CHAPTER 7 – THE CONVERSION CYCLE

A dynamic component of AIS is represented by manufacturing systems. Lean manufacturing and

conventional mass production (batch) processing are two distinct manufacturing environments that are
discussed in Chapter 7 along with the technologies and methods utilized to support them. Information
technologies like enterprise resource planning (ERP), manufacturing resources planning (MRP II), and
materials needs planning (MRP) are what power these settings (ERP). In contrast to two alternative
models, value stream accounting and activity-based costing (ABC), the chapter discusses the drawbacks
of the conventional cost accounting paradigm.

Learning Objectives

After studying this chapter, you should:

■ Understand the basic elements and procedures encompassing a traditional production process.

■ Understand the data flows and procedures in a traditional cost accounting system.

■ Be familiar with the accounting controls found in a traditional environment.

■ Understand the principles, operating features, and technologies that characterize lean manufacturing.

■ Understand the shortcomings of traditional accounting methods in a world-class environment.

■ Be familiar with the key features of activity-based costing and value stream accounting.

■ Be familiar with the information systems commonly associated with lean manufacturing and world
class companies.

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The Traditional Manufacturing Environment
The physical and informational processes involved in creating goods for sale make up the conversion
cycle. Figure 7-1's context-level data flow diagram (DFD) demonstrates the conversion cycle's
fundamental function and its linkages with other business cycles.

A corporation will use one of the following manufacturing techniques, depending on the kind of product
being produced:

1. Continuous processing produces a homogeneous result by executing a continuous sequence of

standardized processes. Cement and petrochemicals are produced during this manufacturing
process. Businesses typically use this strategy to keep finished goods inventories at the levels
required to meet anticipated sales demand. This procedure is triggered by information on
current inventory levels and sales projections.
2. Making discrete products to order entails manufacturing them in accordance with client
specifications. This process is initiated by sales orders rather than low inventory levels.
3. Distinct groups of products (batches) are produced using batch processing. Each piece in the
batch is comparable and needs the same processes and raw materials.

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BATCH PROCESSING SYSTEM

The batch processing system is conceptually shown in Figure 7-2 by the DFD, which is composed of four
fundamental processes: plan and control production, perform production operations, maintain
inventory control, and perform cost accounting.

Documents in the Batch Processing System

 The production schedule is the formal plan and authorization to begin production. This document
describes the specific products to be made, the quantities to be produced in each batch, and the
manufacturing timetable for starting and completing production.
 The bill of materials (BOM) specifies the types and quantities of the raw material (RM) and
subassemblies used in producing a single unit of finished product. The RM requirements for an
entire batch are determined by multiplying the BOM by the number of items in the batch.
 A route sheet shows the production path that a particular batch of product follows during
manufacturing. It is similar conceptually to a BOM. Whereas the BOM specifies material
requirements, the route sheet specifies the sequence of operations (machining or assembly) and the
standard time allocated to each task.
 The work order (or production order) draws from BOMs and route sheets to specify the materials
and production (machining, assembly, and so on) for each batch. These, together with move tickets
(described next), initiate the manufacturing process in the production departments.
 A move ticket records work done in each work center and authorizes the movement of the job or
batch from one work center to the next.
 A materials requisition authorizes the storekeeper to release materials (and subassemblies) to
individuals or work centers in the production process. This document usually specifies only standard
quantities.

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PRODUCTION PLANNING AND CONTROL. We first examine the production planning and control
function. This consists of two main activities: (1) specifying materials and operations requirements and
(2) production scheduling.

MATERIALS AND OPERATIONS REQUIREMENTS. The RM requirement for a batch of any given product is
the difference between what is needed and what is available in the RM inventory. This information
comes from analysis of inventory on hand, the sales forecast, engineering specifications (if any), and the
BOM.

PRODUCTION SCHEDULING. The second activity of the planning and control function is production
scheduling. The master schedule for a production run coordinates the production of many different
batches. The schedule is influenced by time constraints, batch size, and specifications derived from
BOMs and route sheets.

WORK CENTERS AND STOREKEEPING. The actual production operations begin when workers obtain raw
materials from storekeeping in exchange for materials requisitions. These materials, as well as the
machining and the labor required to manufacture the product, are applied in compliance with the work
order.

INVENTORY CONTROL. The inventory control function consists of three main activities. First, it provides
production planning and control with status reports on finished goods and raw materials inventory.
Second, the inventory control function is continually involved in updating the raw material inventory
records from materials requisitions, excess materials requisitions, and materials return tickets.

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CONTROLS IN THE TRADITIONAL ENVIRONMENT

World-Class Companies and Lean Manufacturing

WHAT IS A WORLD-CLASS COMPANY?

