AIS Chapter 5: Transaction Cycles and Accounting Applications

CHAPTER FIVE
TRANSACTION CYCLES AND ACCOUNTING APPLICATIONS

5.1 Organizing accounting applications

Transaction process applications process financial transactions. A financial transaction was
defined inChapter 1 asan economic event that affects the assets and equities of the firm, is
reflected in its accounts, and is measured in monetary terms. The most common financial
transactions are economic exchanges with external parties. These include the sale of goods or
services, the purchase of inventory, the discharge of financial obligations, and the receipt of
cash on account from customers. Financial transactions also include certain internal events
such as the depreciation of fixed assets; the application of labor, raw materials, and overhead to
the production process; and the transfer of inventory from one department to another.
Financial transactions are common business events that occur regularly. For instance, thousands
of transactions of a particular type (sales to customers) may occur daily. To deal efficiently with
such volume, business firms group similar types of transactions into transaction cycles.

5.2 Processing models

Three transaction cycles process most of the firm’s economic activity: the expenditure
cycle, the conversion cycle, and the revenue cycle. These cycles exist in all types of businesses—
both profit-seeking and not-for-profit. For instance, every business (1) incurs expenditures in
exchange for resources (expenditure cycle), (2) provides value added through its products or
services (conversion cycle), and (3) receives revenue from outside sources (revenue cycle).
Figure 5-1 shows the relationship of these cycles and the resource flows between them.
5.3 The Revenue Cycle
Firms sell their finished goods to customers through the revenue cycle, which involves
processing cash sales, credit sales, and the receipt of cash following a credit sale. Revenue cycle
transactions also have a physical and a financial component, which are processed separately. The
primary subsystems of the revenue cycle are briefly outlined below.
Sales order processing.
processing. The majorities of business sales are made on credit and involve
tasks such as preparing sales orders, granting credit, shipping products (or
rendering of a service) to the customer, billing customers, and recording the
transaction in the accounts(accounts receivable, inventory, expenses, and sales).

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 AIS Chapter 5: Transaction Cycles and Accounting Applications
Cash receipts.
receipts. For credit sales, some period of time (days or weeks) passes between the
point of sale and the receipt of cash. Cash receipts processing includes collecting cash,
depositing cash in the bank, and recording these events in the accounts (accounts
receivable and cash).

• What are the four basic revenue cycle business activities?

1 Sales order entry
2 Shipping
3 Billing and accounts receivable
4 Cash collections

1. Sales order entry

Sales order entry process entails three steps:
1. Taking the customer’s order
2. Checking and approving the customer’s credit
3. Checking inventory availability

• The revenue cycle’s primary objective is to provide the right product in the right place at
the right time for the right price.

To accomplish the revenue cycle’s primary objective, management must make the following key
decisions:
 To what extent can and should products be customized to individual customers’ needs
and desires?
 How much inventory should be carried, and where should that inventory be located?
 How should merchandise be delivered to customers? Should the company perform the
shipping function itself or outsource it to a third party that specializes in logistics?
 Should credit be extended to customers?
 How much credit should be given to individual customers?
 What credit terms should be offered?
 How can customer payments be processed to maximize cash flow?
• The AIS should provide the operational information needed to perform the following
functions:
– Respond to customer inquiries about account balances and order status.

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 AIS Chapter 5: Transaction Cycles and Accounting Applications
– Decide whether to extend credit to a customer.
• Determine sufficient inventory availability to fill accepted orders.
• Decide what types of credit terms to offer.
• Set prices for products and services.
• Set policies regarding sales returns and warranties.
• Select methods for delivering merchandise.
 Internally generated documents produced by sales order entry are:
– sales order
– packing slip
– picking ticket
• Warehouse workers are responsible for filling customer orders by removing items from
inventory.
• Key decisions and information needs:
– Determine the delivery method.
• in-house
• outsource

Threats and Applicable Control Procedures toSales Order Entry

Threat Applicable Control Procedures

1. Incomplete or inaccurate Data entry edit checks

customer orders

2. Credit sales to customers with Credit approval by credit manager, not by sales function;
poor credit accurate records of customer account balances

