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 setting organizational objectives.
Every individual in the organization, from business operations to top management, needs information to
accomplish his or her tasks.
Information Flows
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.
 The vertical flow distributes summarized information about operations and other activities
upward to managers at all levels. Management uses this information to support its various
planning and control functions. Information also flows downward from senior managers to
junior managers and operations personnel in the form of instructions, quotas, and budgets.
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 they receive differ considerably. For example:
 Managers cannot use the highly detailed information needed by operations personnel.
Management information is thus more summarized and oriented toward reporting on overall
performance and problems rather than routine operations.
 External stakeholders, 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:
1. 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.
2. 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. They lack a common purpose, however, and
thus do not form a system.
3. 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 composed of many smaller subsystems, such as the circulatory subsystem and the
respiratory subsystem.
4. Purpose.
A system must serve at least one purpose, but it may serve several. Whether a system provides
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.
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 AIS and MIS Distinction
The distinction between AIS and MIS centers on the concept of a transaction, as illustrated by Figure 1-
4.
 The AIS (Accounting Information System) subsystems process financial transactions and
nonfinancial transactions that directly affect the processing of financial transactions.
o 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 MIS (Management Information System) processes nonfinancial transactions that are not
normally processed by traditional AIS.
Definition of a Transaction
A transaction is defined 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.
 Financial Transaction: An economic event that affects the assets and equities of the
organization, is reflected in its accounts, and is measured in monetary terms.
o Examples: Sales of products to customers, purchases of inventory from vendors, and
cash disbursements and receipts.
 Nonfinancial Transaction: Events that do not meet the narrow definition of a financial
transaction.
o Example: Adding a new supplier of raw materials to the list of valid suppliers.
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
End users fall into two general groups: external and internal.
 External Users:
These include creditors, stockholders, potential investors, regulatory agencies, tax authorities,
suppliers, and customers.
o Institutional users such as banks, the SEC, and the IRS receive information in the form of
financial statements, tax returns, and other reports that the firm has a legal obligation
to produce.
 o Trading partners (customers and suppliers) receive transaction-oriented information,
including purchase orders, billing statements, and shipping documents.
 Internal Users:
These include management at every level of the organization, as well as operations personnel.
o Internal reporting is governed by what gets the job done and involves balancing user
needs with legal and economic concerns such as control, security, accountability, and
costs.
Data vs. Information
Before discussing the data sources, we must make an important distinction between the terms data and
information:
 Data: Facts that may or may not be processed and have no direct effect on the user.
 Information: Causes the user to take an action that they otherwise would not have taken.
Information is not just a set of processed facts; it allows users to take action to resolve conflicts, reduce
uncertainty, and make decisions.
Data Sources
Data sources are financial transactions that enter the information system from both internal and
external sources:
1. External Financial Transactions:
Economic exchanges with other business entities and individuals outside the firm.
o Examples: Sale of goods and services, purchase of inventory, receipt of cash, and
disbursement of cash (including payroll).
2. Internal Financial Transactions:
The exchange or movement of resources within the organization.
o Examples: Movement of raw materials into work-in-process (WIP), transfer of WIP into
finished goods inventory, and depreciation of plant and equipment.
Data Collection
The objective is to ensure that event data entering the system are valid, complete, and free from
material errors.
 Relevance: Only data that ultimately contribute to information are relevant.
 Efficiency: Data should be captured only once to avoid redundancy and inconsistency.
Data Processing
Once collected, data usually require processing to produce information. Tasks in the data processing
stage range from simple (e.g., summarizing data) to complex (e.g., mathematical algorithms for
production scheduling).
Database Management
The organization’s database is its physical repository for financial and nonfinancial data. The contents
can be represented in a logical hierarchy:
1. Data Attribute: The most elemental piece of potentially useful data.
2. Record: A complete set of attributes for a single occurrence within an entity class.
3. File: A complete set of records of an identical class.
Information Generation
The process of compiling, arranging, formatting, and presenting information to users. Useful information
has the following characteristics:
 Relevance: Serves a purpose (e.g., decision-making or task performance).
  Timeliness: Must not be older than the time period of the action it supports.
 Accuracy: Free from material errors.
 Completeness: No essential piece of information should be missing.
 Summarization: Information should be aggregated according to the user’s needs.
Feedback
Feedback is a form of output that is sent back to the system as a source of data. Feedback can be:
 Internal: Signals that initiate or alter a process (e.g., inventory status report prompting reorder).
 External: Used to adjust policies or actions (e.g., uncollected customer accounts prompting
credit policy changes).
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. However, three fundamental objectives are
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
Organizations usually acquire information systems in two ways:
1. Developing Customized Systems
o Organizations develop customized systems from scratch through in-house systems
development activities.
o Larger organizations with unique and frequently changing needs engage in this method.
