chapter The begins with a review of data coding techniques
used in transaction processing systems and for
general ledger design. It explores several coding schemes
and their respective advantages and disadvantages. Next,
the chapter examines the objectives, operational features, and
control issues of two related systems: the general ledger system
(GLS) and the financial reporting system (FRS). Finally, the management
reporting system (MRS) is examined. The MRS is distinguishable
from the FRS in one key respect: financial reporting is
mandatory and management reporting is discretionary. Management
reporting information is needed for planning and controlling
business activities. Organization management implements MRS
applications at their discretion, based on internal user needs.
Data Coding Schemes
In previous chapters we saw how primary and secondary keys link together transaction
and master records for file updating. This is one application of data coding. We delve
more deeply into this subject here to examine various types of data coding schemes and
how they are used in data processing systems. To emphasize the importance of data codes,
we first consider a hypothetical system that does not use them.
A System without Codes
Firms process large volumes of transactions that are similar in their basic attributes. For
instance, a firms accounts receivable (AR) file may contain accounts for several different
customers with the same name and similar addresses. To process transactions accurately
against the correct accounts, the firm must be able to distinguish one John Smith from
another. This task becomes particularly difficult as the number of similar attributes and
items in the class increase.
Consider the most elemental item a machine shop wholesaler firm might carry in its
inventorya machine nut. Assume that the total inventory of nuts has only three distinguishing
attributes: size, material, and thread type. As a result, this entire class of inventory
must be distinguished on the basis of these three features, as follows:
1. The size attribute ranges from inch to 13/4 inches in diameter in increments of 1/64 of
an inch, giving 96 sizes of nuts.
2. For each size subclass, four materials are available: brass, copper, mild steel, and
case-hardened steel.
3. Each of these size and material subclasses come in three different threads: fine, standard,
and coarse.
By these assumptions, this class of inventory could contain 1,152 separate items (96 3 4 3 3).
The identification of a single item in this class thus requires a description featuring these
distinguishing attributes. To illustrate, consider the following journal entry to record the
receipt of $1,000 worth of half-inch, case-hardened steel nuts with standard threads supplied
by Industrial Parts Manufacturer of Cleveland, Ohio.
DR CR
Inventorynut, 1/2 inch, case-hardened
steel, standard thread 1,000
APIndustrial Parts Manufacturer,
Cleveland, Ohio 1,000
This uncoded entry takes a great deal of recording space, is time consuming to record,
and is obviously prone to many types of errors. The negative effects of this approach may
be seen in many parts of the organization:
1. Sales staff. Properly identifying the items sold requires the transcription of large
amounts of detail onto source documents. Apart from the time and effort involved,
this tends to encourage clerical errors and incorrect shipments.
2. Warehouse personnel. Locating and picking goods for shipment are impeded and
shipping errors will likely result.
3. Accounting personnel. Postings to ledger accounts will require searching through the
subsidiary files using lengthy descriptions as the key. This will be painfully slow, and
postings to the wrong accounts will be common.
A System with Codes
These problems are solved, or at least greatly reduced, by using codes to represent each
item in the inventory and supplier accounts. Lets assume the inventory item in our previous
example had been assigned the numeric code 896, and the supplier in the AP account
is given the code number 321. The coded version of the previous journal entry can now
be greatly simplified:
ACCOUNT DR CR
896 1,000
321 1,000
This is not to suggest that detailed information about the inventory and the supplier is of
no interest to the organization. Obviously it is! These facts will be kept in reference files
and used for such purposes as the preparation of parts lists, catalogs, bills of material,
and mailing information. The inclusion of such details, however, would clutter the task
of transaction processing and could prove dysfunctional, as this simple example illustrates.
Other uses of data coding in Accounting Information Systems (AIS) are to:
1. Concisely represent large amounts of complex information that would otherwise be
unmanageable.
2. Provide a means of accountability over the completeness of the transactions
processed.
3. Identify unique transactions and accounts within a file.
4. Support the audit function by providing an effective audit trail.
The following discussion examines some of the more commonly used coding techniques
and explores their respective advantages and disadvantages.
Numeric and Alphabetic Coding Schemes
Sequential Codes
As the name implies, sequential codes represent items in some sequential order (ascending
or descending). A common application of numeric sequential codes is the prenumbering of
source documents. At printing, hard-copy documents are each given a unique sequential
code number. This number becomes the transaction number that allows the system to track
each transaction processed and to identify any lost or out-of-sequence documents. Digital documents
are similarly assigned a sequential number by the computer when they are created.
Advantages. Sequential coding supports the reconciliation of a batch of transactions, such
as sales orders, at the end of processing. If the transaction processing system detects any
gaps in the sequence of transaction numbers, it alerts management to the possibility of
a missing or misplaced transaction. By tracing the transaction number back through the
stages in the process, management can eventually determine the cause and effect of the
error. Without sequentially numbered documents, problems of this sort are difficult to
detect and resolve.
Disadvantages. Sequential codes carry no information content beyond their order in the
sequence. For instance, a sequential code assigned to a raw material inventory item tells
us nothing about the attributes of the item (type, size, material, warehouse location, and so on). Also, sequential coding schemes are difficult to change. Inserting a new item at
some midpoint requires renumbering the subsequent items in the class accordingly. In applications
where record types must be grouped together logically and where additions and
deletions occur regularly, this coding scheme is inappropriate.
Block Codes
A numeric block code is a variation on sequential coding that in part remedies the disadvantages
just described. This approach can be used to represent whole classes of items
by restricting each class to a specific range within the coding scheme. A common application
of block coding is the construction of a chart of accounts.
A well-designed and comprehensive chart of accounts is the basis for the general ledger
and is thus critical to a firms financial and management reporting systems. The more
extensive the chart of accounts, the more precisely a firm can classify its transactions and
the greater the range of information it can provide to internal and external users. Figure 8-1
presents an example of accounts using block codes.
