Chapter 3 Transaction Processing PDF

THE ACCOUNTING SYSTEM Accounting systems should respond effectively to the ever-rising demand for information from management, investors, lenders, government, regulators, and others. The starting point is to group transactions in keeping with the information needs of the users of f...

THE ACCOUNTING SYSTEM Accounting systems should respond effectively to the ever-rising demand for information from management, investors, lenders, government, regulators, and others. The starting point is to group transactions in keeping with the information needs of the users of financial statements. An account is an individual record of increases and decreases in an item of interest or importance. Accounts are the building blocks of the accounting system. Let’s take a few examples to understand how an account works. To know the amount of cash available, you would summarize all cash receipts and payments. To find out the salaries expense, you would put together salaries paid on various dates. To know the amount due from customers, you would need information about sales and collections. To find out the amount of goods in the store, you would assemble information about purchases and sales. In each of these examples, you need a record that enumerates transactions relating to an item that you are interested in, such as cash, salaries expense, trade receivables, and inventories. The cash account records all cash receipts and payments. The salaries expense account records salaries paid. The trade receivables account records credit sales and collections. The inventory account records purchases and sales of goods. Business organizations have accounts for revenue, expense, asset, liability and equity items. A ledger is a collection of accounts. A chart of accounts is a complete list of the account titles used in an organization. The number of accounts and the specific account titles depend on the business. Thus, banks keep accounts for deposits, loans, interest income and interest expense. Supermarkets track store inventories. Automobile manufacturers record cost of production. An accounting system has separate accounts for asset, liability and equity items. In this chapter, we use the general ledger, the most commonly used type of ledger. Exhibit 3.1 presents an illustrative chart of accounts. Accounts may have codes. Often the accounting staff refer to account codes rather than account titles. In the chart below, the first digit tells us whether an account is an asset, liability or equity item and the next two digits identify the specific item. Thus, all asset accounts begin with 1, liability accounts begin with 2, and so on. Every organization should develop a chart of accounts that is most appropriate for its purposes. For example, a large company may use a 10-digit system in order to identify the division or business unit, plant, product line, and so on. The chart of accounts is much more detailed than the line items that appear in financial statements. EXHIBIT 3.1 Chart of Accounts A chart of accounts lists the account titles and codes used by an organization.. Account Title Code Account Title Code Assets Revenues and Other Income Buildings 101 Sale of goods 401 Office equipment 102 Revenue from services 402 Office supplies 103 Interest income 403 Trade receivables 104 Gain on sale of assets 404 Cash 105 Expenses and Losses Prepaid rent 106 Cost of goods sold 501 Liabilities Salaries expense 502 Borrowings 201 Office supplies expense 503 Trade payables 202 Electricity expense 504 Unearned revenue 203 Advertisement expense 505 Equity Telephone expense 506 Share capital 301 Rent expense 507 Securities premium 302 Insurance expense 508  Retained earnings 303 Interest expense 509 Currency translation reserve 304 Income tax expense 510 Dividends 305 Loss on sale of assets 511 Special ledgers are used to record the details of accounts in the general ledger. For example, the trade receivables ledger has the accounts of the individual receivable accounts of customers. The balance of the trade receivables account in the general ledger should be equal to the sum of the individual receivable accounts. Special ledgers are often kept for trade payables, property, plant and equipment, and inventories. COMMONLY USED ACCOUNTS Let’s now see some commonly used accounts. Assets are what a business owns. Land, buildings, equipment, trade receivables, bills receivable, cash, prepaid expense, unbilled revenue and interest receivable are examples of asset accounts. Liabilities are what a business owes. Salaries payable, warranty payable, trade payables, bills payable, bonds payable, tax payable, unearned revenue, and interest payable are examples of liability accounts. Equity is the owners’ claim on the business. Share capital, retained earnings, sales revenue, interest income, cost of goods sold, advertisement expense, interest expense, drawings, and dividends are examples of equity accounts. The accounting system builds an organization’s memory. An organization remembers what is recorded in its accounts. There will be no trace of what is not recorded. Writer and Nobel laureate, Garcia Gabriel Marquez says, “What matters in life is not what happens to you but what you remember and how you remember it.” The accounting system determines what activities an organization ‘remembers’ and ‘how’ it remembers them. The number of accounts and specific account titles used by an enterprise depend on the nature and complexity of the enterprise’s business. For example, an automobile company will keep detailed accounts for its plant and equipment, whereas a bank will need meticulous information about its various deposits, investments and loans, and its cash