ACCOUNTING INFORMATION SYSTEM An accounting information system collects and processes

transaction data and then disseminates the financial information to interested parties. Accounting
information systems vary widely from one business to another. Various factors shape these systems: the
nature of the business and the transactions in which it engages, the size of the firm, the volume of data
to be handled, and the informational demands that management and others require. As we discussed in
Chapters 1 and 2, in response to the requirements of the Sarbanes-Oxley Act (SOX), companies are
placing a renewed focus on their accounting systems to ensure relevant and reliable information is
reported in financial statements.1 A good accounting information system helps management answer
such questions as: • How much and what kind of debt is outstanding? • Were our sales higher this
period than last? • What assets do we have? • What were our cash inflows and outflows? • Did we make
a profit last period? • Are any of our product lines or divisions operating at a loss? • Can we safely
increase our dividends to stockholders? • Is our rate of return on net assets increasing? Management
can answer many other questions with the data provided by an efficient accounting system. A well-
devised accounting information system benefits every type of company. Basic Terminology Financial
accounting rests on a set of concepts (discussed in Chapters 1 and 2) for identifying, recording,
classifying, and interpreting transactions and other events relating to enterprises. You therefore need to
understand the basic terminology employed in collecting accounting data. 1 A recent survey indicates
that a majority of companies have significantly or moderately improved their internal control over
financial reporting (ICFR) structure since they were required to begin complying with Sarbanes-Oxley
(SOX) Section 404 (b). Other findings represent even better news. In many cases, ICFR improvements and
other compliance work are being used by organizations to drive continuous improvement of business
processes related to financial reporting throughout the organization. See “Changes Abound Amid Drive
for Stability and Long-Term Value,” 2015 Sarbanes-Oxley Compliance Survey (Protiviti Company, May
2015). EVENT. A happening of consequence. An event generally is the source or cause of changes in
assets, liabilities, and equity. Events may be external or internal. TRANSACTION. An external event
involving a transfer or exchange between two or more entities. ACCOUNT. A systematic arrangement
that shows the effect of transactions and other events on a specifi c element (asset, liability, and so on).
Companies keep a separate account for each asset, liability, revenue, and expense, and for capital
(stockholders’ equity). Because the format of an account often resembles the letter T, it is sometimes
referred to as a T-account. (See Illustration 3-3, page 83.) BASIC TERMINOLOGY Accounting Information
System 81 Debits and Credits The terms debit (Dr.) and credit (Cr.) mean left and right, respectively.
These terms do not mean increase or decrease, but instead describe where a company makes entries in
the recording process. That is, when a company enters an amount on the left side of an account, it debits
the account. When it makes an entry on the right side, it credits the account. When comparing the totals
of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits.
An account shows a credit balance if the credit amounts exceed the debits. The positioning of debits on
the left and credits on the right is simply an accounting custom. We could function just as well if we
reversed the sides. However, the United States adopted the custom, now the rule, of having debits on
the left side of an account and credits on the right side, similar to the custom of driving on the right-hand
side of the road. This rule applies to all accounts. REAL AND NOMINAL ACCOUNTS. Real (permanent)
accounts are asset, liability, and equity accounts; they appear on the balance sheet. Nominal
(temporary) accounts are revenue, expense, and dividend accounts; except for dividends, they appear on
the income statement. Companies periodically close nominal accounts; they do not close real accounts.
LEDGER. The book (or computer printouts) containing the accounts. A general ledger is a collection of all
the asset, liability, stockholders’ equity, revenue, and expense accounts. A subsidiary ledger contains the
details related to a given general ledger account. JOURNAL. The “book of original entry” where the
company initially records transactions and selected other events. Various amounts are transferred from
the book of original entry, the journal, to the ledger. Entering transaction data in the journal is known as
journalizing. POSTING. The process of transferring the essential facts and fi gures from the book of
original entry to the ledger accounts. TRIAL BALANCE. The list of all open accounts in the ledger and their
balances. The trial balance taken immediately after all adjustments have been posted is called an
adjusted trial balance. A trial balance taken immediately after closing entries have been posted is called
a post-closing (or after-closing) trial balance. Companies may prepare a trial balance at any time.
