The Traditional Accounting Information System Chapter 3

Objectives Describe the nature of the traditional accounting cycle and its relationship to business events Describe the impact of IT on the traditional accounting system Describe the limitations of the traditional accounting system architecture Describe how the traditional accounting system architecture limits accounting’s ability to enhance value

Pacioli: The Father of Traditional Accounting Pacioli was not really the inventor, but was “the first accountant to combine his knowledge with the technology that enabled authors to print books using a movable type and a printing press to instruct the world on the subject in print”. Pacioli documented the double entry, chart of account classification scheme used to record and store accounting data. To keep the accounts in balance, Pacioli proposed a rigorous process for recording, maintaining, and reporting accounting data. Pacioli suggested the use of three books: the memorandum book, the journal and the ledger. The memorandum book should include notations of every transaction, large and small, in whatever currency was being used and in as much detail as time and circumstance allowed. The journal was the source for the ledger, where the double entry bookkeeping was done. It was in the ledger that the businessman could learn before anyone else whether he was a success or a failure

Rules for Accounting Chart of Accounts See Exhibit 3-1 classify and summarize financial measurements nominal accounts vs real accounts One compendium of sample charts of accounts and accounting procedures for different industries is The Encyclopedia of Accounting Systems Charles Sprague “Any occurrence [accounting transaction] must be either an increase or a decrease of values, and there are three classes of values [assets, liabilities, and equity] ... in every transaction at least two of the occurrences must appear ... on opposite sides of the above list.” Assets = Liabilities + Owner’s Equity

Exhibit 2-1 Sample Chart of Accounts Account Title Account Account Title Account Current Assets Cash 110 Accounts Receivable 130 Allowance for Doubtful Accounts 140 Inventory 160 Prepaid Insurance 180 Notes Receivable 190 Property, Plant, and Equipment: 200 Land 210 Building 220 Accumulate Depreciation Building 230 Equipment 240 Accumulated Deprec. Equipment 250 Current Liabilities: Accounts Payable 310 Long-Term Debt: Bonds Payable 410 Stockholder’s Equity: Common Stock 510 Capital in Excess 520 Retained Earnings 550 Revenue and Expense Summary 590 Revenue: Revenue 610 Interest Revenue 620 Rent Revenue 630 Expenses: Purchases 710 Freight on Purchases 720 Purchase Returns 730 Selling Expenses 740 General and Admin. Expenses 750 Interest Expense 760 Extraordinary Loss (pretax) 770

Exhibit 3-2: Steps in the Accounting Cycle and Their Objectives During the accounting period

Exhibit 3-2: Steps in the Accounting Cycle and Their Objectives At the end of the accounting period

Exhibit 3-2: Steps in the Accounting Cycle and Their Objectives At the beginning of the next accounting period

Accounting Cycle Process Financial statements and notes Audit Business event Nonfinancial systems Information customers Accounting Cycle Process Analyze business event data Ignore event data Financial statement notes Prepare statements and notes Ledgers Post journal data to the ledger Trial balance Prepare and adjust the trial balance Journals Record transaction data Correct and adjust Irwin/McGraw-Hill Ó The McGraw-Hill Companies, Inc., 2000

Step : Identify Accounting Transactions to be Recorded The purposes of this first step are to identify the business events that can be considered accounting transactions and to collect relevant economic data about those transactions. Accounting transactions are the business events that cause a change in the organization’s assets, liabilities, or owner’s equity. These events include Exchanges of resources and obligations between the reporting firm and outside parties (reciprocal transfers or non-reciprocal transfers) Internal Events within the firm that affect its resources or obligations but that do not involve outside parties Economic and environmental events beyond the control of the company (changes in values) Accounting transactions are typically accompanied by a source document prepared by someone other than the accountant

Step 2 - Journalize Accounting Transaction Data Measure and record the economic impact of transactions Transactions are recorded in a journal - Debit, Credit, date, account number, amounts ,and descriptions General journal and Special Journals Historical Cost Principle Posting References and page numbers