The formal process by which this is accomplished is called the system development life
cycle.
2. Purchasing Preprogrammed Commercial Systems
o Organizations purchase preprogrammed systems from software vendors.
o This approach is common for smaller companies and larger firms with standardized
information needs.
Three basic types of commercial software include:
 Turnkey Systems:
Finished and tested systems ready for implementation. These are general-purpose or industry-
specific systems.
o Examples: Enterprise Resource Planning (ERP) systems like Oracle and SAP.
 Backbone Systems:
A basic system structure on which to build, with primary processing logic preprogrammed. The
vendor designs user interfaces to meet the client’s unique needs.
 Vendor-Supported Systems:
Custom or customized systems purchased commercially rather than developed in-house. The
vendor designs, implements, and maintains the system for the client.
Organizational Structure
The structure of an organization reflects the distribution of responsibility, authority, and
accountability throughout the organization. These flows are illustrated in Figure 1-7. Firms achieve
their overall objectives by establishing measurable financial goals for their operational units.
 For example, budget information flows downward. This is the mechanism by which senior
management conveys to their subordinates the standards against which they will be measured
for the coming period.
 The results of the subordinates’ actions, in the form of performance information, flow upward
to senior management.
Understanding the distribution pattern of responsibility, authority, and accountability is essential for
assessing user information needs.
Business Segments
Business organizations consist of functional units or segments. Firms organize into segments to
promote internal efficiencies through the specialization of labor and cost-effective resource
allocations. Managers within a segment can focus their attention on narrow areas of responsibility
to achieve higher levels of operating efficiency. Three of the most common approaches include
segmentation by:
1. Geographic Location
Many organizations have operations dispersed across the country and around the world. They
do this to gain access to resources, markets, or lines of distribution. A convenient way to
manage such operations is to organize the management of the firm around each geographic
segment as a quasi-autonomous entity.
2. Product Line
Companies that produce highly diversified products often organize around product lines,
creating separate divisions for each. Product segmentation allows the organization to devote
specialized management, labor, and resources to segments separately, almost as if they were
separate firms.
3. Business Function
Functional segmentation divides the organization into areas of specialized responsibility based
on tasks. The functional areas are determined according to the flow of primary resources
through the firm. Examples of business function segments are marketing, production, finance,
and accounting.
Some firms use more than one method of segmentation. For instance, an international
conglomerate may segment its operations first geographically, then by product within each
geographic region, and then functionally within each product segment.
Functional Segmentation
Segmentation by business function is the most common method of organizing. To illustrate it, we
will assume a manufacturing firm that uses these resources: materials, labor, financial capital, and
information. Table 1-2 shows the relationship between functional segments and these resources.
The titles of functions and even the functions themselves will vary greatly among organizations,
depending on their size and line of business. A public utility may have little in the way of a marketing
function compared to an automobile manufacturer. A service organization may have no formal
production function and little in the way of inventory to manage. One firm may call its labor
resource personnel, whereas another uses the term human resources.
Keeping in mind these variations, we will briefly discuss the functional areas of the hypothetical firm
shown in Figure 1-8. Because of their special importance to the study of information systems, the
accounting and information technology (IT) functions are given separate and more detailed
treatment.
Functional Areas of a Firm
Materials Management
The objective of materials management is to plan and control the materials inventory of the
company. A manufacturing firm must have sufficient inventories on hand to meet its production
needs and yet avoid excessive inventory levels.
 Every dollar invested in inventory is a dollar that is not earning a return. Furthermore, idle
inventory can become obsolete, lost, or stolen.
 Ideally, a firm would coordinate inventory arrivals from suppliers such that they move directly
into the production process. As a practical matter, however, most organizations maintain safety
stocks to carry them through the lead time between placing the order for inventory and its
arrival.
Materials management has three subfunctions:
1. Purchasing
o Responsible for ordering inventory from vendors when inventory levels fall to their
reorder points.
o The nature of this task varies among organizations. In some cases, purchasing is no more
than sending a purchase order to a designated vendor. In other cases, this task involves
soliciting bids from several competing vendors.
2. Receiving
o Involves accepting the inventory previously ordered by purchasing.
o Activities include counting and checking the physical condition of these items. This is an
organization’s first opportunity to detect incomplete deliveries and damaged
merchandise before they move into the production process.
3. Stores
o Takes physical custody of the inventory received and releases these resources into the
production process as needed.
Production
Production activities occur in the conversion cycle, where raw materials, labor, and plant assets are
used to create finished products. Specific activities include:
1. Primary Manufacturing Activities:
o Shape and assemble raw materials into finished products.
2. Production Support Activities:
o Ensure that primary manufacturing activities operate efficiently and effectively.
o Examples include:
 Production Planning: Scheduling the flow of materials, labor, and machinery to
efficiently meet production needs.
