The Information System: An Accountant’s Perspective

The Information System: An Accountant’s Perspective

Unlike many other accounting subjects, such as intermediate accounting, accounting information systems (AIS) lacks a well-defined body of knowledge. Much controversy exists among college faculty as to what should and should not be covered in the AIS course. To some extent, however, the controversy is being resolved through recent legislation. The Sarbanes-Oxley Act (SOX) of 2002 established new corporate governance regulations and standards for public companies registered with the Securities and Exchange Commission (SEC). This wide- sweeping legislation impacts public companies, their management, and their auditors. Of particular importance to AIS students is the impact of SOX on internal control standards and related auditing procedures. Whereas SOX does not define the entire content of the AIS course, it does identify critical areas of study that need to be included for account- ants. These topics and more are covered in several chapters of this text.

The purpose of this chapter is to place the subject of AIS in perspective for accountants. Toward this end, the chapter is divided into four major sections, each dealing with a different aspect of information systems. The first section explores the information environment of the firm. It introduces basic systems concepts, identifies the types of information used in business, and describes the flows of information through an organization. This section also presents a framework for viewing AIS in relation to other information systems components. The second section of the chapter deals with the impact of organizational structure on AIS. Here we examine the business organization as a system of functional areas. The accounting function plays an important role as the purveyor of financial information for the rest of the organization. The third section reviews the evolution of information systems. Over the years, AIS has been represented by a number of different approaches or models.

Five AIS models are examined. The final section discusses the role of accountants as users, designers, and auditors of AIS.

The Information Environment

We begin the study of AIS with the recognition that information is a business resource. Like the other business resources of raw materials, capital, and labor, information is vital to the survival of the contemporary business organization. Every business day, vast quantities of information flow to decision makers and other users to meet a variety of internal needs. In addition, information flows out from the organization to external users, such as customers, suppliers, and stakeholders who have an interest in the firm. Figure 1-1 presents an overview of these internal and external information flows.

The pyramid in Figure 1-1 shows the business organization divided horizontally into several levels of activity. Business operations form the base of the pyramid. These activities consist of the product-oriented work of the organization, such as manufacturing, sales, and distribution. Above the base level, the organization is divided into three management tiers: operations management, middle management, and top management. Operations management is directly responsible for controlling day-to-day operations. Middle management is accountable for the short-term planning and coordination of activities necessary to accomplish organizational objectives. Top management is responsible for longer-term planning and set- ting organizational objectives. Every individual in the organization, from business operations to top management, needs information to accomplish his or her tasks.

Notice in Figure 1-1 how information flows in two directions within the organization: horizontally and vertically. The horizontal flow supports operations-level tasks with highly detailed information about the many business transactions affecting the firm. This includes information about events such as the sale and shipment of goods, the use of labor and materials in the production process, and internal transfers of resources from one department to another. The vertical flow distributes information downward from senior managers to junior managers and operations personnel in the form of instructions, quotas, and budgets. In addition, summarized information pertaining to operations and other activities flows upward to managers at all levels. Management uses this information to support its various planning and control functions.

A third flow of information depicted in Figure 1-1 represents exchanges between the organization and users in the external environment. External users fall into two groups: trading partners and stakeholders. Exchanges with trading partners include customer sales and billing information, purchase information for suppliers, and inventory receipts information. Stakeholders are entities outside (or inside) the organization with a direct or indirect interest in the firm. Stockholders, financial institutions, and government agencies are examples of external stakeholders. Information exchanges with these groups include financial statements, tax returns, and stock transaction information. Inside stakeholders include accountants and internal auditors.

All user groups have unique information requirements. The level of detail and the nature of the information these groups receive differ considerably. For example, managers cannot use the highly detailed in- formation needed by operations personnel. Management information is thus more summarized and oriented toward reporting on overall performance and problems rather than routine operations. The information must identify potential problems in time for management to take corrective action. External stake- holders, on the other hand, require information very different from that of management and operations users. Their financial statement information, based on generally accepted accounting principles (GAAP), is accrual based and far too aggregated for most internal uses.

WHAT IS A SYSTEM?

