CH 5: The

Expenditure Cycle Part I:

Purchases and Cash Disbursements
Procedures
 Chapter Introduction
 5-1The Conceptual System
 5-1aOverview of Purchases and Cash Disbursements Activities
 5-2Physical Systems
 5-2aBasic Technology Expenditure Cycle
 5-2bAdvanced Technology Expenditure Cycle
 5-2cIntegrated Purchases Processing System
 5-2dIntegrated Cash Disbursements System
 5-2eExpenditure Cycle Risks and Internal Controls
 5-2fReengineering Using EDI
 5-3Chapter Review
 5-3aSummary
 5-3bKey Terms
 5-3cReview Questions
 5-3dDiscussion Questions
 5-3eMultiple-Choice Questions
 5-3fProblems
 5-3gInternal Control Cases

Chapter Introduction
Learning Objectives
After studying this chapter, you should:

 Recognize the fundamental tasks that constitute the purchases and cash disbursements process.
 Be able to identify the functional areas involved in purchases and cash disbursements activities,
and trace the flow of these transactions through the organization.
 Be able to specify the documents, journals, and accounts that provide audit trails, promote the
maintenance of historical records, and support internal decision making and financial reporting.
 Understand the risks associated with purchases and cash disbursements activities and be familiar
with the controls that reduce these risks.
  Be aware of the operational features and the control implications of technologies used in
purchases and cash disbursements systems.

The objective of the expenditure cycle is to convert the organization’s cash into physical
materials and human resources it needs to conduct business. In this chapter, we
concentrate on systems and procedures for acquiring raw materials and finished goods
from suppliers. We examine payroll and fixed asset systems in Chapter 6.

Most business entities operate on a credit basis and do not pay for resources until after
acquiring them. The time lag between these events splits the procurement process into
two phases:

 (1) the physical phase, involving the acquisition of the resource, and
 (2) the financial phase, involving the disbursement of cash.
As a practical matter, these are treated as independent transactions that are processed
through separate subsystems.

This chapter examines the principal features of the two major subsystems that constitute
the expenditure cycle:

 (1) the purchases processing subsystem and

 (2) the cash disbursements subsystem.
This chapter is organized into two main sections. The first section provides an overview
of the conceptual system, including the logical tasks, the key entities, the sources and
uses of information, and the flow of key documents through an organization. The second
section deals with physical systems, which are composed, to varying degrees, of
technology and human activity. This section reviews system options that lie at different
points on the technology/human continuum. Two objectives drive this discussion. The
first is to illustrate system functionality, efficiency issues, and work flow characteristics
of different technologies. The second is to demonstrate how internal control issues differ
between systems at various points on the technology/human continuum. As part of this
discussion, we examine basic technology systems and advanced integrated systems. We
conclude the chapter with an overview of electronic data interchange (EDI).

5-1The Conceptual System

5-1aOverview
of Purchases and Cash
Disbursements Activities
In this section, we examine the expenditure cycle conceptually. Using data flow diagrams
(DFDs) as a guide, we will trace the sequence of activities through the purchases
processing and cash disbursements procedures. Payroll and fixed asset systems, which
also support the expenditure cycle, are covered in Chapter 6.
 As in Chapter 4, the conceptual system discussion is intended to be technology-neutral.
The tasks described in this section may be performed manually or by computer. At this
point, our focus is on what (conceptually) needs to be done, not how (physically) it is
accomplished. At various stages in the processes, we will examine specific documents,
journals, and ledgers as they are encountered. Again, this review is technology-neutral.
These documents and files may be physical (hard copy) or digital (computer-generated).
Later in this chapter, we examine examples of physical systems.

Purchases Processing Procedures

Purchases procedures include the tasks involved in identifying inventory needs, placing
the order, receiving the inventory, and recognizing the liability. The relationships
between these tasks are presented with the DFD in Figure 5-1. In general, these
procedures apply to both manufacturing and retailing firms. A major difference between
the two business types lies in the way purchases are authorized. Manufacturing firms
purchase raw materials for production, and their purchasing decisions are authorized by
the production planning and control function. These procedures are described in Chapter
7. Merchandising firms purchase finished goods for resale. The inventory control
function provides the purchase authorization for this type of firm.

Figure 5-1DFD for Purchase System

Monitor Inventory Records

Firms deplete their inventories by transferring raw materials into the production process
(the conversion cycle) and by selling finished goods to customers (revenue cycle). Our
illustration assumes the latter case, in which inventory control monitors and records
finished goods at inventory levels. When inventories drop to a predetermined reorder
point, a purchase requisition is prepared and sent to the prepare purchase order (PO)
function to initiate the purchase process. Recall that the task of identifying a low-level
inventory condition and creating a purchase requisition is a revenue cycle activity that
was described in detail in Chapter 4. Figure 5-2 presents an example of a purchase
requisition.

Figure 5-2Purchase Requisition
For efficiency and control purposes, the purchase requisition contains routine ordering
information taken from the inventory subsidiary ledger and valid vendor file. This
includes the name and address of the primary supplier, the economic order quantity  of
the item, and the standard or expected unit cost of the item. Providing this information to
the purchasing agent allows him or her to deal with routine purchases as efficiently as
good control permits and to devote his or her primary efforts to nonroutine problems
such as sourcing scarce, expensive, or unusual inventory items. The valid vendor file
provides an important control by listing only approved vendors. The purpose is to ensure
that the organization purchases inventories only from authorized vendors. This helps to
reduce certain vendor fraud schemes such as an agent buying from suppliers with whom
he or she has a relationship (a relative or friend) or buying at excessive prices from
vendors in exchange for a kickback or bribe.

