CHAPTER TWO

Overview of
Business Processes and
transactions

1
 Objectives

1 Explain the three basic functions performed by

an accounting information system (AIS).
2 Describe the documents and procedures used in
an AIS to collect and process transaction data.
3 Discuss the types of information that can be
provided by an AIS.
4 Describe the basic internal control objectives of
an AIS and explain how they are accomplished.

2
 Learning Objective 1

Explain the three basic functions

an accounting information
system (AIS) performs.

3
 The Three Basic Functions
Performed by an AIS
1 To collect and store data about the
organization’s business activities and
transactions efficiently and effectively:
– Capture transaction data on source
documents.
– Record transaction data in journals, which
present a chronological record of what
occurred.
– Post data from journals to ledgers, which sort
data by account type.

4
 The Three Basic Functions
Performed by an AIS
2 To provide management with information
useful for decision making:
– In manual systems, this information is
provided in the form of reports that fall into
two main categories:
– financial statements
– managerial reports

5
 The Three Basic Functions Performed
by an AIS
3 To provide adequate internal controls:
– Ensure that the information produced by the
system is reliable.
– Ensure that business activities are performed
efficiently and in accordance with
management’s objectives.
– Safeguard organizational assets.

6
 Basic Subsystems in the AIS

1. The revenue cycle: involves activities of

selling goods or services and collecting
payment for those sales.
2. The expenditure cycle: involves activities of
buying and paying for goods or services used
by the organization.
3. The human resources/payroll cycle: involves
activities of hiring and paying employees.
7
 Basic Subsystems in the AIS

4. The production cycle: involves activities

converting raw materials and labor into
finished goods.

5. The financing cycle: involves activities of

obtain in g n e ce ss a r y f u n d s t o r u n t h e
organization, repay creditors, and distribute
profits to investors.
8
 Basic Subsystems in the AIS

Financing Human
Cycle Resources

General Ledger & Reporting System

Production Revenue
Cycle Cycle

9
 10
Business Process

Accounting Information System

11
 The Data Processing Cycle

• The data processing cycle consists of four

steps:
1. Data input
2. Data storage
3. Data processing
4. Information Output

12
 The Data Processing Cycle

• The trigger for data input is usually

business activity. Data must be collected
about:
1. Each event of interest
2. The resources affected by each event
3. The agents who participate in each event

13
 1. Revenue Cycle
• The revenue cycle is a recurring set of business
activities and related information processing
operations associated with providing goods and
services to customers and collecting cash in payment
for those sales.
• The primary external exchange of information is with
customers.
• Information about revenue cycle activities also flows
to the other accounting cycles.
 Interaction of Revenue Cycle
• For example, the expenditure and production
cycles use information about sales transactions to
initiate the purchase or production of additional
inventory to meet demand.
• The human resources management/payroll cycle
uses information about sales to calculate sales
commissions and bonuses.
• The general ledger and reporting function uses
information produced by the revenue cycle to
prepare financial statements and performance
reports.
 Revenue Cycle
v The revenue cycle’s primary objective is to provide the right
product in the right place at the right time for the right price.
v To accomplish that objective, management must make the
following key decisions:
Ø To what extent can and should products be customized to
individual customers’ needs and desires?
Ø How much inventory should be carried, and where should that
inventory be located?
Ø 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?
Ø What are the optimal prices for each product or service?
Ø Should credit be extended to customers? If so, what credit terms
should be offered? How much credit should be extended to
individual customers?
Ø How can customer payments be processed to maximize cash flow?
 Revenue Cycle

Basic Activities:

Sales Cash
Order Shipping Billing collection
entry s
 Components of the Revenue Cycle

– Sales Order Processing

– Credit Management
– Order Fulfillment
– Billing
– Collections
– Cash Application
Revenue Cycle
RC: Sales-Cash collection
 Revenue Cycle Business Activities:
Sales Order Entry

Sales order entry process entails three steps:

1. Taking the customer’s order
2. C h e c k i n g a n d a p p r o v i n g t h e
customer’s credit
3. Checking inventory availability
 Revenue Cycle Business Activities:
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

 Revenue Cycle Business Activities:
Billing and Accounts Receivable
The third basic activity in the revenue cycle
involves:
1. Billing customers

2. Updating accounts receivable

Billing
 Revenue Cycle Business Activities:
Cash Collections
The fourth step in the revenue cycle is cash
collections.
It involves:
1. Handling customer remittances
2. Depositing remittances in the bank
 Revenue Cycle –
Key Decisiosns
• The revenue cycle’s primary objective is to
provide the right product in the right place
at he right time for the right price.
– How does a company accomplish this
objective?
• To accomplish the revenue cycle’s primary
objective, management must make the following
key decisions:
 Revenue Cycle–
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?
 Revenue Cycle –
Key Decisions
Key decisions, continued
• 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?
 Sales Order Entry (Activity 1)
• This step includes all the activities involved in
soliciting and processing customer orders.
• Key decisions and information needs:
– decisions concerning credit policies, including the
approval of credit
– information about inventory availability and customer
credit status from the inventory control and
accounting functions, respectively
 Sales Order Entry (Activity 1)
• The sales order entry function involves
three main activities:
1 Responding to customer inquiries
2 Checking and approving customer credit
3 Checking inventory available
 Orders 1.1
Customer Take Customer
Order
Re
jec
ted Orders
Ord
ers
Response
Inquiries

