Two-dimensional accounting: a new management demand.

Two-Dimensional Accounting: A New Management Demand

Management is tired of hearing accounting say "The information is not available," or "The time it will take is . . ." or "Accounting is too busy." Accounting cannot respond to management's informational needs. Since accounting cannot respond, management backs off from its "wants" to a different and lower level of informational requests that accounting can respond to. This is no good, because it keeps management from doing its job properly.

Accounting has done an excellent job of recording and presenting information for financial reporting purposes; however the financial reporting systems fail to respond to management's questions. The systems were not designed for it. Management requires responsiveness to its questions and the accounting systems must be redesigned to accommodate this need, in addition to accommodating financial reporting. It is obvious that accounting will not initiate this redesign because of organizational and behavioral reasons; and the responsibility falls on upper management to initiate this redesign.

There is a way for accounting to be responsive - two-dimensional accounting. To understand the difficulties with conventional accounting systems consider the following question: "How much do trade shows cost?" Conventional accounting systems can only partially answer this question - if they can at all.

When a trade show cost center (organization) or a trade show expense account is in the chart of accounts, some trade show expenses would be coded there, including space rentals, on-site advertising and possibly some salaries. However, travel to the trade show and entertainment most likely will be coded as travel expense, entertainment expense, or travel and entertainment expense, without any indication of the purpose of the trip. Some salaries of the participants, e.g. sales representatives, technical personnel, or trainees would be coded as salaries - each in their home department but not as trade show salaries. Literature, promotional items, and other expenses would be coded as individual expense items depending on their nature, with no recognition of the trade show function.

Two-dimensional accounting can cope with this situation because it codes both the function (trade shows) and the nature (salaries, travel, etc.) for each expense item. There are two classifications to detail expense coding: functional, e.g. manufacturing, marketing, administration, etc.; and natural, e.g. materials, wages, travel, etc. Two-dimensional accounting records both a functional and a natural code for each expense item. This allows management to ask questions about trade shows and obtain all of the natural expenses associated with them (one of which is travel) or ask questions about travel and obtain all of the functions which required travel (one of which is trade shows), or ask questions about travel to trade shows and obtain all of the costs associated with travel to trade shows.

The conventional chart of accounts can be made to accommodate all of these details only by assigning unique detail codes, which lengthens the number of accounts to be learned. Coding clerks and management reviewers of these codes have to know a long chart of accounts in order to identify the proper code. A long chart of accounts is prone to inaccurate codings because of its diversity, and it requires extensive training and experience for coding clerks to be accurate.

An extended chart of accounts can easily have omissions. Two-dimensional accounting may also face the problem of omissions, but the extent of such omissions would be far less than in the conventional approach, and whenever such an omission occurs in two-dimensional accounting it would also have occurred in the conventional approach. The converse is not true. To correct such an omission in two-dimensional accounting, the chart of accounts only needs a new natural code or a new functional code whereas the conventional approach would require many new entries throughout.

In conventional charts of accounts, an omission forces the creation of accounts when needed and may assign specific account numbers outside the logical framework, thereby compounding the problem of accurate coding.

Two-dimensional accounting makes the coding process much easier because the small number of functional codes and the small number of natural codes can easily be mastered and used effectively. Most organizations using this scheme would find that fewer than 100 codes are required. This small number can easily be learned and mastered very quickly.

Management can have confidence that its coding is being done accurately and quickly, and doesn't require extensive training of coding clerks or managers.

Constructing a chart of accounts is a task that has not received much attention in the accounting world. Because of a lack of conceptual guidelines, most practicing accountants probably borrow accounting schemes they have seen elsewhere. While some of these are very useful for financial reporting, they lead to confusing or wrong answers to management's questions. A cursory review of some active charts of accounts reveals that organizations tend to use hybrid systems that are selected combinations of functional and natural codes.

Many larger organizations solve this problem by using organizational codes (departments) to specify the functional area and, within the organizational codes, they use natural codes for the detail expense items. There are two serious problems with this scheme, namely:

* Many activities in departments cross functional boundaries to other departments. For example, if an engineer working in a production department travels to a customer's site to investigate a product design revision, the coding for this airfare would usually be treated only as travel, in this individuals' home department, production. The true functional nature of the activity, product development, would be lost.

* The functional details get lost in large departments when small departments are prohibited. (Sub-departments by function are desirable but not used in industry, e.g., an individual function with only a single person employed would not be used so as to keep that person's salary confidential.) For example, within the personnel department there are usually significant sub-functions: record keeping, benefits, and labor relations; but seldom are such sub-functions segregated by organizational codes.

The chart of accounts should identify both the functional and natural classifications for each monetary expenditure. Individual functional and natural codes should be assigned to each expenditure as it is being coded for inclusion in the chart of accounts. This is two dimensional accounting.

The natural classification answers the question: "What did we pay for?" The functional classification answers the question: "How in the organization did we benefit from it?" One-dimensional coding schemes can answer only one of these questions at a time. This answer is accurate only to the extent that the natural code (or functional code) has been consistently selected when originally recorded. The coding clerk has to pick either the functional code or the natural code to record the expenditure; hence, for all practical purposes, the other code on each transaction is lost.

As in our example, hybrid schemes usually allow both codes to be selected for some groups of transactions, but do not allow for choosing both codes for all transactions. The example herein (appendix A), is a hybrid scheme where wages are broken down by functional code, but travel and insurance are only coded as to their natural characteristics.

