ACCOUNTING SYSTEM ANALYSIS AND DESIGN

5.1 INTRODUCTION
This unit introduces you to the components and principles of accounting systems. A system is
a way of doing something. There are various ways of doing things.
Let’s say you decided to go home when you go out of your office. There are many ways to do
that: You can either take a taxi or you can walk the whole distance home; you can take the
main road, or you may wish to use a short cut and so forth.
In accounting also, it is true that almost all business record, process and report business
transactions. However, the speed and efficiency of the processing depends on which
accounting system they use.
The accounting information system collects and processes transaction data and
communicates financial information to decision makers. It includes each of the steps in the
accounting cycle that you studied in earlier chapters. It also includes the documents that
provide evidence of the transactions, and the records, trial balances, worksheets, and financial
statements that result. An accounting system may be either manual or computerized. Most
businesses these days use some sort of computerized accounting system, whether it is an off-
the-shelf system for small businesses, like QuickBooks or Peachtree, or a more complex
custom-made system.
Efficient and effective accounting information systems are based on certain basic principles.
These principles are: (1) cost effectiveness, (2) usefulness, and (3) flexibility. If the
accounting system is cost effective, provides useful output, and has the flexibility to meet
future needs, it can contribute to both individual and organizational goals.

5.2 Components of an Accounting System

There are five basic elements of an accounting system. These are:
5.2.1 Source Documents
Source documents provide the basic information to be processed by the accounting system.
Invoices from suppliers, bills sent to customers, and payroll records are some examples of
source documents. You have already seen their meaning and importance in previous chapter.
5.2.2 Input Devices
Input devices capture information from source documents and enable its transfer to the
information-processing component of the system. Journal entries, both papers based and
electronic are a type of input devices.
5.2.3 Information Processors
An information processor is a system that interprets, transforms and summarizes information
for use in analysis and reporting. The information processing in an accounting system can be
manual or computerized.
Now a day, computers are being increasingly used to process information. Many businesses in
Ethiopia, for example, use the Peachtree accounting software to process accounting
information.
5.2.4 Information Storage
After being input, processed data are usually saved for use in future analysis or report.
Information storage is the component of an accounting system that keeps data in a form
accessible to information processors.

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5.2.5 Output Device
Output devices are the means to take information out of an accounting system and make it
available to users. Output devices include printers, and monitors, which provide such outputs
as financial statements, bills to customers and internal reports.
5.3 Fundamental Principles of Accounting Systems
5.3.1 Control Principle
Any accounting information system should allow managers to control and monitor business
activities. To achieve this, accounting system must have internal control as an element.
Internal controls are methods and procedures that direct operations to one goal, ensure
reliability of financial reports and safeguard business assets. Internal controls are discussed
separately and at a greater detail in the next chapter.
5.3.2 Relevance Principle
The information that an accounting system provides should be relevant to decision makers.
This means, an information system should be designed to capture data that make difference in
decision. To ensure this, it is important that all decision makers, be considered when
identifying relevant information for disclosure.
5.3.3 Compatibility Principle
The compatibility principle requires that an accounting system conform to the company’s
activities, personnel and structure. The system must also be customized to the unique
characteristics of the company.
All in all, accounting systems must be consistent with the aims of the company, i.e., they
should work in harmony with company goals.
5.3.4 Flexibility Principle
Accounting information systems must be flexible to adjust to changes in the company, in the
business environment and needs of decision makers. These changes can be technological
developments, consumer tastes or company activities.
A system must be designed to adapt to these and other changes.
5.3.5 Cost-Benefit-Principle
You wouldn’t do anything in your daily life without first weighing the costs and the benefits.
Likewise, the benefits of performing an activity in an accounting system should be greater
than its costs.
For example, when you decided whether or not to report certain information, you have to
compare the benefits (its usefulness to decision making) and the costs (of computing,
personnel and other indirect costs).

