the Obsolescence of Cost Accounting Systems part 9
IX: The Practicality of Separation: Maintaining GAAP Compliance While Gaining Managerial Relevance
This is the critical discussion to address the CPA's institutional resistance, job security, and fear of non-compliance.
The Illusion of Necessity: The CPA operates under the misconception that the information used for GAAP financial reporting must be the same information used for internal management decisions [Smith (1999), 212, 223, 276, 368]. This belief leads companies to make internal management accounting subservient to external financial reporting [Johnson and Kaplan, 151].
The Misconception and the Decline of Management Accounting
The core issue facing modern business measurement systems is rooted in a fundamental error in thinking: the belief that internal reports used to manage a company must match the financial reports prepared for external parties.
The CPA operates under the misconception that the information used for GAAP financial reporting must be the same information used for internal management decisions [Smith (1999), 212, 223, 276, 368].
This belief is widespread [Johnson and Kaplan, 2; Smith (1999), 306, 371] and has caused the internal tools managers rely on to become inadequate for today's complex business environment [Johnson and Kaplan, 2].
A Historical Flaw: External Rules Take Over
The idea that management must use GAAP numbers for internal control is a relatively recent phenomenon [Johnson and Kaplan, 3].
Historically, cost accounts were created by managers and engineers to aid managerial decisions (such as pricing) and were kept separate from the official financial statements [Johnson and Kaplan, 16, 17]. These early management accounting systems developed specifically to monitor the efficiency and profitability of internal processes [Johnson and Kaplan, 3, 14, 23, 129].
This independent system changed dramatically during the early 20th century:
Rise of Public Ownership: As corporations sold shares to a wider public, the demand for financial reports audited by independent public accountants increased [Johnson and Kaplan, 18, 127].
Auditor Demands: Auditors and regulators, focused on protecting stockholders and creditors, insisted on "integrated" financial statements [Johnson and Kaplan, 18, 130, 131]. Integration meant that all cost figures, whether reported as assets or expenses, had to be traced back to the original historical cost transactions recorded in the company’s books [Johnson and Kaplan, 130, 131, 137, 392].
Subservience: Because maintaining parallel accounting systems was costly, managers eventually yielded the design of their internal cost management systems to financial accountants and auditors [Johnson and Kaplan, 19].
This belief leads companies to make internal management accounting subservient to external financial reporting [Johnson and Kaplan, 151].
Management accounting systems became little more than a by-product of the financial reporting process [Johnson and Kaplan, 147]. Since the goal of the resulting system was to value inventory and calculate historical cost of goods sold for external reporting (GAAP compliance) [Johnson and Kaplan, 135, 136, 148, 267], the internal system lost its relevance for guiding day-to-day decisions [Johnson and Kaplan, 3, 136, 144].
The Failure of GAAP Numbers for Management
The information mandated by GAAP is designed to be objective, auditable, and consistent [Johnson and Kaplan, 131, 376]. However, these very qualities make the information largely useless for internal managers who need information that is relevant, timely, and focused on future profitability [Smith (1999), 307, 365; Johnson and Kaplan, 6, 10].
Why GAAP Data is Dysfunctional
Reliance on the GAAP-driven system creates management problems primarily because the resulting figures are flawed in two key ways:
1. Too Slow and Aggregated: Financial reporting is driven by the cycle of the profit and loss statement, usually monthly or quarterly [Johnson and Kaplan, 6, 194, 226]. This cost information is produced too late and at too aggregate a level to help managers make real-time decisions necessary for operational control [Johnson and Kaplan, 6, 194, 226, 228]. For instance, a production manager dealing with an efficiency problem needs data daily or hourly; receiving a compiled monthly report in the middle of the following month is useless for fixing a current issue [Johnson and Kaplan, 184, 185, 225].
2. Too Distorted by Arbitrary Allocation: GAAP requires the calculation of fully absorbed cost for inventory valuation, which means large, fixed factory expenses (overhead) must be assigned to individual products [Johnson and Kaplan, 7, 18, 128]. This allocation is often accomplished using simplistic and arbitrary measures, such as direct labor hours [Johnson and Kaplan, 7, 133].
This process results in calculated "product costs" that are systematically biased and distorted [Johnson and Kaplan, 7, 12, 266]:
For example, if a firm allocates factory overhead based on labor hours, a product that is simple to make but uses a lot of labor will be arbitrarily assigned a huge portion of the overhead, making it appear artificially expensive (a cross subsidy) [Johnson and Kaplan, 7].
Relying on this misleading and irrelevant cost information leads to misguided decisions on pricing, product mix, and how to respond to rivals [Johnson and Kaplan, 7, 12, 124, 228].