Ac 1.2
kn DFD for
ow
led Approve
gm Credit Sales Order Entry
en
t
Customer Approved
Orders

1.3
1.4 Check
Sales Order Inv. Inventory
Resp. to
Avail.
Cust. Inq. Bac
k Or
ders
Sales Sales Picking
Order Order List

Ware- Purchas-
Shipping Billing
house ing
 Information Needs
and Procedures
• The AIS should provide the operational
information needed to perform the
following functions:
– Respond to customer inquires about account
balances and order status.
– Decide whether to extend credit to a customer.
 Sales Order Entry (Activity 1)

• Regardless of how customer orders are initially

received, the following edit checks are
necessary:
– Validity checks
– A Completeness test
• Automatic lookup of reference data like customer address.
– Reasonableness tests
• comparing quantity ordered to past history.
– Credit approval
• General authorization
– Credit limit (for existing customers)
• Specific authorization
– Limit checks (new, have past-due balances, Exceeding)
 Sales Order Entry (Activity 1)
• Next, the system checks whether the
inventory is sufficient to fill accepted
orders.
• Internally generated documents produced
by sales order entry:
– sales order
– packing slip
– picking ticket
 Information Needs
and Procedures
• Determine inventory availability.
• 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.
 Shipping (Activity 2)

• 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
 Shipping
Sales Picking List 2.1
Order Pick &
Entry Pack

Goods &
Sales Packing
Order List
Sales Order

2.2
Bill of Ship Inventory
Lading & Goods
Packing Slip

Billing & Goods,

Packing Slip,
Accts.
& Bill of Lading
Shipments
Rec.

Carrier
 Shipping (Activity 2)

• Documents, records, and procedures:

– The picking ticket printed by the sales order entry
triggers the shipping process and is used to identify
which products to remove from inventory and the
quantities. The packing slip lists the quantity and
description of each item in the shipment.
– A physical count is compared with the quantities on
the picking ticket (Warehouse) and packing slip
(Shipping). If there are discrepancies, a back order is
initiated.
– Some spot checks are made and a bill of lading is
prepared.
 Shipping (Activity 2)

• The bill of lading is a legal contract that defines

responsibility for goods in transit
• 3 copies: (shipping, billing, and carrier)
• It identifies:
– The carrier
– The source
– The destination
– Special shipping instructions
– Who pays for the shipping?
 Billing and Accounts
Receivable (Activity 3)

• Two activities are performed at this stage of

the revenue cycle:
1 Invoicing customers
2 Maintaining customer accounts
• Key decisions and information needs:
• Accurate billing is crucial and requires
information identifying the items and
quantities shipped, prices, and special
sales terms.
 p&
Packing Sli
Sales g
Sales Order 3.1 Bill of Ladin
Order Shipping
Entry Billing

Invoice
Sales

General
Ledger &
Rept. Sys. Customer Sales Customer

s
ment
State
ly
onth
M
3.2
Billing and Maintain Mailroom
Accounts Accts. Remittance
Rec. List
Receivable
 Billing and Accounts
Receivable (Activity 3)
• The documents in this activity:
– The sales invoice notifies customers of the amount
to be paid and where to send payment.
– A monthly statement summarizes transactions that
occurred and informs customers of their current
account balance.
– A credit memo authorizes the billing department to
credit a customer’s account.
– credit manager may issue a credit memo for:
• Returns
• Allowances for damaged goods
• Write-offs as uncollectible
 Billing and Accounts
Receivable (Activity 3)
• Types of billing systems:
– In a post billing system, invoices are prepared after
confirmation that the items were shipped.
– 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.
 Billing and Accounts
Receivable (Activity 3)
• Methods for maintaining accounts
receivable:
– open invoice method
– balance-forward method
• To obtain a more uniform flow of cash
receipts, many companies use a process
called cycle billing.
 Billing and Accounts
Receivable (Activity 3)

