Chapter 7

The Conversion Cycle

Accounting Information Systems, 7e

James A. Hall

Hall, Accounting Information Systems, 7e

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1
 Objectives for Chapter 7
▪ Elements and procedures of a traditional production
process
▪ Data flows and procedures in a traditional cost
accounting system
▪ Accounting controls in a traditional environment
▪ Principles, operating features, and technologies of lean
manufacturing
▪ Shortcomings of traditional accounting methods in the
world-class environment
▪ Key features of activity based costing and value stream
accounting
▪ Information systems of lean manufacturing and world-
class companies
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 The Conversion Cycle

▪ Transforms input resources, raw materials,

labor, and overhead into finished products
or services for sale
▪ Consists of two subsystems:
▪ Physical activities – the production system
▪ Information activities – the cost
accounting system

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 Conversion Cycle in Relation to Other Cycles

Marketing
System

Sales
Forecast

Purchase Requisitions
Revenue Cycle Sales Orders
Conversion Expenditure
Cycle Cycle
Labor Usage

Work
Finished
In
Goods
Process

General Ledger
and Financial
Reporting
System
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 Production System

▪ Involves the planning, scheduling, and control

of the physical product through the
manufacturing process
▪ determining raw materials requirements
▪ authorizing the release of raw materials into
production
▪ authorizing work to be conducted in the
production process
▪ directing the movement of work through the
various stages of production
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 Production Methods
▪ Continuous Processing creates a homogeneous
product through a continuous series of standard
procedures.
▪ Batch Processing produces discrete groups
(batches) of products.
▪ Make-to-Order Processing involves the
fabrication of discrete products in accordance with
customer specifications.

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 Overview: Traditional Batch
Production Model…
▪ consists of four basic processes:
▪ plan and control production
▪ perform production operations
▪ maintain inventory control
▪ perform cost accounting

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 Batch Production System

▪ Production Planning and Control

▪ Materials and operations requirements
▪ Production scheduling
▪ Materials and Operations Requirements
▪ Materials requirement – the difference between what
is needed and what is available in inventory
▪ Operations requirements – the assembly and/or
manufacturing activities to be applied to the product

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 Batch Production System

▪ Production Scheduling
▪ Coordinates the production of multiple batches
▪ Influenced by time constraints, batch size, and
other specifications
▪ Work Centers and Storekeeping
▪ Production operations begin when work centers
obtain raw materials from storekeeping.
▪ It ends with the completed product being sent to
the finished goods (FG) warehouse .

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 Batch Production System
▪ Inventory Control
▪ Objective: minimize total inventory cost while
ensuring that adequate inventories exist of
production demand
▪ Provides production planning and control with
status of finished goods and raw materials
inventory
▪ Continually updates the raw material inventory
during production process
▪ Upon completion of production, updates finished
goods inventory
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 EOQ Inventory Model

▪ Very simple too use, but assumptions are not always

valid
▪ demand is known and constant
▪ ordering lead time is known and constant
▪ total cost per year of placing orders decreases as
the order quantities increase
▪ carrying costs of inventory increases as quantity of
orders increases
▪ no quantity discounts

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 EOQ Inventory Model
INVENTORY LEVEL

Inventory Cycle Daily Demand

EOQ

Reorder
Point

Lead Time Time (days)

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 Information: Documents in the
Batch Production System
▪ Sales Forecast - expected demand for
the finished goods
▪ Production Schedule - production plan
and authorization to produce
▪ Bill of Materials (BOM) - specifies the
types and quantities of the raw materials
and subassemblies used to produce a
single finished good unit
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Hall, Accounting Information Systems, 7e 14
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 Information: Documents in the
Batch Production System

▪ Route Sheet - details the production path a

particular batch will take in the manufacturing
process
▪ sequence of operations
▪ time allotted at each station
▪ Work Order - uses the BOM and route sheet
to specify the exact materials and production
processes for each batch
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Hall, Accounting Information Systems, 7e 16
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 Information: Documents in the
Batch Production System

▪ Move Ticket - records work done in each

work center and authorizes the movement
of the batch
▪ Materials Requisition - authorizes the
inventory warehouse to release raw
materials for use in the production process

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 Production Planning and Control
Sales Forecast Raw Materials Requirements
Inventory Status Report (Purchase Requisitions)