For many, the term system generates mental images of computers and programming. In fact, the term has much broader applicability. Some systems are naturally occurring, whereas others are artificial. Natural systems range from the atom—a system of electrons, protons, and neutrons—to the universe—a system of galaxies, stars, and planets. All life forms, plant and animal, are examples of natural systems. Artificial systems are man-made. These systems include everything from clocks to submarines and social systems to information systems.

Elements of a System

Regardless of their origin, all systems possess some common elements. To specify:

A system is a group of two or more interrelated components or subsystems that serve a common purpose.

Let’s analyze the general definition to gain an understanding of how it applies to businesses and information systems.

MULTIPLE COMPONENTS. A system must contain more than one part. For example, a yo-yo carved from a single piece of wood and attached to a string is a system. Without the string, it is not a system.

RELATEDNESS. A common purpose relates the multiple parts of the system. Although each part functions independently of the others, all parts serve a common objective. If a particular component does not contribute to the common goal, then it is not part of the system. For instance, a pair of ice skates and a volleyball net are both components; however, they lack a common purpose, and thus do not form a system.

SYSTEM VERSUS SUBSYSTEM. The distinction between the terms system and subsystem is a matter of perspective. For our purposes, these terms are interchangeable. A system is called a subsystem when it is viewed in relation to the larger system of which it is a part. Likewise, a subsystem is called a system when it is the focus of attention. Animals, plants, and other life forms are systems. They are also subsystems of the ecosystem in which they exist. From a different perspective, animals are systems com- posed of many smaller subsystems, such as the circulatory subsystem and the respiratory subsystem.

PURPOSE. A system must serve at least one purpose, but it may serve several. Whether a system pro- vides a measure of time, electrical power, or information, serving a purpose is its fundamental justification. When a system ceases to serve a purpose, it should be replaced.

An Example of an Artificial System

An automobile is an example of an artificial system that is familiar to most of us and that satisfies the definition of a system provided previously. To simplify matters, let’s assume that the automobile system serves only one purpose: providing conveyance. To do so requires the harmonious interaction of hundreds or even thousands of subsystems. For simplicity, Figure 1-2 depicts only a few of these.

In the figure, two points are illustrated of particular importance to the study of information systems: system decomposition and subsystem interdependency.

SYSTEM DECOMPOSITION. Decomposition is the process of dividing the system into smaller sub- system parts. This is a convenient way of representing, viewing, and understanding the relationships among subsystems. By decomposing a system, we can present the overall system as a hierarchy and view the relationships between subordinate and higher-level subsystems. Each subordinate subsystem performs one or more specific functions to help achieve the overall objective of the higher-level system. Figure 1-2 shows an automobile decomposed into four primary subsystems: the fuel subsystem, the propulsion sub- system, the electrical subsystem, and the braking subsystem. Each contributes in a unique way to the sys- tem’s objective, conveyance. These second-level subsystems are decomposed further into two or more subordinate subsystems at a third level. Each third-level subsystem performs a task in direct support of its second-level system.

SUBSYSTEM INTERDEPENDENCY. A system’s ability to achieve its goal depends on the effective functioning and harmonious interaction of its subsystems. If a vital subsystem fails or becomes defective and can no longer meet its specific objective, the overall system will fail to meet its objective. For example, if the fuel pump (a vital subsystem of the fuel system) fails, then the fuel system fails. With the fail- \\ure of the fuel system (a vital subsystem of the automobile), the entire system fails. On the other hand, when a nonvital subsystem fails, the primary objective of the overall system can still be met. For instance, if the radio (a subsystem of the electrical system) fails, the automobile can still convey passengers.

Designers of all types of systems need to recognize the consequences of subsystem failure and provide the appropriate level of control. For example, a systems designer may provide control by designing a

backup (redundant) subsystem that comes into play when the primary subsystem fails. Control should be provided on a cost-benefit basis. It is neither economical nor necessary to back up designers, information system designers need to identify critical subsystems, anticipate the risk of their failure, and design cost-effective control procedures to mitigate that risk. As we shall see in subsequent chapters, accountants feature prominently in this activity.

AN INFORMATION SYSTEMS FRAMEWORK

The information system is the set of formal procedures by which data are collected, processed into information, and distributed to users.