Notice that each account type is represented by a unique range of codes or blocks.
Thus balance sheet and income statement account classifications and subclassifications
can be depicted. In this example, each of the accounts consists of a three-digit code. The
first digit is the blocking digit and represents the account classification, for example, current
assets, liabilities, or operating expense. The other digits in the code are sequentially
assigned.
Advantages. Block coding allows for the insertion of new codes within a block without
having to reorganize the entire coding structure. For example, if advertising expense is
account number 626, the first digit indicates that this account is an operating expense. As
new types of expense items are incurred and have to be specifically accounted for, they may be added sequentially within the 600 account classification. This three-digit code
accommodates 100 individual items (X00 through X99) within each block. Obviously,
the more digits in the code range, the more items that can be represented.
Disadvantages. As with the sequential codes, the information content of the block code
is not readily apparent. For instance, account number 626 means nothing until matched
against the chart of accounts, which identifies it as advertising expense.
Group Codes
Numeric group codes are used to represent complex items or events involving two or
more pieces of related data. The code consists of zones or fields that possess specific
meaning. For example, a department store chain might code sales order transactions from
its branch stores as follows:
Store Number Dept. Number Item Number Salesperson
04 09 476214 99
Advantages. Group codes have a number of advantages over sequential and block codes.
1. They facilitate the representation of large amounts of diverse data.
2. They allow complex data structures to be represented in a hierarchical form that is
logical and more easily remembered by humans.
3. They permit detailed analysis and reporting both within an item class and across different
classes of items.
Using the previous example to illustrate, Store Number 04 could represent the Hamilton
Mall store in Allentown; Dept. Number 09 represents the sporting goods department;
Item Number 476214 is a hockey stick; and Salesperson 99 is Jon Innes. With this
level of information, a corporate manager could measure profitability by store, compare
the performance of similar departments across all stores, track the movement
of specific inventory items, and evaluate sales performance by employees within and
between stores.
Disadvantages. Ironically, the primary disadvantage of group coding results from its
success as a classification tool. Because group codes can effectively present diverse information,
they tend to be overused. Unrelated data may be linked simply because it can
be done. This can lead to unnecessarily complex group codes that cannot be easily interpreted.
Finally, overuse can increase storage costs, promote clerical errors, and increase
processing time and effort.
Alphabetic Codes
Alphabetic codes are used for many of the same purposes as numeric codes. Alphabetic
characters may be assigned sequentially (in alphabetical order) or may be used in block
and group coding techniques.
Advantages. The capacity to represent large numbers of items is increased dramatically
through the use of pure alphabetic codes or alphabetic characters embedded within
numeric codes (alphanumeric codes). The earlier example of a chart of accounts using a
three-digit code with a single blocking digit limits data representation to only 10 blocks of accounts0 through 9. Using alphabetic characters for blocking, however, increases
the number of possible blocks to 26A through Z. Furthermore, whereas the two-digit
sequential portion of that code has the capacity of only 100 items (102), a two-position
alphabetic code can represent 676 items (262). Thus by using alphabetic codes in the
same three-digit coding space, we see a geometric increase in the potential for data
representation
(10 blocks 3 100 items each) = 1,000 items
to
(26 blocks 3 676 items each) = 17,576 items
Disadvantages. The primary drawbacks with alphabetic coding are (1) as with numeric
codes, there is difficulty rationalizing the meaning of codes that have been sequentially
assigned and (2) users tend to have difficulty sorting records that are coded alphabetically.
Mnemonic Codes
Mnemonic codes are alphabetic characters in the form of acronyms and other combinations
that convey meaning. For example, a student enrolling in college courses may enter
the following course codes on the registration form:
Course Type Course Number
Acctg 101
Psyc 110
Mgt 270
Mktg 300
This combination of mnemonic and numeric codes conveys a good deal of information
about these courses; with a little analysis, we can deduce that Acctg is accounting, Psyc is
psychology, Mgt is management, and Mktg is marketing. The sequential number portion
of the code indicates the level of each course. Another example of the use of mnemonic
codes is assigning state codes in mailing addresses:
Code Meaning
NY New York
CA California
OK Oklahoma
Advantages. The mnemonic coding scheme does not require the user to memorize meaning;
the code itself conveys a high degree of information about the item that is being
represented.
Disadvantages. Although mnemonic codes are useful for representing classes of items,
they have limited ability to represent items within a class. For example, the entire class
of accounts receivable could be represented by the mnemonic code AR, but we would
quickly exhaust meaningful combinations of alphabetic characters if we attempted to
represent the individual accounts that make up this class. These accounts would be represented
better by sequential, block, or group coding techniques. The General Ledger System
Figure 8-2 characterizes the GLS as a hub connected to the other systems of the firm
through spokes of information flows. Transaction cycles process individual events that
are recorded in special journals and subsidiary accounts. Summaries of these transactions
flow into the GLS and become sources of input for the MRS and financial reporting
system. The bulk of the flows into the GLS come from the transaction processing subsystems.
Note, however, that information also flows from the FRS as feedback into the GLS.
We shall explore this point more thoroughly later. In this section we review key elements
of the GLS.
The Journal Voucher
The source of input to the general ledger is the journal voucher illustrated in Figure 8-3.
A journal voucher, which can be used to represent summaries of similar transactions or
a single unique transaction, identifies the financial amounts and affected GL accounts.
Routine transactions, adjusting entries, and closing entries are all entered into the general
ledger via journal vouchers. Because a responsible manager must approve The GLS Database
The GLS database includes a variety of files. Whereas these will vary from firm to firm,
the following examples are representative.
