Chapter Four

Accounting Systems

Basic Accounting Systems

An accounting system is the methods and procedures for collecting, classifying, summarizing,
and reporting a business’s financial and operating information.
Accounting systems for large businesses must be able to collect, accumulate, and report many
types of transactions.
Accounting systems evolve through a three-step process as a business grows and changes. The
first step in this process is analysis, which consists of (1) identifying the needs of those who use
the business’s financial information and (2) determining how the system should provide this
information. In the second step, the system is designed so that it will meet the users’ needs. This
system included a chart of accounts, a two-column journal, and a general ledger. Finally, the
system is implemented and used. Once a system has been implemented, feedback, or input,
from the users of the information can be used to analyze and improve the system.
Internal controls and information processing methods are essential in an accounting system.
Internal controls are the policies and procedures that protect assets from misuse, ensure that
business information is accurate, and ensure that laws and regulations are being followed.
Processing methods are the means by which the system collects, summarizes, and reports
accounting information. These methods may be either manual or computerized. In the following
sections, we will discuss internal controls, manual accounting systems that use special journals,
and computerized accounting systems.
Internal Control
Businesses use internal controls to guide their operations, safeguard assets, and prevent abuses of
their systems.
Objectives of Internal Control
The objectives of internal control are to provide reasonable assurance that:
1. Assets are safeguarded and used for business purposes.
2. Business information is accurate.
3. Employees comply with laws and regulations.

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Internal control can safeguard assets by preventing theft, fraud, misuse, or misplacement. One of
the most serious breaches of internal control is employee fraud. Employee fraud is the
intentional act of deceiving an employer for personal gain. Such deception may range from
purposely overstating expenses on a travel expense report in order to receive a higher
reimbursement to embezzling millions of dollars through complex schemes. Accurate business
information is necessary for operating a business successfully. The safeguarding of assets and
accurate information often go hand-in-hand. The reason is that employees attempting to defraud
a business will also need to adjust the accounting records in order to hide the fraud.
Businesses must comply with applicable laws, regulations, and financial reporting standards.
Examples of such standards and laws include environmental regulations, contract terms, safety
regulations, and generally accepted accounting principles (GAAP).
Elements of Internal Control
How does management achieve its internal control objectives? Management is responsible for
designing and applying five elements of internal control to meet the three internal control
objectives. These elements are:
1. the control environment
2. risk assessment
3. control procedures
4. monitoring
5. information and communication

Control Environment
A business’s control environment is the overall attitude of management and employees about the
importance of controls. One of the factors that influence the control environment is
management’s philosophy and operating style. A management that overemphasizes operating
goals and deviates from control policies may indirectly encourage employees to ignore controls.
For example, the pressure to achieve revenue targets may encourage employees to fraudulently
record sham sales. On the other hand, a management that emphasizes the importance of controls
and encourages adherence to control policies will create an effective control environment.
The business’s organizational structure, which is the framework for planning and controlling
operations, also influences the control environment. For example, a department store chain might
organize each of its stores as separate business units. Each store manager has full authority over

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pricing and other operating activities. In such a structure, each store manager has the
responsibility for establishing an effective control environment.
Personnel policies also affect the control environment. Personnel policies involve the hiring,
training, evaluation, compensation, and promotion of employees. In addition, job descriptions,
employee codes of ethics, and conflict-of-interest policies are part of the personnel policies. Such
policies and procedures can enhance the internal control environment if they provide reasonable
assurance that only competent, honest employees are hired and retained.
Risk Assessment
All organizations face risks. Examples of risk include changes in customer requirements,
competitive threats, regulatory changes, changes in economic factors such as interest rates, and
employee violations of company policies and procedures. Management should assess these risks
and take necessary actions to control them, so that the objectives of internal control can be
achieved. Once risks are identified, they can be analyzed to estimate their significance, to assess
their likelihood of occurring, and to determine actions that will minimize them. For example, the
manager of a warehouse operation may analyze the risk of employee back injuries, which might
give rise to lawsuits. If the manager determines that the risk is significant, the company may take
action by purchasing back support braces for its warehouse employees and requiring them to
wear the braces.
Control Procedures
Control procedures are established to provide reasonable assurance that business goals will be
achieved, including the prevention of fraud. In the following paragraphs, we will briefly discuss
control procedures that can be integrated throughout the accounting system.
Competent Personnel, Rotating Duties, and Mandatory Vacations The successful operation
of an accounting system requires procedures to ensure that people are able to perform the duties
to which they are assigned. Hence, it is necessary that all accounting employees be adequately
trained and supervised in performing their jobs. It may also be advisable to rotate duties of
clerical personnel and mandate vacations for non clerical personnel. These policies encourage
employees to adhere to prescribed procedures. In addition, existing errors or fraud may be
detected.
Separating Responsibilities for Related Operations To decrease the possibility of inefficiency,
errors, and fraud, the responsibility for related operations should be divided among two or more