5.4. Computerized and Manual Accounting Systems

5.4.1. Computerized Accounting Systems
Many small businesses eventually replace their manual accounting system with a
computerized general ledger accounting system. General ledger accounting systems are
software programs that integrate the various accounting functions related to sales, purchases,
receivables, payables, cash receipts and disbursements, and payroll.
They also generate financial statements. Computerized systems have a number of advantages
over manual systems. First, the company typically enters data only once in a computerized
system. Second, because the computer does most steps automatically, many errors resulting

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from human intervention in a manual system, such as errors in posting or preparation of
financial statements, are eliminated.
Computerized systems also provide information up-to-the-minute. More timely information
results in better business decisions. Many different general ledger software packages are
available.
Choosing a Software Package
To identify the right software for your business, you must understand your company’s
operations. For example, consider its needs with regard to inventory, billing, payroll, and cash
management. In addition, the company might have specific needs that are not supported by all
software systems. For example, you might want to track employees’ hours on individual jobs
or to extract information for determining sales commissions. Choosing the right system is
critical because installation of even a basic system is time-consuming, and learning a new
system will require many hours of employee time.
Entry-Level Software
Software publishers tend to classify businesses into groups based on revenue and the number
of employees. Companies with revenues of less than $5 million and up to 20 employees
generally use entry-level programs. The two leading entry-level programs are Intuit’s
QuickBooks and Sage Software’s Peachtree. These programs control more than 90% of the
market. Each of these entry-level programs comes in many different industry-specific
versions. For example, some are designed for very specific industry applications such as
restaurants, retailing, construction, manufacturing, or non-profit. (Quality entry-level
packages typically involve more than recording transactions and preparing financial
statements. Here are some common features and benefits:
• Easy data access and report preparation. Users can easily access information related to
specific customers or suppliers. For example, you can view all transactions, invoices,
payments, as well as contact information for a specific client.
• Audit trail. As a result of the Sarbanes-Oxley Act, companies are now far more concerned
that their accounting system minimizes opportunities for fraud. Many programs provide an
“audit trail” that enables the tracking of all transactions.
• Internal controls. Some systems have an internal accounting review that identifies
suspicious transactions or likely mistakes such as wrong account numbers or duplicate
transactions.
• Customization. This feature enables the company to create data fields specific to the needs
of its business.
• Network-compatibility. Multiple users in the company can access the system at the same
time.

ENTERPRISE RESOURCE PLANNING SYSTEMS

Enterprise resource planning (ERP) systems are typically used by manufacturing

companies with more than 500 employees and $500 million in sales. ERP systems go far
beyond the functions of an entry-level general ledger package. They integrate all aspects of

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the organization, including accounting, sales, human resource management, and
manufacturing. Because of the complexity of an ERP system, implementation can take three
years and cost five times as much as the purchase price of the system. Purchase and
implementation of ERP systems can cost from $250,000 to as much as $50 million for the
largest multinational corporations.

5.4.2. Manual Accounting Systems

Manual accounting systems perform each of the steps in the accounting cycle by hand. For
example, someone manually enters each accounting transaction in the journal and manually
posts each to the ledger. Other manual computations must be made to obtain ledger account
balances and to prepare a trial balance and financial statements. In the remainder of this
chapter, we illustrate the use of a manual system.
You might be wondering, “Why cover manual accounting systems if the real world uses
computerized systems?” First, small businesses still abound. Most of them begin operations
with manual accounting systems and convert to computerized systems as the business grows.
You may work in a small business, or start your own someday, so it is useful to know how a
manual system works. Second, to understand what computerized accounting systems do, you
also need to understand manual accounting systems.

5.5. Special Journals and Subsidiary Ledgers

5.5.1 Subsidiary Ledgers
When a business has so many customers and suppliers, a control account for Accounts
Receivable and a control account for Accounts Payable are established in the general ledger.
But in addition to these, subsidiary ledger for receivables and payables may be added to the
accounting system to show the balances for each individual customer and supplier separately.
A control account is an account in the general ledger that shows the total balances of all the
subsidiary accounts related to it.
Subsidiary ledger accounts show the details supporting the related general ledger control
account balance. For example, the subsidiary (supporting) accounts for accounts Receivable
may be used to send out to each customer statements showing the balance they owe the
company.
A subsidiary ledger is therefore, a group of related accounts showing the details of the
balance of general ledger accounts.
Subsidiary ledgers are used to relieve the general ledger of a mass of detail. Thereby, the
general ledger trial balance is shortened. What’s more, having separate ledgers promotes the
division of labor as one employee can handle the control account while its subsidiary can be
assigned to another employee.
The relationship between a control account in the general ledger and its subsidiary accounts
can be illustrated as follows in T- account form.
Subsidiary accounts in the
Control account in the
Accounts Receivable subsidiary
General Ledger
Ledger