The general ledger master file is the principle file in the GLS database. This file is based
on the organizations published chart of accounts. Each record in the general ledger master
is either a separate GL account (for example, sales) or the control account (such as
ARcontrol) for a subsidiary ledger in the transaction processing system. Figure 8-4 illustrates
the structure of a typical GL master file. The FRS draws upon the GL master to produce
the firms financial statements. The MRS also uses this file to support internal information
reporting.
The general ledger history file has the same format as the GL master. Its primary purpose
is to provide historic financial data for comparative financial reports.
The journal voucher file is the total collection of the journal vouchers processed in the
current period. This file provides a record of all general ledger transactions and replaces
the traditional general journal.
The journal voucher history file contains journal vouchers for past periods. This historic
information supports managements stewardship responsibility to account for resource utilization. Both the current and historic journal voucher files are important links in the
firms audit trail.
The responsibility center file contains the revenues, expenditures, and other resource
utilization data for each responsibility center in the organization. The MRS draws upon
these data for input in the preparation of responsibility reports for management.
Finally, the budget master file contains budgeted amounts for revenues, expenditures,
and other resources for responsibility centers. These data, in conjunction with the responsibility
center file, are the basis for responsibility accounting, which is discussed later in
the chapter.
GLS Procedures
As we have seen in previous chapters, certain aspects of GLS update procedures are
performed as either a separate operations or integrated within transaction processing
systems. Our focus in the next section is on the interrelationship between the GLS
and financial reporting. This involves additional updates in the form of reversing,
adjusting, and closing entries. Lets now turn our attention to the financial reporting
system.
The Financial Reporting System
The law dictates managements responsibility for providing stewardship information
to external parties. This reporting obligation is met via the financial reporting system
(FRS). Much of the information provided takes the form of standard financial statements,
tax returns, and documents required by regulatory agencies such as the Securities and
Exchange Commission.
The primary recipients of financial statement information are external users, such as
stockholders, creditors, and government agencies. Generally speaking, outside users of
information are interested in the performance of the organization as a whole. Therefore,
they require information that allows them to observe trends in performance over time and
to make comparisons between different organizations. Given the nature of these needs,
financial reporting information must be prepared and presented by all organizations in a
manner that is generally accepted and understood by external users.
Sophisticated Users with Homogeneous Information Needs
Because the community of external users is vast and their individual information needs
may vary, financial statements are targeted at a general audience. They are prepared on
the proposition that the audience comprises sophisticated users with relatively homogeneous
information needs. In other words, it is assumed that users of financial reports
understand the conventions and accounting principles that are applied and that the statements
have information content that is useful.
Financial Reporting Procedures
Financial reporting is the final step in the overall accounting process that begins in the
transaction cycles. Figure 8-5 presents the FRS in relation to the other information
subsystems. The steps illustrated and numbered in the figure are discussed briefly in the
following section. balance
sheet (permanent) accounts are carried forward from the previous year. From this
point, the following steps occur:
1. Capture the transaction. Within each transaction cycle, transactions are recorded in
the appropriate transaction file.
2. Record in special journal. Each transaction is entered into the journal. Recall that frequently
occurring classes of transactions, such as sales, are captured in special journals.
Those that occur infrequently are recorded in the general journal or directly on
a journal voucher.
3. Post to subsidiary ledger. The details of each transaction are posted to the affected
subsidiary accounts.
4. Post to general ledger. Periodically, journal vouchers, summarizing the entries made
to the special journals and subsidiary ledgers, are prepared and posted to the general
ledger accounts. The frequency of updates to the general ledger will be determined by
the degree of system integration.
5. Prepare the unadjusted trial balance. At the end of the accounting period, the ending
balance of each account in the general ledger is placed in a worksheet and evaluated
in total for debitcredit equality.
6. Make adjusting entries. Adjusting entries are made to the worksheet to correct errors
and to reflect unrecorded transactions during the period, such as depreciation.
7. Journalize and post adjusting entries. Journal vouchers for the adjusting entries are
prepared and posted to the appropriate accounts in the general ledger.
8. Prepare the adjusted trial balance. From the adjusted balances, a trial balance is prepared
that contains all the entries that should be reflected in the financial statements.
9. Prepare the financial statements. The balance sheet, income statement, and statement
of cash flows are prepared using the adjusted trial balance.
10. Journalize and post the closing entries. Journal vouchers are prepared for entries that
close out the income statement (temporary) accounts and transfer the income or loss
to retained earnings. Finally, these entries are posted to the general ledger.
11. Prepare the post-closing trial balance. A trial balance worksheet containing only the
balance sheet accounts may now be prepared to indicate the balances being carried
forward to the next accounting period.
The periodic nature of financial reporting in most organizations establishes it as a batch
process, as illustrated in Figure 8-5. This often is the case for larger organizations with
multiple streams of revenue and expense transactions that need to be reconciled before
being posted to the general ledger. Many organizations, however, have moved to realtime
general ledger updates and financial reporting systems that produce financial statements
on short notice. Figure 8-6 presents an FRS using a combination of batch and
real-time computer technology.
Controlling the FRS
Sarbanes-Oxley legislation requires that management design and implement controls over
the financial reporting process. This includes the transaction processing systems that feed
data into the FRS. In previous chapters we studied control techniques necessary for the various transaction systems. Here we will examine only the controls that relate to the
FRS. The potential risks to the FRS include:
1. A defective audit trail.
2. Unauthorized access to the general ledger.
3. General ledger accounts that are out of balance with subsidiary accounts.
4. Incorrect general ledger account balances because of unauthorized or incorrect journal
vouchers.
If not controlled, these risks may result in misstated financial statements and other
reports, thus misleading users of this information. The potential consequences are litigation,
significant financial loss for the firm, and sanctions specified by SOX legislation.
COSO/SAS 78 Control Issues
This discussion of FRS physical controls will follow the COSO/SAS 78 framework, which
by now is familiar to you. Transaction Authorization
The journal voucher is the document that authorizes an entry to the general ledger. Journal
vouchers have numerous sources, such as the cash receipts processing, sales order processing,
and the financial reporting group. It is vital to the integrity of the accounting records that the
journal vouchers be properly authorized by a responsible manager at the source department.