Engineering Specifications
BOM and Route Sheets Operations Requirements

Production Scheduling
Work Orders
Move Tickets
Materials Requisitions
Open Work Orders
Work Centers
Job Tickets Cost Accounting
Time Cards Payroll
Completed Move Tickets Prod. Plan. and Control
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Upon Completion of the Production Process…
Finished Product Finished Goods Warehouse
and Closed Work Order

Closed Work Order

Inventory Control
Status Report of Raw Materials
and Finished Goods Prod. Plan. and Control

Journal Voucher General Ledger

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 Cost Accounting System
▪ Records the financial effects of the
events occurring in the production
process
▪ Initiated by the work order
▪ Cost accounting clerk creates a new
cost record for the batch and files in
WIP file
▪ The records are updated as materials
and labor are used
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Elements of the Cost Accounting System

Inventory Control Work Centers

materials requisitions job tickets
completed move tickets

COST ACCOUNTANTS
Update WIP accounts
STANDARDS DL
DM
Mfg. OH.
Compute Variances

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 Cost Accounting System
▪ Receipt of last move ticket signals
completion of the production
process
▪ clerk removes the cost sheet from
WIP file
▪ prepares a journal voucher to transfer
balance to a finished goods inventory
account and forwards to the General
Ledger department
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 Summary of Internal Controls

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 Internal Controls
▪ Transaction authorizations
▪ work orders – reflect a legitimate need
based on sales forecast and the finished
goods on hand
▪ move tickets – signatures from each work
station authorize the movement of the
batch through the work centers
▪ materials requisitions – authorize the
warehouse to release materials to the work
centers
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 Internal Controls
▪ Segregation of duties
▪ production planning and control
department is separate from the work
centers
▪ inventory control is separate from materials
storeroom and finished goods warehouse
▪ cost accounting function accounts for WIP
and should be separate from the work
centers in the production process

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 Internal Controls

▪ Supervision
▪ work center supervisors oversee the usage
of raw materials to ensure that all released
materials are used in production and waste
is minimized
▪ employee time cards and job tickets are
checked for accuracy

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 Internal Controls
▪ Access control
▪ direct access to assets
• controlled access to storerooms, production
work centers, and finished goods
warehouses
• quantities in excess of standard amounts
require approval
▪ indirect access to assets
• controlled use of materials requisitions,
excess materials requisitions, and
employee time cards
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 Internal Controls
▪ Accounting records
▪ pre-numbered documents
▪ work orders
▪ cost sheets
▪ move tickets
▪ job tickets
▪ material requisitions
▪ WIP and finished goods files

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 Internal Controls
▪ Independent verification
▪ cost accounting reconciles material usage (material
requisitions) and labor usage (job tickets) with
standards
• variances are investigated
▪ GL dept. verifies movement from WIP to FG by
reconciling journal vouchers from cost accounting and
inventory subsidiary ledgers from inventory control
▪ internal and external auditors periodically verify the
raw materials and FGs inventories through a physical
count
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 World-Class Companies…

▪ continuously pursue improvements in all

aspects of their operations, including
manufacturing procedures
▪ are highly customer oriented
▪ have undergone fundamental changes
from the traditional production model
▪ often adopt a lean manufacturing model

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 Principles of Lean Manufacturing
▪ Pull Processing – products are pulled from the consumer
end (demand), not pushed from the production end
(supply)
▪ Perfect Quality –pull processing requires zero defects in
raw material, WIP, and FG inventories
▪ Waste Minimization – activities that do not add value or
maximize the use of scarce resources are eliminated
▪ Inventory Reduction – hallmark of lean manufacturing
▪ Inventories cost money
▪ Inventories can mask production problems
▪ Inventories can precipitate overproduction

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 Principles of Lean Manufacturing
▪ Production Flexibility – reduce setup time to a
minimum, allowing for a greater diversity of
products, without sacrificing efficiency
▪ Established Supplier Relations – late deliveries,
defective raw materials, or incorrect orders will
shut down production since there are inventory
reserves
▪ Team Attitude – each employee must be vigilant
of problems that threaten the continuous flow of
the production line
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 Lean Manufacturing Model
▪ Achieve production flexibility by means of:
▪ Changes in the physical organization of
production facilities
▪ Employment of automated technologies
• CIM, AS/RS, robotics, CAD, and CAM
▪ Use of alternative accounting models
• ABC and value stream accounting
▪ Use of advanced information systems
• MRP, MRPII, ERP, and EDI

