the expenditure cycle part i: purchases and cash disbursements

chapte r 5The Expenditure CyclePart I: Purchases and CashDisbursements Procedures

The objective of the expenditure cycle is to convertthe organization’s cash into the physical materialsand the human resources it needs to conduct busi-

ness. In this chapter we concentrate on systems and proce-dures for acquiring raw materials and finished goods fromsuppliers. We examine payroll and fixed asset systems inthe next chapter.

Most business entities operate on a credit basis and donot pay for resources until after acquiring them. The timelag between these events splits the procurement process intotwo phases: (1) the physical phase, involving the acquisitionof the resource, and (2) the financial phase, involving thedisbursement of cash. As a practical matter, these are treatedas independent transactions that are processed through sepa-rate subsystems.

This chapter examines the principal features of the twomajor subsystems that constitute the expenditure cycle:(1) the purchases processing subsystem and (2) the cash dis-bursements subsystem. The chapter is organized into twomain sections. The first section provides an overview of theconceptual system, including the logical tasks, the key enti-ties, the sources and uses of information, and the flow ofkey documents through an organization. The second sectiondeals with the physical system. We first use a manual sys-tem to reinforce the reader’s understanding of key concepts.We then examine several computer-based systems, focusingon the operational and control implications of alternativedata processing methods.

�� Learning Objectives

After studying this chapter, you should:

� Recognize the fundamental tasksthat constitute the purchases andcash disbursements process.

� Be able to identify the functionalareas involved in purchases and cashdisbursements activities and tracethe flow of these transactionsthrough the organization.

� Be able to specify the documents,journals, and accounts that provideaudit trails, promote the mainte-nance of historical records, and sup-port internal decision making andfinancial reporting.

� Understand the exposures associ-ated with purchases and cash dis-bursements activities and recognizethe controls that reduce these risks.

� Be aware of the operational featuresand the control implications of tech-nology used in purchases and cashdisbursements systems.

The Conceptual SystemOVERVIEW OF PURCHASES AND CASH DISBURSEMENTS ACTIVITIESIn this section we examine the expenditure cycle conceptually. Using data flow diagrams (DFDs) as aguide, we will trace the sequence of activities through two of the processes that constitute the expenditurecycle for most retail, wholesale, and manufacturing organizations. These are purchases processing andcash disbursements procedures. Payroll and fixed asset systems, which also support the expenditurecycle, are covered in Chapter 6.

As in the previous chapter, the conceptual system discussion is intended to be technology-neutral. Thetasks described in this section may be performed manually or by computer. At this point our focus is onwhat (conceptually) needs to be done, not how (physically) it is accomplished. At various stages in theprocesses, we will examine specific documents, journals, and ledgers as they are encountered. Again, thisreview is technology-neutral. These documents and files may be physical (hard copy) or digital (computergenerated). Later in the chapter, we examine examples of physical systems.

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

MONITOR INVENTORY RECORDS. Firms deplete their inventories by transferring raw materialsinto the production process (the conversion cycle) and by selling finished goods to customers (revenuecycle. Our illustration assumes the latter case, in which inventory control monitors and records finishedgoods inventory levels. When inventories drop to a predetermined reorder point, a purchase requisitionis prepared and sent to the prepare purchase order function to initiate the purchase process. Figure 5-2presents an example of a purchase requisition.

Although procedures will vary from firm to firm, typically a separate purchase requisition will be pre-pared for each inventory item as the need is recognized. This can result in multiple purchase requisitionsfor a given vendor. These purchase requisitions need to be combined into a single purchase order (dis-cussed next), which is then sent to the vendor. In this type of system, each purchase order will be associ-ated with one or more purchase requisitions.