• Open-invoice method:
– Customers pay according to each invoice.
– Two copies of the invoice are typically sent to the
customer.
• Customer is asked to return one copy with payment.
• This copy is a turnaround document called a
remittance advice.
– Advantages of open-invoice method:
• Conducive to offering early-payment discounts
• Results in more uniform flow of cash collections
– Disadvantages of open-invoice method:
• More complex to maintain
 Billing and Accounts
Receivable (Activity 3)
• Balance forward method:
– Customers pay according to amount on their
monthly statement, rather than by invoice.
– Monthly statement lists transactions since the
last statement and lists the current balance.
– Advantages of balance-forward method:
• It’s more efficient and reduces costs because you
don’t bill for each individual sale.
• It’s more convenient for the customer to make one
monthly remittance.
 Information Needs
and Procedures
• What are examples of additional information the
AIS should provide? (performance Evaluation.)
• Respond time to customer inquiries
• Time required to fill and deliver orders
• Percentage of sales that required back orders
• Customer satisfaction rates and trends
• Profitability analyses by product, customer, and sales
region
• Sales volume in both dollars and number of
customers
• Effectiveness of advertising and promotions
• Sales staff performance
• Bad debt expenses and credit policies
 Cash Collections (Activity 4)
• Two areas are involved in this activity:
1 The cashier, who reports to the treasurer,
handles customer remittances and
deposits them in the bank
2 The accounts receivable function
 Cash Collections (Activity 4)
• 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.
 Cash Collections (Activity 4)
• Documents, records, and procedures:
– Checks are received and deposited.
– A remittance list is prepared and entered on-
line showing the customer, invoice number,
and the amount of each payment.
– The system performs a number of on-line edit
checks to verify the accuracy of data entry.
 Control: Objectives,
Threats, and Procedures
• In the revenue cycle (or any cycle), The
second function of a well-designed AIS is
to provide adequate controls to ensure
that the following objectives are met:
– Transactions are properly authorized.
(emp_ write off account)
– Recorded transactions are valid.
Showing false revenues in a financial statement
 Control: Objectives,
Threats, and Procedures

Objectives, continued

– Valid, authorized transactions are

recorded. Don’t show Discounts higher net sales
– 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 Sales Order Entry

Threat Applicable Control Procedures

1. Incomplete or inaccurate Data entry edit checks
customer orders
2. Credit sales to customers Credit approval by credit manager, not
with poor credit by sales function; accurate records of
customer account balances
3. Legitimacy of orders Signatures on paper documents; digital
signatures and digital certificates for e-
business
4. Stockouts, carrying costs Inventory control systems
and markdowns
Carrying Cost: warehousing costs such

as rent, utilities and salaries

 Threats and Applicable Control Procedures to
Shipping

Threat Applicable Control Procedures

1. Shipping errors: Reconciliation of sales order with
• Wrong merchandise picking ticket and packing slip; bar code
• Wrong quantities scanners; data entry application 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
 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;
Prenumbering 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
accounts receivable receivable ledger with general ledger;
monthly statements to customers
 Threat and Applicable Control Procedures to
Cash Collections

Threat Applicable Control Procedures

1. 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
 General Control Issues

Threat Applicable Control Procedures

1. Loss of Data Backup and disaster recovery
procedures; access controls
(physical and logical)
2. Poor performance Preparation and review of
performance reports
 Revenue Cycle Information Needs:
Operational Data
Operational Data are needed to monitor
performance and to perform the following
recurring tasks:
• Respond to customer inquiries about account
balances and order status
• Decide whether to extend credit to a particular
customer
• Determine inventory availability
• Select methods for delivering merchandise
 Revenue Cycle Information Needs: Current
and Historical Information
Current and historical information is needed to
enable management of make the following
strategic decisions:
• Setting prices for products and services
• Establishing policies regarding sales returns and
warranties
• Deciding what types of credit terms to offer
• Determining the need for short-term borrowing
• Planning new marketing campaigns
 Revenue Cycle Information Needs:
Performance Evaluation
The AIS must also supply the information needed to evaluate
performance of the following critical processes:
• Respond time to customer inquiries
• Time required to fill and deliver orders
• Percentage of sales that required back orders
• Customer satisfaction rates and trends
• Profitability analyses by product, customer, and sales region
• Sales volume in both dollars and number of customers
• Effectiveness of advertising and promotions
• Sales staff performance
• Bad debt expenses and credit policies
The Expenditure Cycle:
Purchasing to Cash
Disbursements
 INTRODUCTION

• Questions to be addressed in this chapter

include:
– What are the basic business activities and
data processing operations that are performed
in the expenditure cycle?
– What decisions need to be made in the
expenditure cycle, and what information is
needed to make these decisions?
– What are the major threats in the expenditure
cycle and the controls related to those threats?
 INTRODUCTION

• The primary external exchange of information is with

suppliers (vendors).
• Information flows to the expenditure cycle from other
cycles, e.g.:
– The revenue cycle, production cycle, inventory control, and
various departments provide information about the need to
purchase goods and materials.
• Information also flows from the expenditure cycle:
– When the goods and materials arrive, the expenditure
cycle provides information about their receipt to the parties
that have requested them.
– Information is provided to the general ledger and reporting
function for internal and external financial reporting.
 INTRODUCTION

• The primary objective of the expenditure

cycle is to minimize the total cost of acquiring
and maintaining inventory, supplies, and
services.
 INTRODUCTION

• Decisions that must be made include:

– What level of inventory and supplies should we
carry?
– What vendors provide the best price and quality?
– Where should we store the goods?
– Can we consolidate purchases across units?
– How can IT improve inbound logistics?
– Is there enough cash to take advantage of early
payment discounts?
– How can we manage payments to maximize cash
flow?
 INTRODUCTION