Although procedures vary from firm to firm, typically a separate purchase requisition is
prepared for each inventory item as the need is recognized. This often results in multiple
purchase requisitions for a single vendor. The purchase requisitions therefore need to be
combined into a single purchase order (discussed next), which is then sent to the vendor.
In this type of system, each purchase order is associated with one or more purchase
requisitions.

Prepare Purchase Order

The prepare purchase order function receives the purchase requisitions, which are then
sorted by the vendor if necessary. Next a purchase order (PO), which is illustrated
in Figure 5-3, is prepared for each vendor. A copy of the PO is sent to the vendor. In
addition, a copy is sent to the set up accounts payable (AP) function for filing temporarily
in the AP pending file, and a blind copy is sent to the receive goods function, where it is
 held until the inventories arrive. The last copy is filed in the open/closed purchase
order file.

Figure 5-3Purchase Order

Receive Goods
Most firms encounter a time lag (sometimes a significant one) between placing the order
and receiving the inventory. During this time, the copies of the PO reside in temporary
files in various departments. Note that no economic event has yet occurred. At this point,
the firm has received no inventories and incurred no financial obligation. Hence, there is
no basis for making a formal entry into any accounting record. Companies will often,
however, make memo entries of pending inventory receipts and associated obligations.

The next event in the expenditure cycle is the receipt of the inventory. Goods arriving
from the vendor are reconciled with the blind copy of the PO. The blind copy, illustrated
in Figure 5-4, contains no quantity or price information about the products being
received. The purpose of the blind copy is to force the receiving clerk to count and
inspect inventories prior to completing the receiving report. At times, receiving docks are
very busy, and receiving staff are under pressure to unload the delivery trucks and sign
the bills of lading so the truck drivers can go on their way. If receiving clerks are
provided with quantity information, they may be tempted to accept deliveries on the
basis of this information alone, rather than verify the quantity and condition of the goods.
Shipments that are missing items or contain damaged or incorrect items must be
detected before the firm accepts and places the goods in the inventory. The blind copy is
an important control in reducing this risk.

Figure 5-4Blind Copy Purchase Order

 Upon the completion of the physical count and inspection, the receiving clerk prepares
a receiving report, stating the quantity and condition of the inventories. Figure 5-
5 presents an example of a receiving report. One copy of the receiving report
accompanies the physical inventories to either the raw materials storeroom or finished
goods warehouse for safekeeping. Another copy is filed in the open/closed PO file to
close out the PO. The third copy of the receiving report is sent to the set up account
payable function, where it is filed in the AP pending file. The fourth copy of the receiving
report is sent to inventory control for updating the inventory records. Finally, a copy of
the receiving report is placed in the receiving report file.

Figure 5-5Receiving Report
 Update Inventory Records
Depending on the inventory valuation method in place, the inventory control procedures
may vary somewhat among firms. Organizations that use a standard cost system carry
their inventories at a predetermined standard value regardless of the price actually paid
to the vendor. Figure 5-6 presents a copy of a standard cost inventory ledger.

Figure 5-6Inventory Subsidiary Ledger Using Standard Cost

Posting to a standard cost inventory ledger requires only information about the
quantities received. Because the receiving report contains the quantity information, it
serves this purpose. Updating an actual cost inventory ledger requires additional
financial information, such as a copy of the supplier’s invoice when it arrives.
 Set up Accounts Payable

During the course of this transaction, the set up AP function has received and temporarily
filed copies of the PO and receiving report. The organization has received inventories
from the vendor and has incurred (realized) an obligation to pay for the goods.

At this point in the process, however, the firm has not received the supplier’s invoice   
containing the financial information needed to record the transaction. The firm will thus
defer recording (recognizing) the liability until the invoice arrives. This common
situation creates a slight lag (a few days) in the recording process, during which time the
firm’s liabilities are technically understated. As a practical matter, this misstatement is a
problem only at period-end when the firm prepares financial statements. To close the
books, the accountant will need to estimate the value of the obligation until the invoice
arrives. If the estimate is materially incorrect, an adjusting entry must be made to correct
the error. Because the receipt of the invoice typically triggers AP procedures, accountants
need to be aware that unrecorded liabilities may exist at period-end closing.

When the invoice arrives, the AP clerk reconciles the financial information with the
receiving report and PO in the AP pending file. This is called a three-way match, which
verifies that what was ordered was received and is fairly priced. Once the reconciliation
is complete, the AP clerk prepares an AP packet, which consists of the supporting
documents (PO, receiving report, and invoice), and files the AP packet in the open AP
file. Once reconciled, the AP packet is the formal authority to record the liability and to
subsequently make payment. Next, the transaction is recorded in the purchases journal
and posted to the supplier’s account in the AP subsidiary ledger. Figure 5-7 shows the
relationship between these accounting records.
Figure 5-7Relationship between Purchase Journal, AP Subsidiary Ledger,
and Journal Voucher

Recall that the inventory valuation method will determine how inventory control will
have recorded the receipt of inventories. If the firm is using the actual cost method, the
AP clerk will send a copy of the supplier’s invoice to inventory control. If standard costing
is used, this step is not necessary.

Finally, the AP clerk summarizes the entries in the purchases journal for the period (or
batch) and prepares a journal voucher for the general ledger function (see Figure 5-7).
Assuming the organization uses the perpetual inventory method, the journal entry will
be:
 DR CR

Inventory—Control 6,800.00

   Accounts Payable—Control 6,800.00

If the periodic inventory method is used, the entry will

be:

DR CR

Purchases 6,800.00 6,800.00

   Accounts Payable—Control

Vouchers Payable System

As an alternative to the AP procedures described in the previous section, some firms use
a vouchers payable system. Under this system, the AP department uses cash
disbursement vouchers and maintains a voucher register. After the AP clerk performs
the three-way match, he or she prepares a cash disbursement voucher to approve
payment. Vouchers provide improved control over cash disbursements and allow firms
to consolidate several payments to the same supplier on a single voucher, thus reducing
the number of checks written. Figure 5-8 shows an example of a voucher.
Figure 5-8Cash Disbursement Voucher

Each voucher is recorded in the voucher register, as illustrated in Figure 5-9. The

voucher register reflects the AP liability of the firm; the sum of the unpaid vouchers in
the register (those with no check numbers and paid dates) is the firm’s total AP balance.
The AP clerk files the cash disbursement voucher, along with supporting source
documents, in the vouchers payable file. This file is equivalent to the open AP file
discussed earlier.

