Chapter 2 :

Accounting System
Analysis & Decision

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 Objectives
Describe the nature of the traditional accounting
cycle and its relationship to business events

Describe the impact Describe the

of IT on the limitations of the
traditional traditional
accounting system accounting system
architecture

Describe how the traditional

accounting system architecture limits
accounting’s ability to enhance value

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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.

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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 = “Any Liabilities
AssetsSprague +
occurrence [accounting Equities
transaction]
Debit Creditan increase
must be either Debit Credit of values,
or a decrease Debit
and there Credit
are
(Left) (Right)
three classes (Left) liabilities,
of values [assets, (Right) and equity]
(Left) ... in (Right)
every
Increase Decrease
transaction Decrease
at least two Increase must
of the occurrences Decrease
appear ...Increase
on
+
opposite - of the above
sides - list.” + - +
Assets = Liabilities + Owner’s Equity

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 Exhibit 2-1 Sample Chart of Accounts
Account Title Account Account Title Account

Current Assets Stockholder’s Equity:

Cash 110 Common Stock 510
Accounts Receivable 130 Capital in Excess 520
Allowance for Doubtful Accounts 140 Retained Earnings 550
Inventory 160 Revenue and Expense Summary 590
Prepaid Insurance 180 Revenue:
Notes Receivable 190 Revenue 610
Property, Plant, and Equipment: 200 Interest Revenue 620
Land 210 Rent Revenue 630
Building 220 Expenses:
Accumulate Depreciation Building 230 Purchases 710
Equipment 240 Freight on Purchases 720
Accumulated Deprec. Equipment 250 Purchase Returns 730
Current Liabilities: Selling Expenses 740
Accounts Payable 310 General and Admin. Expenses 750
Long-Term Debt: Interest Expense 760
Bonds Payable 410 Extraordinary Loss (pretax) 770
Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000
 Exhibit 3-2: Steps in the Accounting Cycle and
Their Objectives
Step Description Objective
1 Identify Transaction or To gather information, generally in the form of source
Event to be Recorded documents, about transactions or events
2 Journalize Transaction To identify, assess and record the economic impact of
and Events transactions on the firm in a chronological record ( a journal),
in a form that facilitiates transfer to the accounts
3 Posting from Journals to To transfer the information from the journal to the ledger, the
Ledgers device that stores the accounts

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 Exhibit 3-2: Steps in the Accounting Cycle and
Their Objectives
Step Description Objective
4 Prepare Unadjusted To provide a convenient listing to check for debit-credit
Trial Balance equality, and a starting point for adjusting entries
5 Journalize and Post To record accruals, expiration of deferrals, estimations, and
Adjusting Journal other events often not signaled by a new source document
Entries
6 Prepare Adjusted Trial To check for debit-credit equality and to simplify preparation
Balance of the financial statements
7 Prepare Financial To communicate summarized financial information to external
Statements decision makers
8 Journalize and Post To close temporary accounts and transfer the net income
Closing Entries amount to retained earnings
9 Prepare Post-Closing To check for debit-credit equality after the closing entries
Trial Balance

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 Exhibit 3-2: Steps in the Accounting Cycle and
Their Objectives
Step Description Objective
10 Journalize and Post To simplify certain subsequent journal entries and reduce
Reversing Entries accounting costs.

At the beginning of the

next accounting period

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 Business Nonfinancial Financial Audit
event systems Information statements statements
customers and notes and notes

Accounting Cycle Process

Analyze Record Post journal Prepare and Prepare

business transaction data to the adjust the statements
event data data ledger trial balance and notes

Financial
Trial statements
Ignore Journals Ledgers and notes
event balance
data
Financial Correct and
statement adjust
notes
Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000
 Step 1 : 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
Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000
 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

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 Exhibit 3-5 Unadjusted Trail Balance
Illustrated
Sonora, Inc.
Unadjusted Trial Balance
31-Dec-98

Account Debit Credit

Assets: Cash $67,300
Accounts Receivable 45,000
Allowance for Doubful Accounts
Notes Receivable 8,000
Inventory (Jan. 1 balance, periodic system) 75,000
Prepaid Insurance 600
Land 8,000
Building 160,000
Accumulated depreciation, building 90,000
Equipment 91,000
Accumulated depreciation, equipment 27,000
Liabilities Accounts Payable 29,000
Bonds Payable 50,000
Owner's Equity Common Stock 150,000
Contributed Capital in exces of par 20,000
Retained Earnings 31,500
Revenues Sales Revenue 325,200
Interest Revenue 500
Rent Revenue 1,800
Expenses Purchases 130,000
Freight on purchases 4,000
Purchase Returns 2,000
Selling expenses 104,000
General and Administration 23,600
Interest expense 2,500
Extraordinary loss (pretax) 9000
$ 728,000.00 $ 728,000.00

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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
Source documents
depreciation)
from earlier
Correct Errors transactions are the
Record Changes in Estimates primary information
Recording Deferrals sources for adjusting
Recording Accruals entries.
Reclassifying balances
Recognizing inventory losses

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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
Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000
 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.

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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.

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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.

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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.

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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.

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 The Proliferation of Accounting
Business
Subsystems
Event

System A System B System C System D

Edit Edit Edit Edit

Audit Audit Audit Audit
Calculate Calculate Calculate Calculate
Summarize Summarize Summarize Summarize

Stored Stored Stored Stored

Data Data Data Data

Functional Functional Functional Functional

Views Views Views Views

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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).

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 • Based primarily on financial
reporting:
Architecture – Income Statement & Balance
of Sheet

Traditional • Build new/alternative systems

for alternative views of
Accounting business data.
• Confine recorded information
to “accounting transactions.”
• Store and summarize
information in ledgers.

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 Accounting Data: A Subset of
Business Data

(Limited view &

limited data)
Data that
describes Acct.
Business Data
Activities
Business Accountants General Limited Output
Activities filter data Ledger Views / Formats

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 The Heart of the Problem
with Traditional Systems

Process:
Output:
Input: Classifies
Produces
Narrow set and
narrow
of summarizes
functional
transactions transaction
views
data

Narrow functional views drive the selection of

transactions, classification, and summarization

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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.

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 Ways That Accounting Can Enhance
Its Value to the Organization

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

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 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.

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 Event-Driven IT Application Overview

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

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

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

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

 The End

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000