Internal Accounting

Purpose of Internal Accounting

Analysis Made for the Internal Accounting Configuration
By Emanuel Schwarz

Feb. 28, 2000 (Pro2Net) — Past articles have examined the importance of creating a specific Internal Accounting structure. This refers not only to establishing a few accounts with their subsidiary accounts, but to produce a whole new Chart of Accounts related strictly to the information needs expressed by management interested in good internal managerial reports.

General Accounting, established nearly a century ago, has primarily focused on Financial and External Accounting, catering to external stakeholders interested in a company’s economic position. As a result, External Accounting was never designed as an internal cost-related system, leaving a gap in managerial cost analysis and operational financial management.

As a result, CPAs and auditing firms have spent the past 90 years largely neglecting the development of a robust Internal Accounting structure for manufacturing industries, leaving businesses without the tailored financial tools needed for effective cost management and operational control.

Financial Accounting terminology remains insufficient for addressing true internal cost structures. Terms like “overhead accounts” and “work in process inventory accounts” were originally introduced by general accountants to fit within Financial Accounting frameworks rather than to support a dedicated Internal Accounting system. As a result, these terms fail to provide the depth needed for comprehensive managerial cost analysis and operational decision-making.

Financial Accountants said these few subsidiary accounts would be good enough for managerial information. Unfortunately, these statements were not at all correct.

For seven decades, university professors have failed to establish a true Internal Accounting framework. Even in its most recent editions, Stanford University’s cost accounting books continue to feature the same transaction graphics as they did 40 years ago—an ongoing issue seen across major universities throughout the United States.

These criticisms are not mine alone. There are other professionals that agree about the need to have a specific Chart of Accounts for Internal Accounting… many voices calling for an important change in accounting education and a professional approach to Internal Accounting.
James A. Brimson and Callie Berliner CMA-I, Arlington, Texas: “Management Accounting”, March 1988:
“We believe that the authors of ‘In Defense of Management Accounting’ did an extremely poor job of supporting their thesis that management accounting does not need to undergo major changes. They present a naive belief that management accounting is practiced according to the broad definitions on which the article dwells. This is contrary to our experience. The dissatisfaction with current management accounting systems is evidenced by:
  • Cost management seminars which are sold out months in advance.
  • A 1986 CMA-I survey which found that 62 % of the respondents were dissatisfied with cost reporting."
Robert S. Kaplan Professor at Harvard University In his article: “Yesterday’s Accounting Undermines Production”
“Efforts to revitalize manufacturing industries cannot succeed if outdated accounting and control systems remain unchanged. Many U.S. companies are now exploiting new process technologies… but these developments, promising as they are, rest on a foundation that is obsolete and in need of repair. Most accounting and control system have major problems: they distort product costs, they do not produce the key non financial data required for effective and efficient operations; and the data they do produce reflect external reporting requirements far more than they do the reality of the new manufacturing environment. Most companies still use the same cost accounting and management control system that were developed decades ago for a competitive environment drastically different from that of today.”
Robert S. Kaplan Professor at Harvard University In his article ” One Cost System is not Enough” Harvard Business Review, January 1988
“Are managers getting the information they need to value inventory, control operations and measure product costs? Many companies now recognize that their cost systems are inadequate for today’s powerful competition. Systems designed mainly to value inventory for financial and tax statements are not giving managers the accurate and timely information they need to promote operating efficiencies and measure product costs.”

Developing an Internal Accounting Structure

Establishing an Internal Accounting structure requires a dedicated Chart of Accounts tailored to cost management and operational analysis. Meanwhile, External Accounting should continue to focus on traditional financial elements—Assets, Liabilities, Capital, Expenses, and Revenue—ensuring clarity for external stakeholders while maintaining distinct internal cost methodologies.

Internal Accounting should begin with the expired expense amounts—those directly tied to functional activities within a given accounting period. These amounts align with the matching principle in traditional accounting education, ensuring that costs are appropriately recognized in relation to revenue generation. By structuring expense recognition this way, businesses gain a clearer understanding of cost allocation and financial performance.

The initial classification of accounts, termed Cost Elements, encompasses all accounts essential for both Direct Costs and Indirect Costs. This structured approach ensures a clear distinction in cost allocation, facilitating accurate financial analysis and managerial decision-making.

After defining Cost Elements, Direct Costs are assigned to specific accounts within Class 5: Production Cost, ensuring precise tracking of expenses tied to manufacturing activities. Indirect Costs, meanwhile, are categorized accordingly and distributed across departments based on their functional relevance, supporting a structured and transparent Internal Accounting framework.

By following this process, accounts related to the Responsibility Accounting System are categorized under Class 3. Meanwhile, in Class 4, the operating costs of direct production departments are systematically absorbed by the production completed within the designated time period, ensuring accurate cost allocation and financial transparency.

Departmental operating costs are allocated to various production accounts under Class 5, ensuring precise expense tracking. Upon completion, finished production is transferred from Class 6 to Inventory accounts in Class 7, maintaining a structured and transparent accounting flow.

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