Segregation of Duties
In previous chapters, we have seen how the general ledger provides verification control
for the accounting process. To do so, the task of updating the general ledger must be
separate from all accounting and asset custody responsibility within the organization.
Therefore, individuals with access authority to general ledger accounts should not:
1. Have record-keeping responsibility for special journals or subsidiary ledgers.
2. Prepare journal vouchers.
3. Have custody of physical assets.
Notice that in Figure 8-6 transactions are authorized, processed, and posted directly to the
general ledger. To compensate for this potential risk, the system should provide end users
and general ledger departments with detailed listings of journal voucher and account activity
reports. These documents advise users of the automated actions taken by the system
so that errors and unusual events, which warrant investigation, can be identified.
Access Controls
Unauthorized access to the general ledger accounts can result in errors, fraud, and misrepresentations
in financial statements. Sarbanes-Oxley explicitly addresses this area of
risk by requiring organizations to implement controls that limit database access to only
authorized individuals. A number of IT general controls designed to serve this purpose
are presented in Chapter 16.
Accounting Records
The audit trail is a record of the path that a transaction takes through the input, processing,
and output phases of transaction processing. This involves a network of documents,
journals, and ledgers designed to ensure that a transaction can be accurately traced
through the system from initiation to final disposition.
An audit trail facilitates error prevention and correction when the data files are conveniently
and logically organized. Also, the general ledger and other files that constitute the
audit trail should be detailed and rich enough to (1) provide the ability to answer inquiries,
for example, from customers or vendors; (2) be able to reconstruct files if they are completely
or partially destroyed; (3) provide historical data required by auditors; (4) fulfill government
regulations; and (5) provide a means for preventing, detecting, and correcting errors.
Independent Verification
In previous chapters we have portrayed the general ledger function as an independent
verification step within the AIS. The FRS produces two operational reportsjournal
voucher listing and the general ledger change reportthat provide proof of the accuracy
of this process. The journal voucher listing provides relevant details about each journal
voucher posted to the GL. The general ledger change report presents the effects of journal
voucher postings to the general ledger accounts. Figure 8-7 and Figure 8-8 present
examples of these reports. The Management Reporting System
Management reporting is often called discretionary reporting because it is not mandated
as is financial reporting. One could take issue with the term discretionary, however, and
argue that an effective management reporting system (MRS) is mandated by SOX legislation,
which requires that all public companies monitor and report on the effectiveness of
internal controls over financial reporting. Indeed, management reporting has long been
recognized as a critical element of an organizations internal control structure. An MRS
that directs managements attention to problems on a timely basis promotes effective
management and thus supports the organizations business objectives.
Factors that Influence the MRS
Designing an effective MRS requires an understanding of the information managers need
to deal with the problems they face. This section examines several topics that provide
insight into factors that influence management information needs. These are: management principles; management function, level, and decision type; problem structure; types of
management reports; responsibility accounting; and behavioral considerations.
Management Principles
Management principles provide insight into management information needs. The principles
that most directly influence the MRS are formalization of tasks, responsibility and
authority, span of control, and management by exception.
Formalization of Tasks
The formalization of tasks principle suggests that management should structure the firm
around the tasks it performs rather than around individuals with unique skills. Under this
principle, organizational areas are subdivided into tasks that represent full-time job positions.
Each position must have clearly defined limits of responsibility.
The purpose of formalization of tasks is to avoid an organizational structure in which
the organizations performance, stability, and continued existence depend on specific
individuals. The organizational chart in Figure 8-9 shows some typical job positions in a
manufacturing firm.
Although a firms most valuable resource is its employees, it does not own the resource.
Sooner or later, key individuals leave and take their skills with them. By formalizing tasks, the firm can more easily recruit individuals to fill standard positions left open by those who
leave. In addition, the formalization of tasks promotes internal control. With employee
responsibilities formalized and clearly specified, management can construct an organization
that avoids assigning incompatible tasks to an individual.
Implications for the MRS. Formalizing the tasks of the firm allows formal specification
of the information needed to support the tasks. Thus when a personnel change occurs,
the information the new employee will need is essentially the same as for his or her predecessor.
The information system must focus on the task, not the individual performing
the task. Otherwise, information requirements would need to be reassessed with the appointment of each new individual to the position. Also, internal control is strengthened
by restricting information based on need as defined by the task, rather than the whim or
desire of the user.
Responsibility and Authority
The principle of responsibility refers to an individuals obligation to achieve desired
results. Responsibility is closely related to the principle of authority. If a manager delegates
responsibility to a subordinate, he or she must also grant the subordinate the authority to
make decisions within the limits of that responsibility. In a business organization, managers
delegate responsibility and authority downward through the organizational hierarchy
from superior to subordinates.
Implications for the MRS. The principles of responsibility and authority define the vertical
reporting channels of the firm through which information flows. The managers location
in the reporting channel influences the scope and detail of the information reported.
Managers at higher levels usually require more summarized information. Managers at
lower levels receive information that is more detailed. In designing a reporting structure,
the analyst must consider the managers position in the reporting channel.
Span of Control
A managers span of control refers to the number of subordinates directly under his or
her control. The size of the span has an impact on the organizations physical structure. A
firm with a narrow span of control has fewer subordinates reporting directly to managers.
These firms tend to have tall, narrow structures with several layers of management.
Firms with broad spans of control (more subordinates reporting to each manager) tend
to have wide structures, with fewer levels of management. Figure 8-10 illustrates the relationship
between span of control and organizational structure.