Driving Illogical Behavior (Examples)
By making management accounting subservient to financial reporting, companies reward managers for actions that damage the long-term health of the firm:
Short-Term Sacrifice: Managers under pressure to meet aggressive short-term ROI targets may reduce "discretionary investments" (like R&D, maintenance, and training) [Johnson and Kaplan, 8, 9, 201]. Since GAAP requires these investments to be expensed immediately in the current period, cutting them artificially boostsreported short-term profits, even though the company is compromising its long-term competitive ability [Johnson and Kaplan, 6, 9, 198, 201].
The Inventory Trap: Standard financial reporting rules reward the building of inventory [Smith (1999), 402]. This is because the fixed overhead cost is shifted from the income statement (as an expense) to the balance sheet (as an asset, part of inventory value) [Smith (1999), 401]. This creates a powerful incentive to overproduce and hide declining profits by building inventory, generating "false profit" through accounting manipulation, even though the company's real cash flow health is deteriorating [Smith (1999), 325, 388, 391, 401].
The goal of management accounting is to provide information for decisions that maximize return on investment (ROI) [Smith (1999), 305, 375]. By allowing the external reporting system to dictate internal practices, managers are using historical cost data that are demonstrably wrong for operational and strategic decisions [Smith (1999), 371]. The recommended solution is to adopt systems like Throughput Accounting internally and use a simple reconciliation process at month-end to satisfy GAAP for external reporting [Smith (1999), 316, 377, 379, 429].
The Simple Bridge: Demonstrate that maintaining both GAAP compliance and management relevance is possible and simple [Smith (1999), 282, 284]. The solution is to use Throughput Accounting (or direct costing)as the primary internal reporting format for decision-making, and then convert this information to full-absorption GAAP at month-end using a simple reconciliation bridge [Smith (1999), 224, 284, 369].
Why Management Needs Different Numbers and How to Get Them
A common and costly issue in business is the widespread belief that the financial information used for external reporting must also be used to manage the company internally [Smith (1999), 212, 276, 368]. This mindset forces internal management reporting to become secondary to the requirements of external financial reporting [Johnson and Kaplan, 151].
However, the sources demonstrate that it is both possible and simple to maintain systems that satisfy both external auditing requirements and internal management's need for relevant data [Smith (1999), 282, 284].
The Need for Two Different Views
The essential difficulty is that external financial reporting rules (Generally Accepted Accounting Principles, or GAAP) and internal managerial decision-making have fundamentally different goals:
GAAP (External Reporting): GAAP’s purpose is to report the company’s past historical performance in a consistent, objective, and verifiable manner for external stakeholders like investors, creditors, and regulatory agencies [Smith (1999), 363, 365, 408; Johnson and Kaplan, 17, 131]. It must compile costs using full-absorption accounting, which means assigning fixed factory overhead to every product unit in inventory [Smith (1999), 408, 411; Johnson and Kaplan, 7].
Management (Internal Decisions): Managers need information that is forward-looking, timely, and relevant to decide how to maximize future profit [Smith (1999), 307, 330, 363, 365]. GAAP information is too distorted, too aggregated, and too late to be useful for daily operational control or strategic planning [Johnson and Kaplan, 7].
Because GAAP reports are inadequate for decision-making and because external compliance is mandatory for doing business, the organization must adopt a dual approach:
Both GAAP compliance and throughput accounting are necessary conditions for companies to do business successfully [Smith (1999), 344].
The Internal Solution: Throughput Accounting
The recommended solution for internal management reporting is to adopt a system based on Throughput Accounting (TA), which is essentially the same as direct costing or variable costing taught in management accounting textbooks [Smith (1999), 327, 407].
The solution is to use Throughput Accounting (or direct costing) as the primary internal reporting format for decision-making... [Smith (1999), 284, 369].
TA (or direct costing) is preferred internally for several reasons:
Relevance: TA focuses on truly relevant costs—those that change directly with production volume, primarily raw materials [Smith (1999), 410, 415; Noreen, Smith, and Mackey (1995), 498].
Cash Flow: TA is closer to a cash flow concept of income because fixed expenses (like salaries, rent, and utilities) are immediately recognized in the period they occur, not capitalized in inventory [Smith (1999), 411; Noreen, Smith, and Mackey (1995), 481, 503].
Better Behavior: TA does not create incentives to build up inventories [Noreen, Smith, and Mackey (1995), 481]. Because fixed costs cannot be hidden in inventory, TA prevents the dysfunctional behavior often encouraged by full-absorption GAAP, which allows companies to manipulate short-run reported profit by overproducing [Smith (1999), 365, 391].
By making TA the standard internal reporting format, the company avoids the confusion and pitfalls associated with GAAP’s standard costing information [Smith (1999), 409].
The Simple Reconciliation Bridge
The reason managers resist adopting a dual system is the misconception that they would need to maintain two complicated, integrated sets of books [Smith (1999), 408]. The sources argue that the reconciliation process is actually straightforward and already common practice [Smith (1999), 276, 277].