Figure 1-3 shows the information system of a hypothetical manufacturing firm decomposed into its elemental subsystems. Notice that two broad classes of systems emerge from the decomposition: the accounting information system (AIS) and the management information system (MIS). We will use this framework to identify the domain of AIS and distinguish it from MIS. Keep in mind that Figure 1-3 is a conceptual view; physical information systems are not typically organized into such discrete packages. More often, MIS and AIS functions are integrated to achieve operational efficiency.

The distinction between AIS and MIS centers on the concept of a transaction, as illustrated by Figure 1-4.

The information system accepts input, called transactions, which are converted through various processes into output information that goes to users. Transactions fall into two classes: financial transactions and nonfinancial transactions. Before exploring this distinction, let’s first broadly define:

A transaction as an event that affects or is of interest to the organization and is processed by its information system as a unit of work.

This definition encompasses both financial and nonfinancial events. Because financial transactions are of particular importance to the accountant’s understanding of information systems, we need a precise definition for this class of transaction:

A financial transaction is an economic event that affects the assets and equities of the organization, is reflected in its accounts, and is measured in monetary terms.

Sales of products to customers, purchases of inventory from vendors, and cash disbursements and receipts are examples of financial transactions. Every business organization is legally bound to correctly process these types of transactions.

Nonfinancial transactions are events that do not meet the narrow definition of a financial transaction.

For example, adding a new supplier of raw materials to the list of valid suppliers is an event that may be processed by the enterprise’s information system as a transaction. Important as this information obviously is, it is not a financial transaction, and the firm has no legal obligation to process it correctly—or at all.

Financial transactions and nonfinancial transactions are closely related and are often processed by the same physical system. For example, consider a financial portfolio management system that collects and tracks stock prices (nonfinancial transactions). When the stocks reach a threshold price, the system places an automatic buy or sell order (financial transaction). Buying high and selling low is not against the law, but it is bad for business. Nevertheless, no law requires company management to design optimal buy- and-sell rules into their system. Once the buy-or-sell order is placed, however, the processing of this financial transaction must comply with legal and professional guidelines.

The Accounting Information System

AIS subsystems process financial transactions and nonfinancial transactions that directly affect the processing of financial transactions. For example, changes to customers’ names and addresses are processed by the AIS to keep the customer file current. Although not technically financial transactions, these changes provide vital information for processing future sales to the customer.

The AIS is composed of three major subsystems: (1) the transaction processing system (TPS), which supports daily business operations with numerous reports, documents, and messages for users throughout the organization; (2) the general ledger/financial reporting system (GL/FRS), which produces the traditional financial statements, such as the income statement, balance sheet, statement of cash flows, tax returns, and other reports required by law; and (3) the management reporting system (MRS), which pro- vides internal management with special-purpose financial reports and information needed for decision making such as budgets, variance reports, and responsibility reports. We examine each of these subsystems later in this chapter.

The Management Information System

Management often requires information that goes beyond the capability of AIS. As organizations grow in size and complexity, specialized functional areas emerge, requiring additional information for production planning and control, sales forecasting, inventory warehouse planning, market research, and so on. The man- agement information system (MIS) processes nonfinancial transactions that are not normally processed by traditional AIS. Table 1-1 gives examples of typical MIS applications related to functional areas of a firm.

Why Is It Important to Distinguish between AIS and MIS?

SOX legislation requires that management design and implement internal controls over the entire finan- cial reporting process. This includes the financial reporting system, the general ledger system, and the transaction processing systems that supply the data for financial reporting. SOX further requires that man- agement certify these controls and that the external auditors express an opinion on control effectiveness. Because of the highly integrative nature of modern information systems, management and auditors need a conceptual view of the information system that distinguishes key processes and areas of risk and legal responsibility from the other (nonlegally binding) aspects of the system. Without such a model, critical management and audit responsibilities under SOX may not be met.

AIS SUBSYSTEMS

We devote separate chapters to an in-depth study of each AIS subsystem depicted in Figure 1-3. At this point, we briefly outline the role of each subsystem.

Transaction Processing System

The TPS is central to the overall function of the information system by converting economic events into financial transactions, recording financial transactions in the accounting records (journals and ledgers), and distributing essential financial information to operations personnel to support their daily operations.

