THE INFORMATION SYSTEM: AN ACCOUNTANT'S PERSPECTIVE 1-1

Part 1: Overview of Accounting Information Systems

CHAPTER 1
THE INFORMATION SYSTEM: AN ACCOUNTANT'S PERSPECTIVE

OUTLINE OF CHAPTER 1
Learning Objectives
The Information Environment
What is a system?
Elements of a System
A Framework for Information Systems
The Accounting Information System
The Management Information System
The Changing Role of Accounting Information
Why Distinguish Between AIS and MIS?
AIS Subsystems
Transaction Processing System
General Ledger/Financial Reporting Systems
Management Reporting System
A General Model for AIS
End Users
Data Sources
Data Collection
Data Processing
Database Management
Information Generation
Feedback
Information System Objectives
Acquisition of Information Systems
Organizational Structure
Business Segments
Functional Segmentation
Materials Management
Production
Marketing
Distribution
Personnel
Finance
The Accounting Function
The Value of Information
Accounting Independence
The Computer Services Function
Centralized Data Processing
Distributed Data Processing
The Need for Careful Analysis
The Evolution of Information System Models
The Manual Process Model
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The Flat File Model

Data Storage
Data Updating
Currency of Information
Task-Data Dependency
Flat Files Limit Data Integration
The Database Model
The REA Model
Resources
Events
Agents
ERP Systems
The Role of the Accountant
Accountants as Users
Accountants as System Designers
Accountants as System Auditors
External Auditing
Internal Auditing
Summary

LECTURE NOTES

Learning Objectives
 To understand the primary information flows within the business environment.
 To understand the difference between accounting information systems (AIS) and management
information systems (MIS).
 To understand the difference between a financial transaction and a nonfinancial transaction.
 To be able to distinguish between information and data.
 To know the three fundamental objectives of all information systems.
 To know the principal features of the general model for information systems.
 To be familiar with the functional areas of a business and their principal activities.
 To recognize the need for functional independence between accounting and other business areas.
 To know the basic differences between the centralized and distributed approaches to data
processing.
 To understand the stages in the evolution of information systems.
 To understand the relationship between external auditing, internal auditing, and IT auditing.

Purpose of Chapter 1: To put AIS in perspective for accountants by discussing:

 The “information environment,” the types and flows of information used in business, highlighting
information systems components, and the differences between financial and non-financial
transactions.
 The impact of the organizational structure on the business’ AIS, defining the business as a system
of functional areas and the role of accounting information in that system.
 THE INFORMATION SYSTEM: AN ACCOUNTANT'S PERSPECTIVE 1-3

 The evolution of information systems models including manual processes, flat file systems,
databases, the REA (resources, events, agents) model, and ERP (enterprise resource planning)
systems.
 The roles and responsibilities of accountants as AIS users, designers, and auditors.
 Distinguishing AIS from other IS applications by the legal and regulatory requirements.

The Information Environment

Information is a vital resource to a company, similar to capital, raw materials, and labor.
[Refer to Figure 1-1 Internal and External Information Flows found in the text and/or use an
overhead transparency.]

The pyramid depicts four strata of information users (top management, middle management,
operations management, operations personnel) within the business organization as well as the flow of
information (budget, operating, performance) among those users. Horizontal information flows
(more detailed, operations-oriented information) are compared to vertical information flows
(summarized, condensed information). Also, information flows to and from the outside environment
involve stakeholders and trading partners. The picture demonstrates that the information that flows
through a business organization will vary greatly in terms of quantity of detail and relevance to users.

What is a system?

Elements of a System
A broad definition of a system: a group of two or more interrelated components or subsystems
which serve a common purpose. The key aspect of this definition is the multiple, interrelated
components. The study of AIS involves the study of how components relate to one another.

 The perspective or scope of the system defines whether or not you have a system or a subsystem.

 A system must have at least one purpose, and serving that purpose is its fundamental job. If a
system is not performing its job, then it should be replaced.