...then convert this information to full-absorption GAAP at month-end using a simple reconciliation bridge [Smith (1999), 224, 284, 369].
The reconciliation bridge uses a routine adjustment process that is already known by every CPA practice dealing with small manufacturing firms [Smith (1999), 276, 346]. This approach is simple, effective, elegant, and inexpensive, requiring no complex software investment [Smith (1999), 277].
How the Bridge Works: Timing Differences
The key to the reconciliation is understanding that the difference between the two systems is fundamentally a timing difference regarding when fixed manufacturing costs are recognized as expenses [Smith (1999), 411, 413].
Throughput Accounting (TA): Fixed manufacturing overhead is expensed in the period it is incurred. Inventory is valued using variable costs only (e.g., raw materials) [Smith (1999), 411, 413].
Full-Absorption GAAP: Fixed manufacturing overhead is assigned to the product and carried as part of the inventory valuation until the product is sold [Smith (1999), 411]. It is only expensed as cost of sales when the product leaves inventory.
The difference in reported net income between the two methods is solely due to the decision to build inventory(or draw it down) and how the overhead cost is assigned to that inventory [Smith (1999), 369, 370].
The Reconciliation Procedure: The reconciliation schedule calculates the change in the value of fixed costs (labor and overhead) embedded in the inventory between the start of the reporting period and the end of the period [Smith (1999), 413, 418]. This simple calculation converts the internally generated TA statement into a GAAP-compliant absorption statement [Smith (1999), 414].
If inventory levels increase, fixed costs are temporarily held as an asset under GAAP, leading to a higher reported profit than under TA.
If inventory levels decrease, stored fixed costs are released as expenses under GAAP, leading to a lower reported profit than under TA.
Crucially, the total gross profit and net profit amounts are the same under both scenarios after the reconciliation adjustment is made [Smith (1999), 418, 419].
Example: Imagine a company maintains its internal system on a throughput basis. At the end of the month, the accountant finds that inventory volume increased. To satisfy GAAP, the accountant simply calculates the amount of fixed overhead that must be moved from the current period’s operating expenses and added to the value of the ending inventory asset. This simple, routine calculation satisfies external auditors, while management retains the timely, relevant TA data needed for strategic decisions, such as which products to emphasize based on contribution margin (throughput) per limiting resource unit [Smith (1999), 420]. This approach allows management to focus and leverage its resources for maximum return on investment (ROI) while still meeting financial reporting obligations [Smith (1999), 282, 369].
The Auditor's Acceptance: Crucially, this reconciliation process is not new or complex; it is performed by every small accounting firm with cash-basis clients [Smith (1999), 284]. The reconciliation methodology, using direct costing internally and converting to GAAP externally, has been successfully reviewed and approved by "Big 5" accounting firms [Smith (1999), 371]. This removes the CPA’s fear of regulatory and professional sanction.
The Simple, Proven Way to Satisfy Both Managers and Auditors
The necessity for companies to maintain systems that produce information relevant for internal managers while simultaneously complying with external financial rules creates the well-known "accounting dilemma" [Smith (1999), 370, 371]. This dilemma requires solving two necessary, but seemingly conflicting, requirements: providing internal management information and achieving external compliance [Smith (1999), 373].
Why Managers Need Different Numbers
For internal management purposes, systems based on Throughput Accounting (TA) or direct costing are preferred because they provide relevant, timely, and focused information necessary for decision-making [Smith (1999), 327, 407, 409]. This internal system supports key strategic decisions, such as which products to emphasize, by focusing on Throughput (revenue minus truly variable costs, usually just materials) generated by the company’s limited resources [Smith (1999), 327, 427].
In contrast, Generally Accepted Accounting Principles (GAAP) requires that fixed manufacturing overhead expenses be fully absorbed, or assigned, to every product unit in inventory [Smith (1999), 408, 411]. This external reporting method is necessary to satisfy outside reporting requirements (for stakeholders like investors, creditors, and regulatory agencies) [Smith (1999), 371, 421]. However, this method distorts product costs and rewards the creation of excess inventory, leading to dysfunctional management decisions [Smith (1999), 365, 391].
The Solution: A Simple Bridge
Since GAAP compliance and throughput accounting are both necessary conditions for successful business operation, the solution is not to merge them into one flawed system, but to keep them separate for their respective purposes [Smith (1999), 373].
The method to achieve this is surprisingly simple:
Maintain systems on a Throughput Accounting basis for internal management, and convert using a simple month-end reconciliation to satisfy GAAP for external reporting [Smith (1999), 224, 369].
There is a widespread misconception that a company needs to maintain two sets of complicated, integrated books for TA and GAAP reporting to coexist [Smith (1999), 408, 421]. However, this reconciliation process is not new or complex[Smith (1999), 284, 375].