The TPS deals with business events that occur frequently. In a given day, a firm may process thou-sands of transactions. To deal efficiently with such volume, similar types of transactions are grouped together into transaction cycles. The TPS consists of three transaction cycles: the revenue cycle, the expenditure cycle, and the conversion cycle. Each cycle captures and processes different types of financial transactions. Chapter 2 provides an overview of transaction processing. Chapters 4, 5, 6, and 7 examine in detail the revenue, expenditure, and conversion cycles.

General Ledger/Financial Reporting Systems

The general ledger system (GLS) and the financial reporting system (FRS) are two closely related subsystems. However, because of their operational interdependency, they are generally viewed as a single integrated system—the GL/FRS. The bulk of the input to the GL portion of the system comes from the transaction cycles. Summaries of transaction cycle activity are processed by the GLS to update the general ledger control accounts. Other, less frequent, events such as stock transactions, mergers, and lawsuit settlements, for which there may be no formal processing cycle in place, also enter the GLS through alternate sources.

The FRS measures and reports the status of financial resources and the changes in those resources. The FRS communicates this information primarily to external users. This type of reporting is called non- discretionary because the organization has few or no choices in the information it provides. Much of this information consists of traditional financial statements, tax returns, and other legal documents.

Management Reporting System

The MRS provides the internal financial information needed to manage a business. Managers must deal immediately with many day-to-day business problems, as well as plan and control their operations. Man- agers require different information for the various kinds of decisions they must make. Typical reports produced by the MRS include budgets, variance reports, cost-volume-profit analyses, and reports using current (rather than historical) cost data. This type of reporting is called discretionary reporting because the organization can choose what information to report and how to present it.

A GENERAL MODEL FOR AIS

Figure 1-5 presents the general model for viewing AIS applications. This is a general model because it describes all information systems, regardless of their technological architecture. The elements of the general model are end users, data sources, data collection, data processing, database management, informa- tion generation, and feedback.

End Users

End users fall into two general groups: external and internal. External users include creditors, stockholders, potential investors, regulatory agencies, tax authorities, suppliers, and customers. Institutional users such as banks, the SEC, and the Internal Revenue Service (IRS) receive information in the form of financial statements, tax returns, and other reports that the firm has a legal obligation to produce. Trading partners (customers and suppliers) receive transaction-oriented information, including purchase orders, billing statements, and shipping documents.

Internal users include management at every level of the organization, as well as operations personnel. In contrast to external reporting, the organization has a great deal of latitude in the way it meets the needs of internal users. Although there are some well-accepted conventions and practices, internal reporting is governed primarily by what gets the job done. System designers, including accountants, must balance the desires of internal users against legal and economic concerns such as adequate control and security, proper accountability, and the cost of providing alternative forms of information. Thus, internal reporting poses a less structured and generally more difficult challenge than external reporting.

DATA VERSUS INFORMATION. Before discussing the data sources portion of Figure 1-5, we must make an important distinction between the terms data and information. Data are facts, which may or may not be processed (edited, summarized, or refined) and have no direct effect on the user. By contrast, information causes the user to take an action that he or she otherwise could not, or would not, have taken. Information is often defined simply as processed data. This is an inadequate definition. Information is determined by the effect it has on the user, not by its physical form. For example, a purchasing agent receives a daily report listing raw material inventory items that are at low levels. This report causes the agent to place orders for more inventory. The facts in this report have information content for the purchasing agent. However, this same report in the hands of the personnel manager is a mere collection of facts, or data, causing no action and having no information content.

We can see from this example that one person’s information is another person’s data. Thus, information is not just a set of processed facts arranged in a formal report. Information allows users to take action to resolve conflicts, reduce uncertainty, and make decisions. We should note that action does not neces-arily mean a physical act. For instance, a purchasing agent who receives a report showing that inventory levels are adequate will respond by ordering nothing. The agent’s action to do nothing is a conscious de- cision, triggered by information and different from doing nothing because of being uninformed.

The distinction between data and information has pervasive implications for the study of information systems. If output from the information system fails to cause users to act, the system serves no purpose and has failed in its primary objective.

