Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

FUNDAMENTALS OF ACCOUNTING-I
CHAPTER 4
Accounting Systems Design

4.1 Accounting Information System

In earlier chapters, we have seen that the effects of various business transactions are identified,
measured, recorded, and reported within an entity’s accounting system. An Accounting
Information System (AIS) is the methods and procedures for collecting, classifying,
summarizing, and reporting a business’s financial and operating information. It refers to the way in
which management is given the information for use in conducting the affairs of the business and in
reporting to owners, creditors, and other interested parties.

It collects and process data from transactions and events, organize them in useful forms, and
communicate results to decision makers. AIS includes the entire network of communications used
by a business to provide needed information and consists of the business documents, journals,
ledgers, procedures, and internal controls needed to produce reliable financial statements and other
accounting reports.

AIS range from simple manual systems in which accounting records are maintained by hand =
Manual Accounting Sytem – to sophisticated systems in which accounting records are maintained
electronically - Computerized (Computer-Based) Accounting System. The accounting system to
be used in any given company should be especially tailored to the size and to the information needs
of the business.

4.2 Principles of Accounting Systems Design

All decision makers in practice today need to have a basic knowledge of how accounting
information system works. This knowledge gives decision makers a competitive edge as they gain a
better understanding of information constraints, measurement limitations, and potential
applications. It allows them to make more informed decisions and to better balance the risks and
returns of various strategies. This section explains five fundamental principles of accounting
information systems. These principles are: control, relevance, compatibility, flexibility, and
favorable cost/benefit relationship.

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

4.2.1 Control Principle - Managers need to control and monitor business activities. To this end,
the Control Principle requires an accounting information system to have internal controls.
Internal controls are methods and procedures allowing managers to control and monitor
business activities. They include, among other things, policies to direct operations toward
common goal; procedures to ensure reliable financial reports; safeguards to protect company
assets; and methods to achieve compliance with laws and regulations.

4.2.2 Relevance Principle – Decision makers need relevant information to make informed
decisions. The relevance principle requires that an accounting information system report
useful, understandable, timely, and pertinent (relatable) information for effective decision-
making. This means an accounting information system should be designed in such a way
that it is capable of capturing data that make a difference in decisions. To ensure this, it is
important that all decision makers be considered when identifying relevant information for
disclosure.

4.2.3 Compatibility Principle - Accounting information system must be consistent with the aims
of the company. The Compatibility Principle requires that an accounting information
system conform with (fit in) a company’s activities, personnel, and structure. It also must
adapt to the unique characteristics of a company. The system must not be intrusive, but
rather work in harmony with and be driven by company goals.

For example, a company can organize its marketing efforts by region or by product. If a
company is organized by region, its accounting system should report revenues and expenses
by region. On the other hand, if a company is organized by product, its system should report
revenues and expenses first by product and then by region.

4.2.4 Flexibility Principle - Accounting information system must be able to adjust to changes.
The Flexibility Principle requires that an accounting information system be able to adapt to
changes in the company, business environment, and needs of decision makers.
Technological changes, competitive pressures, customer tastes, regulations, and company
activities constantly change. A system must de designed to adapt to this changes.

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
Businesses do not stay the same. They grow, offer new products, add new branch offices,
sell existing divisions, or make other changes that require adjustments in the accounting
system.

A carefully designed system allows a business to grow and change without making major
alterations. For example, the chart of accounts should be designed to allow the addition of
new asset, liability, owner’s equity, revenue, and expense accounts.

4.2.5 Cost-Benefit Principle – the most important principle, the Cost-Benefit Principle, holds
that the benefits derived from an accounting system and the information it generates must
be equal to or greater than its cost. Beyond certain routine tasks – preparing payroll and tax
reports and financial statements, and maintaining internal control – management may want
or need other information. That information must be reliable, timely, and useful. The
benefits of additional information must be weighed against both the tangible and the
intangible costs of gathering it. Among the tangible costs are those for personnel, forms, and
equipment. One of the intangible costs is the cost of wrong decisions stemming from the
lack of good information. For instance, wrong decisions can lead to loss of sales, production
stoppages, or inventory losses.

Some companies have spent thousands of dollars on computer systems that do not offer
enough benefits. On the other hand, some managers have failed to realize important benefits
that could be gained from investing in more advanced systems. It is the job of the
accountant and the systems analyst to weigh the costs and benefits. One important point that
has to be borne in mind is that decisions regarding other principles (control, relevance,
compatibility, and flexibility) are also affected by the cost-benefit principle.