 System decomposition breaks down the larger system into smaller subsystems and sub-
components. Decomposition allows us to better understand the purposes of each of the
subsystems and to determine how the interrelated sub-components assist in accomplishing their
purpose.

 The study of subsystem interdependency will make us aware of the importance of each
subsystem within the larger system and of the consequences of a failure of a particular subsystem.
Some subsystems are critical to the overall system performance while others are not. Accountants
must anticipate the cost of their possible failure, and design cost-effective control procedures.

Figure 1-2 illustrates system decomposition and interdependency with the example of an automobile.

A Framework for Information Systems: The AIS and the MIS

The information system is the set of formal procedures by which data are collected, processed into
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information, and distributed to users. Information systems process both financial and nonfinancial
information, which are often processed by the same physical system. There are two widely
acknowledged types of information systems: the accounting information system and the management
information system. This separation is conceptual as most information systems are not physically
separated, but rather integrated.

Figure 1-3 illustrates the difference between AIS and MIS. Explain that the AIS subsystems
illustrated in this Figure 1-3 will be discussed during the course.

The Accounting Information System

The AIS has three major subsystems:
 The TPS: Transaction Processing System for daily operations: has three subsystems: the revenue
cycle, the expenditure cycle and the conversion cycle.
 The GL/FRS: General Ledger/Financial Reporting System: takes and summarizes the data in the
TPS to update the general ledger accounts and to create reports that are for both internal and
external users.
 The MRS: Management Reporting System: takes and summarizes data in the TPS and the
GL/FRS to create reports for internal users. Discretionary reporting refers to specific contents
and formats that reflect a particular management’s needs.

The Management Information System

Management Information Systems [the other side of the framework in Figure 1-3] in addition,
process nonfinancial transactions and provide management with information that goes beyond the
limitations of AIS. [Note the groupings under MIS in Figure 1-3: Financial Management Systems,
Marketing Systems, Production Systems, Human Resource Systems]

The distinction between AIS and MIS systems centers on the concept of a transaction.
A transaction is an event that affects or is of interest to the organization and that is processed by its
information system as a unit of work. There are two types of business transactions: financial and
nonfinancial. Figure 1-4 makes this illustration utilizing the concept of a transaction.

 A financial transaction, the focus of the AIS, is an economic event that affects the assets and
equities of the organization, is reflected in its accounts, and is measured in monetary terms.
 Nonfinancial transactions, the focus of the MIS, include all other business transactions (e.g.
adding a new supplier or potential customer. Until there is an order, it is not a financial
transaction).
 The AIS processes all financial transactions and those nonfinancial transactions that directly affect
the processing of financial transactions.

[Use Table 1-1 to illustrate examples of MIS applications if you feel further distinctions are needed]

The Changing Role of Accounting Information

More and more, businesses are demanding integrated AIS and MIS system information. In response,
the structure of information systems have evolved into integrated approaches such as REA and ERP
models, and the role of accountants has changed from provider of financial information to consultant
for management in all functional areas.
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Why Distinguish Between AIS and MIS?

Even if businesses are integrating their AIS and MIS systems, we need to distinguish them because of
existing legal and professional standards designed to protect the resources of a business from the
many possible risks.

[Go back to Figure 1-3 to transition to the discussion of the three primary subsystems of the AIS.]

AIS Subsystems

Transaction Processing System

The TPS is central to the AIS because it converts economic events into financial transactions,
because it records those transactions in the accounting journals and ledgers, and because it distributes
essential financial information to daily operations personnel. Frequent, similar transactions
(shipments, receipts, payments, etc.) are organized into efficient cycles. The three primary
transaction cycles are the revenue cycle, the expenditure cycle, and the conversion cycle.

General Ledger/Financial Reporting Systems

The bulk of the inputs to the GL are from the transaction cycles. Summaries of these cycles are
utilized to update the GL control accounts. Non-frequent or unique transactions are entered with
specialized methods. The FRS reports the status of financial resources and the changes in those
resources, primarily for external users (typically termed “nondiscretionary reporting” because the
content and format are typically required by professional or regulatory standards such as GAAP, IRS,
GAAS).

