was never meant to be used for managerial cost accounting. During the last 15 years many articles have been written about the need to separate External from Internal Accounting.

My research project has studied this necessity - and I have developed an Internal accounting structure, totally integrated yet separate from General Accounting. A new Chart of Accounts has been structured – specifically for Internal Accounting use.

This Internal Chart of accounts - starts with the accounts showing the Cost Elements for the period. These Cost elements should be identified as Direct and Indirect Costs. The Indirect cost will be allocated to the different Departments in our company.

We recommend strongly, to no longer use the term called Overhead. This term is absolutely inadequate.

With accounts prepared for all departments - we have created a clear picture of a Responsibility Accounting system. For management this Responsibility Accounting structure provides important information that is today unavailable from traditional cost systems. With this new structure we incorporate a comprehensive RE-ALLOCATION system.

Next we have developed the Class of Accounts that correspond to the Functional Activities where we have set up production accounts; for each product that we produce, cost of maintenance (preventive) and repair and for our own internal production (if we produce our own tools, etc.).

We reject the term Work in Process Inventory.

Today this WIP Inventory is used to show the production cost of the month. University professors have created this WIP Inventory account - so they may use it as an Asset account. As these Professors did not have Internal Accounting - this term was created from necessity, and then included in this term the word Inventory - which is totally wrong. Nobody is making an inventory of these products in process. We have these product just during one nighttime - the next day - these work in process has changed.

We have created a totally new concept of Internal Accounting. We arrive at different cost for our production - because we have several Direct Production Departments - and use not just one Overhead account. Our present conventional methods are absolutely obsolete.

With Internal Accounting we are prepared to establish Absorption and Variances costing. This information provides Management an absolutely invaluable and intimate view of the cost of production – something that could never be obtained from External Accounting.

This detailed information is provided in reports specifically designed for department managers.

Internal Accounting Cost-flow can be quantified and schematized so precisely that it will help students understand the various transactions within Internal Accounting, and also help managers and supervisors understand internal cost-flow and instill in them the proper cost awareness.

These, then, are the five basic Internal Accounting Principles:

1. Internal Accounting shows specific costs matching the month of accounting. These costs are the expired portion of expenditures accrued in External Accounting.

2. Internal Accounting includes procedures for Allocating costs to Departments or directly to Production Cost Accounts. 

3. Production Cost accounts control maintenance, repair, and internal production.

4. Internal Accounting supports an internal machine lease procedure.

5. Internal Accounting includes a Cost of Capital account for each product. This is a totally new concept for modern production Cost accounting.

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What are the differences between Financial and Internal Accounting?

External accounting represents the everyday general accounts; GL, AR, AP and Fixed Assets. These basic systems, designed generations ago, were not originally meant for internal accounting ,( which aims to provide internal information to managers about the cost of production), but were intended financial reports for bankers, stockholders, etc., and that is why they are termed External Accounting. The internal world has not been afforded in the United States the same scientific attention that the external accounting has received. External accounting has the Income Statement, Balance Sheet, Profit and Loss Statement, standard ledgers and journals, etc., but there are no standards in place today for internal accounting.

Internal accounting consists of a set of structured accounts, designed to mirror a companies business.

Accounts are set up for cost elements (expenses from external accounting), departments (cost centers), functional activities and production accounts. By preparing budget amounts for cost allocation, reallocation and absorption accounts, internal accounting systematically assigns the cost elements to a department, then reallocates some of these costs to the appropriate departments (based on a mapping of internal accounts), before absorbing costs to an appropriate production account. Every step is orderly, account based (debits and credits), and done on a foundation of a structured set of internal accounts, designed to provide management with the information they need to manage costs.

The detail information provided to managers from such a system cannot be over-estimated. Such rich detail, uniformity and reporting of internal cost accounting information designed with a managerial emphasis.

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What is the Manager's role, and what benefits are obtained from using an Internal Accounting system?