Our two-dimensional view of the coding of accounts forces the source of accounting information to be available to answer questions related to either dimension, or both. Viewed as an arrangement of codes in two dimensions, we can diagram the chart of accounts as shown in figure 1a.

Any expense would be coded with both its functional and natural characters. For example, wages paid for assembly would be coded as both wages for the natural code and assembly for the functional code (figure 1b).

This would allow a summary of wages across the row showing total organizational wages, with details by functional areas such as power, research, etc. It would allow a summary of assembly expenses with details by natural codes.

While hybrid systems may be able to respond to these questions for significantly gross areas, they fail to capture all relevant details. They also impose a great problem when a new function is created (or one functional area is split into multiple areas) or a new natural classification is recognized or created.

The addition of such a new area requires a review of the entire chart of accounts, which requires judgments to be made as to applicability and usefulness account by account. The two-dimensional approach merely adds the new functional code or the new natural code and all the appropriate new accounts are automatically available (figure 1c).

In a hybrid system, when only one code needs to be assigned, the human tendency would be to code the easier choice between functional and natural (usually natural). For example, if an engineer working in a production department travels to a customer's site to investigate a product design revision, the coding for this airfare would usually be treated as travel, and the functional nature of the activity, product development, would be lost. The two-dimensional scheme requires more work when the expenditure is originally coded, but the benefit is better information. This increase in additional work is so little that the expenditure is clearly justified by the benefit of better information.

In practice, it is the hybrid system which requires more work. For a hybrid system to incorporate all of the information that a two-dimensional system contains, many more accounts are required. For example, if there are 100 functional codes and 100 natural codes, a coding clerk would have to master 10,000 (100 x 100) different account codes in the hybrid system; however, in two-dimensional accounting, the coding clerk would only have to master 200 (100 + 100) different codes. This large number of accounts - 10,000 - precludes a hybrid system from being operationally feasible at the same level of detail.

The two-dimensional scheme is even larger than just the natural/functional breakout already described. As shown in figure 2, there are also:

* Functional/functional expenditures - Where one functional area performs services for another functional area - for example, the research area provides some services for the assembly department (interfunctional allocations).

* Natural/natural expenditures - For example, travel incurred on behalf of wages: here, for example, the achievement award (see appendix A), where travel is a perk to wages.

* Functional/natural expenditures (very rare) - If a functional area, say research, were to provide a service on behalf of a natural area (appendix A, for example), like the research effort expended to prepare an insurance benefits poster.

In order to demonstrate our two-dimensional approach (appendix C), there is a need to analyze the details of each transaction and code each transaction in both of its dimensional characteristics - for example, according to whether the transaction is natural/functional, natural/natural, etc. This would ordinarily be done when each item was coded during normal processing. The extended example in appendix C demonstrates the approach.

Hybrid systems attempt to encompass the natural/functional and functional/natural spectrum of accounts. They usually make no provision for the functional/natural or natural/natural accounts. Even that which they do attempt to consider is often not done very well. Let us consider both the functional codes and natural codes in a hybrid system.

Many hybrid systems use departments as their functional identification. However, the function should be more detailed than the organization's department structure. Many departments perform more than one function, and some functions are performed in more than one department. Functions should also be detailed enough to allow inspection of individual business activities whether performed in-house or out-of-house. For example, legal services or data processing services are often coded as natural categories, and their functional aspects ignored.

Within the personnel department there are functional areas such as record-keeping, benefits, labor relations, etc. These different functions may emphasize or use different natural codes. Labor relations may require travel while record-keeping does not. The hybrid system approach could detail natural codes within the personnel department, whereas the two-dimensional approach shows much more detail (see figure 3).

If we are reviewing the costs to add staff in the personnel department, we can inspect the expenses at the functional area where the need is. We could expect that the new level of expenses will include an increase in travel if the new position is in labor relations; we could expect that there will not be any increase in travel if the position is in record keeping or benefits.

Natural account codes are reasonably well-handled in hybrid systems in many areas, but not in all. The two-dimensional approach solves this consistency issue by creating the same natural codes throughout the organization's functional areas. This consistency is valuable for evaluating natural expenses throughout the organization. All of an organization's fringe expenses can be summarized and reviewed as a straight forward analysis.

For example, in a hybrid system, if fringes were included as "fringes" in the personnel department, as "fringes and overtime" in one of the manufacturing departments and as "salaries and fringes" in one of the remote sales districts, one might never be able to determine the fringe expenses in the whole organization.

Management's questions and outside reporting requirements are important and always changing. The chart of accounts needs to be responsive to management, and therefore needs to be flexible, consistent, and dynamic. The hybrid schemes fail on all these criteria.

No chart of accounts can anticipate all future informational needs. The two-dimensional approach, however, provides consistency by design, is flexible, and allows for growth, expansion and change along consistent lines. Each new informational request needs to be faced only once, either in terms of its natural coding schemes or its functional coding scheme. In the hybrid approach, each new issue must be reviewed repeatedly in each section of the one-dimensional chart of accounts where it appears.

Our two-dimensional approach provides greater accuracy in the coding of accounting transactions by separating the functional and natural codes and thereby reducing the number of codes to be mastered by coding clerks (from 10,000 to 200 in our example). Management's unusual or one-time questions can be answered simply and quickly when compared to hybrid systems. Analyses and key totals and subtotals are readily available. Information and data, once not easily available, are available for graphics, statistical, and other more sophisticated management uses.

PHOTO : Chart of Accounts Diagram Figure 1

PHOTO : A Range Extension Figure 2

PHOTO : The Hybrid System vs. The Two-Dimensional Approach Figure 3