kept in various forms. Again, a small bakery that sells for cash can possibly manage with a few accounts, while a large multinational company will have thousands of accounts. In deciding on the level of detail in the accounts, a firm should also consider relevant legal requirements. For example, the Companies Act requires disclosure of directors’ remuneration; the Income Tax Act disallows many kinds of entertainment expenses. It is necessary to keep separate accounts for such items. Recognition is the process of recording an item that meets the definition of an element (revenue, expense, asset, liability, or equity). Derecognition is the process of removing an item that no longer meets the definition of an element. TEST YOUR UNDERSTANDING 3.1 Classifying Accounts State whether the following are asset, liability or equity accounts: (a) Directors’ fees  (b) Cost of materials consumed (c) Gain on sale of investments (d) Provision for leave wages (e) Security deposit with Customs (f) Work-in-progress ONE-MINUTE QUIZ 3.1 Account Which of the following statements about account is correct? There may be more than one correct answer. (a) An account records all increases and decreases in an item. (b) The trade payables account describes credit purchases and payments to suppliers of goods and services. (c) The Companies Act has a model chart of accounts. (d) An accountant records important increases and decreases in an item. DISCUSSION Should revenues and expenses relating to an enterprise’s core and peripheral activities QUESTION 3.1 be collected in separate accounts?....................................................................................................................................................................................................................................... THE DOUBLE-ENTRY SYSTEM In Chapter 2, we analyzed the effect of transactions on the accounting equation. Recall that each transaction affects two columns. For example, receiving cash from customers for past invoices increases cash and decreases trade receivables. Thus, we record each transaction in two accounts so that the accounting equation, Assets = Liabilities + Equity, is always in balance. This balancing is as important to the accountant as safe landing is to an airline pilot: the number of times an aircraft takes off must equal the number of times it lands (needless to add, safely). This principle of duality is valid regardless of the complexity of a transaction. The double-entry system records every transaction with equal debits and credits. As a result, the total of debits must equal the total of credits. Luca Pacioli (pronounced pot- chee-oh-lee), an Italian monk, first articulated the double-entry system in 1494 in his book titled Summa de Arithmetica, Geometria, Proportioni et Proportionalita (which means “Everything about Arithmetic, Geometry, and Proportions”).18 The T Account The common form of an account has three parts: 1. Title describing the asset, liability or equity account. 2. Debit side, or left side. 3. Credit side, or right side. This form of account is called a T account because it looks like the letter T, as shown below. Title of Account Left = Debit Right = Credit Debits and credits Accountants use the terms debit and credit, respectively, to refer to the left side and right side of an account. To debit an account is to enter an amount on the left side of an account and to credit an account is to enter an amount on the right side of an account. Note that in accounting debit and credit do not have any value connotations such as bad and good. They are simply the accountant’s terms for left and right – and nothing more. The T account explained In the illustration in Chapter 2, Softomation received and paid cash. We record these transactions in the cash account below, with receipts on the left or debit side and payments on the right or credit side: Cash Date Explanation Amount Date Explanation Amount 20XX 20XX March 1 Owner’s investment 50,000 March 3 Cash purchase of computer 58,000 2 Loan from Manish 20,000 12 Payment to suppliers 2,000 9 Cash sales 12,000 26 Salaries 4,000 23 Refund for supplies returned 1,900 26 Office rent 1,200 30 Drawings 3,500 Total 83,900 Total 68,700 31 Balance 15,200 The debit and credit totals, or footings in accounting jargon, are an intermediate step in determining the cash at the end of the month. The difference between the total debits and the total credits is the balance. If the total debits exceed the total credits, the account has a debit balance. If the total credits exceed the total debits, the account has a credit balance. The cash account has a debit balance of `15,200 (`83,900 – `68,700). It represents the cash available on March 31. You would have observed that the cash account has the same information as that in the cash column in Exhibit 2.1. Standard Form of Account The T account is a convenient way to record transactions. In practice, accountants use the standard form, given in Exhibit 3.2. The standard form shows the balance after every transaction and is, therefore, more useful and efficient than the T account. Your bank statement is an everyday example of the standard form. EXHIBIT 3.2 Standard Form of Account The standard form is more efficient than the T form. The bank statement follows the standard form. Cash Date Explanation Post. Ref. Debit Credit Balance 20XX March 1 Owner’s investment 50,000 50,000 2 Loan from Manish 20,000 70,000  3 Cash purchase of computer 58,000 12,000 9 Cash sales 12,000 24,000 12 Payment to suppliers 2,000 22,000 23 Refund for supplies returned 1,900 23,900 26 Salaries 4,000 19,900 26 Office rent 1,200 18,700 30 Drawings 3,500 15,200 Here is a common