Figure 5-9Voucher Register

Post to General Ledger

The general ledger function receives a journal voucher from the AP department and an
account summary from inventory control. The general ledger function posts the data
contained in the journal voucher to the inventory and AP control accounts and reconciles
the inventory control account with the inventory subsidiary summary. The journal
voucher is then filed in the approved journal voucher file. With this step, the purchases
phase of the expenditure cycle is completed.

The Cash Disbursements System

The cash disbursements system processes the payment of obligations created in the
purchases system. The principal objective of this system is to ensure that only valid
creditors receive payment and that amounts paid are timely and correct. If the system
makes payments early, the firm forgoes interest income that it could have earned on the
funds. If obligations are paid late, however, the firm will lose purchase discounts or may
damage its credit standing. Figure 5-10 presents a DFD conceptually depicting the
information flows and key tasks of the cash disbursements system.
Figure 5-10DFD for Cash Disbursements System

Identify Liabilities Due

The cash disbursements process begins in the AP department, where each day the AP
clerk reviews the open AP file for items due for payment. Typically, this file is organized
by payment due date to ensure that debts are paid on the last possible date without
missing due dates and losing discounts. The clerk sends payment approval in the form of
the AP packet (PO, receiving report, and supplier’s invoice) to the cash disbursements
department.

Prepare Cash Disbursement

The cash disbursements clerk receives the AP packet and reviews the documents for
completeness and clerical accuracy. For each disbursement, the clerk prepares a check
and records the check number, dollar amount, and other pertinent data in the check
register, which is also called the cash disbursements journal. Figure 5-11 shows an
example of a check register.
Figure 5-11Cash Disbursements Journal (Check Register)

Depending on the organization’s materiality threshold, the check may require additional
approval by the cash disbursements department manager or treasurer (not shown
in Figure 5-10). The negotiable portion of the check is mailed to the supplier; a copy of it
is attached to the AP packet as proof of payment; and a check copy is filed in the
department. The clerk marks the documents in the packet paid and returns them to the
AP clerk. Finally, the cash disbursements clerk summarizes the entries made to the check
register and sends a journal voucher with the following journal entry in to the general
ledger function:

DR CR

Accounts Payable XXXX.XX

Cash XXXX.XX

Update AP Record
Upon receipt of the paid AP packet, the AP clerk removes the liability by debiting the
vendor’s AP subsidiary ledger account. The AP packet is then filed in the closed AP file,
and an account summary is prepared and sent to the general ledger function.

Post to General Ledger

The general ledger function receives the journal voucher from cash disbursements and
the AP account summary from accounts payable. The voucher shows the total reductions
in the firm’s obligations and cash account as a result of payments to suppliers. These
numbers are reconciled with the AP summary, and the AP control and cash accounts in
the general ledger are updated accordingly. The approved journal voucher is then filed.
This concludes the cash disbursements procedures.
 5-2Physical Systems
We saw in Chapter 4 that physical accounting information systems are a combination of
computer technology and human activity. The mix of possible technology/human options
creates a continuum. At one end are minimal technology systems that rely heavily on
human involvement and manual procedures. At the other end of the continuum are
advanced technology systems, which replace human activity with automated processes.

Systems at different points on the continuum operate differently and present different
internal control issues. The objectives of this section are to:

 (1)
illustrate accounting information systems (AIS) functionality and work flow
patterns under different levels of technology and

 (2)
demonstrate how the internal control profile changes as the technology/human
mix changes.
To accomplish this we review examples of systems at different points on the continuum.
The first example is a basic technology system that employs independent PCs, which
function primarily as record-keeping devices. The second example is an advanced
technology system that integrates all business functions through a centralized computer
application.
5-2aBasic Technology Expenditure Cycle
This section presents examples of basic technology expenditure cycle systems. The
computers used in these systems are independent (non-networked) PCs. Therefore,
information flows between departments are communicated via hard-copy documents. In
addition, in such systems, maintaining physical files of source documents is critical to the
audit trail. As we walk through the flowcharts, notice that in many departments, after an
individual completes his or her assigned task, documents are filed as evidence that the
tasks were performed.

Basic Technology Purchases Processing System

The system flowchart in Figure 5-12 shows the processes, documents, and data files of a
basic technology sales order system. The following sections outline the key activities in
this system.

Figure 5-12Basic Technology Purchases System

 Inventory Control
The process begins when the inventory control clerk prints purchase requisitions from
his PC by accessing the purchase requisition file. Recall that this file was created during
the sales activity when the inventories dropped to their predetermined reorder point.
One copy of the requisition is sent to the purchasing department, and one copy is placed
in the hard-copy open purchase requisition file. Note that to provide proper
authorization control, the inventory control department is segregated from the
purchasing department, which executes the purchase transaction.

Purchasing Department
The purchasing department receives the purchase requisitions, sorts them by vendor,
and adds a record to the digital open purchase order file. The clerk then prints a
multipart PO for each vendor. One copy of the PO is sent to the vendor. One copy is sent
to inventory control, where the clerk files it with the open purchase requisition. One copy
of the PO is sent to the AP for filing in the AP pending file. One copy (the blind copy) is
sent to the receiving department, where it is filed until the inventories arrive. The clerk
files the last copy along with the purchase requisition in the department.