Data Sources

Data sources are financial transactions that enter the information system from both internal and external sources. External financial transactions are the most common source of data for most organizations. These are economic exchanges with other business entities and individuals outside the firm. Examples include the sale of goods and services, the purchase of inventory, the receipt of cash, and the disbursement of cash (including payroll). Internal financial transactions involve the exchange or movement of resources within the organization. Examples include the movement of raw materials into work-in-process (WIP), the application of labor and overhead to WIP, the transfer of WIP into finished goods inventory, and the depreciation of plant and equipment.

Data Collection

Data collection is the first operational stage in the information system. The objective is to ensure that event data entering the system are valid, complete, and free from material errors. In many respects, this is the most important stage in the system. Should transaction errors pass through data collection undetected, the system may process the errors and generate erroneous and unreliable output. This, in turn, could lead to incorrect actions and poor decisions by the users.

Two rules govern the design of data collection procedures: relevance and efficiency. The information system should capture only relevant data. A fundamental task of the system designer is to determine what is and what is not relevant. He or she does so by analyzing the user’s needs. Only data that ultimately contribute to information (as defined previously) are relevant. The data collection stage should be designed to filter irrelevant facts from the system.

Efficient data collection procedures are designed to collect data only once. These data can then be made available to multiple users. Capturing the same data more than once leads to data redundancy and inconsistency. Information systems have limited collection, processing, and data storage capacity. Data redundancy overloads facilities and reduces the overall efficiency of the system. Inconsistency among redundant data elements can result in inappropriate actions and bad decisions.

Data Processing

Once collected, data usually require processing to produce information. Tasks in the data processing stage range from simple to complex. Examples include mathematical algorithms (such as linear programming models) used for production scheduling applications, statistical techniques for sales forecasting, and posting and summarizing procedures used for accounting applications.

Database Management

The organization’s database is its physical repository for financial and nonfinancial data. We use the term database in the generic sense. It can be a filing cabinet or a computer disk. Regardless of the database’s physical form, we can represent its contents in a logical hierarchy. The levels in the data hierarchy— attribute, record, and file—are illustrated in Figure 1-6.

DATA ATTRIBUTE. The data attribute is the most elemental piece of potentially useful data in the database. An attribute is a logical and relevant characteristic of an entity about which the firm captures data. The attributes shown in Figure 1-6 are logical because they all relate sensibly to a common entity— accounts receivable (AR). Each attribute is also relevant because it contributes to the information content of the entire set. As proof of this, the absence of any single relevant attribute diminishes or destroys the information content of the set. The addition of irrelevant or illogical data would not enhance the information content of the set.

RECORD. A record is a complete set of attributes for a single occurrence within an entity class. For example, a particular customer’s name, address, and account balance is one occurrence (or record) within the AR class. To find a particular record within the database, we must be able to identify it uniquely. Therefore, every record in the database must be unique in at least one attribute.1 This unique identifier at- tribute is the primary key. Because no natural attribute (such as customer name) can guarantee unique- ness, we typically assign artificial keys to records. The key for the AR records in Figure 1-6 is the customer account number. This is the only unique identifier in this record class. The other attributes possess values that may also exist in other records. For instance, multiple customers may have the same name, sales amounts, credit limits, and balances. Using any one of these as a key to find a record in a

large database would be a difficult task. These nonunique attributes are, however, often used as secondary keys for categorizing data. For example, the account balance attribute can be used to prepare a list of customers with balances greater than $10,000.

FILES. A file is a complete set of records of an identical class. For example, all the AR records of the organization constitute the AR file. Similarly, files are constructed for other classes of records such as inventory, accounts payable, and payroll. The organization’s database is the entire collection of such files.

DATABASE MANAGEMENT TASKS. Database management involves three fundamental tasks: storage, retrieval, and deletion. The storage task assigns keys to new records and stores them in their proper location in the database. Retrieval is the task of locating and extracting an existing record from the database for processing. After processing is complete, the storage task restores the updated record to its place in the database. Deletion is the task of permanently removing obsolete or redundant records from the database.

Information Generation

Information generation is the process of compiling, arranging, formatting, and presenting information to users. Information can be an operational document such as a sales order, a structured report, or a message on a computer screen. Regardless of physical form, useful information has the following characteristics: relevance, timeliness, accuracy, completeness, and summarization.