question that comes up in the early stages of an accounting course: We record receipts as debits and payments as credits in the cash account. But the bank credits our account when we deposit money and debits our account when we withdraw money. It’s confusing, isn’t it? Answer: The cash account in our records is the mirror image of our deposit account kept by the bank. While our deposits with the bank are our assets, they are the bank’s liabilities. The bank credits our account when we deposit cash because it owes us more; it debits our account for withdrawals because it owes us less. Debit and Credit Rules Under the double-entry system, we enter increases in assets on the debit side of the account, and increases in liabilities and equity on the credit side. Figure 3.1 describes the recording procedure in terms of the accounting equation: The rules for debit and credit for assets, liabilities, and equity are as follows: 1. Assets: Debit increase in asset to asset account. Credit decrease in asset to asset account. 2. Liabilities and equity: Credit increase in liability or equity to liability or equity account. Debit decrease in liability or equity to liability or equity account. From Chapter 2, you know the following expanded form of the accounting equation: Assets = Liabilities + Capital + Revenues – Expenses – Drawings (or Dividends) We can rewrite this equation as follows: Assets + Expenses + Drawings (or Dividends) = Liabilities + Capital + Revenues We can now extend the rules for recording increase and decrease in equity to revenues, expenses, drawings, and dividends. Thus, we credit revenues to increase them; we debit expenses, drawings, and dividends to increase them. Figure 3.2 summarizes the rules for debit and credit.  The double-entry system is the workhorse of accounting. Shortly, you will be able to appreciate its great value in organizing and processing information. Though debits and credits may seem irksome, knowing them is a big help in communicating with accountants. However, the significance of the double-entry system goes far beyond its usefulness as a system of accounting mechanics. The German economic historian, Werner Sombart, noted that capitalism derives from the spirit of double-entry bookkeeping. ONE-MINUTE QUIZ 3.2 Debits and Credits Which of the following statements about debits and credits is correct? There may be more than one correct answer. (a) Debit balance represents something unfavourable; credit balance represents something favourable. (b) Debit is left and credit is right. (c) Balance is the net of debits and credits in an account. (d) A transaction must have equal debits and credits. Consider the following two accounts. HANDHOLD 3.1 Figuring out Transactions from Accounts Equipment. 10,000.. Cash... 10,000 The debit in the equipment account indicates purchase of equipment. The credit in the cash account indicates payment of cash. Therefore, the transaction is: Bought equipment for cash, `10,000. HANDHOLD 3.2 Processing Transactions Salma sets up FreeHand Company, a creative writing school. Let us take the company’s first two transactions to illustrate the four steps in processing transactions: (1) analysis; (2) rules; (3) entry; (4) accounts. Italics signify change. We have the following four steps for each transaction4: Step 1 ANALYSIS Study the changes in asset, liability and equity items. Step 2 RULES State the debit and credit rules relevant to the transaction. Step 3 ENTRY Record the transaction showing the accounts to debit and credit. Step 4 ACCOUNTS Present the related accounts after recording the transaction. The balance is the result of recording more increase than decrease. We debit asset, expense, drawing, and dividend accounts to record increase, and credit to record decrease in those accounts. As a result, asset and expense accounts usually have debit balances. Since we credit liability, share capital and revenue accounts to record increase and debit to record decrease, these accounts usually have credit balances. The usual type of balance for an account is its normal balance. Figure 3.3 summarizes the normal balances for the various types of accounts. QUICK QUESTION Cash account balance Can the cash account have a credit balance?. TEST YOUR UNDERSTANDING 3.3 Normal Balances Indicate the normal balance of the accounts in Test Your Understanding 3.1.. DISCUSSION We don’t need to learn double-entry accounting when we can use accounting software. Do QUESTION 3.2 you agree?....................................................................................................................................................................................................................................... COMPREHENSIVE ILLUSTRATION: VOGUE COMPANY To illustrate the procedure for recording transactions, let us set up Vogue Company, a business that supplies new designs for dresses. In this illustration, you will learn how to record a transaction in terms of debits and credits. RECORDING TRANSACTIONS Journal The journal is a chronological record of an enterprise’s transactions. The word ‘journal’ derives from the Latin word diurnalis meaning “diurnal” which implies “of or during the day time”. The journal is called the book of original entry or primary book because this is the accounting record where we first record transactions. It provides in one place a complete record of all transactions with necessary explanation. A journal entry has transaction date, individual accounts, debit and credit amounts, and narration. Journalizing is the process of recording transactions in the journal. Day book is another term for journal. Companies usually maintain several kinds of journals. The nature of operations and the frequency of a particular type of transaction in a company determine the number and design of journals. This book describes the general journal, the most common type of journal. It has separate columns to record the following information about each transaction: 1. Date; 2. Individual accounts; 3. Debit and credit amounts; 4. Brief explanation of the transaction; and 5. Posting reference. Exhibit 3.4 illustrates the general journal using two transactions of Vogue Company. EXHIBIT 3.4 VOGUE COMPANY: Journal The procedure for recording transactions in the general journal is as follows: 1. Enter the year, month, and date of the transaction in the Date column. There is no need to repeat the year and month for subsequent entries until the start of a new page, or a new month. 