Receiving
The receiving department clerk receives the goods and the packing slip from the vendor
and reconciles the goods with the blind copy of the PO. Upon completion of the physical
count and inspection, the receiving clerk adds a digital record to the receiving report file
and prints a multipart hard-copy receiving report stating the quantity and condition of
the inventories. One copy of the receiving report accompanies the physical inventories to
the storeroom. Another copy is sent to the purchasing department, where the purchasing
clerk reconciles it with the open PO and closes the digital record in the open PO file. The
purchasing clerk then files the hard-copy receiving report along with the previously filed
purchase requisition and the PO.

The third copy of the receiving report is sent to inventory control where (assuming a
standard cost system) the clerk uses the department PC to update the digital inventory
subsidiary ledger. The system automatically removes the “on-order” flag that was set
when the purchase requisition was created. The inventory control clerk then files the
hard-copy receiving report in the department, along with the PO and the purchase
requisition.

The fourth copy of the receiving report is sent to the AP department, where it is filed in
the AP pending file. Finally, the receiving clerk files the blind copy PO and the packing
slip in the receiving department.
 AP Department
When the supplier’s invoice arrives, the AP clerk reconciles the invoice, purchase order,
and receiving report (three-way match) and prepares an AP packet, which in this paper-
oriented system is simply a folder containing the reconciled supporting documents. The
clerk next records the transaction in the digital purchases journal, and posts the liability
to the supplier’s account in the AP subsidiary ledger. The clerk then files the AP packet in
the open AP file.

General Ledger Department

The general ledger department receives a journal voucher from the AP department and
an account summary from inventory control. The general ledger clerk reconciles these
and posts to the inventory and AP control accounts. With this step, the purchases phase
of the expenditure cycle is completed.

Basic Technology Cash Disbursements System

A detailed system flowchart of a basic cash disbursements system is presented in Figure
5-13. The tasks performed in each of the key processes are discussed next.

Figure 5-13Basic Technology Cash Disbursements System

 AP Department
Each day, the AP clerk reviews the AP packets in the open AP file for items due, and sends
the supporting documents to the cash disbursements department.

Cash Disbursements Department

The cash disbursements clerk receives the AP packets and reviews the documents for
completeness and clerical accuracy. For each disbursement, the clerk prepares a three-
part check and records the check number, dollar amount, and other pertinent data in the
check register.

The check, along with the supporting documents, goes to the cash disbursements
department manager, or treasurer, for his or her signature. The negotiable portion of the
check is mailed to the supplier. The clerk returns the AP packet and check copy to the AP
department and files one copy of the check. Finally, the clerk summarizes the entries
made to the check register and sends a journal voucher to the general ledger department.

AP Department
Upon receipt of the AP packet, the AP clerk removes the liability by debiting the vendor’s
digital AP subsidiary record. Next, the AP packet is filed in the closed AP file. Finally, the
clerk sends an AP summary to the general ledger department.

General Ledger Department

Based on the journal voucher from cash disbursements and the account summary from
accounts payable, the general ledger clerk uses the department PC to post to the GL
control accounts and files the documents. This concludes the cash disbursements
procedures.

5-2bAdvanced Technology Expenditure

Cycle
Recall from Chapter 4 that the purpose of advanced technologies in AIS is to integrate
accounting and other business functions through a common information system.
Integration improves operational performance and reduces costs by eliminating
nonvalue-added tasks. In this section, we see how advanced technologies can
significantly alter and simplify the expenditure cycle, compared to the basic technology
system presented in the previous section. We begin by reviewing the operational
features of an integrated purchases system, and then we examine an integrated cash
disbursements system.
5-2cIntegrated Purchases Processing
System
The flowchart in Figure 5-14 illustrates an integrated purchases system. Notice that the
level of departmental activity is significantly lower than that of the basic technology
system presented in Figure 5-12. Labor-intensive activities that characterize the basic
technology system add greatly to the cost of system operation and result in human error.
In the advanced technology system, computer programs perform many clerical tasks,
which is much cheaper and far less prone to error. Although the traditional department
structure still exists in advanced technology environments, personnel responsibilities are
refocused on financial analysis and exception-based problem-solving, rather than on day-
to-day clerical tasks. As a result, these departments are smaller and more efficient than
their basic technology counterparts. Each phase of this reengineered system is described
next.

Figure 5-14Integrated Purchases System

 Computer Operations
The purchases computer application performs the following tasks automatically:

1. The system reads the purchases requisition file for items that need to be
replenished. The requisitions are then sorted by the vendor and matched against
the valid vendor file for vendor address and contact information.
2. Hard-copy purchase orders are prepared and sent to the vendor.
3. A record is added to the open PO file.
4. A digital transaction listing of POs is created, which is downloaded by the
purchasing agent, reviewed, and filed in the department.

Receiving Department
When the goods arrive, the receiving clerk accesses a blind copy of the open PO file in
real time by entering the PO number taken from the packing slip. The receiving screen,
illustrated in Figure 5-15, then prompts the clerk to enter the quantities received for each
item on the PO. The following tasks are performed automatically by the system:

1. A record is added to the receiving report file.

2. Quantities of items received are matched against the open PO record, and the PO
is closed by placing the receiving report number in the PO closed flag. Figure 5-
16 presents possible structures for the PO and receiving report files.
3. The inventory subsidiary records are updated to reflect the receipt of the
inventory items.
4. The general ledger inventory control account is updated.