3. Legitimacy of orders Signatures on paper documents; digital signatures and

digital certificates for e-business

4. Stock outs, carrying costs and Inventory control systems

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 AIS Chapter 5: Transaction Cycles and Accounting Applications
2. Shipping
The second basic activity in the revenue cycle – filling customer orders and shipping the desired
merchandise – entails two steps:
1. Picking and packing the order
2. Shipping the order
Two activities are performed at this stage of the revenue cycle:
3. Invoicing customers
4. Maintaining customer accounts

Threats and Applicable Control Procedures to Shipping

Threat Applicable Control Procedures

1. Shipping errors: Reconciliation of sales order with picking ticket and

• Wrong merchandise packing slip; bar code scanners; data entry application
• Wrong quantities controls
• Wrong address

2. Theft of inventory Restrict physical access to inventory; Documentation of

all internal transfers of inventory; periodic physical
counts of inventory and reconciliation of counts of
recorded amounts

3. Billing and accounts receivable

The third basic activity in the revenue cycle involves:
1. Billing customers
2. Updating accounts receivable
Key decisions and information needs:
o Accurate billing is crucial and requires information identifying the items and quantities
shipped, prices, and special sales terms.
o The sales invoice notifies customers of the amount to be paid and where to send payment.
o A monthly statement summarizes transactions that occurred and informs customers of their
current account balance.
o A credit memo authorizes the billing department to credit a customer’saccount.

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 AIS Chapter 5: Transaction Cycles and Accounting Applications

Types of billing systems:

2. In a post-billing system, invoices are prepared after confirmation that the items
were shipped.
3. In a pre-billing system, invoices are prepared (but not sent) as soon as the order
is approved.
The inventory, accounts receivable, and general ledger files are updated at this time.
time.

• Key decisions and information needs:

– Reduction of cash theft is essential.
– The billing/accounts receivable function should not have physical access to cash
or checks.
– The accounts receivable function must be able to identify the source of any
remittances and the applicable invoices that should be credited.
• a well-designed AIS is to provide adequate controls to ensure that the following
objectives are met:
– Transactions are properly authorized.
– Recorded transactions are valid.
Control:
– Valid, authorized transactions are recorded.
– Transactions are recorded accurately.
– Assets (cash, inventory, and data) are safeguarded from loss or theft.
– Business activities are performed efficiently and effectively.

Threats and Applicable Control Procedures to Billing and Accounts Receivable

Threat Applicable Control Procedures

1.Failure to bill customers Separation of shipping and billing functions; Pre-numbering of all
shipping documents and periodic reconciliation to invoices;
reconciliation of picking tickets and bills of lading with sales orders

2. Billing errors Data entry edit control, Price lists

3. Posting errors in updating Reconciliation of subsidiary accounts receivable ledger with

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 AIS Chapter 5: Transaction Cycles and Accounting Applications
accounts receivable general ledger; monthly statements to customers

4. cash collections
The fourth step in the revenue cycle is cash collections. It involves:
1. Handling customer remittances
2. Depositing remittances in the bank
 Two areas are involved in this activity:
1. The cashier
2. The accounts receivable function

Threat and Applicable Control Procedures toCash Collections

Threat Applicable Control Procedures

Theft of Cash Segregation of duties; minimization of cash handling; lockbox

arrangements; prompt endorsement and deposit of all receipts
Periodic reconciliation of bank statement with records by someone not
involved in cash receipts processing

5.4 The Expenditure Cycle

Business activities begin with the acquisition of materials, property, and labor in exchange cash
—the expenditure cycle. Figure 5-1 shows the flow of cash from the organization to the various
providers of these resources. Most expenditure transactions are based on a credit relationship
between the trading parties. The actual disbursement of cash takes place at some point after the
receipt of the goods or services. Days or even weeks may pass between these two events. Thus,
from a systems perspective, this transaction has two parts: a physical component (the
acquisition of the goods) and a financial component(the
component(the cash disbursement to the supplier). A
separate subsystem of the cycle processes each component. The major subsystems of the
expenditure cycle are outlined below.
Purchases/accounts payable system, this system recognizes the need to acquire
physical inventory (such as raw materials) and places an order with the vendor. When
the goods are received, the purchases system records the event by increasing inventory
and establishing an account payable to be paid at a later date.