2. Write the account titles under the Description column. Enter the account to debit on the first line of the entry next to the left margin.If there are several accounts to debit, enter them one after the other. Enter the account to credit on the line below the account(s) to debit and indent it to set the account apart from the account(s) to debit. If there are several accounts to credit, enter them one after the other. Use the account titles from the company’s chart of accounts. A compound entry has more than one debit and/or credit items. 3. Enter the amount of the debit in the Debit column alongside the account to debit and the amount of the credit in the Credit column alongside the account to credit. 4. Write a brief explanation of the transaction. 5. Post. Ref. (Posting Reference) is left blank at the time of making the journal entry. Special journals are used to record transactions of specific types. For example, the purchases journal records credit purchases, the sales journal records credit sales and the cash book records cash receipts and payments. QUICK QUESTION Special journal Is a special journal a journal or a ledger?. DISCUSSION Does it make sense to keep only the journal and no ledger? QUESTION 3.3....................................................................................................................................................................................................................................... LEDGER Posting is the process of transferring information from the journal to the ledger. We enter each amount in the Debit column in the journal on the debit side of the appropriate account and each amount on the Credit column in the journal on the credit side of the appropriate account. The frequency of posting could be daily, weekly, or monthly, depending on the number of transactions. Posting has the following steps: 1. Locate in the ledger the account(s) to debit.  2. Enter the date of the transaction in the account. 3. Enter the relevant journal page number in the Post. Ref. column of the account. 4. Enter the debit amount appearing in the journal in the Debit column of the account. 5. Enter the account code or the ledger folio number in the Post. Ref. column of the journal. 6. Repeat steps 1 to 5 for the account(s) to credit. Exhibit 3.5 illustrates these steps separately for the debit and credit parts of a journal entry. Entering the account code in the “Post. Ref.” column of the journal is the last step in posting. It indicates that the accountant has transferred all the information in the journal entry to the ledger. In addition, the account codes in this column are a convenient means for locating any additional information about an amount appearing in an account. Since this book does not use account codes, you don’t have to complete this column. The next step in the recording process is the preparation of trial balance. ONE-MINUTE QUIZ 3.3 Journal and Ledger Which of the following statements about the journal is correct? There may be more than one correct answer. (a) The number of accounts debited in a journal entry must equal the number of accounts credited in the entry. (b) The total amount debited in a journal entry must equal the total amount credited in the entry. (c) Transactions are first recorded in the journal and then in the ledger. (d) At the end of a day, the journal will show the balance of the accounts.  For a beginner in accounting, recording the effect of a transaction can be confusing at times. Recall that an account is a record of increases and decreases in an item. We use journal entries to record changes in an account. To illustrate, suppose a business has cash of `2,100 and a receivable of `1,000 from a customer, besides other items. The customer pays `600, a part of the receivable of `1,000. The journal entry, Debit Cash 600; Credit Trade Receivables 600, records this transaction. As a result, Cash increases by `600 and Trade Receivables decreases by `600. The new balance of Trade Receivables is `400, i.e. beginning balance, `1,000 – collection, `600. The new balance of Cash is `2,700, i.e. beginning balance, `2,100 + collection, `600. We do not record a journal entry for the balance amount. The balance is the difference between the debit and the credit totals. Transaction entries record delta (∆), the mathematical shorthand for change. So remember that journal entries record changes, not balances. Materiality The materiality threshold (also known as the materiality principle) saves us from having to make tedious calculations or disclosing needless detail, not warranted in most cases. An item is material if it is sufficiently large or important for users of the information to be influenced by it. The materiality threshold helps in balancing the costs and benefits of disclosures and accounting methods. Materiality questions are pervasive in financial reporting. For instance: Should all inventory