  Quality Control: Monitoring the manufacturing process at various points to
ensure finished products meet quality standards.
 Maintenance: Keeping the firm’s machinery and other facilities in running order
through preventive measures.
Marketing
The marketplace needs to know about, and have access to, a firm’s products. The marketing
function addresses strategic problems such as:
 Product promotion.
 Advertising.
 Market research.
On an operational level, marketing also performs daily activities like sales order entry.

Distribution
Distribution is the activity of getting the product to the customer after the sale. This step is critical,
as much can go wrong before the customer takes possession of the product:
 Excessive delays in order fulfillment, incorrect shipments, or damaged goods can result in
customer dissatisfaction and lost sales.
 Success depends on accurate order fulfillment in the warehouse, proper packaging, and quick
shipping to the customer.
Personnel
Competent and reliable employees are a valuable resource to a business. The objective of the
personnel function is to effectively manage this resource. Activities include:
 Recruiting, training, continuing education, and counseling.
 Evaluating performance, managing labor relations, and administering compensation.
Finance
The finance function manages the financial resources of the firm through:
 Banking and treasury activities.
 Portfolio management and credit evaluation.
 Cash disbursements and receipts.
Because of the cyclical nature of business, financial planners seek lucrative investments during
periods of excess funds and low-cost lines of credit during cash deficits. The finance function also
administers the daily flow of cash in and out of the firm.
Accounting Function
The accounting function manages the financial information resource of the firm. Its roles include:
1. Capturing and Recording Financial Effects:
o Includes events such as the movement of raw materials, shipment of finished products,
cash flows, inventory acquisitions, and financial obligation settlements.
2. Distributing Transaction Information:
o Provides data to operations personnel to coordinate their tasks.
o Activities include inventory control, cost accounting, payroll, accounts payable, accounts
receivable, billing, fixed asset accounting, and general ledger maintenance.
The Information Technology (IT) Function
Like accounting, the IT function is associated with the information resource. Its activities can be
organized in several ways. One extreme structure is the centralized data processing approach; at
the other extreme is the distributed data processing approach. Most organizational structures fall
somewhere between these extremes and embody elements of both.

Centralized Data Processing

Under the centralized data processing model, all data processing is performed by one or more large
computers housed at a central site that serves users throughout the organization. Figure 1-9
illustrates this approach, in which IT activities are consolidated and managed as a shared
organizational resource. End users compete for these resources based on need. The IT function is
usually treated as a cost center, with operating costs charged back to the end users.
Figure 1-10 shows the IT areas of operation in more detail, which include:
1. Database Administration
o Centrally organized companies maintain their data resources in a central location shared
by all end users.
o A special independent group, database administration, headed by the database
administrator, is responsible for the security and integrity of the database.
2. Data Processing
o Manages the computer resources used for day-to-day transaction processing.
o Functions include:
 Data Control: Traditionally responsible for receiving transaction documents
from users and distributing computer output (e.g., reports) back to them.
 Data Conversion: Transcribes transaction data from source documents to digital
media suitable for processing by the central computer.
 Computer Operations: Manages central computer processing schedules.
 Data Library: Provides safe storage for offline data files (e.g., magnetic tapes or
disk packs). The role of data librarians has diminished with the rise of real-time
processing.
3. Systems Development and Maintenance
o The systems development group analyzes user needs and designs new systems.
Participants include:
 Systems Professionals: Systems analysts, database designers, and programmers
who design and build the system.
 End Users: Managers and operations personnel who use the system.
 Stakeholders: Internal and external parties with an interest in the system (e.g.,
auditors, consultants).
o Once implemented, the systems maintenance group keeps the system updated to meet
user needs. Over its life span, 80–90% of a system’s cost is attributable to maintenance.
Distributed Data Processing (DDP)
An alternative to the centralized model, DDP involves reorganizing the IT function into smaller
information processing units (IPUs) distributed to end users and placed under their control. Figure
1-11 illustrates this structure, in which IPUs may be distributed by business function, geographic
location, or both.
Advantages of DDP:
 Cost Reductions: Inexpensive, small-scale systems can perform specialized tasks effectively.
 Improved Cost Control Responsibility: Empowers managers with control over resources critical
to their operations.
 Improved User Satisfaction: Users gain control over systems professionals and involvement in
system development.
 Backup Capability: Excess capacity in IPUs allows disaster recovery through redundancy.
Disadvantages of DDP:
 Loss of Control: Organization-wide resources may be mismanaged.
 Hardware/Software Incompatibility: Independent decisions may result in systems that cannot
communicate.
 Redundant Tasks: Efforts may be duplicated across IPUs.
 Inadequate Segregation of Duties: Combining incompatible functions in small units may violate
internal controls.
 Difficulty Hiring Professionals: Smaller units may struggle to attract qualified IT personnel.