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  Accounts Receivable Customer A Customer B
 2001 2001 2001
Dec. 31 Dec. 31 Dec. 31
Bal. 10,000 Bal. 1,000 Bal. 4,000
Customer C Customer D

2001 Dec, 31 2001 Dec.31

Bal. 2,000 Bal 3,000
As you can see the sum of all balances in the subsidiary accounts (1,000 + 2,000 + 4,000 +
3,000) on December 31, 2001 is equal to the balance in the control account (10,000).
When a transaction is recorded as a journal entry, it must indicate which of the subsidiary
ledger accounts is affected. Posting will be made to both the control account and the
subsidiary ledger account.
Example
A Br. 450 sale was made on account to Gome Balcha on January 2, 20X2. The journal entry
would be:
Jan. 2 Accounts Receivable-Gome 450
Sales 450
The Br. 450 would be posted as a debit to both the Account Receivable control account in the
general ledger and G.Balcha’s account in the subsidiary ledger. The credit would, of course,
be to the Sales account in the general ledger.
The following can be a summary of what’s discussed above:
General ledger
Control Account Subsidiary ledger
Accounts Receivable Accounts Receivable subsidiary
Ledger (account for each customer)
Accounts Payable Accounts Payable subsidiary
Ledger (account for each supplier)
Office Equipment, Equipment subsidiary ledger
Delivery Equipment, (Account for each item of
Office Furniture equipment).

Advantages of Subsidiary Ledgers

Subsidiary ledgers have several advantages:
1. They show in a single account transactions affecting one customer or one
creditor, thus providing up-to-date information on specific account balances.
2. They free the general ledger of excessive details. As a result, a trial balance of the
general ledger does not contain vast numbers of individual account balances.
3. They help locate errors in individual accounts by reducing the number of accounts
in one ledger and by using control accounts.

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 4. They make possible a division of labour in posting. One employee can post to the
general ledger while someone else posts to the subsidiary ledgers.

5.5.2 Special Journals

A general journal is an all-purpose journal where we can record any transaction. However, as
the transactions of a company increase, it is better to use special journals along with the
general journal to record transactions of similar type in one, such as sales on account or cash
payments. Special journals record transactions of a similar nature.
Special journals are designed to systematize the original recording of major transactions,
which occur very repeatedly.
The number and format of special journals used by a company depends on the nature and size
of the company’s business transactions.
The following are some of the typical examples of special journals used by most
merchandising businesses.
1. Sales Journals 2. Cash Receipt journal
for recording credit sales. for recording cash receipts.

3. Purchase journal
for recording credit 4. Cash payment journal
purchases. for recording cash payments

5. General journal for transactions

not recorded in any of the special
journal

5.5.2.1 Advantages of using special journals

A- Time is saved in journalizing. The amount of writing is reduced because it is not
necessary to repeat the account titles printed already at the top of the special columns
for every debit and credit.
B- Time is saved in posting- many amounts are posted as column totals rather than
individually.
C- Detail is eliminated from the general ledger column. Totals are posted to the ledger
means that detail is left in the special journals.

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 D- Division of labor is promoted. Several persons can work simultaneously on the
accounting records. This allows management to fix responsibility and quickly locate
errors.
E- Management analysis is aided. The special journal can be useful to management in
analyzing classes of transactions, such as sales, because similar transactions are in one
place.
5.5.2.2 Sales Journal
The sales journal is used to record sales of merchandise on credit; sales on cash are recorded
in a cash receipts journal. Sales of assets other than merchandise on credit are recorded in the
general journal
Each transaction recorded in the sales journal has a debit to Accounts Receivable and a credit
to Sales. Therefore, only one column is needed for these two accounts. The posting reference
(P/R) column is not used when transactions are recorded; instead this column is used when
posting.
Posting
Sales journal entries are posted as shown with the arrow line in the illustration. Individual
transactions in the sales journal are posted regularly (daily) to subsidiary customer accounts in
the accounts receivable subsidiary ledger. These postings keep customer accounts up to date.
The sales journals amount column is totaled at the end of the period. The total is debited to
accounts Receivable and credited to sales.
Date Description Invoic Ck A/R dr Sales cr Vat
e No. no. payable cr