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persons. For example, the responsibilities for purchasing, receiving, and paying for computer
supplies should be divided among three persons or departments. If the same person orders
supplies, verifies the receipt of the supplies, and pays the supplier, the following abuses are
possible:
1. Orders may be placed on the basis of friendship with a supplier, rather than on price,
quality, and other objective factors.
2. The quantity and quality of supplies received may not be verified, thus causing payment
for supplies not received or poor-quality supplies.
3. Supplies may be stolen by the employee.
4. The validity and accuracy of invoices may be verified carelessly, thus causing the
payment of false or inaccurate invoices.
The “checks and balances” provided by dividing responsibilities among various departments
requires no duplication of effort. The business documents prepared by one department are
designed to coordinate with and support those prepared by other departments.
Separating Operations, Custody of Assets, and Accounting Control policies should establish
the responsibilities for various business activities. To reduce the possibility of errors and fraud,
the responsibilities for operations, custody of assets, and accounting should be separated. The
accounting records then serve as an independent check on the individuals who have custody of
the assets and who engage in the business operations. For example, the employees entrusted with
handling cash receipts from credit customers should not record cash receipts in the accounting
records. To do so would allow employees to borrow or steal cash and hide the theft in the
records. Likewise, if those engaged in operating activities also record the results of operations,
they could distort the accounting reports to show favorable results. For example, a store manager
whose year-end bonus is based upon operating profits might be tempted to record fictitious sales
in order to receive a larger bonus.
Proofs and Security Measures Proofs and security measures should be used to safeguard assets
and ensure reliable accounting data. This control procedure applies to many different techniques,
such as authorization, approval, and reconciliation procedures. For example, employees who
travel on company business may be required to obtain a department manager’s approval on a
travel request form. Other examples of control procedures include the use of bank accounts and
other measures to ensure the safety of cash and valuable documents. A cash register that displays

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the amount recorded for each sale and provides the customer a printed receipt can be an effective
part of the internal control structure. An all-night convenience store could use the following
security measures to deter robberies:
1. Locate the cash register near the door, so that it is fully visible from outside the store;
have two employees work late hours; employ a security guard.
2. Deposit cash in the bank daily, before 5 p.m.
3. Keep only small amounts of cash on hand after 5 p.m. by depositing excess cash in a
store safe that can’t be opened by employees on duty.
4. Install cameras and alarm systems.

Monitoring
Monitoring the internal control system locates weaknesses and improves control effectiveness.
The internal control system can be monitored through either ongoing effort by management or by
separate evaluations. Ongoing monitoring efforts may include observing both employee behavior
and warning signs from the accounting system. Separate monitoring evaluations are generally
performed when there are major changes in strategy, senior management, business structure, or
operations. In large businesses, internal auditors who are independent of operations normally are
responsible for monitoring the internal control system. Internal auditors can report issues and
concerns to an audit committee of the board of directors, who are independent of management.
In addition, external auditors also evaluate internal control as a normal part of their annual
financial statement audit.
Information and Communication
Information and communication are essential elements of internal control. Information about the
control environment, risk assessment, control procedures, and monitoring are needed by
management to guide operations and ensure compliance with reporting, legal, and regulatory
requirements. Management can also use external information to assess events and conditions that
impact decision making and external reporting. For example, management uses information from
the Financial Accounting Standards Board (FASB) to assess the impact of possible changes in
reporting standards.