items be physically verified? Should every piece of equipment be recorded as an asset and depreciated or can items of low value be expensed at the time of acquisition? How operating segments should be selected for reporting? Can expenses be grouped into categories? The answers will depend on the facts and circumstances of each case. For example, a payment of `10,000 is most probably not material for a business that reports a profit of `250 million. However, it could very well be material for a business reporting a profit of `250,000. Schedule III requires disclosure of any item of income or expenditure which exceeds 1 per cent of the revenue from operations or `100,000, whichever is higher. Judgment is required in determining materiality. DISCUSSION Should small amounts of fines and penalties be disclosed? QUESTION 3.4....................................................................................................................................................................................................................................... TRIAL BALANCE The trial balance is a list of account balances. Pacioli is said to have advised that the bookkeeper should not go to sleep at night until the debits equalled the credits. Exhibit 3.6 shows a trial balance for Vogue Company. The trial balance lists each account in the ledger that appears in Exhibit 3.3, with the debit balances in the left column, and the credit balances in the right column. Each column has a total, and the two totals must be equal. When this happens, the trial balance is said to be “in balance.” EXHIBIT 3.6 VOGUE COMPANY: Trial Balance, June 30, 20XX The trial balance lists ledger balances on a specified date. It is a basic check on bookkeeping.. Equipment ` 3,000 Office supplies 3,700 Trade receivables 7,000 Cash 46,930 Prepaid insurance 720 Trade payables 2,500 Unearned revenue 1,500 Share capital 50,000 Dividends 2,200 Revenue from services 14,000 Rent expense 1,500 Telephone expense 200 Salaries expense 800 Electricity expense 150 Office supplies expense 1,800 Total 68,000 68,000 We are quite pleased that the debits equalled the credits in the Vogue Company illustration. This is because we followed double entry meticulously and recorded the transactions and amounts accurately. ERRORS IN ACCOUNTING RECORDS A trial balance that balances is a necessary condition for error-free accounting but it is not a sufficient condition. This means that it can be trusted to detect some types of error but not others. All errors should be corrected, whether they affect the trial balance or not. In most cases, a correcting entry would be necessary to fix the error. The three steps in correcting errors are: 1. Understand the erroneous entry. 2. Visualize the correct entry. 3. Record the correcting entry. Errors that Don’t Affect the Trial Balance First, let us see some errors that don’t affect the trial balance. Suppose the accountant made the following errors in the Vogue Company illustration: Error Type Example Effect Incorrect 1. June 3: Recorded rent paid as Rent expense less, and telephone classification telephone expense. expense more, by `1,500. Omission 2. June 10: Omitted the credit Trade receivables and revenue less by sale. `9,000. Repetition 3. June 2: Recorded the purchase Cash balance less, and office supplies twice. more, by `2,000. Compensating 4. June 7: Recorded `200 in both Cash and revenue less by `1,800. error cash and revenue. Suppose we notice the errors at the month-end. Let’s now see how to correct the above errors. June 3: Recording rent paid as telephone expense, `1,500. This resulted in understating rent expense by `1,500 and overstating telephone expense by a like amount. The following entry corrects the error: June 30 Rent Expense 1,500 Telephone Expense 1,500 June 10: Omitting the credit sale, `9,000. This resulted in understating both trade receivables and revenue by `9,000. We correct the error by recording the transaction: June 30 Trade Receivables 9,000 Revenue from Services 9,000 June 2: Recording the purchase twice, `2,000. This resulted in understating cash, and overstating office supplies, by `2,000. We correct the error by cancelling the duplicate entry: June 30 Cash 2,000 Office Supplies 2,000 June 7: Recording `200 in both cash and revenue. This resulted in understating both cash and revenue by `1,800. We correct the error by recording the difference: June 30 Cash 1,800 Revenue from Services 1,800 The above journal entries are posted and the account balances are recalculated. Errors that Affect the Trial Balance Now, we will see how to correct errors that affect the trial balance. Suppose the accountant made the following errors in the Vogue Company illustration: Error Type Example Effect Omitting a debit 5. June 25: Omitted the debit to trade Trade receivables less receivables.  by `2,000. Omitting a credit 6. June 6: Omitted the credit to cash. Cash more by `720. Recording a debit as a 7. June 7: Credited instead of debiting Cash less by `4,000. credit cash. Recording a credit as a 8. June 25: Debited instead of Revenue from debit crediting revenue from services. services less by `6,000. Recording different 9. June 4: Debited equipment `3,000 Cash more by amounts in debit and and credited cash `300. `2,700. credit Transposing digits 10. June 22: Debited office supplies Office supplies expense `8,100 instead of `1,800. expense more by `6,300. Since these errors contravene double entry, the trial balance will not balance. We initially note the difference as suspense. Let us take three examples from the above. June 25: Omitting the debit to trade receivables, `2,000. As a result, trade receivables has a balance of `5,000, which is `2,000 