The following features characterize the world-class company:

 World-class companies must maintain strategic agility and be able to turn on a dime. Top
management must be intimately aware of customer needs and not become rigid and resistant
to paradigm change.
 World-class companies motivate and treat employees like appreciating assets. To activate the
talents of everyone, decisions are pushed to the lowest level in the organization. The result is a
flat and responsive organizational structure.
 A world-class company profitably meets the needs of its customers. Its goal is not simply to
satisfy customers, but to positively delight them. This is not something that can be done once
and then forgotten. With competitors aggressively seeking new ways to increase market share, a
world-class firm must continue to delight its customers.
 The philosophy of customer satisfaction permeates the world-class firm. All its activities, from
the acquisition of raw materials to selling the finished product, form a chain of customers. Each
activity is dedicated to serving its customer, which is the next activity in the process. The final
paying customer is the last in the chain.
 Finally, manufacturing firms that achieve world-class status do so by following a philosophy of
lean manufacturing. This involves doing more with less, eliminating waste, and reducing
production cycle time.

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PRINCIPLES OF LEAN MANUFACTURING

Lean manufacturing evolved from the Toyota Production System (TPS), which is based on the just-in-
time (JIT) production model. This manufacturing approach is in direct opposition to traditional
manufacturing, which is typified by high inventory levels, large production lot sizes, process
inefficiencies, and waste. The goal of lean production is improved efficiency and effectiveness in every
area, including product design, supplier interaction, factory operations, employee management, and
customer relations.

PULL PROCESSING. As the name implies, pull processing involves pulling products from the consumer
end (demand), rather than pushing them from the production end (supply). Under the lean approach,
inventories arrive in small quantities from vendors several times per day, just in time to go into
production.

PERFECT QUALITY. Success of the pull processing model requires zero defects in RM, WIP, and FG
inventory. Poor quality is very expensive to a firm. Consider the cost of scrap, reworking, scheduling
delays, and extra inventories to compensate for defective parts, warranty claims, and field service.

WASTE MINIMIZATION. All activities that do not add value and maximize the use of scarce resources
must be eliminated. Waste involves financial, human, inventory, and fixed assets. The following are
examples of waste in traditional environments, which lean manufacturing seeks to minimize.

INVENTORY REDUCTION. The hallmark of lean manufacturing firms is their success in inventory
reduction. Such firms often experience annual inventory turnovers of 100 times per year. While other
firms carry weeks and even months of inventories, lean firms have only a few days or sometimes even a
few hours of inventory on hand. The three common problems outlined below explain why inventory
reduction is important.

PRODUCTION FLEXIBILITY. Long machine setup procedures cause delays in production and encourage
overproduction. Lean companies strive to reduce setup time to a minimum, which allows them to
produce a greater diversity of products quickly, without sacrificing efficiency at lower volumes of
production.

ESTABLISHED SUPPLIER RELATIONS. A lean manufacturing firm must have established and cooperative
relationships with vendors. Late deliveries, defective raw materials, or incorrect orders will shut down
production immediately because this production model allows no inventory reserves to draw upon.

TEAM ATTITUDE. Lean manufacturing relies heavily on the team attitude of all employees involved in
the process. This includes those in purchasing, receiving, manufacturing, shipping—everyone. Each
employee must be vigilant of problems that threaten the continuous flow operation of the production
line.

Techniques and Technologies That Promote Lean Manufacturing

Modern consumers want quality products, they want them quickly, and they want variety of choice. This
demand profile imposes a fundamental conflict for traditional manufacturers, whose structured and

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inflexible orientation renders them ineffective in this environment. In contrast, lean companies meet the
challenges of modern consumerism by achieving manufacturing flexibility.

Accounting in a Lean Manufacturing Environment

The lean manufacturing environment carries profound implications for accounting. Traditional
information produced under conventional accounting techniques does not adequately support the
needs of lean companies. They require new accounting methods and new information that:

1. Shows what matters to its customers (such as quality and service).

2. Identifies profitable products.
3. Identifies profitable customers.
4. Identifies opportunities for improvement in operations and products.
5. Encourages the adoption of value-added activities and processes within the organization and
identifies those that do not add value.
6. Efficiently supports multiple users with both financial and nonfinancial information.

Information Systems That Support Lean Manufacturing

MATERIALS REQUIREMENT PLANNING (MRP)

MRP is an automated production planning and control system used to support inventory management.
Its operational objectives are to:

 Ensure that adequate raw materials are available to the production process.
 Maintain the lowest possible level of inventory on hand.
 Produce production and purchasing schedules and other information needed to control
production.

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MANUFACTURING RESOURCE PLANNING (MRP II)

MRP II is an extension of MRP that has evolved beyond the confines of inventory management. It is both
a system and a philosophy for coordinating a wide range of manufacturing activities. MRP II integrates
product manufacturing, product engineering, sales order processing, customer billing, human resources,
and related accounting functions.