Management Reporting System

The MRS provides the internal financial information needed by management. Managers need this
information to plan, execute and control their operations (e.g., budgets, variances, price lists, etc.).
These are typically termed “discretionary” reporting because the content and format for each of these
reports can be determined by each organization.

A General Model for AIS

The general model in Figure 1-5 applies to all information systems, regardless of their specific design.
The diagram reads from left to right, where at the far left and bottom left, data enters the system
from both external and internal sources. External data are created from financial transactions with
outside entities; internal data are created within the organization as resources move throughout the
organization. The primary elements of this model are: end users, data sources, data collection, data
processing, database management, information generation, and feedback.

End Users
Looking at the far right and bottom right of this Figure 1-5, end users fall into two groups: external
and internal users. External users include creditors, investors, the IRS, etc., and receive reports that
are very structured and static in format. Internal users include both operational employees and
management. The structures of these reports are more flexible and typically more difficult to design.
When designing an AIS for the internal users, the accountant must be concerned with both the
internal users’ needs and adequate control, security, accountability, and information-production cost.
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Data versus Information:

Data are raw or processed measurements of fact that have no direct effect on the users.
Information is data that causes a user to take an action that he or she would not have taken without
receiving that information. This definition depends on the effect on the users. Data for one person
may be information for another person. If an information system does not create a reaction in the
designed-for user, the information system may fail in its purpose.

Data Sources
External sources of financial transactions are those involving other legal entities: sales, purchases,
payments, etc. Internal sources of financial transactions usually involve the movement of resources
within a business: moving materials into production, adding labor costs to inventories, etc.

Data Collection
This first step is a crucial, if not the most important, phase of the system since here lies the first and
best opportunity to ensure that data is valid, correct, and free from material errors. Two rules govern
data collection: relevance and efficiency. Only data that contributes to the user’s information needs
are relevant. Efficient procedures collect data once, and make them available to a variety of users.
Redundancy in data collection can lead to inconsistencies and poor decisions.

Data Processing
Many times, raw data needs to be processed before it is considered information to the user.
Processing can be as simple as sorting events alphabetically or adding up like events, or as complex
as statistical modeling.

Database Management
[Use Figure 1-6]
Database management involves the tasks of storing, retrieving and deleting collected and processed
data. Data is typically represented in a logical hierarchy from smallest to largest where:
 Data attributes refer to the most elemental characteristics of a record such as the address of a
supplier, or the unit cost of an inventory item. Each attribute must logically pertain to the
record and must be relevant in terms of affecting the user. Attributes are often called columns
or fields.
 A record refers to the set of attributes for a single occurrence within an entity class, such as a
customer, an invoice, or a piece of machinery. Each record must have a unique identifier
attribute, termed the “primary key,” to distinguish it from the other records (e.g., social security
number for each student). Other fields may have secondary purposes, for example, for
summarizing purposes (e.g., total sales), and these attributes are termed “secondary keys.”
 A file is a complete set of similar records for an identical class, for example, all customers or all
invoices.
 A database is the organization’s collection of files. Database management involves the storage,
retrieval and deletion of data.

Information Generation
Data is compiled, arranged, formatted, and presented to make it meaningful and useful to end users.
To be effective, information must be relevant, timely, accurate, complete, and summarized. Without
these characteristics, information will lack value to external users, such as creditors, stockholders,
 THE INFORMATION SYSTEM: AN ACCOUNTANT'S PERSPECTIVE 1-7

and potential investors, and to internal users, such as management and operations personnel.
 Relevance: the data must serve a purpose.
 Timeliness: the data is received by the user before the decision is made. The data must be no
older than the time period of the action that it supports.
 Accuracy: the data is free from material errors. The user’s purpose determines the degree of
accuracy needed. Accuracy usually trades off with timeliness.
 Completeness: no relevant related data is missing.
 Summarization: the data is aggregated to the level demanded by the user’s purposes.