ADJUSTING ENTRIES. Entries made at the end of an accounting period to bring all accounts up to date on
an accrual basis, so that the company can prepare correct fi nancial statements. FINANCIAL
STATEMENTS. Statements that refl ect the collection, tabulation, and fi nal summarization of the
accounting data. Four statements are involved. (1) The balance sheet shows the fi nancial condition of
the enterprise at the end of a period. (2) The income statement measures the results of operations
during the period. (3) The statement of cash fl ows reports the cash provided and used by operating,
investing, and fi nancing activities during the period. (4) The statement of retained earnings reconciles
the balance of the retained earnings account from the beginning to the end of the period. CLOSING
ENTRIES. The formal process by which the enterprise reduces all nominal accounts to zero and
determines and transfers the net income or net loss to a stockholders’ equity account. Also known as
“closing the ledger,” “closing the books,” or merely “closing.” 82 Chapter 3 The Accounting Information
System The equality of debits and credits provides the basis for the double-entry system of recording
transactions (sometimes referred to as double-entry bookkeeping). Under the universally used double-
entry accounting system, a company records the dual (two-sided) effect of each transaction in
appropriate accounts. This system provides a logical method for recording transactions. It also offers a
means of proving the accuracy of the recorded amounts. If a company records every transaction with
equal debits and credits, then the sum of all the debits to the accounts must equal the sum of all the
credits. Illustration 3-1 presents the basic guidelines for an accounting system. Increases to all asset and
expense accounts occur on the left (or debit side) and decreases on the right (or credit side). Conversely,
increases to all liability and revenue accounts occur on the right (or credit side) and decreases on the left
(or debit side). A company increases stockholders’ equity accounts, such as Common Stock and Retained
Earnings, on the credit side, but increases Dividends on the debit side. The Accounting Equation In a
double-entry system, for every debit there must be a credit, and vice versa. This leads us, then, to the
basic equation in accounting (Illustration 3-2). ILLUSTRATION 3-1 Double-Entry (Debit and Credit)
Accounting System Asset Accounts Liability Accounts Expense Accounts Stockholders' Equity Accounts
Revenue Accounts + (increase) – (decrease) – (decrease) + (increase) Debit + (increase) Debit + (increase)
+ (increase) Credit + (increase) Credit + (increase) Credit – (decrease) Debit – (decrease) Debit –
(decrease) Debit Normal Balance—Debit Normal Balance—Credit Credit – (decrease) Credit – (decrease)
Assets = + Liabilities Stockholders' Equity ILLUSTRATION 3-2 The Basic Accounting Equation Illustration 3-
3 expands this equation to show the accounts that make up stockholders’ equity. The figure also shows
the debit/credit rules and effects on each type of account. Study this diagram carefully. It will help you
understand the fundamentals of Accounting Information System 83 the double-entry system. Like the
basic equation, the expanded equation must also balance (total debits equal total credits). Assets = +
Liabilities Stockholders’ Equity Basic Equation Expanded Equation Debit/Credit Rules Assets Dr. +
Liabilities Common Stock Retained Earnings Dividends Revenues Expenses Cr. – Dr. – Cr. + Dr. – Cr. + Dr. –
Cr. + Dr. + Cr. – Dr. – Cr. + Dr. + Cr. – = ++–+– ILLUSTRATION 3-3 Expanded Equation and Debit/Credit Rules
and Effects Every time a transaction occurs, the elements of the accounting equation change. However,
the basic equality remains. To illustrate, consider the following eight different transactions for Perez Inc.
