Accounting Information System: with Sub-System and Accounting Equation

Accounting Information System: with Sub-System and Accounting Equation!

Accounting Information System:

A system has a set of elements which operate together to attain a goal. Generally a system has three activities – (1) input, (2) processing of input, and (3) output. Similarly, accounting comprises a series of activities that are linked together from the ‘stage of observation to the stage of communication’. The activities include collecting, recording, analysing the data to formulate into information to be communicated to the users. The output is in the form of financial statements which the users need to know for decision making.

Accounting information system (AIS) follows the principles, concepts, conventions, standards prescribed on scientific lines while generating the information required for users (investors, creditors, managers). Further, accounting information system links the information source (books of accounts), a channel of communication or the output (financial statements), and the set of users or decision makers (both internal and external).

Figure 6.3 depicts the accounting information system. Reporting information to interested users requires that the AIS describes various aspects of the business enterprise’s economic condition as well as the activities that it has initiated. The description includes the resources (assets), liabilities (claims of creditors and others) and dues to owners (owner’s equity).

Accounting Sub-System:

Accounting may be sub-divided into several sub-systems of which financial accounting and cost and management accounting are very significant. This is because they provide a base for analysis and interpretation to make decisions.

Financial accounting is concerned with collecting, recording, classifying and reporting business information about economic events that involve a specific accounting entity. The basis for preparing financial accounting is GAAP enunciated by the accounting profession. The function of financial accounting is to provide financial information of the business enterprise to its users.

The purpose of providing this information is two-fold:

1. To provide performance information to the enterprise’s management.

2. To communicate the performance report to external users for decision making.

For example, if one wants to buy a few shares in one of the thriving companies, say Tata Consultancy Services, WIPRO, Reliance, etc., how does one invest? One way is to review financial reports and compare the financial performance and conditions of each company and decide as to where to invest.

The major purpose of financial accounting is to provide such information to the users in addition to the basic purpose of providing performance information to the enterprise’s management/owners.

Cost and management accounting relates to reporting information useful to ‘management decision makers’ within the business enterprise. The managers need different types of information for planning and controlling.

Performance reports, cost reports, budgets, forecasts, and other types of special emphasis reports, etc., constitute the needs of the managers. Such information is normally supplied by the cost accountant or managerial accountant working within the enterprise.

The managerial accountant relies on economic decision models, quantitative techniques for preparing such reports based on the specific needs of the users. For example, an enterprise intends to ascertain the cost-effectiveness of a product or forecast the market viability. Sometimes, enterprises outsource the managerial accountant’s services through consultancy.

Compared to financial accounting, managerial accounting information is more detailed and specific to the time and issue concerned for decision making. Management reporting is a part of management accounting system which attempts to summarize and present the desired information to various levels of management, at regular intervals for the purposes of evaluating the performance and for undertaking remedial action if the performance is not up to the expectations of the business enterprise.

Failing ethical standards often have been the outcome of high pressure to show the results in the enterprise despite adversities. The present practice of linking managerial remuneration to profits, stock-based incentive method (stock option), etc., have lured accountants to manipulate the accounting reports by sidelining the ethical standards.

In fact, by adhering to the principles, concepts, conventions and accounting standards, many ethical questions that arise in practice cannot be answered. Therefore, accountants are forced to decide on the basis of the facts and circumstances rather than strictly adhering to ethical practices.

Recording in the Books:

How Not to Record:

The accountant did several things throughout the year for recording the transactions. He recorded using historical cost and monetary units measure that –

(i) The sports shop was purchased at Rs.45,000;

(ii) The sports equipment were purchased at Rs.50,000; and

(iii) The accountant salary was at Rs.24,000.

On the going concern concept, Mr. Sumith assumed that the business would continue for future. He ignored to record investments and withdrawals made by the proprietor and also the whole sellers’ offer to buy one-fourth of the remaining equipment.

How Not to Report:

Applying periodicity concept Mr. Sumith prepared the income statement for the year ending on March 2010 in which he matched revenues with expenses. Revenue valued at Rs.75,000 (three-fourth of the equipment sold), i.e., sales during the year and matched the expenses relating to this sales, i.e., three-fourth of the cost of goods Rs.37,5000 + Accountants salary Rs.24,000, which resulted in a net income of Rs.13,500 [75,000 – (37,500 + 24,000) = 13,500] and submitted the report to Mr. Kumble, the proprietor.

By analysing the data recorded by the accountant, we see that most of the accounting principles were not applied in any pre-determined sequence. Instead, the accountant used need-based professional judgment for recording the transactions and prepared the financial statement. Here, the output generated being incomplete the accounting information lacks general acceptability as a system.

Transactions, Financial Statements and Information Reporting:

Once the transaction data have been collected, the accounting principles, concepts, conventions and the standards should be followed to process the data, generate information and report information. If not, the accounting information communicated, however ‘robust’, may well be considered useless.