Feedback
Feedback is decision related to a system output that is sent back to the system as a source of data.
Feedback may be internal or external, for example, ordering low stock items, or changing your
credit policies.

Information System Objectives

The objectives of information systems are:
 to support management in its responsibility for the firm's resources
 to support management in decision making, and
 to support the day-to-day operations of the firm.

Acquisition of Information Systems

Businesses either build their own information systems in-house (especially true for large businesses)
utilizing the standards of the system development life cycle, or they purchase commercial systems
from software vendors.

The three basic types of commercial software are:

 Turnkey systems: finished, tested, and ready for standard use. Some examples of turnkey systems
are general accounting systems, office automation systems, word processing packages, database
management systems, electronic spreadsheet packages, and desktop publishing systems.
 Backbone systems: basic structure upon which you can build your system to fit your particular
needs.
 Vendor supported systems: customized systems developed by vendor rather than
in-house.

Organizational Structure
Figures 1-7 and 1-8 are useful to explain the roles of responsibility, authority, and accountability.

The structure of an organization reflects the distribution of responsibility, authority and accountability
throughout the organization. Plans flow downward, and performance measures of the results of
subordinates’ actions flow upward. [Some undergraduate students may never have seen an
organizational chart, so you may want to discuss the layout and the "trickling down" effect of
responsibilities. If you choose to walk through the eight functional areas, save Accounting and
Computer Services for last.]

The most common forms of organizational structure are by geographic region (taking advantage of
the local markets and channels), by business segment or product line (promoting internal efficiencies
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through specializations of knowledge and process), or by functional segmentation. Functional

segmentation is by far the most common organization method.

Functional Segmentation
Table 1-2 illustrates this concept.
In functional segmentation, management should determine the needed segments by mapping
resources to business functions.

Functions will vary greatly across organizations, depending upon their size and line of business. Due
to the topics of this course, the following functional segments will be discussed in more detail:
materials management, production, marketing, distribution, personnel, finance, accounting, and
computer services.

Materials Management
The objective is to plan and control the materials inventory for production needs while minimizing
the investment. Materials management has three sub-functions:
 Purchasing: responsible for ordering materials from vendors.
 Receiving: responsible for counting and checking the physical goods as they come in.
 Stores: responsible for the physical custody and safety of the materials until they are released into
production.

Production
Production coverts the raw materials utilizing labor and factory resources into finished goods. There
are primary manufacturing activities and production support activities (overhead):
 Production Planning: scheduling the flow of resources by information received about sales
orders, raw materials inventories, finished goods inventories, and machine and labor availability.
 Quality Control: monitors the manufacturing process to detect problems as early as possible.
 Maintenance: keeping the factory resources in efficient and effective order.

Marketing
Marketing is responsible for product promotion, advertising, and market research.

Distribution
Distribution involves getting the product to the customer quickly and safely.

Personnel
Personnel is responsible for hiring, developing, and firing employees.

Finance
Finance manages the cash, banking, and treasury resources, forecasting cash flows in order to keep
the business liquid while maximizing the return on excess funds.

The Accounting Function

The accounting function captures and records the firm's financial transactions in the database (sales,
payments) and distributes transaction information throughout the organization.
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The Value of Information

Information value is determined by its reliability. Reliable information must have integrity, that is, it
must be relevant, accurate, complete, summarized, and timely since users will be depending on it,
both internally and externally. (Bad examples: selling inventory you do not have to sell, or promising
a schedule that cannot be met!)

Accounting Independence
Reliability of accounting information is founded on the concept that the accounting department is
independent from the other operational departments that maintain physical custody of the assets of
the business. Independence ensures integrity of the recorded data.

The Computer Services Function

Like accounting, the computer services function manages information. Computer service functional
areas can be structured as Centralized Data Processing or as Distributed Data Processing.