less than the correct June 30 balance. So the trial balance debit total would be `2,000 less than the credit total. Initially, we take the difference to the debit of an account called Suspense. The following entry corrects the error: June 30 Trade Receivables 2,000 Suspense 2,000 After posting the above entry, Trade Receivables has a debit balance of `7,000 and Suspense has zero balance, as shown below: Suspense June 30 Difference in trial balance 2,000 June 30 Correcting entry 2,000 June 7: Crediting instead of debiting cash, `2,000. As a result, cash has a balance of `42,930, which is `4,000 less than the correct June 30 balance. So the trial balance debit total would be less than the credit total by `4,000. Initially, we take the difference to the debit of Suspense. The following entry corrects the error: June 30 Cash 4,000 Suspense 4,000 After posting the above entry, Cash has a debit balance of `46,930 and Suspense has zero balance, as shown below:  Suspense June 30 Difference in trial balance 4,000 June 30 Correcting entry 4,000 June 22: Crediting office supplies expense `8,100 instead of `1,800. As a result, office supplies has a balance of `8,100, which is `6,300 more than the correct June 30 balance. So the trial balance debit total would be more than the credit total by `6,300. Initially, we take the difference to the credit of Suspense. The following entry corrects the error: June 30 Suspense 6,300 Office Supplies Expense 6,300 After posting the above entry, Office Supplies Expense has a debit balance of `1,800 and Suspense has zero balance, as shown below: A better alternative to correcting errors is not to make them in the first place. That said, learning how to correct errors is arguably the best test of your grasp of the double-entry system. ONE-MINUTE QUIZ 3.4 Trial Balance and Errors Which of the following statements about the trial balance is correct? There may be more than one correct answer. (a) If a trial balance balances, it implies that the debits and credits in the accounts are equal. (b) If a trial balance balances, it means that the transactions in a period have been recorded. (c) Crediting unearned revenue instead of revenue earned will cause a trial balance difference. (d) Debiting trade payables instead of trade receivables will cause a trial balance difference.. TEST YOUR UNDERSTANDING 3.5 Correcting Errors Prepare correcting entries for the remaining errors in the Vogue Company illustration. TECHNOLOGY IN ACCOUNTING Rapid changes in technology have a profound effect on accounting. We will now look at how three major advances in technology — cloud computing, blockchain technology, and machine learning — are changing the work of accountants. Cloud Computing Cloud computing eliminates the need to buy, run and maintain in-house technology infrastructure, such as servers and software. Instead, cloud applications are made available over the Internet. Users share applications, while the software vendor manages the applications and the storage space. Cloud computing includes SaaS (Software-as-a-service), IaaS (Infrastructure- as-a-service), and Platform-as-a-service (PaaS). The vendor owns the software and runs it in its data centre. The customer does not buy the software or server, but rents it for a periodic fee. Many customers can access the same software and server at a time. Many applications such as payroll, sales tax and VAT, income tax return preparation, invoice management, and enterprise resource planning (ERP) run on cloud. Cloud computing firms claim a number of benefits for their products, such as quick implementation, anytime access anywhere with an Internet connection, lower initial investment in hardware and software, no or low maintenance costs, reduced support costs, easy and regular upgrades, and disaster recovery and back-up capabilities. Cloud computing risks and difficulties include safety of users’ data, unscheduled downtime, low Internet bandwidth, and data ownership and migration. Blockchain Technology Blockchain is a shared public database for recording transactions in a way that does not allow the record to be altered at a later date. Blockchain technology underpins bitcoin, the cryptocurrency. The technology has the potential to transform accounting systems. Managers can trust their own books because of the checks built in double-entry bookkeeping. Gaining the trust of outsiders is a different and difficult matter. To illustrate, suppose that Seller Company has a receivable of `10,000 from Buyer Company. This would make sense only if Buyer Company has a payable of `10,000 to Seller Company. Currently, Seller Company sends and records the invoice and other documents and accountants review the records to make sure that it is all fine. In contrast, the blockchain has both the transaction and a shared ledger for that transaction. Using blockchain, Seller and Buyer share the same data. There is one ledger for this transaction that is shared between the two companies. Since both Seller and Buyer are looking at exactly the same data, we can certainly say Buyer owes Seller `10,000. Using blockchain technology, businesses can record their transactions directly in a joint register. The entries are distributed and cryptographically sealed. So falsifying or destroying transactions to conceal activity is practically impossible. It is an electronic verification system. The law requires tamper-proof recordkeeping. It is easy to detect modification in physical records. Electronic records are vulnerable because they can’t be seen physically. Using blockchain it is possible to generate hash string of the file. It is the digital fingerprint of that file. That fingerprint is immutably timestamped into the