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 Physical Reorganization of the
Production Facilities
▪ Inefficiencies in traditional plant layouts increase
handling costs, conversion time, and excess
inventories.
▪ Employees tend to feel ownership over their
stations, contrary to the team concept.
▪ Reorganization is based on flows through cells
which shorten the physical distance between
activities.
▪ This reduces setup and processing time, handling costs,
and inventories.
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 Progression of Automation in the
Manufacturing Process

Traditional Islands of Computer

Technology Integrated
Manufacturing

Progression of Automation toward World-Class Status

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 Automating Manufacturing

▪ Traditional Approach to Automation

▪ Consists of many different types of
machines which require a lot of setup time
▪ Machines and operators are organized in
functional departments
▪ WIP follows a circuitous route through the
different operations

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 Automating Manufacturing

▪ Islands of Technology
▪ Stand alone islands which employ computer numerical
controlled (CNC) machines that can perform multiple
operations with less human involvement
▪ Computer Numerical Controlled (CNC )
Machines
▪ Reduce the complexity of the physical layout
▪ Arranged in groups and in cells to produce an entire
part from start to finish
▪ Need less set-up time

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 Automating Manufacturing
▪ Computer Integrated Manufacturing (CIM)
▪ A completely automated environment which
employs automated storage and retrieval
systems (AS/RS) and robotics
▪ Automated Storage and Retrieval Systems
(AS/RS)
▪ Replaces traditional forklifts and their human
operators with computer-controlled conveyor
systems
▪ Reduce errors, improved inventory control, and
lower storage costs
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 Computer-Integrated Manufacturing
(CIM) System

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 Automating Manufacturing
▪ Robotics
▪ Use special CNC machines that are useful in
performing hazardous, difficult, and
monotonous tasks
▪ Computer-Aided Design (CAD)
▪ Increases engineers’ productivity
▪ Improves accuracy
▪ Allows firms to be more responsive to market
demands
▪ Interfaces with CAM and MRPII systems
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 Automating Manufacturing

▪ Computer Aided Manufacturing

(CAM)
▪ Uses computers to control the physical
manufacturing process
▪ Provides greater precision, speed, and
control than human production
processes

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 Achieving World-Class Status
▪ The world-class firm needs new accounting
methods and new information systems that:
▪ show what matters to its customers
▪ identify profitable products
▪ identify profitable customers
▪ identify opportunities for improving operations and
products
▪ encourage the adoption of value-added activities and
processes and identify those that do not add value
▪ efficiently support multiple users with both financial
and nonfinancial information

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 What’s Wrong with Traditional
Accounting Information?
▪ Inaccurate cost allocations – automation changes the
relationship between direct labor, direct materials, and
overhead cost
▪ Promotes nonlean behavior – incentives to produce
large batches and inventories, and conceal waste in
overhead allocations
▪ Time lag – data lag due to assumption that control can
be applied after the fact to correct errors
▪ Financial orientation – dollars as the standard unit of
measure
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 Activity Based Costing (ABC)…

▪ is an information system that provides

managers with information about activities
and cost objects
▪ assumes that activities cause costs and
that products (and other cost objects)
create a demand for activities
▪ is different from traditional accounting
system since ABC has multiple activity
drivers, whereas traditional accounting has
only one, e.g. machine hours
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Hall, Accounting Information Systems, 7e 45
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 ABC – Pros and Cons
▪ Advantages
▪ More accurate costing of products/services, customers, and
distribution channels
▪ Identifying the most and least profitable products and customers
▪ Accurately tracking costs of activities and processes
▪ Equipping managers with cost intelligence to drive continuous
improvements
▪ Facilitating better marketing mix
▪ Identifying waste and non-value-added activities
▪ Disadvantages
▪ Too time-consuming and complicated to be practical
▪ Promotes complex bureaucracies in conflict with lean
manufacturing philosophy
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 Value Stream Accounting
▪ Value stream – all the steps in a process that
are essential to producing a product
▪ Value streams cut across functions and
departments
▪ Captures costs by value stream rather than
by department or activity
▪ Simpler than ABC accounting
▪ Makes no distinction between direct and
indirect costs
▪ Including labor costs
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 Cost Assignment to Value Stream

