The Stream by River Logic

Reconciling Managerial and Financial Accounting

April 24, 2014 | By Brett Senentz

>In my efforts to develop and implement prescriptive modeling solutions to real business problems, recognizing the business context of the work can have huge implications on its success. 

One stakeholder who needs to be at least on board with prescriptive modeling (if not its champion) is the Chief Financial Officer (CFO). In addition to funding and working with financial data, prescriptive models will also require work of both business analysts and IS resources, at least one of which could be reporting up through the CFO.

Managerial and Financial Accounting

There is a large (but navigable) difference between managerial accounting and financial accounting.

Financial Accounting

Financial accounting follows GAAP. The reason financial accounting exists is to ensure legal compliance for how businesses track, recognize, and measure revenue, costs, depreciation, intangible assets, goodwill, etc. Governments and investors want all businesses to be measured on the same grading stick and to have confidence that financial measures can be compared across businesses. While the occasional pro-forma statement may be issued, financial accounting is primarily dealing with accounting for historical transactions. Everything must be accounted for. Everything must balance.

Managerial Accounting

In contrast, managerial accounting serves the decision-makers in the business in the interest of making the best business decisions. It does not serve shareholders, creditors, or public regulators. The data used is looking forward to upcoming decisions. The data is also specific to the business process and decision at-hand. Compared to financial data, the managerial accounting data will not necessarily match or account for every last penny.

This makes sense given that it is only for the decision at-hand. Nevertheless to make a good objective decision, we should be able to make the goal something easily measurable by and meaningful to the business - examples include net income or some other key financial metric.

Acknowledge the differences

In order to not scare the CFO, please recognize that these differences exist and that there are ways to meet the needs of business decision-making and financial accounting simultaneously. I have been in meetings (related to prescriptive modeling and not) where the discussion on why the allocation of fixed costs were not considered in the analysis takes over and derails that meeting or an entire project.

You must understand how important correctness and completeness is to financial accounting - remember everything must be accounted for and everything must balance. If you haven’t seen it, it is hard to convey the resistance and fear that can be generated when a CFO is confronted with a managerial decision-making approach that makes the “right” decisions by the “wrong” numbers.

If we only include those costs and pieces of the business related to the decision at hand and don’t include those that are fixed (e.g. won’t change regardless of the decision at hand) then we are at the risk of being right but not getting the buy-in of a key stakeholder.

There is a win-win in this dilemma, by creating models driven by managerial accounting while including the necessary fixed costs and accounting to report the solution in a way that reconciles with financial accounting. Though we may get there differently, good prescriptive modeling should include (or better yet have inherently built in) a way to see the total financial effects of the set of decisions on the business.

These should be comparable directly to financial statements for the business. Enterprise Optimizer (EO) by River Logic has the chart of accounts built-in and central to the optimization process through the use of net income as the objective function. By including both fixed and variable costs in the model, we get optimal solutions for the business while allowing for full pro-forma reporting of financials.

Closing Remarks

Don’t scare the CFO. If you take the approach I have outlined, at worst the CFO will be pleased about the uptick in financial performance and seek out the cause (if not aware already). At best, the CFO will become a champion of prescriptive modeling and make sure that it remains a key part of the business for a long time to come.

Grant Thorton

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