Step 3: Post Journal Data to Ledgers The process of transferring transaction data from the journals to the ledger accounts is called posting General Ledger and Subsidiary Ledgers Totals of Special Journal Columns are posted An audit trail should provide the capability to trace an individual transaction from its initial recording all the way through the accounting process to the final figures in the financial statements Reconciliation is the process of summing the subsidiary ledgers and comparing the total with the balance in the general ledger control account

Step 4: Prepare Unadjusted Trial Balance The unadjusted trial balance is a list of general ledger accounts and their account balances Convenient method of determining that the sum of the Debit account balances equals the sum of the Credit account balances If the trail balance does not balance the source of the error must be investigated

Exhibit 3-5 Unadjusted Trail Balance Illustrated Click to Open

Step 5: Journalize and Post Adjusting Entries Adjusting entries are required when their is no source document to trigger a transaction Passage of time ( interest or depreciation) Correct Errors Record Changes in Estimates Recording Deferrals Recording Accruals Reclassifying balances Recognizing inventory losses Source documents from earlier transactions are the primary information sources for adjusting entries.

Step 6: Prepare Adjusted Trial Balance The adjusted trial balance lists all the account balances that will appear in the financial statements (with the exception of retained earnings, which does not yet reflect the current year’s net income and dividends). The purpose of the adjusted trial balance is to confirm debit-credit equality, taking all Adjusting journal entries into consideration. Confirm Debit Credit Balance Source for preparation of the Financial Statements

Step 7 Prepare Financial Statements The primary objective of financial accounting is to provide information that is useful to decision-makers. Financial statements can be produced for a period of any duration. However, monthly, quarterly, and annual statements are the most common. The income statement, retained earnings statement, and balance sheet are prepared directly from the adjusted trial balance. The temporary account balances are transferred to the income statement, and the permanent account balances are transferred to the balance sheet. FS

Step 8 Journalize and Post Closing Entries Closing entries reduce the temporary accounts (e.g., revenues, expenses, and dividends) to a zero (closed) balance. Closing entries are recorded in the general journal at the end of the accounting period and are posted to the appropriate ledger accounts. Permanent accounts are not closed because they carry asset, liability, and owner's equity balances to the next accounting period. The retained earnings account is the only permanent account involved in the closing process.

Step 9 Prepare Post-Closing Trial Balance A post-closing trial balance lists only the balances of the permanent accounts after the closing process is finished. (The temporary accounts have zero balances.) This step is taken to check for debit-credit equality after the closing entries are posted. Firms with a large number of accounts find this a valuable procedure because the chance of error increases with the number of accounts and postings. The retained earnings account is now stated at the ending balance and is the only permanent account with a balance different from the one shown in the adjusted trial balance.

Step 10 Journalize and Post Reversing Entries At the beginning of the next period, the accountant may prepare and post reversing entries to compensate for the difference in timing between the occurrence of an actual economic reality, and the recording of the economic event in the accounting system. Reversing entries use the same accounts and amounts as adjusting entries but with the debits and credits reversed. These entries reverse adjusting entries made at the end of one period and prepare the accounting records for normal processing of business events in the new period.

Applying Information Technology to the Accounting Cycle Human information processing challenges Human Error Human inefficiency Paper based communication is costly Reasons why IT is not used: technology does not exist technology is not cost effective Using IT to replicate a manual system is not efficient The accounting architecture needs to be changed

Criticisms Of The Traditional Accounting System Architecture One criticism of the traditional architectures is a lack of integration across functional areas of the organization. Example: an international computer manufacturer that maintains a separate chart of accounts and ledgers for its manufacturing and marketing divisions because they have different criteria for reporting financial information. Manufacturing recognizes revenue when a product is shipped to a customer Marketing recognizes revenue when the customer is billed for the product. The entire accounting process is automated. Example: Two business events Shipping to customer 8 Journal entries Billing customer 8 Journal Entries Adjusting for Revenue Recognition 8 Journal Entries

