<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=gif::::/sites/dl/free/0072996501/lo2.gif','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>     Discuss the significance of accounting systems in generating reliable accounting information and understand the five components of internal control per COSO’s Internal Control–Integrated Framework.

An accounting systemThe personnel, procedures, devices, and records used by an organization to develop accounting information and communicate that information to decision makers. consists of the personnel, procedures, technology, and records used by an organization (1) to develop accounting information and (2) to communicate this information to decision makers. The design and capabilities of these systems vary greatly from one organization to another. In small businesses, accounting systems may consist of little more than a cash register, a checkbook, and an annual trip to an income tax preparer. In large businesses, accounting systems include computers, highly trained personnel, and accounting reports that affect the daily operations of every department. But in every case, the basic purpose of the accounting system remains the same: to meet the organization’s needs for information as efficiently as possible.

Many factors affect the structure of the accounting system within a particular organization. Among the most important are (1) the company’s needs for accounting information and (2) the resources available for operation of the system.

Describing accounting as an information system focuses attention on the information accounting provides, the users of the information, and the support for financial decisions that is provided by the information. These relationships are depicted in Exhibit 1–2. While some of the terms may not be familiar to you at this early point in your study of business and accounting, you will be introduced to them more completely as we proceed through this textbook and as you undertake other courses in business and accounting. Observe, however, that the information system produces the information presented in the middle of the diagram—financial position, profitability, and cash flows. This information meets the needs of users of the information—investors, creditors, managers, and so on—and supports many kinds of financial decisions—performance evaluation and resource allocation, among others. These relationships are consistent with what we have already learned—namely, that accounting information is intended to be useful for decision-making purposes.

Exhibit 1–2	ACCOUNTING AS AN INFORMATION SYSTEM
	<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/free/0072996501/wiL96501_ex0102.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

DETERMINING INFORMATION NEEDS

The types of accounting information that a company develops vary with such factors as the size of the organization, whether it is publicly owned, and the information needs of management. The need for some types of accounting information may be prescribed by law. For example, income tax regulations require every business to have an accounting system that can measure the company’s taxable income and explain the nature and source of every item in the company’s income tax return. Federal securities laws require publicly owned companies to prepare financial statements in conformity with generally accepted accounting principles. These statements must be filed with the Securities and Exchange Commission, distributed to stockholders, and made available to the public.

Other types of accounting information are required as matters of practical necessity. For example, every business needs to know the amounts owed to it by each customer and the amounts owed by the company to each creditor, and uses generally accepted accounting principles for financial reporting.

Although much accounting information clearly is essential to business operations, management still has many choices as to the types and amount of accounting information to be developed. For example, should the accounting system of a department store measure separately the sales of each department and of different types of merchandise? The answer to such questions depends on how useful management considers the information to be and the cost of developing the information.

THE COST OF PRODUCING ACCOUNTING INFORMATION

Accounting systems must be cost-effective—that is, the value of the information produced should exceed the cost of producing it. Management has no choice but to produce the types of accounting reports required by law or contract. In other cases, however, management may use cost-effectiveness as a criterion for deciding whether or not to produce certain information.

In recent years, the development and installation of computer-based information systems have increased greatly the types and amount of accounting information that can be produced in a cost-effective manner.

BASIC FUNCTIONS OF AN ACCOUNTING SYSTEM

In developing information about the activities of a business, every accounting system performs the following basic functions:

1. Interpret and record the effects of business transactions.
2. Classify the effects of similar transactions in a manner that permits determination of the various totals and subtotals useful to management and used in accounting reports.
3. Summarize and communicate the information contained in the system to decision makers.

The differences in accounting systems arise primarily in the manner, frequency, and speed with which these functions are performed.

In our illustrations, we often assume the use of a simple manual accounting system. Such a system is useful in illustrating basic accounting concepts, but it is too slow and cumbersome to meet the needs of most business organizations. In a large business, transactions may occur at a rate of several hundred or several thousand per hour. To keep pace with such a rapid flow of information, these companies must use accounting systems that are largely computerbased. The underlying principles within these systems are generally consistent with the basic manual system we frequently refer to in this text. Some small businesses that continue to use manual accounting systems modify these systems to meet their needs as efficiently as possible. Understanding manual systems allows users to understand the needs that must be met in a computerized system.

WHO DESIGNS AND INSTALLS ACCOUNTING SYSTEMS?