Centralized Data Processing

Figures 1-9 and 1-10 illustrate centralized structures

All data processing is done with one or more large computers at a central site that serves users
throughout the organization. Users from all departments compete for these resources on the basis of
need. Centralized data processing departments are typically cost centers. The typical departments
include:
 Database administration: has the responsibility for the security and integrity of the database.
 Data processing: has the responsibility for daily transaction processing including the areas of data
control, data conversion, computer operations, and the data library.
 Systems Development and Maintenance: has the responsibility for analyzing user needs and for
designing new systems to satisfy those needs.

Distributed Data Processing

Figure 11 illustrates a distributed structure.
Each department or team is delegated their small information processing units (IPUs) that are
under the individual control of end users. A network of interconnected but independent IPUs results
in a highly distributed data processing system. The structure of the IPUs is determined by the
business organization.

Disadvantages of distributed data processing (DDP) include loss of control, inefficient use or
mismanagement of resources (overconsumption, hardware and software incompatability, redundant
tasks, difficulty hiring qualified professionals, destruction of audit trails, inadequate segregation of
duties), increased potential for programming errors and systems failure, and lack of standards. These
disadvantages are the advantages of a centralized system.

Advantages of distributed data processing include cost savings (elimination of data preparation and
data control), improved cost control, increased user satisfaction (more timely responses) and
improved operational efficiency (easier backups).

The Need for Careful Analysis

DDP has the allure of leading edge technology which may overwhelm important economic and
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operational considerations. The key is to be careful when considering this strategy.

The Evolution of Information System Models

The Manual Process Model

Figure 1-12 illustrates a manual process.
Manual systems are the oldest and the least used models today. Studying manual systems elevate the
student from the transaction level focus of the other accounting courses to an analysis of the business
processes, cycles, and controls.

Flat File Models

Flat file models are also called large main-frame legacy systems. End users own their data and do not
share their data (as with databases). Flat or fixed, structured files and programs are created and
arranged to satisfy one owner’s needs. Each business process has a separate storage file, and each
owner’s processing is performed stand-alone.

Three significant problems in flat file environments are: data storage, data updating and currency of
information.
 Data Storage: individual data items are stored repeatedly, sometimes with different titles.
 Data Updating: the redundant storage creates inefficient and erroneous updating efforts.
 Currency of Information: due to the difficulties in updating, some data fields may not be the most
current.

Other issues include:

Task-Data Dependency: as tasks needs change, it is hard to change the data/information provided
Limited Data Integration: Structure and format of data is chosen for the owner of the data.

Example: Sales data is needed by accounting, marketing, and production. Each of the data owners
would structure their storage, processing, and reports differently. Therefore, they must either create
their own processes and storage (redundancy), manipulate the existing stored data to fit their needs
(costly), or not use the data for decision support (poor judgment).

The Database Model

Figure 1-13 illustrates the database model.

Database models share data across applications. The data is at the central core of the software,
collected once for all purposes. There are no owners for each application. All users have access to
the shared resource.
 Databases are controlled by software called the database management system (DBMS).
 Users are constrained by the limitations of available data and the legitimacy of their need to access
it.
 Advantages of the database model include:
Elimination of data redundancy,
Single update, and
Current values.
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Flat file and early database systems are called traditional systems because each application functions
independently of the other applications.

Relational database models are more flexible than early database models and allow for the
opportunity for integration between business processes. Database tables are integrated (to different
degrees) in relational database models.

The REA Model

REA models are conceptual models of relational databases that connect a business’ resources,
events, and agents by defining the relationships between them. The availability of multiple user
“views” (e.g., sale, shipment, invoice, cash receipt) and the use of primary keys and foreign keys
permit and promote integration.
 Resources: assets of the organization that are scarce and under control of the business (not
including accounts receivable, which is derived as the difference between sales and cash received
for sales).
 Events: economic occurrences that affect changes in resources (production, sales, etc.)
 Agents: individuals or departments that participate in an economic event, inside or outside an
organization, with the power to use or dispose of economic resources (e.g., clerks, customers,
vendors, bankers, etc.).