blockchain. At anytime it is possible to prove the integrity of the file by again generating the fingerprint and comparing it with the fingerprint stored in the blockchain. Entire processes carried out in many departments or companies can be traced. This generates an audit trail for the use of external auditors and others interested in following through the life cycle of a transaction from say placing a purchase order to paying the vendor. Finally, blockchain allows for smart contracts, i.e. a computer program that executes on its own. For instance, an invoice will get paid automatically after confirming that goods have been received as specified and there is sufficient bank balance. Machine Learning Machine learning, a branch of artificial learning, uses computer programs called algorithms to extract patterns from data and make predictions. Many accounting and auditing procedures are amenable to machine learning. For instance, algorithms can check travel claims and supplier invoices and raise a red flag on suspected fraud cases. It is impossible for auditors to verify the large numbers of transactions. In the past auditors looked at samples of data. Using machine learning technologies auditors can analyze entire journals looking for entries recorded by unexpected people or at odd times. Also, auditors are increasingly trawling the unstructured data in emails, blog posts, posts on Facebook or LinkedIn, or tweets to get a sense of deviant behaviour. The use of analytics can produce significant cost savings and improve the reliability of auditing. INTERNAL CONTROL SYSTEMS Internal control is a process intended to assure that an organization works to achieve its goals efficiently, produces reliable financial statements, complies with relevant laws and regulations and manages its major risks. The board of directors and management require good internal control systems. Equally, outsiders such as shareholders, regulators, and government benefit from internal controls. An internal control system extends beyond matters that relate directly to the functions of the accounting system. Internal controls comprise accounting controls and administrative controls, as illustrated in Exhibit 3.7. EXHIBIT 3.7 Accounting Controls and Administrative Controls Internal controls go beyond the accounting system. 1 Accounting Controls Administrative Controls Objective To safeguard assets and reliability Maintain and improve operational of financial records. efficiency and adhere to management To provide reasonable assurance policies. that — all transactions are authorized by management and are promptly and properly recorded. — access to assets is permitted only in accordance with management’s authorization. Examples (a) Stores can issue materials only (a) Sales managers must meet quarterly when an employee produces a and annual targets for sales volume, proper requisition. product mix, profitability, and (b) Employees must submit travel advertising expense. claims and get them approved by (b) Employees must prepare reports the higher authority for payment of describing the purpose and result of travel expenses. official travel and get them approved by the higher authority. In many cases, an administrative control is the starting point for establishing accounting control. For example, a requirement that every employee must submit a report describing the purpose and result of an official travel is related to the accounting control for payment of official travel expense. In practice, some controls may be meant for both managerial decision-making and custody of property. For instance, a product cost classification may be used for recording the value of inventories (an accounting matter), as also for product pricing (an administrative matter). Administrative controls span different functional areas and are dealt with in courses in management accounting, operations management, and marketing management. Since the accountant is responsible for establishing systems for the safeguarding of assets and the reliability of records, a study of the elements of accounting controls is an important part of a course in financial accounting. The Companies Act requires the directors of a listed company to state that they have laid down “internal financial controls” to be followed by the company and the controls are adequate and are operating effectively. Features of a Good Internal Control System We will now see some of the features of a good internal control system.  Separation of duties The organizational structure should provide for the segregation of functional responsibilities. No individual should be responsible for all phases of a transaction. Segregation of operations, custody, and accounting significantly reduce the chances of fraud, since fraud would become more difficult if two or more individuals have to collude. In a sale transaction, one employee may enter the quantity of the item sold, a second employee may input its price, and a third may post the invoice to the customer’s ledger. Authorizing and recording transactions A competent official in the organization must authorize transactions, preferably by signing or initialling documents. Then the accounting department must record the transactions, by first classifying them on the basis of a carefully devised scheme and then summarizing them according to the classification. There are several mechanisms to verify the correctness of the recording process. For example, preparation of a trial balance is a check on the proper recording of debits and credits. Sound administrative practices All major instructions and procedures should be in writing. Many organizations have manuals that describe the procedures to be followed by