Figure 5-15Receiving Screen
Figure 5-16File Structure for AP Supporting Documents

Accounts Payable Department

When the AP clerk receives the supplier’s invoice, the clerk accesses the system and adds
a record to the vendor invoice file. The clerk then files the hard-copy invoice in the
department. The following tasks are performed automatically by the system:

1. Using the PO number as a common attribute, the system links the vendor invoice
to the associated purchase order and receiving report records (see Figure 5-16).
2. The system reconciles the supporting documents and creates a virtual AP packet
to authorize payment.
3. The system displays the virtual AP packet on the AP clerk’s computer screen for
review. Figure 5-17 presents an example of an AP packet screen display. The
virtual AP packet allows the AP clerk to browse the supporting documents and
modify documents if necessary to reconcile quantity or price discrepancies that
may exist.
4. Assuming no discrepancies that demand the AP clerk’s intervention, the system
automatically approves payment and sets a payment due date.
Figure 5-17Virtual AP Packet

Many companies engaged in business-to-business (B2B) transactions use the vendor

invoice file as a substitute for the traditional purchases journal and AP subsidiary ledger.
The invoices in the file provide a chronological record of total purchases for the period
(equivalent to the purchases journal), and the unpaid invoices at any point in time
constitute the organization’s accounts payable.
5-2dIntegrated Cash Disbursements System
Figure 5-18 illustrates a cash disbursements system in which the organization makes
vendor payments with hard-copy checks that are mailed to the vendor. Organizations
that use electronic funds transfer (EFT) to transmit payments employ different
procedures that are described in Chapter 12. Each day, the DUE DATE fields of the vendor
invoice records are scanned for items due to be paid. The following procedures are
performed on items that are due:

1. Checks are automatically printed, signed, and distributed to the mail room for
mailing to vendors. Checks above a preset materiality threshold will receive
additional signatures (not shown) prior to being mailed.
2. The payments are automatically recorded in the check register file.
3. Vendor invoices are closed by placing the check number in the closed flag field
(see Figure 5-18).
4. The general ledger AP control and cash accounts are updated.
5. Reports detailing these transactions are transmitted via a terminal to the AP and
cash disbursements departments for management review and filing.

Figure 5-18Integrated Cash Disbursements System

5-2eExpenditure Cycle Risks and Internal
Controls
An objective of internal control is to mitigate the risk from errors and fraud. The
following are the primary risks associated with expenditure cycle transactions:

 Unauthorized inventory purchases

 Receiving wrong items, incorrect quantities, or damaged goods
 Inaccurately recording purchases and cash disbursement transactions in journals
and accounts
 Misappropriation of cash and inventory
 Unauthorized access to accounting records and confidential reports
To reiterate an important concept introduced in Chapter 3, internal control activities
consist of

 (1) physical controls and

 (2) IT controls.
The purpose of physical controls is to control the actions of people. These consist of six
classes of internal control activities: transaction authorization, segregation of duties,
supervision, accounting records, access control, and independent verification. IT controls
comprise general controls and application controls. General controls are not specific to a
particular cycle or subsystem and thus do not apply to expenditure cycle risks directly.
Computer application controls consist of input controls, processing controls, and output
controls. The discussion that follows examines and compares how physical and IT control
techniques apply in both basic technology and advanced technology systems to reduce
the risks identified earlier. Table 5-1 at the end of the section provides a summary of this
material.

Table 5-1
Summary of Expenditure Cycle Risks and Controls
Risk Physical Control IT Control

Unauthorized inventory Transaction Authorization—formal purchase Automated purchase approval

purchases requisition

Receiving Incorrect Items Independent verification—Receiving department Scanner technology

reconciles receipt with the PO

Supervision in Receiving Department

Risk Physical Control IT Control

Inaccurate record keeping Transaction authorization—AP department authorizes Input data edits
cash disbursements to make payment
Error Messages
Accounting records—audit trail documents, journals,
accounts, and files Automated posting to accounts

Independent verification—inventory control, accounts File backup

payable, cash disbursements, and GL

Misappropriation of Cash Supervision—receiving department Automated three-way match

and inventory
Independent verification—three-way match Multilevel Security to provide
segregation of duties
Segregation of duties—cash disbursements, GL, AP
function, warehouse, inventory records

Unauthorized access to Access control—source documents, journals, ledgers Password control

data
Segregation of duties—sub-ledgers, GL, asset custody Multilevel security to prevent
unauthorized access to data

Risk of Unauthorized Inventory Purchases

Unauthorized inventory purchases places the decision of what to buy, when to buy, and
from whom to buy solely at the discretion of the purchasing agent. This can result in
excessive inventory levels for some items, while others go out of stock. Either situation is
potentially damaging to the firm. Excessive inventories tie up the organization’s cash
reserves, and stock-outs cause lost sales and manufacturing delays. Furthermore, such
discretion can lead to frauds such as kickbacks to purchasing agents from unapproved
suppliers who charge above-market prices for their inventory.

Physical Controls
Transaction Authorization
The objective of transaction authorization is to ensure that only valid transactions are
processed. When inventory levels drop to their predetermined reorder points, inventory
control formally authorizes replenishment with a purchase requisition to trigger the
purchasing function. Formalizing the authorization process promotes efficient inventory
management and ensures the legitimacy of purchase transactions with valid vendors.

IT Controls
Automated Purchase Approval
The objective of automated purchase approval is to prevent unauthorized purchases
from unapproved vendors. Therefore, computer logic, not a human being, decides when
to purchase, what to purchase, and from which vendor. The key attributes needed to
execute this logic come from the purchase requisition file and the valid vendor file.
Proper functioning of this control depends on adequate procedures for identifying
vendors and placing them on the valid vendor list. If access to the valid vendor file is not
specifically controlled via password and/or encryption (discussed in Chapter 12), an
unapproved vendor could be added to the file, and the control would be circumvented.
To allow for operational flexibility in unusual circumstances, however, the system should
provide a management override option to purchase from unapproved vendors, which
may be performed only by a supervisor. Any such overrides should be fully documented
in management reports.