• Management also has to evaluate the

efficiency and effectiveness of expenditure
cycle processes.
– These evaluations require data about:
• Events that occur.
• Resources affected.
• Agents who participate.
– This data needs to be accurate, reliable, and
timely.
 INTRODUCTION

• In this chapter, we’ll look at how the three

basic AIS functions are carried out in the
expenditure cycle:
– How do we capture and process data?
– How do we store and organize the data for
decisions?
– How do we provide controls to safeguard
resources (including data)?
 EXPENDITURE CYCLE BUSINESS
ACTIVITIES

• The three basic activities performed in the

expenditure cycle are:
– Ordering goods, supplies, and services.
– Receiving and storing these items.
– Paying for these items.
• These activities mirror the activities in the
revenue cycle.
 EXPENDITURE CYCLE BUSINESS
ACTIVITIES

• The three basic activities performed in the

expenditure cycle are:
– Ordering goods, supplies, and services.
– Receiving and storing these items.
– Paying for these items.
• These activities mirror the activities in the
revenue cycle.
 ORDERING GOODS, SUPPLIES, AND
SERVICES

• Key decisions in this process involve

identifying what, when, and how much to
purchase and from whom.
• Weaknesses in inventory control can create
significant problems with this process:
– Inaccurate records cause shortages.
• One of the key factors affecting this process
is the inventory control method to be used.
 ORDERING GOODS, SUPPLIES, AND
SERVICES

• Alternate inventory control methods

– We will consider three alternate approaches to
inventory control:
• Economic Order Quantity (EOQ)
• Just in Time Inventory (JIT)
• Materials Requirements Planning (MRP)
 ORDERING GOODS, SUPPLIES, AND
SERVICES

• Alternate inventory control methods

– We will consider three alternate approaches to
inventory control:
• Economic Order Quantity (EOQ)
• Materials Requirements Planning (MRP)
• Just in Time Inventory (JIT)
ORDERING GOODS, SUPPLIES, AND
SERVICES

• EOQ is the traditional approach to managing

inventory.
– Goal: Maintain enough stock so that production doesn’t get
interrupted.
– Under this approach, an optimal order size is calculated by
minimizing the sum of several costs:
• Ordering costs
• Carrying costs
• Stockout costs
– The EOQ formula is also used to calculate reorder point,
i.e., the inventory level at which a new order should be
placed.
– Other, more recent approaches try to minimize or eliminate
the amount of inventory carried.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• Alternate inventory control methods

– We will consider three alternate approaches to
inventory control:
• Economic Order Quantity (EOQ)
• Materials Requirements Planning (MRP)
• Just in Time Inventory (JIT)
ORDERING GOODS, SUPPLIES, AND
SERVICES

• MRP seeks to reduce inventory levels by

improving the accuracy of forecasting
techniques and carefully scheduling
production and purchasing around that
forecast.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• Alternate inventory control methods

– We will consider three alternate approaches to
inventory control:
• Economic Order Quantity (EOQ)
• Materials Requirements Planning (MRP)
• Just in Time Inventory (JIT)
ORDERING GOODS, SUPPLIES, AND
SERVICES

• JIT systems attempt to minimize or eliminate

inventory by purchasing or producing only in
response to actual (as opposed to forecasted) sales.
• These systems have frequent, small deliveries of
materials, parts, and supplies directly to the location
where production will occur.
• A factory with a JIT system will have multiple
receiving docks for their various work centers.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• Similarities and differences between MRP

and JIT:
– Scheduling production and inventory
accumulation.
• MRP schedules production to meet estimated sales
and creates a stock of finished goods inventory to be
available for those sales.
• JIT schedules production in response to actual sales
and virtually eliminates finished goods inventory,
because goods are sold before they’re made.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• Similarities and differences between MRP

and JIT:
– Scheduling production and inventory
accumulation
– Nature of products
• MRP systems are better suited for products that have
predictable demand, such as consumer staples.
• JIT systems are particularly suited for products with
relatively short life cycles (e.g., fashion items) and for
which demand is difficult to predict (e.g., toys
associated with movies).
ORDERING GOODS, SUPPLIES, AND
SERVICES

• Similarities and differences between MRP

and JIT:
– Scheduling production and inventory
accumulation
– Nature of products
– Costs and efficiency
• Both can reduce costs and improve efficiency over
traditional EOQ approaches.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• Similarities and differences between MRP

and JIT:
– Scheduling production and inventory
accumulation
– Nature of products
– Costs and efficiency
– Too much or too little
• In either case, you must be able to:
– Quickly accelerate production if there is unanticipated
demand.
– Quickly stop production if too much inventory is
accumulating.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• Whatever the inventory control system, the order

processing typically begins with a purchase request
followed by the generation of a purchase order.
• A request to purchase goods or supplies is triggered
by either:
– The inventory control function; or
– An employee noticing a shortage.
• Advanced inventory control systems automatically
initiate purchase requests when quantity falls below
the reorder point.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• The need to purchase goods typically results in the

creation of a purchase requisition. The purchase
requisition is a paper document or electronic form
that identifies:
– Who is requesting the goods
– Where they should be delivered
– When they’re needed
– Item numbers, descriptions, quantities, and prices
– Possibly a suggested supplier
– Department number and account number to be charged
• Most of the detail on the suppliers and the items
purchased can be pulled from the supplier and
inventory master files.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• The purchase requisition is received by a

purchasing agent (aka, buyer) in the
purchasing department, who typically
performs the purchasing activity.
– In manufacturing companies, this function usually
reports to the VP of Manufacturing.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• A crucial decision is the selection of supplier.