The internal accounting structure (the chart of accounts) is designed to show how much of the expense of the month corresponds to internal accounting (cost elements), and which of these costs correspond to the indirect relationships of these costs to their activities. If the activity is not to produce, but to provide a service, a company must still know what it costs to provide this service. To accomplish this, the cost elements must be divided into those that are directly related to the activity, and those that are indirectly related to their activity. This important information, designed for management, provides a clear understanding of how costs are related to their organization. Intuitively, this information will help the Sales, Production, Administrative, Service, Purchasing and Planning Manager to see how powerful an internal accounting structure can be toward controlling costs within the company. The manager who is in charge is able to see his department’s costs in relation to the budget he has prepared, providing him with a clear visibility on the costs affecting his department, and the ultimate cost of those functional activities that are necessary to provide the service or product for the company.

Traditionally, management focuses on the profit and loss statement to determine the financial health of the company. Together with a company’s revenue, the Cost of Goods Sold is represented as a lump sum on the income statement. While this is acceptable for external purposes, Managers need to know how much of these costs are fixed, in relation to the final cost objective, and how much are variable in relation to the final cost objective, so that when a new budget is being prepared, managers have the necessary information to support importance decisions in running the company;

For example;

A Company expects sales to increase next year by 20%. Using Internal accounting the manager knows that the Cost of Goods Sold will increase not by another 20%, but only the direct costs (variable cost) will increase by this amount, and the fixed cost will increase by say 2%. Managers need to know the basics of fixed and variable costs, and have access to the information of how we arrived at the Cost of Goods Sold in detail.

In a traditional Profit and Loss statement, the Cost of Goods are only those costs that are directly related to the cost of the product or service, and the other overhead expenses are separated into other identifiable accounts that are not directly related to the cost of the product or service. General accounting is interested in working only with variable costs, taking these variable costs as Cost of Goods Sold and taking all other costs (Administrative and Manufacturing fixed cost), as a lump sum. This is too simplified for managers.

To determine the true cost of manufacturing a product or providing a service requires detailed information that is not easily presented in traditional cost accounting systems. The cost of a product is not just the cost of Direct Labor and raw material. The true cost is obtained only when the real overhead costs are added, those costs related to the production departments, service and indirect departments.

The lack of clear information in traditional cost accounting systems, has given rise to very specialized industries that attempt to bridge this gap, through non-accounting methods. One example is Activity Based Costing (ABC), where it is acknowledged that the Cost of Goods Sold is not comprised of just direct cost and the lump sum of indirect cost.

Typically, Department heads, Production and Sales managers are not necessarily inclined toward the details of accounting. One reason is that the information provided in current cost accounting systems is not directly related to their daily functions.

An understanding of Internal Accounting changes this, in that managers see clearly how they have direct responsibility towards the final cost objective. They must be aware of which products are making a profit, which are breaking even, and which are losing money, so that appropriate action can be taken. All employees of a company are affected by the decisions based on this information. 

To be effective in today’s market place, companies need to be able to track costs at the lowest levels of detail. Managers need a clear picture of their Internal accounting. An internal chart of accounts that identifies the cost elements, cost centers, functional activities and production accounts is a necessity.

The need to develop an awareness of how this information can be used to maintain a strong presence in a global economy is can no longer be taken for granted.

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Why do some companies still use a General Accounting system for Cost Accounting?

The simple answer is that Cost Accounting as it has been taught in our Universities over the past generation has failed.  One might wonder why more thought and process has not been applied in relation to internal accounting.

We have seen in books like professor’s Robert Kaplan and Thomas Johnson’s ‘Relevance Lost’ and ‘Advanced Managerial Accounting’, that they are giving a clear statement that CPA’s in the United States, while doing a wonderful work relating to financial accounting, are not prepared to work with internal accounting. Evidence of this is that there has been no ‘push’ in academia toward the creation of Responsibility Centers in cost accounting. Today our most advanced cost accounting books still teach the use of a single overhead account, with no further detail. Professor Kaplan’s remarks that we need to ‘develop new points of view that will refer to the needs of internal management.’ are evidence that today’s cost accountants have not been properly trained in the intimate points of cost accounting.