The design and installation of large accounting systems is a specialized field. It involves not just accounting, but expertise in management, information systems, marketing, and—in many cases—computer programming. Thus accounting systems generally are designed and installed by a team of people with many specialized talents.

Large businesses have a staff of systems analysts, internal auditors, and other professionals who work full-time in designing and improving the accounting system. Medium-size companies often hire a CPA firm to design or update their systems. Small businesses with limited resources often purchase one of the many packaged accounting systems designed for small companies in their line of business. These packaged systems are available through office supply stores, computer stores, and software manufacturers.

COMPONENTS OF INTERNAL CONTROL¹

In developing its accounting system, an organization also needs to be concerned with developing a sound system of internal control. Internal controlA process designed to provide reasonable assurance that the organization produces reliable financial reports, complies with applicable laws and regulations, and conducts its operations in an efficient and effective manner. is a process designed to provide reasonable assurance that the organization produces reliable financial reports, complies with applicable laws and regulations, and conducts its operations in an efficient and effective manner. A company’s board of directors, its management, and other personnel are charged with developing and monitoring internal control. The five components of internal control, as discussed in Internal Control-Integrated Framework (Committee of Sponsoring Organizations of the Treadway Commission), are the control environment, risk assessment, control activities, information and communication, and monitoring.

An organization’s control environmentThe foundation for all the other elements of internal control, setting the overall tone for the organization. is the foundation for all the other elements of internal control, setting the overall tone for the organization. Factors that affect a company’s control environment are: (1) the integrity, ethical values, and competence of the company’s personnel, (2) management’s philosophy and operating style, (3) management’s assignment of authority and responsibility, (4) procedures for the hiring and training of personnel, and (5) oversight by the board of directors. The control environment is particularly important because fraudulent financial reporting often results from an ineffective control environment.

Risk assessmentA process of identifying, analyzing, and managing those risks that pose a threat to the achievement of the organization’s objectives. involves identifying, analyzing, and managing those risks that pose a threat to the achievement of the organization’s objectives. For example, a company should assess the risks that might prevent it from preparing reliable financial reports and then take steps to minimize those risks.

Control activitiesPolicies and procedures that management puts in place to address the risks identified during the risk assessment process. are the policies and procedures that management puts in place to address the risks identified during the risk assessment process. Examples of control activities include approvals, authorizations, verifications, reconciliations, reviews of operating performance, physical safeguarding of assets, and segregation of duties.

Information and communicationThe organization’s process for capturing operational, financial, and compliancerelated information necessary to run the business, and communicating that information downstream (from management to employees), upstream (from employees to management), and across the organization. involves developing information systems to capture and communicate operational, financial, and compliance-related information necessary to run the business. Effective information systems capture both internal and external information. In addition, an effective control system is designed to facilitate the flow of information downstream (from management to employees), upstream (from employees to management), and across the organization. Employees must receive the message that top management views internal control as important, and they must understand both their role in the internal control system and the roles of others.

All internal control systems need to be monitored. MonitoringThe process of evaluating the effectiveness of an organization’s system of internal control over time, including both ongoing management and supervisory activities and periodic separate evaluations. enables the company to evaluate the effectiveness of its system of internal control over time. Monitoring is generally accomplished through ongoing management and supervisory activities, as well as by periodic separate evaluations of the internal control system. Most large organizations have an internal audit function, and the activities of internal audit represent separate evaluations of internal control.

As a result of the large financial frauds at Enron and WorldCom the U.S. Congress passed, and President George W. Bush signed, the Sarbanes-Oxley ActA landmark piece of securities law, designed to improve the effectiveness of corporate financial reporting through enhanced accountability of auditors, boards of directors, and management. (SOX) of 2002. SOX has been described as the most far-reaching securities law since the 1930s. One of the SOX requirements is that public companies must issue a yearly report indicating whether they have an effective system of internal control over financial reporting. In essence, management must indicate whether the entity’s internal control system provides reasonable assurance that financial statements will be prepared in accordance with laws and regulations governing financial reporting. In addition, the company’s external auditor must issue its own report as to whether the auditor believes that the company’s internal control system is effective. These requirements are contained in Section 404 of SOX; therefore, many businesspeople describe the above process as the 404 certification and the audit under Section 404. This certification process has been extremely expensive and time-consuming and some businesspeople believe that the costs associated with this certification requirement exceed the benefits.

Critical Thinking Cases  1.3