1. Owners invest $40,000 in exchange for common stock. Assets = + + 40,000 Liabilities Stockholders’
Equity + 40,000 Assets = + – 600 Liabilities Stockholders’ Equity – 600 (expense) 2. Disburse $600 cash for
administrative wages. = + Stockholders’ Equity Assets + 5,200 Liabilities +5,200 3. Purchase offi ce
equipment priced at $5,200, giving a 10 percent promissory note in exchange. = + Assets + 4,000
Liabilities Stockholders’ Equity + 4,000 (revenue) 4. Receive $4,000 cash for services performed. 84
Chapter 3 The Accounting Information System 5. Pay off a short-term liability of $7,000. = + Assets –
7,000 Liabilities – 7,000 Stockholders’ Equity Assets = + Liabilities + 5,000 Stockholders’ Equity – 5,000
Assets = + Liabilities – 80,000 Stockholders’ Equity + 80,000 = + Assets –16,000 +16,000 Liabilities
Stockholders’ Equity 6. Declare a cash dividend of $5,000. 7. Convert a long-term liability of $80,000 into
common stock. 8. Pay cash of $16,000 for a delivery van. Financial Statements and Ownership Structure
The stockholders’ equity section of the balance sheet reports common stock and retained earnings. The
income statement reports revenues and expenses. The statement of retained earnings reports net
income/loss and dividends. Because a company transfers dividends, revenues, and expenses to retained
earnings at the end of the period, a change in any one of these three items affects stockholders’ equity.
Illustration 3-4 shows the stockholders’ equity relationships. The company’s ownership structure dictates
the types of accounts that are part of or affect the equity section. A corporation commonly uses
Common Stock, Paid-in Capital in Excess of Par, Dividends, and Retained Earnings accounts. A
proprietorship or a partnership uses an Owner’s Capital account and an Owner’s Drawings account. An
Owner’s Capital account indicates the owner’s or owners’ investment in the company. An Owner’s
Drawings account tracks withdrawals by the owner(s). Accounting Information System 85 Illustration 3-5
summarizes and relates the transactions affecting equity to the nominal (temporary) and real
(permanent) classifications and to the types of business ownership. Stockholders' Equity Balance Sheet
Statement of Retained Earnings Common Stock (investments by stockholders) Retained Earnings (net
income retained in business) Net Income or Net Loss (revenues less expenses) Income Statement
Dividends ILLUSTRATION 3-4 Financial Statements and Ownership Structure The Accounting Cycle
Illustration 3-6 (on page 86) shows the steps in the accounting cycle. A company normally uses these
accounting procedures to record transactions and prepare financial statements. Identifying and
Recording Transactions and Other Events The first step in the accounting cycle is analysis of transactions
and selected other events. The first problem is to determine what to record. Although GAAP provides
guidelines, no simple rules exist that state which events a company should record. Although
ILLUSTRATION 3-5 Effects of Transactions on Equity Accounts Ownership Structure Proprietorships and
Impact on Partnerships Corporations Transactions Owners’ or Nominal Real Nominal Real Affecting
Owners’ Stockholders’ (Temporary) (Permanent) (Temporary) (Permanent) or Stockholders’ Equity Equity
Accounts Accounts Accounts Accounts Investment by owner(s) Increase Capital Common Stock and
related accounts Revenues recognized Increase Revenue Revenue Expenses incurred Decrease Expense
Capital Expense Retained Withdrawal by owner(s) Decrease Drawings Dividends Earnings }} 86 Chapter 3
The Accounting Information System Reversing entries (optional) Post-closing trial balance (optional)
Posting General ledger (usually monthly) Subsidiary ledgers (usually daily) Closing (nominal accounts)
Trial balance preparation Statement preparation Income statement Retained earnings Balance sheet
Cash flows When the steps have been completed, the sequence starts over again in the next accounting
period. Adjusted trial balance Journalization General journal Cash receipts journal Cash disbursements
journal Purchases journal Sales journal Other special journals Identification and Measurement of
Transactions and Other Events THE ACCOUNTING CYCLE Worksheet (optional) Adjustments Accruals
Prepayments Estimated items ILLUSTRATION 3-6 The Accounting Cycle changes in a company’s personnel
or managerial policies may be important, the company should not record these items in the accounts.