With today's total lack of Internal Accounting,  Managers are not receiving reports based on a Responsibility Accounting system.  This information has never been accepted in our industries  - because the present accounting structure that is taught in our educational centers has created the notion of having one Overhead account.

This procedure is unacceptable  and is creating fictitious information.

The concept of a single plant wide absorption rate - is misleading management into making incorrect decisions -  while the correct information will lead to higher net profits for our companies.

As Internal Accounting has created a special Class of accounts for Functional Activities  - management will turn away from  the Work in Process Inventory account.

This new Internal Accounting system will provide management with very important and reliable information about the Production Cost of the different Job Orders.  This important and detailed production cost information - will identify, and help to increase the actual profit per unit of production.               

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Certainly many companies today try to do some kind of internal accounting, or reporting to measure how well certain departments or products are doing.  How is the this method different from how these companies are doing cost accounting?

It is different in a number of ways. Internal accounting defines Work in Process and Overhead very differently than is currently recognized. Today Overhead and Work in Process are managed within the structure of external accounting, somewhere between expenses and inventory. Internal accounting has a different approach. It utilizes a complete set of accounts for production, specific accounts dedicated to responsibility centers and cost elements. For example, internal accounting divides departmental costs by Administrative, Sales, Direct and Indirect Labor as usual, but makes special provisions for Maintenance, Repair and Service Departments, then systematically and automatically reallocates these costs back to the responsible Direct departments. Internal Accounting is handling what used to be called Overhead, and allocation of labor in a formal, standardized accounting method. It does this within a comprehensive, cohesive and structured chart of accounts.

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What do academic professionals have to say about Dr. Schwarz Internal Accounting research?

Robert S. Kaplan; Dean - Harvard Business School:

"I am in full agreement with the need to keep internal records in more detail than what may be necessary to produce Income Statements and Balance Sheets... Your proposal to keep cost components in separate categories so they can be analyzed better for management purposes is a fine one."

S. Warren; CPA, Ph.D. - University of Georgia:

"In my opinion the system based approach is the approach that will dominate the future. Your manuscript will be viewed by some as revolutionary, but I encourage its publication."

Steven A Moscovie; - University of Nevada:

"I have read over your working paper and thought it was excellent. I agree completely with the importance and value of an integrated type accounting system ."

Herbert E. Norse; President - National Association of Accountants:

"Certainly I can accept your basic thesis, that the production accounts serve a distinct purpose, and should be isolated from the external accounts ."

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In principle, Cost Accounting and Internal Accounting have the same objectives. The considerable difference, is that Internal Accounting requires a specific detailed Chart of Accounts configured from a company's internal structure, and integrates a precise methodology of accounting principles and procedures using that structure to arrive at the most accurate cost of product.

The definition of Cost Accounting as established in the Management Accounting Terminology booklet, reads:

"It is a technique or method for determining the cost of a process...  the Cost is determined by direct measurement, systematic assignment and rational allocation."

To be most effective, the technique, method, measurement, assignment and allocation requires a very special accounting structure.

The necessary internal procedures and transactions belong to a whole new system arrangement.  A new Internal Chart of Accounts.

We will NOT be able to establish a good picture of these procedures if we ONLY USE the Financial Accounting flowchart, because the External Accounting was never  meant to be Cost Accounting.

What system would we have to build in order to comply with these needs and requirements?

A new Chart of Accounts  -  specifically structured for INTERNAL ACCOUNTING  with accounts for Cost Elements, Departments,  Functional Activities, Re-Allocation and a detailed structure for Absorption Costing.

Within Cost Accounting,  or as it may be called  "Internal Accounting",  we have to use an absolutely different approach to questions of evaluations of production costs compared to the general views expressed in GAAP.

The rules and regulations within Internal Accounting must provide specific information for internal use within a company.

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I.A.E.
Copyright © 2000  [Internal Accounting Engineers]. All rights reserved.
Revised: May 18, 2002 .