Criticisms of the Traditional Accounting System Architecture Activities are performed to provide service to the customer Many systems exist to record and report on activities Different managers want different views of the data to make decisions in their area of influence Too many systems

Multiple Views of the Same Business Event Marketing people wants to know about the order to evaluate pricing, plan advertising campaigns, and target selling efforts. Investors and creditors want to know about all orders to assess the profitability of their investments and the likelihood of a return on their investment Executive management wants to know about the order to evaluate its impact on the organization SALE Personnel view Production view Personnel people want to know about the order to pay sales commissions. Production people want to know about the order to plan production processes Marketing view Executive view Investors and creditors view (GAAP)

The Proliferation of Accounting Subsystems Business Event System A Edit Audit Calculate Summarize Stored Data System B Edit Audit Calculate Summarize Stored Data System C Edit Audit Calculate Summarize Stored Data System D Edit Audit Calculate Summarize Stored Data Functional Views Functional Views Functional Views Functional Views

Criticisms of Traditional Accounting Systems and Processes There is a proliferation of often conflicting, nonintegrated systems and subsystems within a single organization. The architecture captures data about a subset of an organization's business events (the accounting transactions). Data are not recorded and processed in real-time The architecture stores and processes only a limited number of characteristics about accounting transactions. The architecture captures and stores duplicate data in a highly summarized form The architecture stores financial data to satisfy one primary view (perspective).

Architecture of Traditional Accounting Based primarily on financial reporting: Income Statement & Balance Sheet Build new/alternative systems for alternative views of business data. Confine recorded information to “accounting transactions.” Store and summarize information in ledgers. Architecture of Traditional Accounting

Accounting Data: A Subset of Business Data (Limited view & limited data) Data that describes Business Activities Acct. Data Business Activities Accountants filter data General Ledger Limited Output Views / Formats

The Heart of the Problem with Traditional Systems Process: Classifies and summarizes transaction data Input: Narrow set of transactions Output: Produces narrow functional views Narrow functional views drive the selection of transactions, classification, and summarization

Are These Criticisms Valid? The criticisms we have presented simply highlight the difficulties of adapting the traditional accounting system architecture to a rapidly changing world. Today's business world is fast paced, more information intensive, and involves complex business transactions beyond Pacioli's wildest dreams Today’s information customers are very demanding. They desire a larger variety of faster, customized information products delivered in a variety of modes. For example, many people now want their information system to produce a much broader array of information products such as balanced scorecards.

Ways That Accounting Can Enhance Its Value to the Organization Helping Management Define Business Process Rules - To help management define business process rules presupposes involvement in an organization’s business processes. We should develop an AIS architecture that enables accountants to exercise influence over the development and implementation of business processes rules throughout the business process. Providing More Useful Information - Traditional accounting measures are expressed almost exclusively in monetary terms: a practice that precludes information on productivity, performance, reliability and other multidimensional data that cannot be easily expressed in monetary terms. Helping to Embed Real-Time Information Processes into Business Processes - Accountants should provide meaningful, direct input into the design, development, and implementation of real-time information processes that execute business rules and gather business data.

Role of the Office of the CFO (Chief Financial Officer) Insightful contributions into the strategy and planning process Measures that focus and motivate the organization Information and analysis that provides insight into how value is being created and how progress is being matched to strategic initiatives. Leadership of major financial initiatives. We think objectives such as these provide justification for changing the architecture of any information system that limits the potential of information providers in adding value to an organization.

Event-Driven IT Application Overview Enterprise-wide Information Customers Business Events Business Event Processor (business and information processing rules) Business Data Repository Reporting Facility (Information processing rules) Business Event Data Useful Information

Characteristics of Future Architecture Based on business events (business activities) rather than information customer views. Supports business process simplification and change. Integrates all business data. Integrates information processes and real-time controls. Characteristics of Future Architecture