Organizational behavior research suggests that wider spans of control are preferable
because they allow more employee autonomy in decision making. This may translate into
better employee morale and increased motivation. An important consideration in setting
the span of control is the nature of the task. The more routine and structured the task, the more subordinates one manager can control. Therefore, routine tasks tend to be
associated with a broad span of control. Less structured or highly technical tasks often
require a good deal of management participation on task-related problems. This close
interaction reduces the managers span of control.
Implications for the MRS. Managers with narrow spans of control are closely involved
with the details of the operation and with specific decisions. Broad spans of control
remove managers from these details. These managers delegate more of their decisionmaking
authority to their subordinates. The different management approaches information. require
different Managers with narrow spans of control require detailed reports.
Managers with broad control responsibilities operate most effectively with summarized
information.
Management by Exception
The principle of management by exception suggests that managers should limit their attention
to potential problem areas (that is, exceptions) rather than being involved with every
activity or decision. Managers thus maintain control without being overwhelmed by the
details.
Implications for the MRS. Managers need information that identifies operations or resources
at risk of going out of control. Reports should support management by exception by
focusing on changes in key factors that are symptomatic of potential problems. Unnecessary
details that may draw attention away from important facts should be excluded
from reports. For example, an inventory exception report may be used to identify items
of inventory that turn over more slowly or go out of stock more frequently than normal.
Management attention must be focused on these exceptions. The majority of inventory
items that fluctuate within normal levels should not be included in the report.
Management Function, Level, and Decision Type
The management functions of planning and control have a profound effect on the management
reporting system. The planning function is concerned with making decisions
about the future activities of the organization. Planning can be long range or short range.
Long-range planning usually encompasses a period of between one and five years, but
this varies among industries. For example, a public utility may plan 15 years ahead in
the construction of a new power plant, while a computer manufacturer deals in a time
frame of only one or two years in the planning of new products. Long-range planning
involves a variety of tasks, including setting the goals and objectives of the firm, planning
the growth and optimum size of the firm, and deciding on the degree of diversification
among the firms products.
Short-term planning involves the implementation of specific plans that are needed
to achieve the objectives of the long-range plan. Examples include planning the marketing
and promotion for a new product, preparing a production schedule for the
month, and providing department heads with budgetary goals for the next three
months.
The control function ensures that the activities of the firm conform to the plan. This
entails evaluating the operational process (or individual) against a predetermined standard
and, when necessary, taking corrective action. Effective control takes place in the
present time frame and is triggered by feedback information that advises the manager
about the status of the operation being controlled. Planning and control decisions are frequently classified into four categories: strategic
planning, tactical planning, managerial control, and operational control. Figure 8-11
relates these decisions to managerial levels.
Strategic Planning Decisions
Figure 8-11 shows that top-level managers make strategic planning decisions, including:
Setting the goals and objectives of the firm.
Determining the scope of business activities, such as desired market share, markets
the firm wishes to enter or abandon, the addition of new product lines and the termination
of old ones, and merger and acquisition decisions.
Determining or modifying the organizations structure.
Setting the management philosophy.
Strategic planning decisions have the following characteristics:
They have long-term time frames. Because they deal with the future, managers making
strategic decisions require information that supports forecasting.
They require highly summarized information. Strategic decisions focus on general
trends rather than detail-specific activities.
They tend to be nonrecurring. Strategic decisions are usually one-time events.
As a result, there is little historic information available to support the specific
decision.
Strategic decisions are associated with a high degree of uncertainty. The decision maker
must rely on insight and intuition. Judgment is often central to the success of the
decision.
They are broad in scope and have a profound impact on the firm. Once made, strategic
decisions permanently affect the organization at all levels.
Strategic decisions require external as well as internal sources of information. Tactical Planning Decisions
Tactical planning decisions are subordinate to strategic decisions and are made by middle
management (see Figure 8-11). These decisions are shorter term, more specific, recurring,
have more certain outcomes, and have a lesser impact on the firm than strategic decisions.
For example, assume that the president of a manufacturing firm makes the strategic decision
to increase sales and production by 100,000 units over the prior years level. One
tactical decision that must result from this is setting the monthly production schedule to
accomplish the strategic goal.
Management Control Decisions
Management control involves motivating managers in all functional areas to use resources,
including materials, personnel, and financial assets, as productively as possible. The supervising
manager compares the performance of his or her subordinate manager to pre-established
standards. If the subordinate does not meet the standard, the supervisor takes corrective
action. When the subordinate meets or exceeds expectations, he or she may be rewarded.
Uncertainty surrounds management control decisions because it is difficult to separate
the managers performance from that of his or her operational unit. We often lack
both the criteria for specifying management control standards and the objective techniques
for measuring performance. For example, assume that a firms top management
places its most effective and competent middle manager in charge of a business segment
that is performing poorly. The managers task is to revitalize the operations of the unit,
and doing so requires a massive infusion of resources. The segment will operate in the red
for some time until it establishes a foothold in the market. Measuring the performance
of this manager in the short term may be difficult. Traditional measures of profit, such
as return on investment (which measures the performance of the operational unit itself),
would not really reflect the managers performance. We shall examine this topic in more
depth later in the chapter.
Operational Control Decisions
Operational control ensures that the firm operates in accordance with pre-established
criteria. Figure 8-11 shows that operations managers exercise operational control. Operational
control decisions are narrower and more focused than tactical decisions because they are
concerned with the routine tasks of operations. Operational control decisions are more
structured than management control decisions, more dependent on details than planning
decisions, and have a shorter time frame than tactical or strategic decisions. These decisions
are associated with a fairly high degree of certainty. In other words, identified symptoms
tend to be good indicators of the root problem, and corrective actions tend to be obvious.
This degree of certainty makes it easier to establish meaningful criteria for measuring
performance. Operational control decisions have three basic elements: setting standards,
evaluating performance, and taking corrective action.