Risk of Receiving Incorrect Items, Quantities, or Damaged Goods

The receiving department is responsible for inspecting and counting large quantities of
valuable assets that arrive from vendors. Once inspected, a receiving report is prepared
and the inventories are stored in the warehouse. Failure to perform the receiving task
correctly places the firm at risk of accepting incorrect items, incomplete orders, and
damaged goods.

Physical Controls
Independent Verification
When goods arrive from the supplier, receiving clerks verify that the items are correct in
type and quantity and inspect them for condition (damage, spoilage, etc.). To perform
this verification, the clerk obtains a “blind copy” of the original PO from purchasing. A
blind PO has all the relevant information about the goods being received except for the
quantities and prices. To obtain quantity information, which is needed for the receiving
report, the receiving personnel are forced to physically count and inspect the goods.

Supervision
Supervision is critical at this point to ensure that the clerks properly carry out these
important duties. Packing slips, which contain quantity information and could be used to
circumvent the inspection process, typically accompany the incoming goods. A
supervisor should take custody of the packing slip while receiving clerks count and
inspect the goods. If receiving clerks are provided with quantity information via an open
PO or packing slip, they may be tempted to transfer this information to the receiving
report without performing a physical count and inspection.

IT Controls
Scanner Technology
The basic concept of inspection can be enhanced through the use of IT controls. Product
code scanners in the receiving department and warehouse will reduce the risk of human
error in receiving and storing incorrect products. When scanned by the receiving clerk
and the warehouse, the system will verify that the items received match those on the
purchase order.

Risk of Inaccurately Recording Transactions in Journals and

Ledgers
Inaccurate record keeping can take many forms. The following outlines some common
expenditure cycle errors but is not intended to be an exhaustive list:

 Purchases from vendors are incorrectly calculated.

  Accounts payable go unrecorded or are recorded in the wrong period.
 Vendor bills customers for items they did not receive (back ordered).
 Vendor cash payments are inaccurately posted to accounts payable or are posted
to the wrong vendor accounts payable.
 Summaries of purchases, accounts payable, cash disbursements, and inventory
levels are incorrectly posted to their respective GL accounts.
Physical Controls
Transaction Authorization
The AP function authorizes cash disbursements via the AP packet. To provide effective
control over the flow of cash from the firm, the cash disbursement function should not
write checks without this explicit authorization.

Accounting Records
The control objective of accounting records is to maintain an audit trail adequate for
tracing a transaction from its source document to the financial statements. The
expenditure cycle employs the following accounting records: AP subsidiary ledger, check
register, and general ledger. The auditor’s concern in the expenditure cycle is
that obligations may be materially understated on financial statements because of
unrecorded transactions. This is a normal occurrence at year-end closing simply because
some supplier invoices do not arrive in time to record the liabilities. This also happens,
however, in an attempt to intentionally underreport liabilities. Hence, in addition to the
routine accounting records, expenditure cycle systems must be designed to provide
supporting information, such as the purchase requisition file, the PO file, and the
receiving report file. By reviewing these peripheral files, auditors may obtain evidence of
inventory purchases that have not been recorded as liabilities.

Independent Verification
The general ledger function provides an important independent verification in the
system. It receives journal vouchers and summary reports from inventory control,
accounts payable, and cash disbursements. From these sources, the general ledger
function verifies that the total obligations recorded equal the total inventories received
and that the total reductions in accounts payable equal the total disbursements of cash.
Many transaction errors that might occur in the source subsystems will be flagged by
discrepancies in the summary numbers that they submit.

IT Controls
Input Data Edits
Recall that a basic assumption in transaction processing system design is that master
files, such as the inventory, the accounts payable, and the general ledger, are “clean” and
error-free. Transaction data, in contrast, are assumed to be “dirty” and contain various
errors such as transposed digits in account numbers, invalid inventory part numbers, and
clerical errors. If not detected before being processed, these errors will corrupt the
master files of the system.

Input controls are edits that focus on the integrity of transaction data being entered into
the application. The following edits are programed into the system to minimize the risk
from data input errors.
 1. Controls, including checks for missing data, numeric-alphabetic data, and invalid
data values, will reduce the risk of undetected data entry errors by clerks in the
AP, inventory control, receiving, and cash disbursements departments.
2. Check digit control will provide control over accessing the wrong accounts. Long
vendor and inventory account numbers are susceptible to transcription and
transposition errors during data entry. A check digit control will reduce the risk of
such errors when department clerks enter account numbers into their systems.
Error Messages
When posting to the inventory and AP subsidiary ledgers, the computer program logic
must correctly identify the inventory and vendor records being updated by matching the
inventory item numbers and the vendor account numbers in the receiving report and
supplier’s invoice to those in the inventory and AP subsidiary files, respectively. Any
mismatch conditions should produce an error message to the computer operator.

Automated Postings to Subsidiary and GL Accounts

The record-keeping functions, which in basic technology systems are performed
manually by accounting clerks, are automated in the advanced technology system. In a
manual environment, segregation of duties among inventory control, purchasing, AP,
cash disbursements, and the general ledger functions is the important physical control
designed to prevent or detect human errors and fraud. In the advanced technology
system, a computer application, which is not subject to human failings such as yielding to
situational pressures and/or lacking ethical standards, decides which accounts to update
and by how much. By eliminating the human element from accounting activities, the
potential for errors and opportunities for fraud are significantly reduced. Also, since
these are labor-intensive activities, automating them greatly improves efficiency of
operations.