• Key considerations are:
– Price
– Quality
– Dependability
• Especially important in JIT systems because late or
defective deliveries can bring the whole system to a
halt.
• Consequently, certification that suppliers meet ISO
9000 quality standards is important. This certification
recognizes that the supplier has adequate quality
control processes.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• Once a supplier has been selected for a

product, their identity should become part of
the product inventory master file so that the
selection process does not have to be carried
out for every purchase.
– A list of potential alternates should also be
maintained.
– For products that are seldom ordered, the
selection process may be repeated every time.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• It’s important to track and periodically

evaluate supplier performance, including data
on:
– Purchase prices
– Rework and scrap costs
– Supplier delivery performance
• The purchasing function should be evaluated
and rewarded based on how well it minimizes
total costs, not just the costs of purchasing
the goods.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• A purchase order is a document or

electronic form that formally requests a
supplier to sell and deliver specified products
at specified prices.
• The PO is both a contract and a promise to
pay. It includes:
– Names of supplier and purchasing agent
– Order and requested delivery dates
– Delivery location
– Shipping method
– Details of the items ordered
ORDERING GOODS, SUPPLIES, AND
SERVICES

• Multiple purchase orders may be completed for one

purchase requisition if multiple vendors will fill the
request.
• The ordered quantity may also differ from the
requested quantity to take advantage of quantity
discounts.
• A blanket order is a commitment to buy specified
items at specified prices from a particular supplier
for a set time period.
– Reduces buyer’s uncertainty about reliable material
sources
– Helps supplier plan capacity and operations
ORDERING GOODS, SUPPLIES, AND
SERVICES

• IT can help improve efficiency and

effectiveness of purchasing function.
– The major cost driver is the number of
purchase orders processed. Time and cost
can be cut by:
• Using EDI to transmit purchase orders
ORDERING GOODS, SUPPLIES, AND
SERVICES
• In a vendor-managed inventory (VMI) program:
• IT can help improve
– Inventory efficiency
control and purchasing areand
outsourced to a
supplier.
effectiveness of purchasing
– The supplier function.
has access to POS and inventory data and
automatically replenishes inventory.
– The major cost driver is the number of
– This approach:
purchase• orders processed.
Reduces amount Time and cost
of inventory carried.
• Eliminates costs of generating purchase orders.
can be– cut by:
Requires good controls to ensure accuracy of inventory
• Using EDI to transmit purchase orders.
records.

• Using vendor-managed inventory systems.

ORDERING GOODS, SUPPLIES, AND
SERVICES

• IT can help improve efficiency and

effectiveness of purchasing function.
– The major cost driver is the number of
purchase orders
• Suppliers processed.
compete Time
with each other anddemand
to meet cost at
can bethecut by:price.
lowest
• Best suited to commodities, rather than critical
• Using EDI to transmit purchase orders.
components, where quality, vendor reliability, and
• Using vendor-managed
delivery inventory
performance are systems.
not crucial.
• Reverse auctions.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• IT can help improve efficiency and

effectiveness of purchasing function.
– The major cost driver is the number of
purchase orders processed. Time and cost
can •beUsed
cutforby:
large purchases that involve formal bids.
• Using EDI auditor
• Internal to transmit purchase
visits each orders.
potential supplier in final
cut to verify accuracy of their bid.
• Using vendor-managed inventory systems.
• May identify mathematical errors in bid which can
• Reverse
produceauctions.
considerable savings.
• Pre-award audits.
ORDERING GOODS, SUPPLIES, AND
SERVICES

• IT can help improve efficiency and

effectiveness of purchasing function.
– The major cost driver is the number of
purchase orders processed. Time and cost
can •beRFID
cutmakes
hereit possible
by: for companies to more
accurately account for actual inventory-related costs
• Using EDI to transmit purchase orders.
by switching to the specific identification method for
• Using vendor-managed
accounting inventory systems.
for inventories..
• Reverse auctions.
• Pre-award audits.
 EXPENDITURE CYCLE BUSINESS
ACTIVITIES

• The three basic activities performed in the

expenditure cycle are:
– Ordering goods, supplies, and services.
– Receiving and storing these items.
– Paying for these items.
• These activities mirror the activities in the
revenue cycle.
 RECEIVING AND STORING GOODS