RELEVANCE. The contents of a report or document must serve a purpose. This could be to support a manager’s decision or a clerk’s task. We have established that only data relevant to a user’s action have information content. Therefore, the information system should present only relevant data in its reports. Reports containing irrelevancies waste resources and may be counterproductive to the user. Irrelevancies detract attention from the true message of the report and may result in incorrect decisions or actions.

TIMELINESS. The age of information is a critical factor in determining its usefulness. Information must be no older than the time of the action it supports. For example, if a manager makes decisions daily to purchase inventory from a supplier based on an inventory status report, then the information in the report should be no more than a day old.

ACCURACY. Information must be free from material errors. However, materiality is a difficult concept to quantify. It has no absolute value; it is a problem-specific concept. This means that, in some cases, in- formation must be perfectly accurate. In other instances, the level of accuracy may be lower. Material error exists when the amount of inaccuracy in information causes the user to make poor decisions or to fail to make necessary decisions. We sometimes must sacrifice absolute accuracy to obtain timely information. Often, perfect information is not available within the user’s decision time frame. Therefore, in providing information, system designers seek a balance between information that is as accurate as possible, yet timely enough to be useful.

COMPLETENESS. No piece of information essential to a decision or task should be missing. For example, a report should provide all necessary calculations and present its message clearly and unambiguously.

SUMMARIZATION. Information should be aggregated in accordance with the user’s needs. Lower- level managers tend to need information that is highly detailed. As information flows upward through the organization to top management, it becomes more summarized. We shall look more closely at the effects that organizational structure and managerial level have on information reporting later in this chapter.

Feedback

Feedback is a form of output that is sent back to the system as a source of data. Feedback may be internal or external and is used to initiate or alter a process. For example, an inventory status report signals the inventory control clerk that items of inventory have fallen to, or below, their minimum allowable levels. Internal feedback from this information will initiate the inventory ordering process to replenish the inventories. Similarly, external feedback about the level of uncollected customer accounts can be used to adjust the organization’s credit-granting policies.

Information System Objectives

Each organization must tailor its information system to the needs of its users. Therefore, specific information system objectives may differ from firm to firm. Three fundamental objectives are, however, common to all systems:

1. To support the stewardship function of management. Stewardship refers to management’s responsibility to properly manage the resources of the firm. The information system provides information about resource utilization to external users via traditional financial statements and other mandated reports. Internally, management receives stewardship information from various responsibility reports.

2. To support management decision making. The information system supplies managers with the information they need to carry out their decision-making responsibilities.

3. To support the firm’s day-to-day operations. The information system provides information to operations personnel to assist them in the efficient and effective discharge of their daily tasks.

ACQUISITION OF INFORMATION SYSTEMS

We conclude this section with a brief discussion of how organizations obtain information systems. Usually, they do so in two ways: (1) they develop customized systems from scratch through in-house systems development activities, and (2) they purchase preprogrammed commercial systems from software vendors. Larger organizations with unique and frequently changing needs engage in in-house development. The formal process by which this is accomplished is called the system development life cycle. Smaller companies and larger firms that have standardized information needs are the primary market for commercial software. Three basic types of commercial software are turnkey systems, backbone systems, and vendor-supported systems.

Turnkey systems are completely finished and tested systems that are ready for implementation. Typically, they are general-purpose systems or systems customized to a specific industry. In either case, the end user must have standard business practices that permit the use of canned or off-the-shelf systems. The better turnkey systems have built-in software options that allow the user to customize input, output, and processing through menu choices. However, configuring the systems to meet user needs can be a formidable task.2

Backbone systems consist of a basic system structure on which to build. The primary processing logic is preprogrammed, and the vendor then designs the user interfaces to suit the client’s unique needs. A backbone system is a compromise between a custom system and a turnkey system. This approach can produce satisfactory results, but customizing the system is costly.

Vendor-supported systems are custom (or customized) systems that client organizations purchase commercially rather than develop in house. Under this approach, the software vendor designs, implements, and maintains the system for its client. This is a popular option with health care and legal services organizations that have complex systems requirements but are not of sufficient magnitude to justify retaining an in-house systems development staff. Indeed, this has become a popular option for many organizations that traditionally have relied on in-house development but have chosen to outsource these activities. In recent years, public accounting firms have expanded their involvement in the vendor- supported market.