Standards. Standards are pre-established levels of performance that managers believe
are attainable. Standards apply to all aspects of operations, such as sales volume, quality
control over production, costs for inventory items, material usage in the production of
products, and labor costs in production. Once established, these standards become the
basis for evaluating performance.
Performance Evaluation. The decision maker compares the performance of the operation
in question against the standard. The difference between the two is the variance. For example, a price variance for an item of inventory is the difference between the
expected pricethe standardand the price actually paid. If the actual price is greater
than the standard, the variance is said to be unfavorable. If the actual price is less than
the standard, the variance is favorable.
Taking Corrective Action. After comparing the performance to the standard, the manager
takes action to remedy any out-of-control condition. Recall from Chapter 3, however,
that we must apply extreme caution when taking corrective action. An inappropriate
response to performance measures may have undesirable results. For example, to achieve
a favorable price variance, the purchasing agent may pursue the low-price vendors of
raw materials and sacrifice quality. If the lower-quality raw materials result in excessive
quantities being used in production because of higher-than-normal waste, the firm will
experience an unfavorable material usage variance. The unfavorable usage variance may
completely offset the favorable price variance to create an unfavorable total variance.
Table 8-1 classifies strategic planning, tactical planning, management control, and
operational control decisions in terms of time frame, scope, level of details, recurrence,
and certainty.
Problem Structure
The structure of a problem reflects how well the decision maker understands the problem.
Structure has three elements.1
1. Datathe values used to represent factors that are relevant to the problem.
2. Proceduresthe sequence of steps or decision rules used in solving the problem.
3. Objectivesthe results the decision maker desires to attain by solving the problem.
When all three elements are known with certainty, the problem is structured. Payroll
calculation is an example of a structured problem:
1. We can identify the data for this calculation with certainty (hours worked, hourly
rate, withholdings, tax rate, and so on). 2. Payroll procedures are known with certainty:
Gross pay = Hours worked 3 Pay rate
Net pay = Gross pay 2 Taxes 2 Withholdings
3. The objective of payroll is to discharge the firms financial obligation to its
employees.
Structured problems do not present unique situations to the decision maker and, because
their information requirements can be anticipated, they are well suited for traditional
data processing techniques. In effect, the designer who specifies the procedures and codes
the programs solves the problem.
Unstructured Problems
Problems are unstructured when any of the three characteristics identified previously are
not known with certainty. In other words, an unstructured problem is one for which we
have no precise solution techniques. Either the data requirements are uncertain, the procedures
are not specified, or the solution objectives have not been fully developed. Such a
problem is normally complex and engages the decision maker in a unique situation. In these
situations, the systems analyst cannot fully anticipate user information needs, rendering
traditional data processing techniques ineffective.
Figure 8-12 illustrates the relationship between problem structure and organizational
level. We see from the figure that lower levels of management deal more with fully structured
problems, whereas upper management deals with unstructured problems. Middlelevel
managers tend to work with partially structured problems. Keep in mind that these
structural classifications are generalizations. Top managers also deal with some highly structured
problems, and lower-level managers sometimes face problems that lack structure.
Figure 8-12 also shows the use of information systems by different levels of management.
The traditional information system deals most effectively with fully structured
problems. Therefore, operations management and tactical management receive the
greatest benefit from these systems. Because management control and strategic planning decisions lack structure, the managers who make these decisions often do not receive adequate
support from traditional systems alone.
Types of Management Reports
Reports are the formal vehicles for conveying information to managers. The term report
tends to imply a written message presented on sheets of paper. In fact, a management
report may be a paper document or a digital image displayed on a computer terminal.
The report may express information in verbal, numeric, or graphic form, or any combination
of these.
Report Objectives
Chapter 1 made the distinction between information and data. Recall that information
leads the user to an action. Therefore, to be useful, reports must have information content.
Their value is the effect they have on users. This is expressed in two general reporting
objectives: (1) to reduce the level of uncertainty associated with a problem facing
the decision maker and (2) to influence the decision makers behavior in a positive way.
Reports that fail to accomplish these objectives lack information content and have no
value. In fact, reliance on such reports may lead to dysfunctional behavior (discussed
later). Management reports fall into two broad classes: programmed reports and ad hoc
reports.
Programmed Reporting
Programmed reports provide information to solve problems that users have anticipated.
There are two subclasses of programmed reports: scheduled reports and on-demand
reports. The MRS produces scheduled reports according to an established time frame.
This could be daily, weekly, quarterly, and so on. Examples of such reports are a daily
listing of sales, a weekly payroll action report, and annual financial statements. On-demand
reports are triggered by events, not by the passage of time. For example, when inventories
fall to their pre-established reorder points, the system sends an inventory reorder report
to the purchasing agent. Another example is an accounts receivable manager responding
to a customer problem over the telephone. The manager can, on demand, display the
customers account history on the computer screen. Note that this query capability is the
product of an anticipated need. This is quite different from the ad hoc reports that we
discuss later. Table 8-2 lists examples of typical programmed reports and identifies them
as scheduled or on-demand.
Report Attributes
To be effective, a report must possess the following attributes: relevance, summarization,
exception orientation, accuracy, completeness, timeliness, and conciseness. Each of these
report attributes is discussed in the following section.
Relevance. Each element of information in a report must support the managers decision.
Irrelevancies waste resources and may even be dysfunctional by distracting a managers
attention from the information content of the report.
Summarization. Reports should be summarized according to the level of the manager
within the organizational hierarchy. In general, the degree of summarization becomes
greater as information flows from lower management upward to top management. Exception Orientation. Control reports should identify activities that are at risk of going
out of control and should ignore activities that are under control. For example, consider a
purchasing agent with ordering responsibility for an inventory of 10,000 different items.
If the agent received a daily report containing the actual balances of every item, he or she
would search through 10,000 items to identify a few that need reordering. An exceptionoriented
report would identify only those inventory items that have fallen to their reorder
levels. From this report, the agent could easily prepare purchase orders.