• The receiving department accepts deliveries

from suppliers.
– Normally, reports to warehouse manager, who
reports to VP of Manufacturing.
• Inventory stores typically stores the goods.
– Also reports to warehouse manager.
• The receipt of goods must be communicated
to the inventory control function to update
inventory records.
 RECEIVING AND STORING GOODS

• The two major responsibilities of the

receiving department are:
– Deciding whether to accept delivery.
– Verifying the quantity and quality of delivered
goods.
• The first decision is based on whether there
is a valid purchase order.
– Accepting un-ordered goods wastes time,
handling and storage.
 RECEIVING AND STORING GOODS

• Verifying the quantity of delivered goods is important so:

– The company only pays for goods received.
– Inventory records are updated accurately.
• The receiving report is the primary document used in this
process:
– It documents the date goods received, shipper, supplier, and PO
number.
– Shows item number, description, unit of measure, and quantity
for each item.
– Provides space for signature and comments by the person who
received and inspected.
• Receipt of services is typically documented by supervisory
approval of the supplier’s invoice.
 RECEIVING AND STORING GOODS

• When goods arrive, a receiving clerk compares the

PO number on the packing slip with the open PO file
to verify the goods were ordered.
– Then counts the goods.
– Examines for damage before routing to warehouse or
factory.
• Three possible exceptions in this process:
– The quantity of goods is different from the amount ordered;
– The goods are damaged; and
– The goods are of inferior quality.
 RECEIVING AND STORING GOODS

• If one of these exceptions occurs, the purchasing

agent resolves the situation with the supplier.
– Supplier typically allows adjustment to the invoice for
quantity discrepancies.
– If goods are damaged or inferior, a debit memo is prepared
after the supplier agrees to accept a return or grant a
discount.
• One copy goes to supplier, who returns a credit memo in
acknowledgment.
• One copy to accounts payable to adjust the account payable.
• One copy to shipping to be returned to supplier with the
actual goods.
 RECEIVING AND STORING GOODS

• IT can help improve the efficiency and

effectiveness of the receiving activity:
– Bar-coding
• Requiring suppliers to bar-code products speeds the
counting process and improves accuracy.
 RECEIVING AND STORING GOODS

• IT can help improve the efficiency and

effectiveness of the receiving activity:
– Bar-coding
– RFID
• Radio frequency identification (RFID) tags eliminate
the need for bar codes to be in the line of sight.
 RECEIVING AND STORING GOODS

• IT can help improve the efficiency and

effectiveness of the receiving activity:
– Bar-coding
– RFID
– EDI and satellite technology
• EDI and satellite technology make it possible to track
the exact location of incoming shipments and have
receiving staff on hand to unload trucks.
• Also enables drivers to be directed to specific loading
docks where goods will be used.
 RECEIVING AND STORING GOODS

• IT can help improve the efficiency and

effectiveness of the receiving activity:
– Bar-coding
– RFID
– EDI and satellite technology
– Audits
• Audits can identify opportunities to cut freight costs
and can ensure that suppliers are not billing for
transportation costs they are supposed to assume.
 EXPENDITURE CYCLE BUSINESS
ACTIVITIES

• The three basic activities performed in the

expenditure cycle are:
– Ordering goods, supplies, and services
– Receiving and storing these items
– Paying for these items
• These activities mirror the activities in the
revenue cycle.
 PAYING FOR GOODS AND SERVICES

• There are two basic sub-processes

involved in the payment process:
– Approval of vendor invoices
– Actual payment of the invoices
 PAYING FOR GOODS AND SERVICES

• There are two basic sub-processes

involved in the payment process:
– Approval of vendor invoices
– Actual payment of the invoices
 PAYING FOR GOODS AND SERVICES

• Approval of vendor invoices is done by

the accounts payable department,
which reports to the controller.
• The legal obligation to pay arises when
goods are received.
– But most companies pay only after
receiving and approving the invoice.
– This timing difference may necessitate
adjusting entries at the end of a fiscal
period.
 PAYING FOR GOODS AND SERVICES

• Objective of accounts payable:

– Authorize payment only for goods and
services that were ordered and actually
received.
• Requires information from:
– Purchasing—about existence of valid
purchase order.
– Receiving—for receiving report indicating
goods were received.
 PAYING FOR GOODS AND SERVICES

• There are two basic approaches to

processing vendor invoices:
– Non-voucher system
• Each invoice is stored in an open invoice file.
• When a check is written, the invoice is marked “paid”
and then stored in a paid invoice file.
 PAYING FOR GOODS AND SERVICES

• There are two basic approaches to

processing vendor invoices:
– Non-voucher system
– Voucher system
• A disbursement voucher is prepared which lists:
– Outstanding invoices for the supplier.
– Net amount to be paid after discounts and allowances.
• The disbursement voucher effectively shows which
accounts will be debited and credited, along with the
account numbers.
 PAYING FOR GOODS AND SERVICES