These automation benefits depend upon the proper functioning of the computer
applications that perform accounting tasks. An undetected program error may affect
thousands or even millions of transactions with devastating consequences to the
financial statements. An organization’s systems development and program change
process is therefore critical to ensuring that computer applications do what they are
intended to do when they are placed into service and are protected from accidental,
malicious, or fraudulent modifications over their service lifetime. In assessing application
integrity, auditors seek answers to such questions as: Is the logic of the computer
program correct? Has anyone tampered with the application since it was last tested?
Have changes been made to the program that could have caused an undisclosed error?
The general controls and audit tests that provide answers to these questions are
discussed at length in Chapter 16.

File Backup
The physical loss, destruction, or corruption of digital accounting records are serious
concerns that were discussed in Chapter 3. File backup procedures need to be in place as
part of the daily processing of transaction data. The accountant should verify that such
procedures are performed for all subsidiary and general ledger files.

Risk of Misappropriation of Cash and Inventory

The greatest risk of inventory theft occurs in the receiving department and the
warehouse. Misappropriation of cash may take the form of fraudulent payments to
individuals posing as vendors. It may also involve erroneous payments for items not
ordered or not received. These risks can be reduced through controls such as
supervision, independent verification, segregation of duties, and automated procedures.

Physical Controls
Supervision
Receiving departments are sometimes hectic and cluttered during busy periods. In this
environment, incoming inventories are exposed to theft until they are secured in the
warehouse. Inadequate supervision can create an environment conducive to the theft of
inventories in transit.

Independent Verification
The AP function plays a vital role in the verification of the work others in this system
have done. Copies of key source documents flow into this department for review and
comparison. Each document contains unique facts about the purchase transaction, which
the AP clerk must reconcile before the firm recognizes an obligation. This control is called
a three-way match and involves the following three documents:

1. The PO, which shows that the purchasing agent ordered only the needed
inventories from a valid vendor.
2. The receiving report, which is evidence of the physical receipt of the goods, their
condition, and the quantities received. The reconciliation of this document with
the PO signifies that the organization has a legitimate obligation to pay.
3. The supplier’s invoice, which provides the financial information needed to record
the obligation as an account payable. The AP clerk verifies that the prices on the
invoice are reasonable compared with the expected prices on the PO.
Segregation of Duties—Inventory Control from Inventory Warehouse
This point was made in Chapter 4. Inventory control keeps the detailed records of the
asset, while the warehouse (stores) has asset custody. These tasks should be kept
separate. At any point, an auditor should be able to reconcile inventory records to the
physical inventory.

Segregation of Duties—Accounts Payable from Cash Disbursements

An individual with combined responsibilities for establishing accounts payable and for
writing checks to vendors in payment of accounts payable could perpetrate a fraud
against the firm. For instance, he or she could establish fraudulent liabilities (to an
associate posing as a vendor company) and then write checks to discharge the phony
obligations. Segregating these functions greatly reduces the potential for this type of
fraud.

IT Controls
Automated Three-Way Match and Payment Approval
An automated three-way match replicates the manual counterpart as follows: When the
AP clerk receives the supplier’s invoice, the clerk accesses the system and adds a record
to the vendor invoice file. This act prompts the system to automatically create a virtual
AP packet by linking the vendor invoice to the associated purchase order and receiving
report records, using the PO number as a common attribute. The application then
reconciles the supporting documents, using programmed criteria for assessing
discrepancies. For example, the system may be programmed to approve payment of any
invoice amount that does not exceed $100 and 1 percent of the estimated price on the
 purchase order. Items that fall within limits are automatically approved and paid on their
due date. Discrepancies in excess of the threshold are submitted to management for
review and manual approval. Through the virtual AP packet screen, management may
view the supporting documents and exercise an override of the system controls to force
payment. The override should be performed only by authorized management and should
be fully documented in management reports.

Multilevel Security
This is a programmed technique that allows multiple individuals to simultaneously
access a system, but provides segregation of duties to limit their access privileges and
activities. This technique is discussed further in the next section.

Risk of Unauthorized Access to Accounting Records and Reports

Accounting information is at risk to unauthorized access from outsiders as well as
employees of the organization. The motives for accessing accounting information
include:

 Attempts to perpetrate a vendor fraud.

 Theft of physical inventory. Access to inventory records allows the perpetrator to
conceal the theft.
 Malicious acts such as corrupting or deleting financial data.
Physical Controls
Access Control
A firm must limit access to documents that control its physical assets. For example, an
individual with access to purchase requisitions, purchase orders, and receiving reports
has the ingredients to construct a fraudulent purchase transaction. With the proper
supporting documents, a fraudulent transaction can be made to look legitimate to the
system and could be paid.

Segregation of Duties
An objective of segregation of duties provided in Chapter 3 states that:

The organization should be so structured that the perpetration of a fraud requires collusion between two or
more individuals.
To achieve this objective, certain record-keeping tasks should be separated. Specifically,
subsidiary ledgers (accounts payable and inventory), journals (purchases and cash
disbursements), and the general ledger should be separately maintained. An individual
with total record-keeping responsibility, in collusion with someone with asset custody, is
in a position to perpetrate a fraud. Although not entirely eliminated, the risk of collusion
is reduced while segregating these tasks. The more people involved in a task, the more
difficult it is to collude and greater the risk of detection. This will have a deterrent effect
on those contemplating fraud.

IT Controls
Password Control
In Chapter 4, we discussed how digital accounting records are vulnerable to
unauthorized access. To mitigate these risks, organization management should
implement a robust password control policy to prevent unauthorized access to computer
files and programs that reside in each of the departments. The application logic should
require, and prompt, users to change passwords periodically. Corporate policy should
require strong passwords of six or eight characters that consist of both alphabetic and
numeric characters. We examine password control issues in detail in Chapter 15.