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

4.3 Accounting System Installation and Revision

Before designing and installing an accounting system for an enterprise, the designer must have a
complete knowledge of the business’s operation. However, the designer should recognize that some
areas of the system, such as the type and design of the forms needed and the number and titles of
the accounts required may be affected by factors that are not known when a business is first
organized. As new information about a business is obtained and as a business “outgrows” its
accounting system when it expands to new operational areas, the system will need to be revised.
Many large businesses continually review their accounting system and may constantly be involved
in changing some part of it.
 The job of installing or changing an accounting system, either in its entirety or only in part,
is made up of four phases:
a) Analysis,
b) Design,
c) Implementation, and
d) Follow up.

4.3.1 Systems Analysis – the goal of this phase is to determine:

1. Information needs;
2. The sources of such information, and
3. Deficiencies in procedures and data processing methods presently used.

 Systems analysis is initiated for three reasons:

a) An existing system is not functioning as it should;
b) A new information requirement may be identified by a long-range system planning
staff or may result from legal or competitive change in the business environment; or
c) Organizations initiate systems analysis to take advantage of a new technology.
 The existing system may be functioning satisfactorily, but since its implementation,
technological change introduced new methods that are more efficient.

The analysis usually begins with a review of organizational structure and the job
descriptions of the personnel affected. This review is followed by a study of the forms,
records, procedures, processing methods, and reports used by the enterprise. The source of
such information is usually the firm’s Systems Manual. In addition to looking at the
shortcomings of the present system, the analyst should determine management’s plan for
changes in operations (volume, products, territories, etc.).

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
4.3.2 Systems Design – during system design, the design team translates recommendations
made in systems analysis into a form that can be implemented.
 The design project team identifies in detail how the system will work, such as:
 The purposes of all computer programs and manual procedures are identified;
 All documents and reports are designed;
 All files are described; and
 The necessary internal controls are identified.

4.3.3 Systems Implementation – New or revised forms, records, procedures, and equipment
must be installed, and any that are no longer useful must be withdrawn. For a large
organization, a major revision such as a change from an obsolete to a modern computer
processing system is usually done gradually over an extended period rather than all at once.
With such a procedure, there is less likelihood that the flow of useful data will be seriously
slowed down during the critical phase of implementation.
Weaknesses or conflicting or unnecessary elements in the design may also become apparent
during the implementation phase. They are more easily seen and corrected when changes in
the system are adopted gradually, and possible chaos is thereby avoided.

4.3.4 Systems Follow Up or Review - After operation of a new system begins, the post-
implementation review of system operation occurs. During this review, members of the
design team, frequently with the aid of an internal auditor, examine the operation of the new
system. The purpose of the review is to determine if the system meets its objectives. It
identifies problems that need correction and provides feedback to the design team
concerning the success of the system. Another activity, which is called system
maintenance, takes place during the follow up phase. These are the tasks that are necessary
to correct errors in the system design or to make minor changes to the system because of
changes in its environment. System maintenance includes both changes to equipment
(hardware maintenance) and changes to computer programs (software maintenance).

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
4.4 Internal Control
We all are aware of reports and experiences involving theft and fraud. These occurrences affect us
and produce various actions. Actions include looking doors, chaining bikes, reviewing sales
receipts, and acquiring alarm systems. A company also takes actions to safeguard, control, and
manage what it owns. Experience tells us that small companies are most vulnerable. This is usually
due to weak internal controls. It is management’s responsibility to set up policies and procedures
to safeguard a company’s assets. To do so, management and employees must understand and apply
principles of internal control. This section describes these principles and how to apply them. It also
examines the impact of information technology on internal control and the limitations of internal
controls.

4.4.1 The Meaning and Purposes of Internal Control

Managers (or owners) of small businesses often control the entire operation. They supervise
workers, participate in all activities, and make major decisions. These managers usually buy all the
assets and services used in the business. They also hire and manage employees, negotiate all
contracts, and sign all checks. These managers know from personal contact and observation
whether the business is actually receiving the assets and services paid for.

Larger companies find it increasingly difficult to maintain this close personal contact. At some
point, managers must delegate responsibilities and relay on formal procedures rather than personal
contact in controlling and knowing all operations of the business. Internal control is defined as all
the policies and procedures management uses to provide reasonable assurance that the enterprise’s
goals and objectives will be achieved. It includes the policies and procedures used to safeguard a
company’s assets and to ensure that reliable financial statements are the end-result of an efficient
accounting system.

The system of internal control includes all measures taken by the organization for the purpose of:
(1) Protecting its resources against waste, fraud, and inefficiency;
(2) Ensuring accuracy and reliability in accounting and operating data;
(3) Securing compliance with company policies; and
(4) Evaluating the level of performance in all divisions of the company.