All completed monetary transactions should be recorded to supply the basic information necessary for preparing the financial statements, such as income statement, statement of owner’s equity, position statement (B/S) and cash flow statement.

Financial statements provide a basis for comparative analysis. The reported financial information of two or more enterprises is compared for the purpose of analysis. Further, changes over time should be taken into account for all the companies considered for comparison. To make the comparative analysis viable, principle of consistency should be followed. Consistency requires the enterprise to use similar accounting procedures over time.

For example, an enterprise acquires two similar assets in two consecutive years. Then it must classify the assets in a similar fashion. Otherwise, comparability is hindered due to inconsistency. Further, materiality concept calls for precise classification of all significant information. For example, tools purchased might have been treated as an ‘expense’ by a large enterprise, whereas the same might have been treated as ‘asset’ by a small enterprise. Such a misclassification defeats the materiality concept.

While reporting accounting information the principle of conservatism should be observed, i.e., the enterprise should report the anticipated losses, but the anticipated gains should not be reported until they actually occur.

For example, suppose a lawsuit is pending against the enterprise, no accounting entry would be made until the lawsuit is finally settled. But, under conservative principle the probable loss, which may be incurred if the lawsuit is lost, should be provided, but not for the anticipated gains if the lawsuit is won.

Accounting Equation:

The rupee value of the assets is exactly equal to the rupee value of the claims in the form of liabilities and owner’s equity against the assets. This fundamental interrelationship of assets, liabilities and owner’s equity is referred to as accounting equation. Assets form the economic resources of the business enterprise and liabilities form the claims. Therefore, the accounting equation is – Economic Resources = Claims. The algebraic form of accounting equation is expressed as –

Assets = Liabilities + Owner’s Equity

Based on this relationship, if any two parts of the above equation are known, the third can be found out by substitution. For example – if the value of assets is Rs.1,50,000 and the value of liabilities is Rs.70,000, then the value of owner’s equity must be Rs.80,000 (1,50,00 – 70,000). Suppose the value of owner’s equity is Rs.1,00,000 and the value of liability is Rs.25,000, then the value of assets must be Rs.1,25,000.

The position statement discloses the nature and value of the investment in assets or resources of the enterprise and the claims against these assets in the form of liabilities and owner’s equity. Generally the position statement which is often called as balance sheet is prepared in a horizontal format (in the form of letter ‘T’) recording assets on the right-hand side and liabilities and owner’s equity on the left-hand side, equating one with the other (Indian style of presenting the balance sheet).

The Americans present the balance sheet in the horizontal format, but in the account form. Here, all the assets are shown on the left-hand side and all liabilities and owner’s equity are shown on the right-hand side, equating one with other.

How to Record in Accounting Format:

The computed financial statements will appear as follows:

At present times, balance sheet is prepared in the vertical format where assets statement and liabilities and owner’s equity statements are presented one below the other and the equation gets established. This format is computer friendly.

The accounting equation established in the balance sheet is based on transaction concept. Transactions are characterized by giving and receiving consideration and the effects of the transactions are recorded in the balance sheet and the equality of the accounting equation is established.

Transaction Analysis:

The recording process is based on accounting equation. In this sense, each monetary transaction involving the business enterprise may be analysed in terms of its impact on the accounting equation. The process of determining the impact of business transaction on assets, liabilities and owner’s equity of the accounting equation is called transaction analysis.

The transaction analysis indicates increase and decrease in the assets, liabilities or owner’s equity of the business enterprise. Different types of business transactions may affect the components of accounting equation.

Classification of Accounts and General Ledger:

An account is a unit of information about a particular economic event. For example, cash account is able to ‘maintain information’ about the opening cash balance, increase in this balance, decrease in this balance and closing balance of cash at the end of the specified period.

Suppose a manager wants to buy furniture for his/her business enterprise. He/she should have prior knowledge about the cash position to make a decision. Similarly, the management of a company needs timely information about their business enterprise to make good decisions.

But the question that comes to mind is that how are accounting systems designed to provide such information? One way of providing this information is by means of transactional analysis resulting in ‘accounting equation’. This system serves the purpose where the transactions are less in number. However, in the case where transactions are innumerable, accounting equation system will fail to serve the purpose. For these cases accounting systems are designed to show in a separate record the increase and decrease in each financial statement item.

More than one account is required for recording all the transactions of a business enterprise. Separate accounts for revenues, expenses, assets, liabilities and owner’s equity are needed to generate systematic information.

Irrespective of whether an enterprise adopts manual system or computerized system for recording business transactions, a proper system of classification of accounts is needed that will facilitate correct and meaningful accounting information. This is done in general ledger.

A group of accounts for a business enterprise are maintained in a ledger. In manual accounting system, the ledger is a large book with separate page for each account. In computerized system, the ledger is a ‘set of reserved storage locations with sub locations reserved for each account’. In either case, the general ledger provides a ‘summarization of the transactions effects’ on the various parts of the financial statements.