ENTERPRISE RESOURCE PLANNING (ERP) SYSTEMS

In recent years MRP II has evolved into large suites of software called ERP systems. ERP integrates
departments and functions across a company into one system of integrated applications that is
connected to a single common database. This enables various departments to share information and
communicate with each other. An ERP system is composed of function-specific modules that reflect
industry best practices. Designed to interact with the other modules (for example, accounts receivable,
accounts payable, purchasing, and so on), these commercial packages support the information needs of
the entire organization, not just the manufacturing functions.

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KEY TAKEAWAYS FROM CHAPTER 7

9
CHAPTER 8 – FINANCIAL REPORTING AND MANAGEMENT REPORTING
SYSTEMS
Chapter 8 examines an organization's nondiscretionary and discretionary reporting systems.

 The first section focuses on the general ledger system (GLS) and the files that comprise a GLS
database.
 The section that follows examines the multi-step reporting method used to deliver financial
statement information to both internal and external consumers. Traditional financial reporting is
changing for many businesses because of new XBRL technology. The salient characteristics of
XBRL are discussed, as well as the implications of this technology for internal control.
 The optional reporting systems of the Management Reporting System are examined in the
following section of the chapter (MRS). Professional standards and legislative legislation
applicable to nondiscretionary financial reporting do not apply to discretionary financial
reporting. Management principles, management functions, levels, and decision types, problem
structure, responsibility accounting, and behavioral considerations all have an impact on it. It is
investigated how each component influences the design of the management reporting system.

Learning Objectives

After studying this chapter, you should:

■ Understand the operational features of the general ledger system (GLS), financial reporting system
(FRS), and management reporting system (MRS).

■ Be able to identify the principal 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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The General Ledger System
Figure 8-1 characterizes the general ledger system (GLS) as a hub connected to the other systems of the
firm through spokes of information flows. Transaction cycles process individual events that are recorded
in special journals and subsidiary accounts. Summaries of these transactions flow into the GLS and
become sources of input for the management reporting system (MRS) and financial reporting system
(FRS). The bulk of the flows into the GLS comes from the transaction processing subsystems. Note,
however, that information also flows from the FRS as feedback into the GLS.

THE JOURNAL VOUCHER

The source of input to the general ledger is the journal voucher. A journal voucher, which can be used to
represent summaries of similar transactions or a single unique transaction, identifies the financial
amounts and affected general ledger (GL) accounts. Routine transactions, adjusting entries, and closing
entries are all entered the GL via journal vouchers. Because a responsible manager must approve journal
vouchers, they offer a degree of control against unauthorized GL entries.

THE GLS DATABASE

The GLS database includes a variety of files. Whereas these will vary from firm to firm, the following
examples are representative.

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The general ledger master file is the principal file in the GLS database. This file is based on the
organization’s published chart of accounts. Each record in the GL master is either a separate GL account
(for example, sales) or the control account (such as AR—control) for a corresponding subsidiary ledger in
the transaction processing system. The FRS draws upon the GL master to produce the firm’s financial
statements. The MRS also uses this file to support internal information reporting.

The general ledger history file has the same format as the GL master. Its primary purpose is to provide
historical financial data for comparative financial reports.

The journal voucher file is the total collection of the journal vouchers processed in the current period.
This file provides a record of all general ledger transactions and replaces the traditional general journal.

The journal voucher history file contains journal vouchers for past periods. This historical information
supports management’s stewardship responsibility to account for resource utilization. Both the current
and historical journal voucher files are important links in the firm’s audit trail.

The responsibility center file contains the revenues, expenditures, and other resource utilization data
for each responsibility center in the organization. The MRS draws upon these data for input in the
preparation of responsibility reports for management.

Finally, the budget master file contains budgeted amounts for revenues, expenditures, and other
resources for responsibility centers. These data, in conjunction with the responsibility center file, are the
basis for responsibility accounting.

GLS PROCEDURES

As we have seen in previous chapters, certain aspects of GLS update procedures are performed as either
a separate operation or integrated within transaction processing systems. Our focus in the next section
is on the interrelationship between the GLS and financial reporting. This involves additional updates in
the form of reversing, adjusting, and closing entries. Let’s now turn our attention to the financial
reporting system.

The Financial Reporting System

The law dictates management’s responsibility for providing stewardship information to external parties.
This reporting obligation is met via the FRS. Much of the information provided takes the form of
standard financial statements, tax returns, and documents required by regulatory agencies such as the
Securities and Exchange Commission (SEC).