employees in carrying out their duties. They lay down the standards of work and specify the responsibilities of individual managers. Also, they prepare budgets and circulate them to key managers. Sound personnel policies Reliable and competent personnel are fundamental to the success of a control system. The organization should verify past experience cited in job applications and investigate significant gaps in experience. At times, it may turn out that a candidate was serving a jail sentence during an unexplained gap in employment. Mass recruitment is risky, because it does not allow for proper pre- employment screening. Wherever necessary, an organization should engage the services of specialist investigation agencies. (In fact, some organizations employ detectives to verify the background of selected candidates.) There should be periodical rotation of employees on different jobs and regular supervision of their work. Many organizations require employees in key positions to take vacation every year in order to let them have a well-deserved break and find out in their absence what they were doing. Fidelity bonds insure the company against employee theft. Internal audit Human ingenuity is inexhaustible. Dishonest employees find out ways of defrauding the organization despite the existence of many controls. The organization should always be alert to possibilities of embezzlements, frauds, and errors. Managers should regularly investigate the systems they are working with. Internal auditors are not directly involved in operations and they should perform regular reviews of internal control systems. They can evaluate both the overall efficiency of operations and the effectiveness of the internal control system. According to an Ernst & Young survey, 41 per cent of respondents said that they employed internal audit to detect fraud.19 The Companies Act requires companies to appoint an internal auditor, who shall be a CA or a cost accountant.  Can journal entries be weapons of mass destruction? Satyam Computer Services is the most high profile case of the collapse of accounting, auditing and corporate governance involving an Indian company. On January 7, 2009, B. Ramalinga Raju, chairman and executive of Satyam, resigned after admitting that he had manipulated the accounts for several years in order to show hugely inflated profits and fictitious assets totaling $1 billion. On that day, Satyam’s stock plunged to `40.25 at the National Stock Exchange, after opening at `179, and touched a low of `6.30 on January 9, 2009, the next trading day. Reacting to this development, the Sensex crashed 7 per cent. As a news report put it, it was “a unique case of upheavals at a single company pulling down the Indian stock market.”20 Fictitious accounting entries were at the core of the fraud. The following entries illustrate the fraud: (a) Trade Receivables 1,000 Revenue from Services 1,000 (b) Cash 1,000 Trade Receivables 1,000 In reality, the company did not provide any services for `1,000 and certainly did not collect anything for those made-up customers. There was an elaborate scheme of manipulation of computerized accounting records in breach of established control systems. Cash, unlike receivables, can be verified easily. Cash is either there or not there. How did the company conjure up the cash? Answer: The company produced fake bank deposit documents. The accounting system organizes information systematically. An account is a record of increases and decreases in an asset, liability or equity item. Accounts can be in T form or standard form. Debit is left and credit is right. Ledger is a collection of accounts. Chart of accounts is a complete list of the account titles used in an organization. Journal is a chronological record of transactions. Trial balance is a list of account balances. Debit and credit rules: Assets, expenses, dividends: Debit to increase. Credit to decrease. Liabilities, capital, revenues: Credit to increase. Debit to decrease. Transaction processing steps: 1. Analyze the changes in asset, liability, capital, revenue, expense and dividend items. 2. Enter the transaction in the journal applying the debit and credit rules. 1. Post the journal entry to the related accounts in the ledger. 2. At the end of a period, balance the accounts and list them in a trial balance.  Asset, expense and dividend accounts normally have normal balances. Liability, capital and revenue accounts normally have credit balances. Errors are the result of incorrect journalizing, incorrect posting and incorrect balancing. Error correction steps: 1. Understand the incorrect entry. 2. Visualize the correct entry. 3. Record the correcting entry. Technological changes such as cloud computing, blockchain technology and machine learning are changing the way accounting and auditing is done. Good internal control systems ensure the reliability of the accounting system. Ganesh started Woodcraft Company on September 1, 20XX. The transactions for the month are as follows: Sep. 1 Invested cash in share capital, `10,000. 4 Paid two months’ rent in advance for a shop, `2,000. 5 Bought equipment for cash, `1,200. 7 Bought supplies on credit, `700. 10 Received payment for remodelling a kitchen, `8,600. 14 Paid for an advertisement, `1,400. 17 Received payment for furnishing an office, `11,200. 23 Billed customers for work done, `13,100. 25 Paid assistant’s wages, `1,500. 28 Paid electricity charges, `240. 29 Received payment from customers billed on September 23, `4,800. 30 Paid a dividend, `2,500. Required 1. Prepare journal entries for the above transactions. 2. Post the journal entries to the ledger. 3. Prepare a trial balance. Solution to the Review Problem 1. Journal entries