Sales Product Warehousing Manufacturing Shipping

Planning

Production Production Cell

Materials Labor Machines

Value Stream Product Family A

Marketing and Product Support Facilities Rent &

Design Labor Distribution Expenses
Selling Maintenance
Expenses

Value Stream Product Family

B
Productio Productio Cel
n Materials n Labo Machine
l
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 Information Systems that Support Lean
Manufacturing
▪ Manufacturing Resources Planning (MRP)
▪ Ensures adequate raw materials for production process
▪ Maintains the lowest possible level of inventory on hand
▪ Produce production and purchasing schedules and other
information needed to control production
▪ MRP II
▪ An extension of MRP
▪ More than inventory management and production
scheduling – it is a system for coordinating the
activities of the entire firm
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Hall, Accounting Information Systems, 7e 50
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 Information Systems that Support Lean
Manufacturing
▪ Enterprise Resource Planning (ERP)
Systems
▪ Huge commercial software packages that support the
information needs of the entire organization, not just
the manufacturing functions
▪ Automates all business functions along with full
financial and managerial reporting capability
▪ Electronic Data Interchange (EDI)
▪ External communications with its customers and
suppliers via Internet or direct connection
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 Chapter 8
Financial Reporting and
Management Reporting
Systems

Accounting Information Systems, 7e

James A. Hall

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©2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part.
 Objectives for Chapter 8
▪ Understand the operational features of the
General Ledger System(GLS), financial
reporting system(FRS), and management
reporting system(MRS).
▪ Be able to identify the principle operational
controls governing the GLS and FRS.
▪ Understand the factors that influence the
design of the MRS.
▪ Understand the elements of a responsibility
accounting system.
▪ Be familiar with the financial reporting issues
surrounding XBRL.
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 IS Functions of GLS
▪ General ledger systems should:
▪ collect transaction data promptly and
Input
accurately.
▪ classify/code data and accounts.
▪ validate collected transactions/ maintain
accounting controls (e.g., equal debits and
credits).
Process
▪ process transaction data.
• post transactions to proper accounts
• update general ledger accounts and transaction
files
Output • record adjustments to accounts
▪ store transaction data.
▪ generate timely financial reports.
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 Relationship of GLS to Other
Information Subsystems

Figure 8-1

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 GLS Database
▪ General ledger master file
▪ principal FRS file based on chart of accounts
▪ General ledger history file
▪ used for comparative financial support
▪ Journal voucher file
▪ all journal vouchers of the current period
▪ Journal voucher history file
▪ journal vouchers of past periods for audit trail
▪ Responsibility center file
▪ financial data by responsibility centers for MRS
▪ Budget master file
▪ budget data by responsibility centers for MRS
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 Journal Voucher Layout for a
General Ledger Master File

Figure 8-2

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 Financial Reporting Process

Figure 8-4
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 GLS Reports
▪ General ledger analysis:
▪ listing of transactions
▪ allocation of expenses to cost centers
▪ comparison of account balances from prior periods
▪ trial balances
▪ Financial statements:
▪ balance sheet
▪ income statement
▪ statement of cash flows
▪ Managerial reports:
▪ analysis of sales
▪ analysis of cash
▪ analysis of receivables
▪ Chart of accounts: coded listing of accounts
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 Potential Risks in the GL/FRS
▪ Improperly prepared journal entries
▪ Unposted journal entries
▪ Debits not equal to credits
▪ Subsidiary not equal to G/L control accounts
▪ Inappropriate access to the G/L
▪ Poor audit trail
▪ Lost or damaged data
▪ Account balances that are wrong because of
unauthorized or incorrect journal vouchers