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Manual Accounting Systems

After the internal control procedures have been developed, the basic processing method must be
selected. Accounting systems may be either manual or computerized. Since an understanding of
manual accounting systems assists managers in recognizing the relationships that exist between
accounting data and accounting reports, we illustrate manual systems first. In preceding chapters,
all transactions for were manually recorded in an all-purpose (two-column) journal. The journal
entries were then posted individually to the accounts in the ledger. Such manual accounting
systems are simple to use and easy to understand. Manually kept records may serve a business
reasonably well when the amount of data collected, stored, and used is relatively small. For a
large business with a large database, however, such manual processing is too costly and time-
consuming.
For example, a large company has millions of long-distance telephone fees earned on account
with millions of customers daily. Each telephone fee on account requires an entry debiting
Accounts Receivable and crediting Fees Earned. In addition, a record of each customer’s
receivable must be kept. Clearly, a simple manual system would not serve the business needs of
the company.
When a business has a large number of similar transactions, using an all-purpose journal is
inefficient and impractical. In such cases, subsidiary ledgers and special journals are useful. In
addition, the manual system can be supplemented or replaced by a computerized system.
Although we will illustrate the manual use of subsidiary ledgers and special journals, the basic
principles described in the following paragraphs also apply to a computerized accounting system.
Subsidiary Ledgers
An accounting system should be designed to provide information on the amounts due from
various customers (accounts receivable) and amounts owed to various creditors (accounts
payable). A separate account for each customer and creditor could be added to the ledger.
However, as the number of customers and creditors increases, the ledger becomes awkward to
use when it includes many customers and creditors. A large number of individual accounts with a
common characteristic can be grouped together in a separate ledger called a subsidiary ledger.
The primary ledger, which contains all of the balance sheet and income statement accounts, is
then called the general ledger. Each subsidiary ledger is represented in the general ledger by a
summarizing account, called a controlling account. The sum of the balances of the accounts in a

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subsidiary ledger must equal the balance of the related controlling account. Thus, you may think
of a subsidiary ledger as a secondary ledger that supports a controlling account in the general
ledger. The individual accounts with customers are arranged in alphabetical order in a subsidiary
ledger called the accounts receivable subsidiary ledger, or customers’ ledger. The controlling
account in the general ledger that summarizes the debits and credits to the individual customer
accounts is Accounts Receivable. The individual accounts with creditors are arranged in
alphabetical order in a subsidiary ledger called the accounts payable subsidiary ledger, or
creditors’ ledger. The related controlling account in the general ledger is Accounts Payable.
Each column in a multicolumn journal is used only for recording transactions that affect a certain
account. For example, a special column could be used only for recording debits to the cash
account, and another special column could be used only for recording credits to the cash account.
The addition of the two special columns would eliminate the writing of Cash in the journal for
every receipt and every payment of cash. Also, there would be no need to post each individual
debit and credit to the cash account. Instead, the Cash Dr. and Cash Cr. columns could be totaled
periodically and only the totals posted. In a similar way, special columns could be added for
recording credits to Fees Earned, debits and credits to Accounts Receivable and Accounts
Payable, and for other entries that are often repeated. An all-purpose multicolumn journal may be
adequate for a small business that has many transactions of a similar nature. However, a journal
that has many columns for recording many different types of transactions is impractical for larger
businesses. The next logical extension of the accounting system is to replace the single
multicolumn journal with several special journals. Each special journal is designed to be used
for recording a single kind of transaction that occurs frequently. For example, since most
businesses have many transactions in which cash is paid out, they will likely use a special journal
for recording cash payments. Likewise, they will use another special journal for recording cash
receipts. Special journals are a method of summarizing transactions, which is a basic feature of
any accounting system.
The format and number of special journals that a business uses depends upon the nature of the
business. A business that gives credit might use a special journal designed for recording only
revenue from services provided on credit. On the other hand, a business that does not give credit
would have no need for such a journal. In other cases, record-keeping costs may be reduced by
using supporting documents as special journals. The transactions that occur most often in a