Accuracy. Information in reports must be free of material errors. A material error will
cause the user to make the wrong decision (or fail to make a required decision). We often
sacrifice accuracy for timely information. In situations that require quick responses, the
manager must factor this trade-off into the decision-making process.
Completeness. Information must be as complete as possible. Ideally, no piece of information
that is essential to the decision should be missing from the report. Like the attribute
of accuracy, we sometimes must sacrifice completeness in favor of timely information.
Timeliness. If managers always had time on their side, they may never make bad decisions.
However, managers cannot always wait until they have all the facts before they act.
Timely information that is sufficiently complete and accurate is more valuable than perfect
information that comes too late to use. Therefore, the MRS must provide managers
with timely information. Usually, information can be no older than the period to which it
pertains. For example, if each week a manager decides on inventory acquisitions based on
a weekly inventory status report, the information in the report should be no more than a
week old.
Conciseness. Information in the report should be presented as concisely as possible.
Reports should use coding schemes to represent complex data classifications and provide
all the necessary calculations (such as extensions and variances) for the user. In addition,
information should be clearly presented with titles for all values. Ad Hoc Reporting
Managers cannot always anticipate their information needs. This is particularly true for
top and middle management. In the dynamic business world, problems arise that require
new information on short notice, and there may be insufficient time to write traditional
computer programs to produce the required information. In the past, these needs often
went unsatisfied. Now database technology provides direct inquiry and report generation
capabilities. Managers with limited computer background can quickly produce ad hoc
reports from a terminal or PC, without the assistance of data processing professionals.
Increases in computing power, point-of-transaction scanners, and continuous reductions
in data storage costs have enabled organizations to accumulate massive quantities
of raw data. This data resource is now being tapped to support ad hoc reporting needs
through a concept known as data mining
Data mining is the process of selecting, exploring, and modeling large amounts of
data to uncover relationships and global patterns that exist in large databases but are
hidden among the vast amount of facts. This involves sophisticated techniques such as
database queries and artificial intelligence that model real-world phenomena from data
collected from a variety of sources, including transaction processing systems, customer
history databases, and demographics data from external sources such as credit bureaus.
Managers employ two general approaches to data mining: verification and discovery
The verification model uses a drill-down technique to either verify or reject a users
hypothesis. For example, assume a marketing manager needs to identify the best target
market, as a subset of the organizations entire customer base, for an ad campaign for
a new product. The data mining software will examine the firms historical data about
customer sales and demographic information to reveal comparable sales and the demographic
characteristics shared by those purchasers. This subset of the customer base can
then be used to focus the promotion campaign.
The discovery model uses data mining to discover previously unknown but important
information that is hidden within the data. This model employs inductive learning
to infer information from detailed data by searching for recurring patterns, trends, and
generalizations. This approach is fundamentally different from the verification model in
that the data are searched with no specific hypothesis driving the process. For example, a
company may apply discovery techniques to identify customer buying patterns and gain a
better understanding of customer motivations and behavior.
A central feature of a successful data mining initiative is a data warehouse of archived
operational data. A data warehouse is a relational database management system that has
been designed specifically to meet the needs of data mining. The warehouse is a central
location that contains operational data about current events (within the past 24 hours)
as well as events that have transpired over many years. Data are coded and stored in the
warehouse in detail and at various degrees of aggregation to facilitate identification of
recurring patterns and trends.
Management decision making can be greatly enhanced through data mining, but only
if the appropriate data have been identified, collected, and stored in the data warehouse.
Because many of the important issues related to data mining and warehousing require
an understanding of relational database technology, these topics are examined further in
Chapters 9 and 11.
Responsibility Accounting
A large part of management reporting involves responsibility accounting. This concept
implies that every economic event that affects the organization is the responsibility of and can be traced to an individual manager. The responsibility accounting system personalizes
performance by saying to the manager, This is your original budget, and this is how
your performance for the period compares to your budget. Most organizations structure
their responsibility reporting system around areas of responsibility in the firm. A fundamental
principle of this concept is that responsibility area managers are accountable only
for items (costs, revenues, and investments) that they control.
The flow of information in responsibility systems is both downward and upward
through the information channels. Figure 8-13 illustrates this pattern. These top-down and
bottom-up information flows represent the two phases of responsibility accounting: (1) creating
a set of financial performance goals (budgets) pertinent to the managers responsibilities
and (2) reporting and measuring actual performance as compared to these goals.
Setting Financial Goals: The Budget Process
The budget process helps management achieve its financial objectives by establishing measurable
goals for each organizational segment. This mechanism conveys to the segment
managers the standards that senior managers will use for measuring their performance.
Budget information flows downward and becomes increasingly detailed as it moves to
lower levels of management. Figure 8-14 shows the distribution of budget information
through three levels of management.
Measuring and Reporting Performance
Performance measurement and reporting takes place at each operational segment in the
firm. This information flows upward as responsibility reports to senior levels of management.
Figure 8-15 shows the relationship between levels of responsibility reports. Notice
how the information in the reports becomes increasingly summarized at each higher level
of management.
Responsibility Centers
To achieve accountability, business entities frequently organize their operations into units
called responsibility centers. The most common forms of responsibility centers are cost
centers, profit centers, and investment centers. Cost Centers. A cost center is an organizational unit with responsibility for cost management
within budgetary limits. For example, a production department may be responsible
for meeting its production obligation while keeping production costs (labor, materials, and
overhead) within the budgeted amount. The performance report for the cost center manager
reflects its controllable cost behavior by focusing on budgeted costs, actual costs, and
variances from budget. Figure 8-16 shows an example of a cost center performance report.
Performance measurements should not consider costs that are outside of the managers
control, such as investments in plant equipment or depreciation on the building.