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 GL/FRS Control Issues
▪ Transaction authorization - journal
vouchers must be authorized by a
manager at the source dept
▪ Segregation of duties – G/L clerks
should not:
▪ have recordkeeping responsibility for
special journals or subsidiary ledgers
▪ prepare journal vouchers
▪ have custody of physical assets
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 GL/FRS Control Issues
▪ Access controls:
▪ Unauthorized access to G/L can result in
errors, fraud, and misrepresentations in
financial statements.
▪ Sarbanes-Oxley requires controls that limit
database access to only authorized
individuals.
▪ Accounting records - trace source
documents from inception to financial
statements and vice versa
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 GL/FRS Control Issues
▪ Independent verification
▪ G/L dept. reconciles journal vouchers
and summaries.
▪ Two important operational reports used:
▪ journal voucher listing – details of each
journal voucher posted to the G/L
▪ general ledger change report – the
effects of journal voucher postings on
G/L accounts
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 GL/FRS Using Database Technology

Figure 8-5
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GL/FRS Using Database Technology
▪ Advantages:
▪ immediate update and reconciliation
▪ timely, if not real-time, information
▪ Removes separation of transaction authorization
and processing
▪ Detailed journal voucher listing and account activity
reports are a compensating control
▪ Centralized access to accounting records
▪ Passwords and authorization tables as controls

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 HTML: Hyper Text Markup
Language
▪ Format used to produce Web pages
▪ defines the page layout, fonts, and graphic elements
▪ used to lay out information for display in an appealing
manner like one sees in magazines and newspapers
▪ using both text and graphics (including pictures)
appeals to users
▪ Hypertext links to other documents on the
Web
▪ Even more pertinent is HTML’s support for hypertext
links in text and graphics that enable the reader to
‘jump’ to another document located anywhere on the
World Wide Web.
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XML: eXtensible Markup Language
▪ XML is a meta-language for describing
markup languages.
▪ Extensible means that any markup language
can be created using XML.
▪ includes the creation of markup languages
capable of storing data in relational form, where
tags (formatting commands) are mapped to data
values
▪ can be used to model the data structure of an
organization’s internal database

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 Comparison of HTML and XML
Documents

Figure 8-6

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 XBRL: eXtensible Business
Reporting Language
▪ XBRL is an XML-based language for standardizing
methods for preparing, publishing, and exchanging
financial information, e.g., financial statements.
▪ XBRL taxonomies are classification schemes.
▪ Advantages:
▪ Business offer expanded financial information to all
interested parties virtually instantaneously.
▪ Companies that use XBRL database technology can
further speed the process of reporting.
▪ Consumers import XBRL documents into internal
databases and analysis tools to greatly facilitate their
decision-making processes.
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 Implications for Accounting
▪ Audit implication for XBRL
▪ taxonomy creation: incorrect taxonomy
results in invalid mapping that may cause
material misrepresentation of financial data
▪ validation of instance documents: ensure
that appropriate taxonomy and tags have
been applied
▪ audit scope and timeframe: impact on
auditor responsibility as a consequence of
real-time distribution of financial statements

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Management Reporting Systems
▪ Produce financial and nonfinancial
information needed by management to
“plan, evaluate, control”
▪ Usually seen as discretionary reporting
▪ Can argue that Sarbanes-Oxley
requires MRS
▪ MRS provide a formal means for
monitoring the internal controls

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Factors That Influence MRS Design
▪ Management principles
▪ Management function, level, and
decision type
▪ Problem structure
▪ Types of management reports
▪ Responsibility accounting
▪ Behavioral considerations

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 Management Principles

▪ Formalization of tasks:
▪ structures the firm around the tasks
performed rather than around
individuals’ unique skills
▪ allows specification of the information
needed to support the tasks

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 Management Principles
▪ Responsibility and authority:
▪ responsibility - obligation to achieve
desired results
▪ authority - power to make decisions within
the limits of that responsibility
▪ delegated by managers to subordinates
▪ define the vertical reporting channels
through which information flows

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 Management Principles
▪ Span of control:
▪ the number of subordinates directly under the
manager’s control
▪ detailed reports for managers with narrow spans of
control
▪ summarized information for managers with broad
spans of control

Narrow Span of Control Wide Span of Control

Figure 8-15
Hall, Accounting Information Systems, 7e 24
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 Management Principles

▪ Management by exception:
▪ Managers should limit their attention
to potential problem areas.
▪ Reports should focus on changes in
key factors that are symptomatic of
potential problems.