Multilevel Security
Chapter 4 introduced the concept of multilevel security, which employs programmed
techniques that permit simultaneous access to a central system by many users with
different access privileges, but prevents them from obtaining information for which they
lack authorization. Two methods for achieving multilevel security are the access control
list (ACL) and role-based access control (RBAC). Through these techniques, purchasing,
receiving, AP, cash disbursements, and general ledger personnel are limited in their
access based on the privileges assigned to them. ACL and RBAC are discussed in greater
detail in later chapters.
5-2fReengineering Using EDI
We saw in Chapter 4 that EDI technology was devised to expedite routine transaction
processing between manufacturers, wholesalers, and retailers by connecting buyer and
seller computers via a private network or the Internet. When the buyer’s computer
system detects the need to order inventory, it automatically transmits a purchase order
to the seller, which is approved and processed by the vendor system with little or no
human involvement.

A key element of successful EDI is the implementation of a trading partner agreement to

eliminate the discrepancies that require human involvement to resolve. In particular, the
receiving function and the AP task of reconciling purchase orders, receiving reports, and
supplier invoices are labor-intensive and costly. The following examples show how
reengineering these activities can produce considerable cost savings.

The Ford Motor Company employed more than 500 clerks in its North American AP
department. Analysis of the function showed that a large part of the clerks’ time was
devoted to reconciling discrepancies among supplier invoices, receiving reports, and POs.
These discrepancies were the result of too many vendors and unreliable vendors. The
first step in solving the problem was to change the business environment; therefore, Ford
initiated trading partner agreements with a reduced number of suppliers. The parties
agreed in advance to terms of trade such as price, quality, quantities to be shipped,
discounts, and lead times. Also, each item used by Ford would be supplied by a single
vendor. With key sources of discrepancy eliminated, Ford reengineered its work flow to
take advantage of the new environment. The key features of the system are as follows:

1. As inventory needs are detected, the system automatically sends a digital EDI
purchase order to the vendor.
2. When the goods arrive, receiving personnel perform only cursory inspection since
quality and quantity are guaranteed by the trading partner agreement.
3. Because the financial information about purchases is known in advance from the
trading partner agreement, the vendor’s invoice provides no critical information
that cannot be derived from the receiving report. By eliminating this source of
potential discrepancy, Ford was able to eliminate the three-way match for the
majority of purchase transactions.
4. Payment is made automatically by EFT directly to the vendor’s bank account.
As a result of its reengineering effort, Ford was able to simplify its work flow and reduce
its AP staff from 500 to 125.

Some organizations have taken reengineering even further by eliminating the receiving
function entirely. The objective of this is to send goods directly to the production
department and thus bypass the receiving area and avoid production delays and the
associated handling costs. An accounting and auditing problem that must be overcome is
how to account for inventory receipts when there is no receiving function and no
receiving report. One way of dealing with this is to calculate the number of parts received
based on the products produced in which the parts are components. Supplier payments
are distributed based on production (part usage), and by having only one supplier per
part, the question of which supplier to pay is self-evident. An additional problem to deal
with is accounting for scrap in the production process. Since scrap does not end up in
finished production, it will not be counted, and vendors will not be paid for materials that
were scrapped. Separate accounting procedures need to be implemented to record and
monitor scrap. This issue is examined in Chapter 7.

EDI Control Issues

EDI poses unique risks for organizations that need to be recognized and controlled. One
of them is ensuring that, in the absence of explicit authorization, only valid transactions
are processed. Another risk is that a trading partner, or someone masquerading as a
trading partner, will access the firm’s accounting records in a way that is unauthorized by
the trading partner agreement. Chapter 12 presents EDI in more detail and its
implications for business. EDI control issues are discussed in Chapter 15.
 Chapter Review

5-3aSummary
This chapter is organized into two primary sections. The first examined conceptually the
expenditure cycle of a typical merchandising firm and focused on (1) the functional areas
and the flow of transaction information that triggers key tasks and (2) the documents,
journals, and accounts that support audit trails, decision making, and financial reporting.

The second section examined physical expenditure cycle systems that lie at different
points on the technology/human continuum. The objectives of this section were to (1)
illustrate system functionality, efficiency issues, and work flow characteristics of
different technologies and (2) demonstrate how internal control issues differ between
systems at various points on the technology/human continuum. The section reviewed
physical controls and computer controls associated with basic technology systems and
advanced integrated systems. The chapter concluded by outlining the benefits, key
features, and risks associated with EDI systems. EDI systems are discussed in detail in
later chapters.
 Chapter Review
5-3bKey Terms
 actual cost inventory ledger
 AP packet
 AP pending file
 AP subsidiary ledger
 blind copy
 cash disbursement vouchers
 cash disbursements journal
 check register
 closed AP file
 open AP file
 open purchase order file
 open purchase requisition file
 open/closed purchase order file
 purchase order
 purchase requisition
 purchase requisition file
 receiving report
 receiving report file
 standard cost system
 supplier’s invoice
 valid vendor file
 vendor’s invoice
 voucher register
 vouchers payable file
 vouchers payable system
 Chapter Review
5-3cReview Questions
1. Differentiate between a purchase requisition and a purchase order.
2. What purpose does a purchasing department serve?
3. Distinguish between an AP file and a vouchers payable file.
4. What are the three logical steps of the cash disbursements system?
5. What general ledger journal entries does the purchases system trigger? From which departments
do these journal entries arise?
6. What two types of risks can close supervision of the receiving department reduce?
7. What is a three-way match?
8. What steps of independent verification does the general ledger department perform?
9. What is (are) the purpose(s) of maintaining a valid vendor file?
10. Some organizations do not use an AP subsidiary ledger or a purchases journal. How is this
possible?
11. What is the purpose of the blind copy of a PO?
12. Give one advantage of using a vouchers payable system.