In fact, the reconciliation methodology is already routine and is performed by every small accounting firm with cash-basis clients [Smith (1999), 284, 375]. This straightforward approach is described as simple, effective, elegant, and inexpensive, requiring no complex software investment [Smith (1999), 277].
The Mechanism and Removal of Regulatory Fear
The reconciliation bridge is possible because the difference between Throughput Accounting profit and GAAP profit is merely a timing difference in recognizing fixed manufacturing overhead costs [Smith (1999), 411, 423, 425].
The Timing Difference
Under Throughput Accounting (TA): Fixed manufacturing overhead is treated as an Operating Expense and is fully expensed in the period it is incurred [Smith (1999), 411, 423]. Inventory is valued using variable costs only(e.g., raw materials) [Smith (1999), 425].
Under Full-Absorption GAAP: Fixed manufacturing overhead is assigned to the product (unitized) and carried as part of the inventory valuation until the product is sold [Smith (1999), 411, 423]. It is only recognized as Cost of Sales when the product is shipped [Smith (1999), 423].
The reconciliation bridge only needs to determine the change in the fixed cost component of inventory:
The difference between throughput and full-absorption accounting is simply a timing difference in regard to when the manufacturing fixed costs will appear as an expense in the financial income statement [Smith (1999), 425].
The Reconciliation Procedure:
The reconciliation involves calculating the change in the dollar value of labor and overhead embedded in the inventory between the start and the end of the period [Smith (1999), 413, 429].
Example: If inventory levels increase during the month, the fixed overhead costs associated with that inventory must be moved from the current period’s operating expenses (where TA left them) and added to the inventory asset on the balance sheet to satisfy GAAP.
Once this calculation is performed, the total gross profit and net profit amounts are the same under both scenarios [Smith (1999), 418, 419, 429].
Removing the Fear of Regulatory Sanction
The major resistance to adopting this simple approach often stems from the CPA's (Certified Public Accountant's) deep concern that using anything other than the traditional full-absorption system internally might invite scrutiny or penalty from auditors or regulators [Smith (1999), 371].
This fear of professional or regulatory sanction is alleviated because the reconciliation methodology:
...using direct costing internally and converting to GAAP externally, has been successfully reviewed and approved by "Big 5" accounting firms [Smith (1999), 371].
In one example, a company that used a throughput basis for internal accounting successfully converted to full-absorption GAAP with a relatively simple month-end adjustment. The company's accounting system, controls, and procedures for this reconciliation were reviewed annually and approved by a “Big 5” accounting firm [Smith (1999), 426].
This professional validation confirms that the internal use of relevant management information (TA/direct costing) is perfectly permissible, provided that the necessary reconciliation is performed at the end of the reporting period to ensure the final external statements comply with GAAP [Smith (1999), 371, 426]. This assures management and accountants that they can use the right tool internally (direct costing) without jeopardizing their external reporting compliance.
By emphasizing the practicality, simplicity, and professional acceptance of separating the systems (Focus Topic 9), and by appealing to the highest economic logic regarding scarcity and efficiency (Focus Topic 7), the CPA can see a path forward that preserves professional integrity and enhances the business, rather than threatening the established institutional order.
Reference books
Relevance Lost: The Rise and Fall of Management Accounting – 1987 by H. Thomas Johnson , Robert S. Kaplan
H. Thomas Johnson (April 18, 1938 – July 3, 2024) was an American accounting historian, and Professor of Business Administration at Portland State University, A 2003 survey by Harvard Business School Press placed him among the 200 leading management thinkers living today. The American Society for Quality awarded him the Deming Medal in 2008, and in 2007 he received a distinguished lifetime achievement award from the American Accounting Association.
Robert Samuel Kaplan (born 1940) is an American accounting academic, and Emeritus Professor of Leadership Development at the Harvard Business School. He is known as co-creator of Balanced Scorecard
The Theory of Constraints and Its Implications for Management Accounting , 1995 by Eric W. Noreen, Debra A. Smith, James T. (Cor) MacKey
Eric W. Noreen (B.A. University of Washington, M.B.A. and Ph.D. Stanford University) is the Accounting Circle Professor of Accounting, Fox School of Business, Temple University. He has taught at INSEAD in France and the Hong Kong Institute of Science and Technology.
Debra Smith is a co- founder and partner of Constraints Management Group (CMG), Debra has extensive experience in public accounting (Deloitte Touche), teaching at University of Puget Sound and University of Washington. She began working with Dr. Eli Goldratt in 1990.
James (Jim) T. Mackey. Professor of Accountancy, California State U.-Sacramento
The Measurement Nightmare: How the Theory of Constraints Can Resolve Conflicting Strategies, Policies, and Measures, 1999 by Debra Smith
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