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 Management Level and Decision Type

Figure 8-16

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 Management Function, Level, and
Decision Type
▪ Strategic planning decisions:
▪ firm’s goals and objectives
▪ scope of business activities
▪ organizational structure
▪ management philosophy
▪ long-term, with broad scope and impact
▪ non-recurring , with high degree of uncertainty
▪ need highly summarized information
▪ require external & internal information sources

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 Management Function, Level, and
Decision Type
▪ Tactical planning decisions:
▪ subordinate to strategic decisions
▪ short term
▪ specific objectives
▪ recur often
▪ fairly certain outcomes
▪ limited impact on the firm
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 Management Function, Level, and
Decision Type
▪ Management control decisions:
▪ using resources as productively as possible in all
functional areas
▪ evaluating the performance of subordinates
against standards
▪ Measuring performance is difficult because
sound decisions with long-term benefits may
negatively impact the short- term bottom line.

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 Management Function, Level, and
Decision Type
▪ Operational control decisions:
▪ deal with routine tasks
▪ narrower focus, dependent on details
▪ highly structured
▪ short time frame
▪ Three basic elements or steps:
▪ set attainable standards
▪ evaluate performance
▪ take corrective action
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 Classification of Decision Types by
Decision Characteristics

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 Problem Structure

▪ Reflects and affects how well

decision makers understand and
solve problems
▪ Elements of problem structure:
▪ data
▪ procedures
▪ objectives
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 Problem Structure

Information System Management Level Problem Structure

Non-Traditional IS

Unstructured

Strategic
Management

Tactical Partially
Management Structured
Traditional IS

Operations Management

Operations
Structured
Figure 8-17
Hall, Accounting Information Systems, 7e 33
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 Management Reports

▪ Report objectives - reports must have

value or information content
▪ They should…
▪ reduce the level of uncertainty associated
with a problem facing the decision maker
▪ influence the behavior of the decision
maker in a positive way

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 Report Attributes
▪ Relevance – useful to decision making
▪ Summarization – appropriate level of detail
▪ Exception orientation – identify risks
▪ Accuracy – free of material errors
▪ Completeness – essential information
▪ Timeliness – in time for decisions
▪ Conciseness – understandable format

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Attributes of Useful Information According to FASB’s
Conceptual Framework
Feedback
Value

Representational Relevant
Faithfulness Timely
Information
Predictive
Reliable Value
Verifiable
Information

Neutral
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 Types of Management Reports

▪ Programmed reports:
▪ scheduled reports – produced at specified
intervals, e.g., weekly
▪ on-demand reports – triggered by events,
e.g., inventory levels drop to a certain level
▪ Ad hoc reports:
▪ designed and created “as needed”
▪ situations arise that require new information

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 Responsibility Accounting

▪ Implies that every economic event

that affects the organization is the
responsibility of and can be traced to
an individual manager
▪ Incorporates the fundamental
principle that responsibility-area
managers are accountable for items
that they control
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Setting Financial Goals: Budgeting

▪ Budgeting helps management achieve

financial objectives by setting measurable
goals for each organizational segment.
▪ Budget information flows downward and
becomes increasingly detailed at each
lower level.
▪ The performance information flows upward
as responsibility reports.

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 Responsibility Centers

▪ Cost center – responsible for keeping

costs within budgetary limits
▪ Profit center – responsible for both cost
control and revenue generation
▪ Investment center – has general authority
to make a wide range of decisions
affecting costs, revenue, and investments
in assets

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 Behavioral Considerations:
Goal Congruence
▪ MRS and compensation schemes help
to appropriately assign authority and
responsibility.
▪ If compensation measures are not
carefully designed, managers may
engage in actions not optimal for the
organization.
▪ Short-term v. long-term measures
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 Behavioral Considerations:
Information Overload
▪ Occurs when managers receive more
information than they can assimilate.
▪ Can cause managers to disregard
formal information and rely on
informal—probably inferior—cues when
making decisions.

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 Behavioral Considerations:
Performance Measures
▪ Appropriate performance measures
▪ Stimulate behavior consistent with firm objectives.
▪ Managers consider all relevant aspects, not just one.
▪ Example of inappropriate measures:
▪ price variance – can affect the quality of the items
purchased
▪ quotas – can affect quality control, material usage
efficiency, labor relations, plant maintenance
▪ profit measures – can affect plant investment,
employee training, inventory reserve levels,
customer satisfaction
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