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Cash disbursements system,
system, when the obligation created in the purchases system is
due,the cash disbursements system authorizes the payment, disburses the funds to the
vendor, and records the transaction by reducing the cash and accounts payable accounts.
Payroll system, the payroll system collects labor usage data for each employee,
computes the payroll, and disburses paychecks to the employees. Conceptually, payroll
is a special-case purchases and cash disbursements system. Because of accounting
complexities associated with payroll, most firms have a separate system for payroll
processing.
Fixed asset system,
system, a firm’s fixed asset system processes transactions pertaining to the
acquisition, maintenance, and disposal of its fixed assets. These are relatively permanent
items that collectively often represent the organization’s largest financial investment.
Examples of fixed assets include land, buildings, furniture, machinery, and motor
vehicles.
FIGURE 5-1 Relationship between Transaction Cycles

5.5 THE CONVERSION CYCLE

The conversion cycle is composed of two major subsystems: the production system and the cost
accounting system. The production system involves the planning, scheduling, and control of
the physical product through the manufacturing process. This includes determining raw
material requirements, authorizing the work to be performed and the release of raw materials into
production, and directing the movement of the work-inprocess through its various stages of
manufacturing. The cost accounting system monitors the flow of cost information related to

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 AIS Chapter 5: Transaction Cycles and Accounting Applications
production. Information produced by this system is used for inventory valuation, budgeting,
cost control, performance reporting, and management decisions, such as make-or-buy decisions.

Manufacturing firms convert raw materials into finished products through formal conversion
cycle operations. The conversion cycle is not usually formal and observable in service and
retailing establishments. Nevertheless, these firms still engage in conversion cycle activities that
culminate in the development of a salable product or service. Theseactivities include the
readying of products and services for market and the allocation of resources such as depreciation
of building, amortization, and prepaid expenses to the proper accounting period. However, unlike
manufacturing firms, merchandising companies do not process these activities through formal
conversion cycle subsystems.

5.6 General Ledger and Reporting System

This section describes the purpose of each type of accounting record used in transaction
cycles.
cycles. We begin with traditional records used in manual systems (documents, journals, and
ledgers) and then examine their magnetic counterparts in computer-based systems.
5.6.1 Manual-Based Systems
I. Documents:
Documents: A document provides evidence of an economic event and may be used to
initiate transaction processing. Some documents are a result of transaction processing. In this
section, we discuss three types of documents:
documents: source documents, product documents,
and turnaround documents.
A. Source Documents. Economic events result in some documents being created at the
beginning (the source) of the transaction. These are called source documents. Source
documents are used to capture and formalize transaction data that the transaction cycle
needs for processing. The economic event (the sale) causes the sales clerk to prepare a
multipart sales order, which is formal evidence that a sale occurred. Copies of this
source document enter the sales system and are used to convey information to various
functions, such as billing, shipping, and accounts receivable. The information in the
sales order triggers specific activities in each of these departments.
B. Product Documents. Product documents are the result of transaction processing rather
than the triggering mechanism for the process. For example, a payroll check to an
employee is a product document of the payroll system.