5.5.2.2. Cash Receipts Journal

In the cash receipts journal, companies record all receipts of cash. The most common types
of cash receipts are cash sales of merchandise and collections of accounts receivable. Many
other possibilities exist, such as receipt of money from bank loans and cash proceeds from
disposal of equipment. A one- or two-column cash receipts journal would not have space
enough for all possible cash receipt transactions.
Therefore, companies use a multiple-column cash receipts journal. Generally, a cash receipts
journal includes the following columns: debit columns for Cash and Sales Discounts, and
credit columns for Accounts Receivable, Sales, and “Other” accounts. Companies use the
“Other Accounts” category when the cash receipt does not involve a cash sale or a collection
of accounts receivable. Under a perpetual inventory system, each sales entry also is
accompanied by an entry that debits Cost of Goods Sold and credits Merchandise Inventory
for the cost of the merchandise sold.
Companies may use additional credit columns if these columns significantly reduce postings
to a specific account. For example, a loan company, such as Household International, receives
thousands of cash collections from customers.
Using separate credit columns for Loans Receivable and Interest Revenue, rather than the
Other Accounts credit column, would reduce postings.

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Posting the Cash Receipts Journal
Posting a multi-column journal involves the following steps.
1. At the end of the month, the company posts all column totals, except for the Other
Accounts total, to the account title(s) specified in the column heading (such as Cash or
Accounts Receivable).The company then enters account numbers below the column totals to
show that they have been posted.
2. The company separately posts the individual amounts comprising the Other Accounts
total to the general ledger accounts specified in the Account Credited column. The total
amount of this column has not been posted. The symbol (X) is inserted below the total to this
column to indicate that the amount has not been posted.
3. The individual amounts in a column, posted in total to a control account (Accounts
Receivable, in this case), are posted daily to the subsidiary ledger account specified in the
Account Credited column.
The symbol CR, used in both the subsidiary and general ledgers, identifies postings from the
cash receipts journal.
Date Receipt custome Description Cash Sales A/R Other Accounts
no. r dr discount CR Dr
cr Acct no amount

5.5.2.3. Purchases Journal

In the purchases journal, companies record all purchases of merchandise on account. Each
entry in this journal results in a debit to Merchandise Inventory and a credit to Accounts
Payable. When using a one-column purchases journal, a company cannot journalize other
types of purchases on account or cash purchases in it.
JOURNALIZING CREDIT PURCHASES OF MERCHANDISE
The journalizing procedure is similar to that for a sales journal. Companies’ make entries in
the purchases journal from purchase invoices. In contrast to the sales journal, the purchases
journal may not have an invoice number column, because invoices received from different
suppliers will not be in numerical sequence. To ensure that they record all purchase invoices,
some companies consecutively number each invoice upon receipt and then use an internal
document number column in the purchases journal. The entries for Karns Wholesale Supply
are based on the assumed credit purchases listed in Illustration below.

Date Supplier Amount

5/6 Jasper Manufacturing Inc. $11,000
5/10 Eaton and Howe Inc. 7,200
5/14 Fabor and Son 6,900
5/19 Jasper Manufacturing Inc. 17,500
5/26 Fabor and Son 8,700
5/29 Eaton and Howe Inc. 12,600

Posting the Purchases Journal

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The procedures for posting the purchases journal are similar to those for the sales journal. In
this case, Karns makes daily postings to the accounts payable ledger; it makes monthly
postings to Merchandise Inventory and Accounts Payable in the general ledger. In both
ledgers, Karns uses P1 in the reference column to show that the postings are from page 1 of
the purchases journal.

5.6. Internal Control

A company’s internal control structure consists of the policies and procedures established to
insure that the company’s goals will be achieved.
As a company grows in size, it becomes difficult to maintain control over all phases of
operation. Therefore, management needs to delegate authority and rely on the control
structure in order to achieve adherence to enterprise goals.

5.6.1 The
The Purpose of Internal Control
Managers use an internal control system to monitor and control business operations. An
internal control system is all the policies and procedures managers use to:
 Protect business assets from theft and misuse. For example, what can be done to
protect cash from theft and misuse?
 Ensure reliability of accounting records. That is, how reliable and accurate are our
records and reports regarding Accounts Receivable, for instance.
 Promote efficiency of operation. Efficiency means achieving organizational goals by
using as minimum resources as possible.
 And make employees adhere to company policy.