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
4.4.2 Effective Systems of Internal Control
 Good internal accounting control has the following characteristics:
4.4.2.1 Competent, Reliable, and Ethical Personnel – Employees should be competent, reliable,
and ethical. Paying top salaries to attract top quality employees, training them to do their job
well, and supervising their work all help to build a competent staff. A business adds
flexibility to its staffing by rotating employees through various jobs. If one employee is sick
or on vacation, a second employee is trained to step in and do the job.

Rotating employees through various jobs also promotes reliability. An employee is less
likely to handle his/her job improperly if s/he knows that his/her misconduct may come to
light when a second employee takes over the job. Companies may cut off their
embezzlement losses by rotating two or more employees through a job.

This same reasoning leads businesses to require that employees take an annual vacation. A
second employee stepping in to handle the position may uncover any wrongdoing. Periodic
reviews by other employees have a way of keeping workers honest and ethical.

4.4.2.2 Assignment of Responsibility - The plan of organization should fix responsibility for
functions and confer the authority necessary to perform them. Responsibility and authority
for a given function should not be shared, because this may result in duplication of effort
and in jobs going undone if individuals think that another person is performing the
assignment. When one person is responsible for a function, praise or blame can be clearly
assigned for specific results. Thus, if a plant supervisor is responsible for staying within
budgeted amounts for labor costs, s/he should be given the authority to assign personnel to
jobs, control overtime, and so on.
4.4.2.3 Proper Authorization – An organization generally has a written set of rules that outlines
approved procedures. Any deviation from standard policy requires proper authorization. For
example, managers or assistant managers of retail stores must approve customer checks for
amounts above the store’s usual limit. Likewise, deans or department chairpersons of
colleges and universities must give the authorization for a junior to enroll in courses
restricted to seniors.

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
4.4.2.4 Separation of Duties – Smart management divides the responsibilities for transactions
between two or more people or departments. Separation of duties limits the chances for
fraud and promotes the accuracy of the accounting records. This crucial component of the
internal control system may be divided into four parts.

 Separation of operations from accounting: - the entire accounting function should be

completely separate from operating departments, such as manufacturing and sales, so
that reliable records may be kept. For example, product inspectors, not machine
operators, should count units produced by a manufacturing process. Accountants, not
sales persons, should keep inventory records.

 Separation of the custody of assets from accounting: - temptation and fraud are
reduced if the accountant does not handle cash and if the cashier does not have access to
the accounting records. If one employee has both cash-handling and accounting duties,
that person can steal cash and conceal the theft by making a bogus entry on the books.
Warehouse employees with no accounting duties should handle inventory. If they were
allowed to account for inventory, they could steal it and write it off as obsolete. In a
computerized system, a person with custody of assets should not have access to the
computer programs. Similarly, the programmer should not have access to tempting
assets such as cash.

 Separation of the authorization of transactions from the custody of related assets: - If

possible, persons who authorize transactions should not handle the related assets. For
example, the same individual should not authorize the payment of a supplier’s invoice
and also sign the check to pay the bill. With both duties, the person can authorize
payments to himself or herself and then sign the checks. When these duties are
separated, only legitimate bills are paid.

 For another example, an individual who handles cash receipts should not have the
authority to write off accounts receivable. (Because that sell on credit declare certain of
their accounts receivable as uncollectible, realizing that these receivables will never be
collected.)

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

 Separation of duties within the accounting function: - Independent performance of the

various phases of accounting helps to minimize errors and opportunities for fraud. For
example, different accountants should be responsible for recording cash receipts and
cash disbursements. The employees who process accounts payable and check requests
should have nothing to do with the approval process.

4.4.2.5 Internal and External Audits – It is not economically feasible for auditors to examine all
the transactions during a period, so they must rely on the accounting system to produce
accurate records. To gauge the reliability of the company’s accounting system, auditors
evaluate its system of internal controls. Auditors also spot the weaknesses in the system and
recommend corrections. Auditors offer objectivity in their reports, while managers
immersed in operations may overlook their own weaknesses.

Auditors are internal or external. Internal auditors are employees of the business reporting
directly to the management of the business. They audit the various segments of the
organization throughout the year. External auditors are entirely independent of the
business. Employed by an accounting (or audit) firm, they are hired by an entity as outsiders
to audit the entity as a whole.

Both groups of auditors are independent of the operations they examine. An auditor may
find that an employee has both cash-handling and cash-accounting duties or may learn that a
cash shortage has resulted from lax efforts to collect accounts receivable. In such cases, the
auditor suggests improvements. Auditors’ recommendations assist the business in running
efficiently.

4.4.2.6 Documents and Records – Business documents and records vary considerably, from source
documents such as sales invoice and purchase orders to special journals and subsidiary
ledgers. Documents should be pre-numbered. A gap in the numbered sequence calls
attention to a missing document.