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C. Turnaround Documents. Turnaround documents are product documents of one
system that become source documents for another system. The customer receives a
perforated two-part bill or statement. The top portion is the actual bill, and the bottom
portion is the remittance advice. Customers remove the remittanceadvice and return it
to the company along with their payment (typically a check). A turnaround document
contains important information about a customer’s account to help the cash receipts
system process the payment. One of the problems designers of cash receipts systems
face is matching customer payments to the correct customer accounts. Providing this
needed information as a product of the sales system ensures accuracy when the cash
receipts system processes it.
II. Journals
A journal is a record of a chronological entry.
entry. At some point in the transaction process,when
all relevant facts about the transaction are known, the event is recorded in a journalin
chronological order. Documents are the primary source of data for journals. Each transaction
requires a separate journal entry, reflecting the accounts affected and the amounts to be debited
and credited. Often, there is a time lag between initiating a transaction and recording it in the
accounts. The journal holds a complete record of transactions and thus provides a means for
posting to accounts. There are two primary types of journals: special journals and general
journals.
Special Journals: Special journals are used to record specific classes of transactions
that occur in high volume.
volume. Such transactions can be grouped together in a special journal
and processed more efficiently than a general journal permits.
General Journals; Firms use the general journal to record nonrecurring, infrequent,
and dissimilar transactions. For example, we usually record periodic depreciation and
closing entries in the general journal.
III. Ledgers
A ledger is a book of accounts that reflects the financial effects of the firm’s transactionsafter
they are posted from the various journals. Whereas journals show the chronologicaleffect of
business activity, ledgers show activity by account type.
type. A ledger indicates theincreases,
decreases, and current balance of each account. Organizations use this information to prepare
financial statements, support daily operations, and prepare internalreports. Figure 5.2 shows the
flow of financial information from the source documents tothe journal and into the ledgers.There
are two basic types of ledgers:

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general ledgers,
ledgers, which contain the firm’s account information in the form of highly
summarized control accounts, and
Subsidiary Ledgers, which contain the details of the individual accounts that constitute
a particular control account.
Figure5.2. Shows the Flow of Economic Events into the General Ledger

The Audit Trail

The accounting records described previously provide an audit trail for tracing transactions from
source documents to the financial statements. Of the many purposes of the audit trail, most
important to accountants is the year-end audit. While the study of financial auditing falls outside
the scope of this text, the following thumbnail sketch of the audit process will demonstrate the
importance of the audit trail.
The external auditor periodically evaluates the financial statements of publicly held business
organizations on behalf of its stockholders and other interested parties. The auditor’s
responsibility involves, in part, the review of selected accounts and transactions to determine
their validity, accuracy, and completeness. Let’s assume an auditor wishes to verify the accuracy
of a client’s accounts receivable (AR) as published in its annual financial statements. The auditor
can trace the AR figure on the balance sheet to the general ledger AR control account. This
balance can then be reconciled with the total for the AR subsidiary ledger. Rather than
examining every transaction that affected the AR account, the auditor will use a sampling
technique to examine a representative subset of transactions. Following this approach, the auditor
can select a number of accounts from the AR subsidiary ledger and trace these back to the sales
journal. From the sales journal, the auditor can identify the specific source documents that
initiated the transactions and pull them from the files to verify their validity and accuracy.

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The audit of AR often includes a procedure called confirmation. This involves contacting
selected customers to determine if the transactions recorded in the accounts actually took place
and that customers agree with the recorded balance. Information contained in source documents
and a subsidiary account enables the auditor to identify and locate customers chosen for
confirmation. The results from reconciling the AR subsidiary ledger with the control account and
from confirming customers’ accounts help the auditor form an opinion about the accuracy of
accounts receivable as reported on the balance sheet. The auditor performs similar tests on all of
the client firm’s major accounts and transactions to arrive at an overall opinion about the fair
presentation of the financial statement. The audit trail plays an important role in this process.
5.6.2 Computer-Based Systems
A. Types of Files
While audit trails in computer-based systems are less observable than in traditional manual
systems, they still exist. Accounting records in computer-based systems are represented by
four different types of magnetic files: master files, transaction files, reference files, and
archive files
Master File. A master file generally contains account data.
data. The general ledger and subsidiary
ledgers are examples of master files. Data values in master files are updated from transactions.
Transaction File. A transaction file is a temporary file of transaction records used to change or
update data in a master file. Sales orders, inventory receipts, and cash receipts are examples of
transaction files.
Reference File.
File. A reference file stores data that are used as standards for processing
transactions. For example, the payroll program may refer to a tax table to calculate the proper
amount of withholding taxes for payroll transactions. Other reference files include price lists
used for preparing customer invoices, lists of authorized suppliers, employee rosters, and
customer credit files for approving credit sales.
Archive File:-An
File:-An archive file contains records of past transactions that are retained for future
reference. These transactions form an important part of the audit trail. Archive files include
journals, prior-period payroll information, lists of former employees, records of accounts
written off, and prior-period ledgers
B. Two types of computer based processing system
i. Batch Processing Using Real-Time Data Collection
A popular data processing approach, particularly for large operations, is to electronically capture
transaction data at the source as they occur. By distributing data input capability to users, certain