Profit Centers. A profit center manager has responsibility for both cost control and revenue
generation. For example, the local manager of a national department store chain may be
responsible for decisions about:
Which items of merchandise to stock in the store.
What prices to charge.
The kind of promotional activities for products.
The level of advertising.
The size of the staff and the hiring of employees.
Building maintenance and limited capital improvements.
The performance report for the profit center manager is different from that of the cost
center. Nevertheless, the reporting emphasis for both should be on controllable items.
Figure 8-17 is an example of a profit center report. Whereas only controllable items are used to assess the managers performance, the profit center itself is assessed by its contribution
after noncontrollable costs.
Investment Centers. The manager of an investment center has the general authority
to make decisions that profoundly affect the organization. Assume that a division of a
corporation is an investment center with the objective of maximizing the return on its
investment assets. The division managers range of responsibilities includes cost management,
product development, marketing, distribution, and capital disposition through investments
of funds in projects and ventures that earn a desired rate of return. Figure 8-18
illustrates the performance report for an investment center.
Behavioral Considerations
Goal Congruence
Earlier in this chapter, we touched on the management principles of authority, responsibility,
and the formalization of tasks. When properly applied within an organization,
these principles promote goal congruence. Lower-level managers pursuing their own objectives
contribute in a positive way to the objectives of their superiors. For example, by
controlling costs, a production supervisor contributes to the division managers goal of
profitability. Thus as individual managers serve their own best interests they also serve
the best interests of the organization.
A carefully structured MRS plays an important role in promoting and preserving goal
congruence. On the other hand, a badly designed MRS can cause dysfunctional actions
that are in opposition to the organizations objectives. Two pitfalls that cause managers to
act dysfunctionally are information overload and inappropriate performance measures. Information Overload
Information overload occurs when a manager receives more information than he or she
can assimilate. This happens when designers of the reporting system do not properly consider
the managers organizational level and span of control. For example, consider the
information volume that would flow to the president if the reports were not properly
summarized (refer to Figure 8-13). The details required by lower-level managers would
quickly overload the presidents decision-making process. Although the report may have
many of the information attributes discussed earlier (complete, accurate, timely, and concise),
it may be useless if not properly summarized.
Information overload causes managers to disregard their formal information and rely
on informal cues to help them make decisions. Thus the formal information system is
replaced by heuristics (rules of thumb), tips, hunches, and guesses. The resulting decisions
run a high risk of being suboptimal and dysfunctional.
Inappropriate Performance Measures
Recall that one purpose of a report is to stimulate behavior consistent with the objectives
of the firm. When inappropriate performance measures are used, however, the report can
have the opposite effect. Lets see how this can happen using a common performance
measurereturn on investment (ROI).
Assume that the corporate management of an organization evaluates division
management performance solely on the basis of ROI. Each managers objective is to
maximize ROI. Naturally, the organization wants this to happen through prudent cost management and increased profit margins. However, when ROI is used as the single
criterion for measuring performance, the criterion itself becomes the focus of attention
and object of manipulation. We illustrate this point with the multiperiod investment
center report in Figure 8-19. Notice how actual ROI went up in 2006 and exceeded the
budgeted ROI in 2007. On the surface, this looks like favorable performance. However,
a closer analysis of the cost and revenue figures gives a different picture. Actual sales
were below budgeted sales for 2007, but the shortfall in revenue was offset by reductions
in discretionary operating expenditures (employee training and plant maintenance). The
ROI figure is further improved by reducing invest ments in inventory and plant equipment
(fixed assets) to lower the asset base.
The manager took actions that increased ROI but were dysfunctional to the organization.
Usually, such tactics can succeed in the short run only. As the plant equipment starts to
wear out, customer dissatisfaction increases (because of stock-outs), and employee dissent
becomes epidemic. The ROI figure will then begin to reflect the economic reality. By
that time, however, the manager may have been promoted based on the perception of
good performance, and his or her successor will inherit the problems left behind. The use of any single criterion performance measure can impose personal goals on
managers that conflict with organizational goals and result in dysfunctional behavior.
Consider the following examples:
1. The use of price variance to evaluate a purchasing agent can affect the quality of the
items purchased.
2. The use of quotas (such as units produced) to evaluate a supervisor can affect quality
control, material usage efficiency, labor relations, and plant maintenance.
3. The use of profit measures such as ROI, net income, and contribution margin can
affect plant investment, employee training, inventory reserve levels, customer satisfaction,
and labor relations.
Performance measures should consider all relevant aspects of a managers responsibility.
In addition to measures of general performance (such as ROI), management should
measure trends in key variables such as sales, cost of goods sold, operating expenses, and
asset levels. Nonfinancial measures such as product leadership, personnel development,
employee attitudes, and public responsibility may also be relevant in assessing management
performance.
Summary
This chapter began by examining the GLS and the financial reporting system, two operationally
interdependent systems that are vital to the economic activities of the organization.
We first learned the importance of data coding schemes and their role in the general
ledger and transaction processing systems as a means of coordinating and managing
a firms transactions. In examining the major types of numeric and alphabetic coding
schemes, we saw how each has certain advantages and disadvantages. We then turned to
a more direct examination of the GLS, focusing on the files that typically make up a GLS
database and on standard GLS procedures. Turning to the FRS, we examined how financial
information is provided to both external and internal users. A step-by-step outline of
the financial reporting process was presented.
Next, the GLS and the FRS were examined as a single, integrated physical system
(GL/FRS). Our principal focus here was on the standard operational controls that govern
this system and on the use of computer technology for improved efficiency in reporting
and record keeping.
This chapter then examined discretionary reporting systems. Discretionary reporting
is not subject to the professional guidelines and legal statutes that govern nondiscretionary
financial reporting. Rather, it is driven by several factors, including management
principles, management function, level, decision type, problem structure, responsibility
accounting, and behavioral considerations The chapter investigated the impact of each
factor on the design of the management reporting system.