• There are two basic approaches to

processing vendor invoices:
– Non-voucher system
– Voucher system
• Advantages of a voucher system:
– Several invoices may be paid at once, which reduces
number of checks written.
– Vouchers can be pre-numbered which simplifies the
audit trail for payables.
– Invoice approval is separated from invoice payment,
which makes it easier to schedule both to maximize
efficiency.
 PAYING FOR GOODS AND SERVICES

• There are two basic sub-processes

involved in the payment process:
– Approval of vendor invoices
– Actual payment of the invoices
 PAYING FOR GOODS AND SERVICES

• Payment of the invoices is done by the

cashier, who reports to the treasurer.
• The cashier receives a voucher package,
which consists of the vendor invoice and
supporting documentation, such as purchase
order and receiving report.
• This voucher package authorizes issuance of
a check or EFT to the supplier.
 PAYING FOR GOODS AND SERVICES

• Referred to as Evaluated Receipt Settlement.

• Processing efficiency can be improved
• Payments are issued based on what is ordered and
by: received.
• Requires that:
– Requiring suppliers
– Suppliers quote to submit
accurate pricesinvoices
when orders by
are placed.
– Receiving personnel count accurately and inspect
EDI. merchandise received.
– Having the system
• Typically, automatically
incorporates match
very timely communications
about shipments and receipts.
invoices to POs and receiving reports.
– Eliminating vendor invoices.
 PAYING FOR GOODS AND SERVICES

• Processing efficiency can be improved

by:
– Requiring suppliers to submit invoices by
EDI.
– Having the system automatically match
invoices to POs and receiving reports.
– Eliminating vendor invoices.
– Using procurement cards for non-
inventory purchases.
 PAYING FOR GOODS AND SERVICES

• Processing efficiency can be improved by:

– Requiring suppliers to submit invoices by EDI.
– Having the system automatically match invoices
to POs and receiving reports.
– Eliminating vendor invoices.
– Using procurement cards for non-inventory
purchases.
– Using company credit cards and electronic
forms for travel expenses.
 PAYING FOR GOODS AND SERVICES

• Processing efficiency can be improved by:

– Requiring suppliers to submit invoices by EDI.
– Having the system automatically match invoices
to POs and receiving reports.
– Eliminating vendor invoices.
– Using procurement cards for non-inventory
purchases.
– Using company credit cards and electronic forms
for travel expenses.
– Preparing careful cash budgets to take
advantage of early-payment discounts.
 PAYING FOR GOODS AND SERVICES

• Processing efficiency can be improved by:

– Requiring suppliers to submit invoices by EDI.
– Having the system automatically match invoices to
POs and receiving reports.
– Eliminating vendor invoices.
– Using procurement cards for non-inventory
purchases.
– Using company credit cards and electronic forms
for travel expenses.
– Preparing careful cash budgets to take advantage
of early-payment discounts.
– Using FEDI to pay suppliers.
REVIEW OF EXPENDITURE CYCLE ACTIVITIES

• Before we move on to discuss internal

controls in the expenditure cycle, let’s
do a brief review of the organization
chart, including:
– Who does what in the expenditure cycle
– To whom do they typically report
 PARTIAL ORGANIZATION CHART FOR UNITS
INVOLVED IN EXPENDITURE CYCLE

CEO

VP of Manufacturing CFO

Purchasing Receiving Inventory Controller Treasurer

Stores

• Selects suitable suppliers Accounts Cashier

• Issues purchase orders
Payable
PARTIAL ORGANIZATION CHART FOR UNITS
INVOLVED IN EXPENDITURE CYCLE

CEO

VP of Manufacturing CFO

Purchasing Receiving Inventory Controller Treasurer

Stores

• Decides whether to accept Accounts Cashier

deliveries
• Counts and inspects
Payable
deliveries
PARTIAL ORGANIZATION CHART FOR UNITS
INVOLVED IN EXPENDITURE CYCLE

CEO

VP of Manufacturing CFO

Purchasing Receiving Inventory Controller Treasurer

Stores

• Stores goods that Accounts Cashier

have been
delivered and Payable
accepted
PARTIAL ORGANIZATION CHART FOR UNITS
INVOLVED IN EXPENDITURE CYCLE

CEO

VP of Manufacturing CFO

Purchasing Receiving Inventory Controller Treasurer

Stores

• Approves invoices Accounts Cashier

for payment
Payable
PARTIAL ORGANIZATION CHART FOR UNITS
INVOLVED IN EXPENDITURE CYCLE

CEO

VP of Manufacturing CFO

Purchasing Receiving Inventory Controller Treasurer

Stores

Accounts Cashier
Payable
• Issues payment to
vendors
 CONTROL: OBJECTIVES, THREATS,
AND PROCEDURES

• In the expenditure cycle (or any cycle), a well-designed

AIS should provide adequate controls to ensure that the
following objectives are met:
– All transactions are properly authorized.
– All recorded transactions are valid.
– All valid and authorized transactions are recorded.
– All transactions are recorded accurately.
– Assets are safeguarded from loss or theft.
– Business activities are performed efficiently and effectively.
– The company is in compliance with all applicable laws and
regulations.
– All disclosures are full and fair.
 CONTROL: OBJECTIVES, THREATS,
AND PROCEDURES