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transaction errors can be prevented or detected and corrected at their source. The result is a
transaction file that is free from most of the errors that plague older legacy systems. The
transaction file is later processed in batch mode to achieve operational efficiency. Figure 2-31
illustrates this approach with a simplified sales order system such as that used in a department
store. Key steps in the process are:
1. The sales department clerk captures customer sales data pertaining to the item(s)
being purchased and the customer’s account.
2. The system then checks the customer’s credit limit from data in the customer
record (account receivable subsidiary file) and updates his or her account balance
to reflect the amount of the sale.
3. Next the system updates the quantity on hand field in the inventory record
(inventory subsidiary file) to reflect the reduction in inventory. This provides up-
to-date information to other clerks as to inventory availability.
4. A record of the sale is then added to the sales order file (transaction file), which is
processed in batch mode at the end of the business day. This batch process
records each transaction in the sales journal and updates the affected general
ledger accounts
ii. Real-Time Processing
Real-time systems process the entire transaction as it occurs. For example, a sales order
processed and can be captured, filled, and shipped the same day. Such a system has many
potential benefits, including improved productivity, reduced inventory, increased inventory
turnover, decreased lags in customer billing, and enhanced customer satisfaction. Because
transaction information is transmitted electronically, physical source documents can be
eliminated or greatly reduced.
Real-time processing is well suited to systems that process lower transaction volumes and those
that do not share common records. These systems make extensive use of local area network
(LAN) and wide area network (WAN) technology. Terminals at distributed sites throughout the
organization are used for receiving, processing, and sending information about current
transactions. These must be linked in a network arrangement so users can communicate

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CHAPTER SUMMARY
This chapter divided the treatment of transaction processing systems into four major sections.
The first section provided an overview of transaction processing, showing its vital role as an
information provider for financial reporting, internal management reporting, and the support of
day-to-day operations. To deal efficiently with large volumes of financial transactions, business
organizations group together transactions of similar types into transaction cycles. Three
transaction cycles account for most of a firm’s economic activity: the revenue cycle, the
expenditure cycle, and the conversion cycle. The second section described the relationship
among accounting records in both manual and computer-based systems.Finally, the chapter
examined two computer techniques used for transaction processing: (1) batch processing using
real-time data collection and (2) real-time processing.
Chapter review questions
I. Short answer question’s
1. What three transaction cycles exist in all businesses?
2. Name the major subsystems of the expenditure cycle.
3. Identify and distinguish between the physical and financial components of the
expenditure cycle.
4. Name the major subsystems of the conversion cycle.

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5. Name the major subsystems of the revenue cycle.
6. Name the three types of documents.
7. Name the two types of journals.
8. Distinguish between a general journal and journal vouchers
II. Multiple choice questions
1. Which statement is not true?
A. .Business activities begin with the acquisition of materials, property, and labor in
exchange for cash.
B. The conversion cycle includes the task of determining raw materials requirements.
C. Manufacturing firms have a conversion cycle but retail firms do not.
D. A payroll check is an example of a product document of the payroll system.
E. A journal voucher is actually a special source document.
2. Which of the following files is a temporary file?
A. transaction file
B. master file
C. reference file
D. none of the above
3. Which of the following is true of the relationship between subsidiary ledgers and general
ledger accounts?
A. The two contain different and unrelated data.
B. All general ledger accounts have subsidiaries.
C. The relationship between the two provides an audit trail from the financial
statements to the source documents.
D. The total of subsidiary ledger accounts usually exceeds the total in the related
general ledger account.
2. Real-time systems might be appropriate for all of the following EXCEPT
A. Airline reservations.
B. Payroll.
C. Point-of-sale transactions.
D. Air traffic control systems.
E. All of these applications typically utilize real-time processing.
END

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