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small- to medium-size service business and the special journals in which they are recorded are as
follows:

The all-purpose two-column journal, called the general journal or simply the journal, can be
used for entries that do not fit into any of the special journals. For example, adjusting and closing
entries are recorded in the general journal.
Manual Accounting System: The Revenue and Collection Cycle
Revenues earned on account create a customer receivable and will be recorded in a revenue
journal. Customers’ accounts receivable are collected and will be recorded in a cash receipts
journal. Internal control is enhanced by separating the function of recording revenue transactions
in the revenue journal from recording cash collections in the cash receipts journal. For example,
if these duties are separated, it is more difficult for one person to embezzle cash collections and
manipulate the accounting records.
Revenue Journal
The revenue journal is used only for recording fees earned on account. Cash fees earned would
be recorded in the cash receipts journal. The sale of products is recorded in a sales journal,
which is similar to the revenue journal. Example:

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Revenue Journal Postings to Ledgers

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Cash Receipts Journal

All transactions that involve the receipt of cash are recorded in a cash receipts journal. Thus, the
cash receipts journal has a column entitled Cash Dr.
Cash Receipts Journal and Postings

Accounts Receivable Control and Subsidiary Ledger

After all posting has been completed for the month, the sum of the balances in the accounts
receivable subsidiary ledger should be compared with the balance of the accounts receivable
controlling account in the general ledger. If the controlling account and the subsidiary ledger do
not agree, the error or errors must be located and corrected. The balances of the individual
customer accounts may be summarized in a schedule of accounts receivable.

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Manual Accounting System: The Purchase and Payment Cycle
The purchase and payment cycle consists of purchases on account and payments of cash to
suppliers.
To make purchases of supplies and other items on account requires establishing a supplier
account payable. These transactions will be recorded in a purchases journal. The payments of
suppliers’ accounts payable will be recorded in the cash payments journal. Internal control is
enhanced by separating the function of recording purchases in the purchases journal from
recording cash payments in the cash payments journal. Separating duties in this way prevents an
individual from establishing a fictitious supplier and then collecting payments for fictitious
purchases from this supplier.
Purchases Journal

The purchases journal is designed for recording all purchases on account. Cash purchases
would be recorded in the cash payments journal. The purchases journal has a column entitled
Accounts Payable Cr. The purchases journal also has special columns for recording debits to the
accounts most often affected.

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Purchases Journal and Postings

Cash Payments Journal

The special columns for the cash payments journal are determined in the same manner as for the
revenue, cash receipts, and purchases journals. The determining factors are the kinds of
transactions to be recorded and how often they occur. The cash payments journal has a Cash Cr.
column. All transactions recorded in the cash payments journal will involve an entry in this
column. Payments to creditors on account happen often enough to require an Accounts Payable

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Dr. column. Debits to creditor accounts for invoices paid are recorded in the Accounts Payable
Dr. column.
Cash Payments Journal and Postings

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Accounts Payable Control and Subsidiary Ledger
After all posting has been completed for the month, the sum of the balances in the accounts
payable subsidiary ledger should be compared with the balance of the accounts payable
controlling account in the general ledger. If the controlling account and the subsidiary ledger do
not agree, the error or errors must be located and corrected. The balances of the individual
supplier accounts may be summarized in a schedule of accounts payable.

Computerized Accounting Systems

Computerized accounting systems have become more widely used as the cost of hardware and
software has declined. In addition, computerized accounting systems have three main advantages
over manual systems. First, computerized systems simplify the record-keeping process.
Transactions are recorded in electronic forms and, at the same time, posted electronically to
general and subsidiary ledger accounts. Second, computerized systems are generally more
accurate than manual systems. Third, computerized systems provide management current
account balance information to support decision making, since account balances are posted as the
transactions occur.

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