• There are several actions a company can take

with respect to any cycle to reduce threats of
errors or irregularities. These include:
– Using simple, easy-to-complete documents with
clear instructions (enhances accuracy and
reliability).
– Using appropriate application controls, such as
validity checks and field checks (enhances
accuracy and reliability).
– Providing space on forms to record who completed
and who reviewed the form (encourages proper
authorizations and accountability).
 CONTROL: OBJECTIVES, THREATS,
AND PROCEDURES

– Pre-numbering documents (encourages recording

of valid and only valid transactions).
– Restricting access to blank documents (reduces
risk of unauthorized transaction).

• In the following sections, we’ll discuss the

threats that may arise in the three major steps
of the expenditure cycle, as well as general
threats, EDI-related threats, and threats related
to purchases of services.
 CRIME TIME

• Before we discuss specific threats, it may be

helpful to have some background on a form
of occupational fraud and abuse which is
broadly referred to as corruption.
• Corruption cases often involve arrangements
between a company’s purchasing agent and
a sales representative for one of the
company’s vendors.
 CRIME TIME

• The vendor’s representative may try to induce the

purchasing agent to buy goods that:
– Are over-priced
– Are of inferior quality
– Aren’t even needed
– Aren’t even delivered
• In exchange, the vendor’s rep typically offers the
purchasing agent something of value. That
“something” might be money, payment of a debt,
a job offer, an expensive vacation, or anything
the purchasing agent might value.
 CRIME TIME

• According to the Fraud Examiner’s Manual

published by the Association of Certified
Fraud Examiners, these schemes usually
take four forms:
– Bribery
• Typically involves the vendor offering a kickback
(something of value) to the buyer to buy inflated,
substandard, un-needed, or un-delivered goods, etc.
• Alternately, may involve an inducement to the buyer
to rig a competitive bidding process so that the
vendor gets the bid.
 CRIME TIME

• According to the Fraud Examiner’s Manual

published by the Association of Certified
Fraud Examiners, these schemes usually
take four forms:
– Bribery
– Conflict of interest
• In conflict of interest cases, the purchasing agent is
usually arranging for his employer to make purchases
from a company in which he has a concealed interest.
• For example, perhaps his wife owns the vendor
company.
 CRIME TIME

• According to the Fraud Examiner’s Manual

published by the Association of Certified
Fraud Examiners, theseisschemes
• Economic extortion basically theusually
reverse of a bribe.
• Instead of the vendor making an offer of something of
take four forms:
value to the purchasing agent, the purchasing agent
– Bribery may tell the vendor that he must provide something of
value to the purchasing agent if he wants to continue
– Conflict to
ofdo
interest
business with his employer.
– Economic extortion
 CRIME TIME

• According to the Fraud Examiner’s Manual

published by the Association of Certified
Fraud Examiners, these
• Illegal gratuities schemes
involve usually
gifts that are given to the
take four forms:
purchasing agent by a vendor after the vendor has
been selected.
– Bribery
• There was no intent by the vendor to influence the
– Conflict selection process; the gift was provided after the fact.
of interest
• But the problem is that the gift is likely to impact
– Economic extortion
future decisions by the purchasing agent.
– Illegal gratuities
 EXPENDITURE CYCLE
INFORMATION NEEDS

• Information is needed for the following

operational tasks in the expenditure cycle,
including:
– Deciding when and how much inventory to order
– Deciding on appropriate suppliers
– Determining if vendor invoices are accurate
– Deciding whether to take purchase discounts
– Determining whether adequate cash is available to
meet current obligations
 EXPENDITURE CYCLE
INFORMATION NEEDS

• Information is also needed for the following

strategic decisions:
– Setting prices for products/services
– Establishing policies on returns and warranties
– Deciding on credit terms
– Determining short-term borrowing needs
– Planning new marketing campaigns
 EXPENDITURE CYCLE
INFORMATION NEEDS

• The AIS needs to provide information to evaluate

the following:
– Purchasing efficiency and effectiveness
– Supplier performance
– Time taken to move goods from receiving to
production
– Percent of purchase discounts taken
• Both financial and operating information are
needed to manage and evaluate these activities.
• Both external and internal information are
needed.
 EXPENDITURE CYCLE
INFORMATION NEEDS

• When the AIS integrates information from the

various cycles, sources, and types, the reports
that can be generated are unlimited. They
include reports on:
– Supplier performance
– Outstanding invoices
– Performance of expenditure cycle employees
– Number of POs processed by purchasing agent
– Number of invoices processed by A/P clerk
– Number of deliveries handled by receiving clerk
 EXPENDITURE CYCLE
INFORMATION NEEDS

– Number of inventory moves by warehouse worker

– Inventory turnover
– Classification of inventory based on contribution to
profitability
• Accountants should continually refine and
improve these performance reports.