 Lack of Standards: Uneven or nonexistent standards for systems development, documentation,
and performance evaluation.
The Evolution of Information System Models
Over the past 50 years, a number of different approaches or models have represented accounting
information systems. Each new model evolved because of the shortcomings and limitations of its
predecessor. An interesting feature in this evolution is that the newest technique does not
immediately replace older models. Thus, at any point in time, various generations of systems exist
across different organizations and may even coexist within a single enterprise.
The modern auditor needs to be familiar with the operational features of all AIS approaches that he
or she is likely to encounter. This book deals extensively with five such models:
1. Manual Processes
2. Flat-File Systems
3. The Database Approach
4. The REA (Resources, Events, and Agents) Model
5. ERP (Enterprise Resource Planning) Systems
Each of these is briefly outlined below.
1. The Manual Process Model
The manual process model is the oldest and most traditional form of accounting systems. Manual
systems constitute the physical events, resources, and personnel that characterize many business
processes.
This includes tasks such as:
 Order-taking
 Warehousing materials
 Manufacturing goods for sale
 Shipping goods to customers
 Placing orders with vendors
Traditionally, this model also includes the physical task of record keeping. While manual record
keeping is often used to teach accounting principles, it is now considered a training aid and is not
used in practice.
Why Study the Manual Process Model?
 Helps establish a link between AIS and other accounting courses.
 Provides insight into where data originates, how it is collected, and how it is used to support
operations.
 Simplifies understanding of business processes by focusing on the tasks, independent of
technology.
 Facilitates understanding of internal control activities like segregation of duties, supervision, and
access controls.
2. The Flat-File Model
The flat-file approach is most often associated with legacy systems. These are large mainframe
systems implemented between the 1960s and 1980s. In this model:
 Data files are not related to other files.
 End users "own" their data files, and there is little sharing across departments.
 Stand-alone applications perform data processing rather than integrated systems.
Issues in the Flat-File Environment:
1. Data Redundancy:
o Multiple versions of the same data are stored across systems.
2. Data Storage:
o Organizations must incur costs for storing duplicate data.
3. Data Updating:
o Updating data in multiple places is inefficient and prone to errors.
4. Currency of Information:
o Outdated information leads to poor decisions.
5. Task-Data Dependency:
o Users are limited to data they possess and control, making it difficult to meet new
information needs.
6. Limited Data Integration:
o Data is structured to meet the specific needs of individual users, making broader data
integration difficult.
3. The Database Approach
The database approach overcomes many of the problems associated with flat-file systems by
centralizing data storage into a single database accessible by multiple users.
Advantages:
 Reduced data redundancy.
 Improved data consistency and currency.
 Enhanced ability to integrate data across functions.
The database approach is covered extensively in later chapters of this book.

4. The REA Model (Resources, Events, and Agents)

The REA model represents a more modern approach to AIS. It views accounting data in terms of
resources (assets), events (economic activities), and agents (individuals or organizations involved in
events).
This approach emphasizes:
 Integration of financial and nonfinancial data.
 Support for decision-making processes beyond traditional accounting needs.
5. ERP (Enterprise Resource Planning) Systems
ERP systems integrate all aspects of an organization’s operations into a unified information system.
These systems:
 Use a single database to store and share data across all functional areas.
 Include modules for accounting, finance, manufacturing, human resources, and more.
 Are highly customizable and allow real-time access to data.
While powerful, ERP systems are also complex and costly to implement and maintain.
The Role of Accountants in AIS
Accountants play several critical roles in the design, implementation, and use of accounting
information systems (AIS). These roles can be grouped into three main categories:
1. Accountants as System Users
o Accountants are primary users of the AIS. They rely on the system to perform their day-
to-day functions, including:
 Collecting and recording transaction data.
 Compiling financial statements.
 Supporting decision-making processes with financial and operational
information.
o Accountants must possess an in-depth understanding of the system's capabilities and
limitations to use it effectively.
2. Accountants as System Designers
o Accountants contribute to the design of AIS by specifying user needs and ensuring the
system complies with accounting principles and organizational policies.
o They assist in:
 Defining information requirements.
 Designing controls to safeguard assets and ensure data reliability.
 Developing reporting formats to meet internal and external user needs.
3. Accountants as System Auditors
o Accountants are responsible for auditing AIS to ensure:
 The system provides accurate and reliable information.
 Internal controls are effective in safeguarding assets and ensuring compliance
with policies and regulations.
 AIS complies with legal and professional standards, such as the Sarbanes-Oxley
Act (SOX).
o Auditors must be familiar with the system's technical components, including:
 Hardware and software architecture.
 Data storage and processing methods.
 Security mechanisms.
o IT auditing is a specialized area of accounting that focuses on evaluating the controls
and risks associated with computerized information systems.