Each ledger account should contain (1) name of the account, (2) account number (to help indexing), (3) date column, (4) particulars’ column, (5) reference column (journal folio), (6) amount column (debit and credit), (7) balance column. The balance column is optional and depends on whether the ledger is prepared in a statement format or in a ‘T’ format.

Amount columns in ledger accounts are identified as debits and credits. They indicate that a business transaction has a debit and a credit. The debits are recorded on the left-hand side and the credits are recorded on the right-hand side in a ‘T’ format. Such entries will either increase or decrease the balance of an account depending on the nature of the account. Further, it should be noted that the amount of debit is equal to the amount of credit.

General ledgers are classified on the following attributes:

1. The business enterprise will have dealings with a number of persons say natural persons or artificial persons (enterprises) to whom the enterprise either owes money or lends money. Such events are all classified under personal accounts.

2. A business enterprise will possess some properties say, cash, furniture, stock, machinery, building, etc. Accounts that deal with properties are classified under real accounts. The business enterprise will also have sources of income, say, sale proceeds, fees that will pay for expenses, say, salary, carriage, and advertising. The accounts that deal with these forms of transactions will be classified under nominal accounts.

The classification of general ledger indicates that to keep full record of transactions, a business enterprise must maintain three sets of classified accounts, i.e., personal accounts, real accounts and nominal accounts.

The significance of debits and credits in relation to various accounting statements are indicated in the following tabular representation:

These mean the following:

1. If expense should be increased, debit it; if it should be reduced, credit it.

2. If revenue should be increased, credit it; if it should be reduced, debit it.

3. If an asset should be increased, debit it.

4. If an asset should be decreased, credit it.

5. If a liability or owner’s equity should be increased, credit it.

6. If a liability or owner’s equity should be decreased, debit it.

Recording Transactions on Double-Entry Principle:

A transaction is an exchange in which the enterprise ‘gives and receives’ considerations of equal economic values. This means that a transaction must be recorded taking into consideration the two aspects affecting at least two accounts.

This duality aspect of recording the transaction forms the base for double-entry principle which equates the value of debits with credits or vice-versa. Verification of equality of debits and credits in each transaction provides the accountant with some assurance that ‘complete effect of transaction was recorded’.

Recording of dual aspects of each transaction is affected by following the ‘rules of debit and credit’.

The rule is applicable for all the three account types stated as follows:

1. Personal accounts Debit the receiver and credit the giver.

2. Real accounts Debit what comes in and credit what goes out.

3. Nominal accounts Debit all expenses and losses, and credit all incomes and gains.

General ledger accounts are flexible. It means any number of accounts may be added as needed. If personal accounts and real accounts balance at the end of a given period, then it directly affects the balance sheet with their balances representing Assets (A), Liabilities (L) and Owner’s Equity (OE). In the case of nominal account, balances become the central elements of income statement or profit and loss account, and the final result of which ultimately affects the balance sheet.

The result of the income statement (profit or loss) will either (1) increase the owner’s equity (profit) or reduce the owner’s equity (loss), or will be entered as (2) retained earnings (undistributed profit) on the liabilities side or loss suffered (unadjusted loss) on the assets side of the balance sheet.

Journal:

Transactions are directly recorded into the general ledger, classifying the business activity by the type of account rather than by the type of transaction. Though, this facilitates the preparation of financial statements, it does not facilitate the recording of transactions in an orderly manner.

When there are innumerable numbers of transactions in a business enterprise, analysing them in a chronological order becomes significant. Therefore, transactions are initially recorded in a chronological order in a rough book (kutcha book) called journal.

As the record of transactions originates from this book, hence it is called as Book of Original Entry or Book of Prime Entry. In this book the transactions are analysed by sequence of their chronological occurrence. However, the journal by itself cannot help the accountant directly prepare financial statements.

Therefore, the entries from the journal are posted to the respective ledger accounts, so that finalizing the balances on each type of account becomes easy. Such finalized closing balances facilitate the accountant in preparing financial statements.

Ledger Accounts Balancing Technique:

When balancing accounts, an accountant should ascertain the higher side total and enter the difference on the lower side to equate the total. The closing balances are always carried forward/down (c/fd or c/d) and the opening balances are brought forward/down (b/fd or b/d).

Further, all asset accounts balances (debits), all liabilities accounts balances (credits) and owner’s equity accounts balances (credit) should be carried forward to the next year/period. In contrast all revenue accounts balances including profits and gains (credits) and all expenses accounts balances including losses (debits) should be transferred to current year’s/period’s income statement to ascertain the net result of the business.

If the net result is net income/profit, it is transferred to the liabilities side of the balance sheet to be added to owner’s equity. If the net result is net loss, it is transferred to the liabilities side of the balance sheet to be deducted from the owner’s equity. In the case of corporate enterprises, the net income/profit is transferred to liabilities side of the balance sheet as retained earnings. If it is a net loss, it is transferred to the assets side of the balance sheet as loss incurred.