REA models are structured around events rather than journals, ledgers, charts of accounts, or double
entry rules. Use the book example of sale and collection to illustrate the difference between
traditional systems and REA models.
The traditional approach: The traditional database approach:
Cost of Goods Sold 270 [Use Figure 1-14.]
Accounts Receivable 350
Sales 350
Inventory 270 The REA approach:
[Use Figure 1-15.]
Cash 200
Accounts Receivable 200
(the subsidiary ledgers must also be updated)

ERP Systems

ERP systems enable total business data and process integration by breaking down barriers and
highlighting common processes between functional areas. Key vendors are SAP, Oracle, Baan, J.D.
Edwards, and PeopleSoft. These systems are very expensive and take years to implement.

Common ERP modules include: Asset Management, Financial Accounting, Human Resources, Plant
Maintenance, Production Planning, Quality Management, Sales and Distribution, Inventory
Management, and Industry-specific Solutions.

ERP modules may need modifications to fit industry needs. These customizations are called “bolt-
ons” and may not be compatible with the ERP package.
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Overview of related coverage in the text

Chapters 2 through 8 deal with business processes, security, fraud, controls, and a variety of other
issues related to traditional (manual, flat file and early database) systems. Chapters 9 through 12
examine advanced database systems (REA, ERP, and other emerging technologies).

The Role of the Accountant

The accountant is and should be firmly connected with a firm's information system. Usually, you will
find accountants involved with the system in three ways: as users, developers or designers, and
auditors of systems.

Accountants as Users
Historically, the accounting function has been the largest single user of computer services. As users,
accountants are responsible to forecast and articulate their needs, in terms of accounting techniques
and internal control requirements to information systems professionals in order to receive optimal
systems.

Accountants as System Designers

In most businesses, accountants assess users’ needs, define the content and format of input and
outputs, specify sources of data, select the most appropriate accounting rules, and determine the
controls necessary to preserve the integrity and efficiency of the information system. At the system
development level, professional accountants are responsible for the conceptual view of the physical
information system, identifying specific needs and desired attributes of the system. This responsibility
should exist whether the firm is creating a custom information system or purchasing a packaged one
from a vendor.

Accountants as System Auditors

Auditing is a form of independent attestation, or professional opinion-providing, concerning whether
a reality conforms to pre-determined standards and rules.

External Auditing
In public accounting, an independent auditor attests to the fairness of a company’s financial
statements, thereby building public trust in that company. Recently, the professional accountant’s
role was expanded to include assurance. Assurance services are designed to improve the quality of
financial and nonfinancial information used by decision makers.

Information technology (IT) audits are one type of assurance services. The IT auditor attests to the
integrity of elements of the organization’s information system by testing its degree of compliance
with organizational objectives and internal control standards.

Internal Auditing
Internal Auditing is an in-house appraisal function. Internal auditors provide a wide variety of
activities including conducting financial statement audits, examining operational compliance with
standards or legal obligations, evaluating operational efficiencies, detecting fraud, etc.
 THE INFORMATION SYSTEM: AN ACCOUNTANT'S PERSPECTIVE 1-13

Summary

 AIS is for financial transactions, MIS for nonfinancial transactions.

 The general model for AIS: data collection, processing, database management, and information
generation.
 Data are facts, information causes user to take action.
 AIS Objectives: to support stewardship, decision-making, and day-to-day operations.
 Segmentation of business areas and organization of AIS, comparing centralized and distributed
approaches.
 Evolution of AIS models: manual, flat file, database, REA, and ERP.
 Accounting roles of user, designer, and auditor. As designer, accountants are responsible for the
conceptual, rather than the physical system (IT’s responsibility).
 Types of audits: external: assurance services, and IT audits; and internal audits.