On the other hand, a company should record all cash sales or purchases—no matter how small. The
concepts we presented in Chapter 2 determine what to recognize in the accounts. An item should be
recognized in the financial statements if it is an element, is measurable, and is relevant and
representationally faithful. Consider human resources. R. G. Barry & Co. at one time reported as
supplemental data total assets of $14,055,926, including $986,094 for “Net investments in human
resources.” AT&T and ExxonMobil also experimented with human resource accounting. Should we value
employees for balance sheet and income statement purposes? Certainly skilled employees are an
important asset (highly relevant), but the problems of determining their value and measuring it reliably
have not yet been solved. Consequently, human resources are not recorded. Perhaps when
measurement techniques become more sophisticated and accepted, such information will be presented,
if only in supplemental form. The FASB uses the phrase “transactions and other events and
circumstances that affect a business enterprise” to describe the sources or causes of changes in an
entity’s assets, liabilities, and equity.2 Events are of two types. (1) External events involve 2 “Elements of
Financial Statements of Business Enterprises,” Statement of Financial Accounting Concepts No. 6
(Stamford, Conn.: FASB, 1985), pp. 259–260. UNDERLYING CONCEPTS Assets are probable economic
benefi ts controlled by a particular entity as a result of a past transaction or event. Do human resources
of a company meet this defi nition? Record and Summarize Basic Transactions 87 interaction between an
entity and its environment, such as a transaction with another entity, a change in the price of a good or
service that an entity buys or sells, a flood or earthquake, or an improvement in technology by a
competitor. (2) Internal events occur within an entity, such as using buildings and machinery in
operations, or transferring or consuming raw materials in production processes. Many events have both
external and internal elements. For example, hiring an employee, which involves an exchange of salary
for labor, is an external event. Using the services of labor is part of production, an internal event. Further,
an entity may initiate and control events, such as the purchase of merchandise or use of a machine. Or,
events may be beyond its control, such as an interest rate change, theft, or a tax hike. Transactions are
types of external events. They may be an exchange between two entities where each receives and
sacrifices value, such as purchases and sales of goods or services. Or, transactions may be transfers in
one direction only. For example, an entity may incur a liability without directly receiving value in
exchange, such as charitable contributions. Other examples include investments by owners, distributions
to owners, payment of taxes, gifts, casualty losses, and thefts. In short, a company records as many
events as possible that affect its financial position. As discussed earlier in the case of human resources, it
omits some events because of tradition and others because of complicated measurement problems.
Recently, however, the accounting profession shows more receptiveness to accepting the challenge of
measuring and reporting events previously viewed as too complex and immeasurable. RECORD AND
SUMMARIZE BASIC TRANSACTIONS Journalizing A company records in accounts those transactions and
events that affect its assets, liabilities, and equities. The general ledger contains all the asset, liability,
and stockholders’ equity accounts. An account (see Illustration 3-3, on page 83) shows the effect of
transactions on particular asset, liability, equity, revenue, and expense accounts. In practice, companies
do not record transactions and selected other events originally in the ledger. A transaction affects two or
more accounts, each of which is on a different page in the ledger. Therefore, in order to have a complete
record of each transaction or other event in one place, a company uses a journal (also called “the book
of original entry”). In its simplest form, a general journal chronologically lists transactions and other
events, expressed in terms of debits and credits to accounts. As an example, Illustration 3-7 shows the
technique of journalizing, using two transactions for Softbyte, Inc. These transactions are: September 1
Stockholders invested $15,000 cash in the corporation in exchange for shares of stock. Purchased
computer equipment for $7,000 cash. The J1 in Illustration 3-7 indicates these two entries are on the
first page of the general journal. LEARNING OBJECTIVE 2 Record and summarize basic transactions.
GENERAL JOURNAL J1 Date Account Titles and Explanation Ref. Debit Credit 2017 Sept. 1 Cash 15,000
Common Stock 15,000 (Issued shares of stock for cash) 1 Equipment 7,000 Cash 7,000 (Purchased
equipment for cash