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
Pre-numbering cash-sale receipts discourages theft by the cashier because the copy retained
by the cashier, which lists the amount of the sale, can be checked against the actual amount
of cash received. If the receipts are not pre-numbered, the cashier can destroy the copy and
pocket the cash sale amount. However, if the receipts are pre-numbered, the missing copy
can easily be identified. In a computerized system, a permanent record of the sale is stored
electronically when the transaction is completed.

4.4.2.7 Physical Protection of Assets: Frequently, management initiates a number of physical

controls to protect company property. For example, only minimal amounts of cash should be
kept on the company premises, and these should be stored in a vault. A firm should keep its
inventory in a secure area and maintain strict controls over issuances and physical counts of
inventory. Security personnel are often engaged to protect inventories and other physical
property. A company may employ outside protection services to safeguard against burglary
and arson and might post gatekeepers at plant entrances and exits to observe employees and
others entering and leaving the plant. A business must be adequately insured against losses
from fire, outside theft, and similar events.

4.4.2.8 Electronic and Other Controls – Businesses use electronic devices to meet their needs for
control over assets and operations. For example, some supermarkets in Addis Ababa control
their inventories by attaching an electronic sensor to merchandise. The cashier removes the
sensor when a sale is made.
If a customer tries to remove from the store an item with the sensor attached, an alarm is
activated. These sensors as such reduce loss due to theft. Accounting systems are relying
less and less on documents and more and more on digital storage devices. Computers
produce accurate records and enhance operational efficiency, but that does not automatically
safeguard assets or encourage employees to behave in accordance with company policies.
What computers have done is shift the internal controls to the people who write the
programs. Programmers can carry out the plans of managers and accountants.

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

4.4.3 Special Journals and Subsidiary Ledgers

In the preceding chapters, all transactions were initially recorded in a two-column journal (general
journal), then posted to the appropriate accounts in the ledger (general ledger). Applying such
detailed procedures to a large number of transactions that are often repeated is impractical. Rather,
as the number of transactions increases, companies must develop more efficient ways of recording
transactions. Special Journals and Subsidiary Ledgers are important parts of an accounting
information system, for internal control.

4.4.3.1 Expanding the General Journal - Special Journals

A General Journal is an all-purpose journal where we can record any transaction, such as: Sales,
Purchases, Cash Receipts, Cash Payments, Sales Returns and Allowances, and Purchases Returns
and Allowance.
 The universal nature of the general journal imposes some limitations that will adversely
affect the efficacy of processing data.
 These are:
 Each debit and credit recorded in the general journal must be posted individually,
requiring a large amount of posting time, and this can make it difficult to provide
accounting information on a timely basis;
 Only one person at a time can record the effects of transactions and post debits and
credits to the ledger accounts, since all entries are recorded in one journal;
 The general journal needs narrations to describe every transaction.

 To avoid these limitations, transactions are grouped into like categories and a special
journal is set up for each category.

4.4.3.2 Types of Special Journal

A special journal is a multi-column journal that is reserved for recording only a particular type of
transaction. Unlike the general journal special journals are not flexible. The transactions that cannot
fit into any one of the special journals are recorded in the general journal.

 Special journals that can be used by a merchandising business are given below with the
type of transactions and abbreviations used in posting.

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 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

Transaction Special Journal Posting Abbreviation

1. Sales on Account Sales Journal SJ
2. Cash Receipts Cash Receipts Journal CRJ
3. Purchase on Account Purchases Journal PJ
4. Cash Disbursement Cash Payments Journal CPJ

Special journals may also be used for returns and allowances of sales and purchases if they are
sufficiently numerous. In this material, however, all returns and allowances will be processed
through the general journal. The combination of the above four journals, together with a general
journal for all other types of transactions, represents a much more efficient way to process data than
the use of a general journal alone. The time require to journalize entries is reduced, and totals rather
than individual entries can be posted to the general ledger accounts in many cases, thus reducing the
cost of accounting labor. The journals allow all necessary detail to be entered in subsidiary ledgers.

Also duties can be efficiently divided by assigning different journals to different employees so that
work can be performed concurrently. Several selected transactions involving a retail company
during the month of January illustrate the four special journals in the next section. The formats used
for the four special journals are typical but not unique. The nature of a given entity determines the
exact formats required. For example, use of a perpetual inventory system rather than the periodic
requires additional columns in most of the special journals.

Some computerized accounting systems do not require the use of special journals, as the computer
can classify and enter data directly to the ledger. Transaction summaries which resemble special
journals in appearance and contain the same data may be printed out if so desired.

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