5.6.2. Components of Internal Control

The internal control structure can be divided in to three elements?
1. The Control Environment
The control environment of an organization represents the overall attitude and awareness of
both management and employees about the importance of controls.
The control environment is influenced by such factors as management’s philosophy &
operating style, the organizational structure of the business and personnel policies.
2. The Accounting System
The accounting system consists of the methods and records established by management to
identify record, process and report a company’s transactions, and to provide assurance that the
objectives of internal control are being met.
3. Control Procedures
Internal control procedures vary from company to company. They depend on the nature of the
business and of its size.
The following are common procedures that you find in the internal control of many
organizations.
a. Requiring Authorization
Management should properly authorize all transactions and activities before they take place.
For example, selling on credit requires management’s approval.
b. Establishing Responsibility
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Proper internal control requires responsibility for each task to be clearly established and
assigned to one person. Otherwise, if responsibility is not identified, it is difficult to say who
is at fault (responsible) when a problem occurs.
For example, if we allow two sales clerks to share access to (use) the same cash register, it
would be difficult to take which sales clerk accountable when and if there is a cash shortage.
c. Maintaining Adequate Records
Reliable records are a source of information that management uses to monitor company
operations. For example, when detailed records of office equipment are kept, items are
unlikely to be lost or stolen with out the discrepancy being noticed.
d. Insuring Assets and Bonding Key Employees
Good internal control dictates that assets be adequately insured against causality. In addition,
employees handling cash should be bonded. Bonding an employee means buying an insurance
policy against losses from theft by that employee.
e. Separating Record Keeping From Custody of Assets
A person who controls or has access to an asset must not keep that asset’s accounting records.
This prevents the loss of the asset from theft because the person who has control over the
asset knows that another person keeps records of the asset. The record keeper doesn’t have
access to the asset and therefore, has no reason to falsify records.
For a fraud to be committed in such a system, the two people must agree (-this is called
collusion). Collusion is usually less likely to occur.
f. Dividing Responsibility for Related Tasks (transactions)
In order to ensure that the work of one employee serves as a check on another, responsibility
for a series of related transactions should be divided between two or more individuals (or
employees) or departments.
This is usually referred to as segregation of duties.
For example, no one individual should be authorized to order merchandise, to receive
merchandise, and to pay the supplier. If one employee is allowed to do these all by herself
(alone), she can place orders with a supplier on the basis of friendship rather than price and
quality; convert goods to her personal use; pay false invoices; and so forth.
g. Rotating Duties
It is advisable to rotate clerical personnel periodically from job to job. This would help them
broaden their understanding of the system. In addition and more importantly, they know that
others would in the future perform their jobs (when rotated). This discourages them to deviate
from prescribed procedures because they fear that the employee who takes up their job will
discover it.
h. Applying Technical Controls
Cash register, check protectors, time clocks, mechanical counters, and personal identification
scanners are examples of control devices that can improve internal control.
A cash register has a locked in tape or electronic file, which makes record of each cash sale.
A check protector perforates the amount written on a check in to its face and makes it difficult
to change the amount.
A time clock registers the exact time an employee arrives and leaves from the job.
Mechanical change and currency counters quickly and accurately count amounts.
Personal scanners limit access to some places only to authorized individuals.

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Performing Regular and Independent Reviews
Regular reviews of internal control systems are needed to ensure that procedure are followed.
Internal auditors who are not directly involved in the operations of the business usually
perform these reviews. This encourages an evaluation on the efficiency and effectiveness of
the internal control system.
5.6.3. Technology and Internal Control
Technology impacts an internal control system in many important ways. Some of these are:
 Technologically advanced systems allow saving time in processing information.
 They allow a regular review and more extensive testing of records as information can
be easily and rapidly accessed.
 Technologically advanced systems reduce the number of errors in processing
information provided the software and data entry are correct.
 They are so efficient these days that they require fewer employees. This makes
separation of crucial responsibilities difficult. The duties of these employees,
therefore, must be monitored to minimize the risk of error or fraud.
5.6.4.
5.6.4. Limitations of Internal Control
No internal control system is perfect. The most serious limiting factors are human error and
human fraud.
Human error can occur from negligence, fatigue or confusion. Human fraud involves a
deliberate act by employees to defeat internal controls for personal gains.
Another important limiting factor of an internal control system is the cost-benefit
consideration. This means that the cost of an internal control system must not exceed its
benefits.

We can’t employ an internal control system simply because it is good. We have to weigh its
costs against its benefits.
For instance, not all companies need to computerize their accounting system if the cost of
automating the system is greater than the benefits.

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