FINANCIAL REPORTING PROCEDURES

1. Capture the transaction. 6. Make adjusting entries.

2. Record in special journal. 7. Journalize and post adjusting entries.
3. Post to subsidiary ledger. 8. Prepare the adjusted trial balance.
4. Post to general ledger. 9. Prepare the financial statements.
5. Prepare the unadjusted trial balance. 10. Journalize and post the closing entries.

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 11. Prepare the post-closing trial balance.

XBRL—Reengineering Financial Reporting

Online reporting of financial data has become a competitive necessity for publicly traded organizations.
Currently, most organizations accomplish this by placing their financial statements and other financial
reports on their respective Web sites as HTML (Hyper Text Markup Language1) documents. These
documents can then be downloaded by users such as the SEC, financial analysts, and other interested
parties. The HTML reports, however, cannot be conveniently processed through IT automation.
Performing any analysis on the data contained in the reports requires them to be manually entered into
the user’s information system.

The solution to this problem is eXtensible Business Reporting Language (XBRL), which is the Internet
standard specifically designed for business reporting and information exchange. The objective of XBRL is
to facilitate the publication, exchange, and processing of financial and business information. XBRL is a
derivative of another Internet standard called XML (eXtensible Markup Language).

XML

XML is a metalanguage for describing markup languages. The term extensible means that any markup
language can be created using XML. This includes the creation of markup languages capable of storing
data in relational form in which tags (or formatting commands) are mapped to data values. Thus, XML
can be used to model the data structure of an organization’s internal database.

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XBRL

Recognizing the potential benefits of XML, the AICPA encouraged research into the creation of an
accounting-specific markup language. XBRL is an XML-based language that was designed to provide the
financial community with a standardized method for preparing, publishing, and automatically
exchanging financial information, including financial statements of publicly held companies. XBRL is
typically used for reporting aggregated financial data but can also be applied to communicating
information pertaining to individual transactions.

Controlling the FRS

Sarbanes-Oxley legislation requires that management design and implement controls over the financial
reporting process. This includes the transaction processing systems that feed data into the FRS. In
previous chapters we studied control techniques necessary for the various transaction systems. Here we
will examine only the controls that relate to the FRS. The potential risks to the FRS include:

1. A defective audit trails.

2. Unauthorized access to the general ledger.
3. GL accounts that are out of balance with subsidiary accounts.
4. Incorrect GL account balances because of unauthorized or incorrect journal vouchers.

If not controlled, these risks may result in misstated financial statements and other reports, thus
misleading users of this information. The potential consequences are litigation, significant financial loss
for the firm, and sanctions specified by SOX legislation.

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The Management Reporting System
Management reporting is often called discretionary reporting because it is not mandated, as is financial
reporting. One could take issue with the term discretionary, however, and argue that an effective
management reporting system (MRS) is mandated by SOX legislation, which requires that all public
companies monitor and report on the effectiveness of internal controls over financial reporting. Indeed,
management reporting has long been recognized as a critical element of an organization’s internal
control structure. An MRS that directs management’s attention to problems on a timely basis promotes
effective management and thus supports the organization’s business objectives.

Factors That Influence the MRS

Designing an effective MRS requires an understanding of the information that managers need to deal
with the problems they face. This section examines several topics that provide insight into factors that
influence management information needs. These are management principles; management function,
level, and decision type; problem structure; types of management reports; responsibility accounting;
and behavioral considerations.

MANAGEMENT PRINCIPLES

Management principles provide insight into management information needs. The principles that most
directly influence the MRS are formalization of tasks, responsibility and authority, span of control, and
management by exception.

i. Formalization of Tasks

The formalization of tasks principle suggests that management should structure the firm around the
tasks it performs rather than around individuals with unique skills. Under this principle,
organizational areas are subdivided into tasks that represent full-time job positions. Each position
must have clearly defined limits of responsibility.

ii. Responsibility and Authority

The principle of responsibility refers to an individual’s obligation to achieve desired results.
Responsibility is closely related to the principle of authority. If a manager delegates
responsibility to a subordinate, he or she must also grant the subordinate the authority to make
decisions within the limits of that responsibility.
iii. Span of Control
A manager’s span of control refers to the number of subordinates directly under his or her
control. The size of the span has an impact on the organization’s physical structure. A firm with a
narrow span of control has fewer subordinates reporting directly to managers. These firms tend
to have tall, narrow structures with several layers of management. Firms with broad spans of
control (more subordinates reporting to each manager) tend to have wide structures, with
fewer levels of management.
iv. Management by Exception
The principle of management by exception suggests that managers should limit their attention
to potential problem areas (that is, exceptions) rather than being involved with every activity or

15
 decision. Managers thus maintain control without being overwhelmed by the details.

MANAGEMENT FUNCTION, LEVEL, AND DECISION TYPE

TYPES OF MANAGEMENT REPORTS

16
KEY TAKEAWAYS FROM CHAPTER 8

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