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

To make the purchasing process efficient, the inventory control function will supply much of the rou-tine ordering information that the purchasing department needs directly from the inventory and valid ven-dor files. This information includes the name and address of the primary supplier, the economic orderquantity1 of the item, and the standard or expected unit cost of the item. This allows the purchasingdepartment to devote its efforts to meeting scarce, expensive, or unusual inventory needs. To obtain thebest prices and terms on special items, the purchasing department may need to prepare detailed productspecifications and request bids from competing vendors. Dealing with routine purchases as efficiently as

1 The economic order quantity model and other inventory models are covered in Chapter 7.

218 P A R T I I Transaction Cycles and Business Processes

F I G U R E

5-1 DFD FOR PURCHASE SYSTEM

PO,RecReport,Invoice

PO, RecReport

Stores

Supplier

PurchaseRequisition

MonitorInventoryRecords

PreparePurchaseOrder

Open/ClosedPO File

PurchaseOrder

PurchaseOrder 4(BlindCopy)Bill of

Lading,PackingSlip

ReceiveGoods

RecReportCopy5

UpdateInventoryRecords

ReceivingReport

QuantityReceived

Inventory SubLedger

Supplier

AmountDue, Due Date

Name,Address, Terms

Valid Vendor File

InventorySubsidiary Ledger

InventoryLevels

PO Copy4

ReceivingReport File

Rec ReportCopy 2

Set upAccountPayable

Receiving Report Copy 4

Receiving Report Copy 3PurchasesJournal

PurchaseDetail

Purchase Order Copy 2

Invoice

AP Pending File

PO, Rec Report

Post toGeneralLedger

Journal Voucher

Open AP File(Voucher Payable)

AP Sub Ledger(Voucher Register)

Inventory Summary

JournalVoucher File

General Ledger

ApprovedJournalVoucher

J V PostingDetail

CH

AP

TE

R5

The

ExpenditureC

yclePartI:Purchases

andC

ashD

isbursementsProcedures

219

F I G U R E

5-2 PURCHASE REQUISITION

Hampshire Supply Co.Purchase Requisition

No. 89631

Suggested Vendor1620 North Main St.Bethlehem PA 18017

Date Prepared Date Needed

Part No. Quantity Description Unit Price Extended Price

TotalAmount

PreparedBy:

ApprovedBy:

VendorAccount

Jones and Harper Co.

8/15/2009 9/1/2009

86329 Engine Block Core Plug $1.10 $220

THJRBJ $220.00 4001

200

F I G U R E

5-3 PURCHASE ORDER

Hampshire Supply Co.Purchase Order

No. 23591

To : Jones and Harper Co.1620 North Main St.Bethlehem PA 18017

Please show theabove number on allshipping documentsand invoices.

Date Ordered

DateNeeded

PurchasingAgent

TermsVendorNumber4001 8/15/09 9/1/09 J. Buell 2/10, n/30

PurchaseReq. No.


896318983489851

863292067145218

200100

10

Engine Block Core PlugBrake ShoesSpring Compressors

$220.00 950.00 330.00

$ 1.10 9.5033.00

PreparedBy :

ApprovedBy :

TotalAmountBKG RMS $1,500.00


good control permits is desirable in all organizations. The valid vendor file contributes to both controland efficiency by listing only those vendors approved to do business with the organization. This referencehelps to reduce certain vendor fraud schemes discussed in Chapter 3.

RECEIVE GOODS. Most firms encounter a time lag (sometimes a significant one) between placing theorder and receiving the inventory. During this time, the copies of the PO reside in temporary files in variousdepartments. Note that no economic event has yet occurred. At this point, the firm has received no inventoriesand incurred no financial obligation. Hence, there is no basis for making a formal entry into any accountingrecord. However, firms often 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 vendorare reconciled with the blind copy of the PO. The blind copy, illustrated in Figure 5-4, contains no quan-tity or price information about the products being received. The purpose of the blind copy is to force thereceiving clerk to count and inspect inventories prior to completing the receiving report. At times, receiv-ing docks are very busy and receiving staff are under pressure to unload the delivery trucks and sign thebills of lading so the truck drivers can go on their way. If receiving clerks are only provided quantity in-formation, they may be tempted to accept deliveries on the basis of this information alone, rather thanverify the quantity and condition of the goods. Shipments that are short or contain damaged or incorrectitems must be detected before the firm accepts and places the goods in inventory. The blind copy is animportant device in reducing this exposure.

Upon completion of the physical count and inspection, the receiving clerk prepares a receiving reportstating the quantity and condition of the inventories. Figure 5-5 contains an example of a receiving report.One copy of the receiving report accompanies the physical inventories to either the raw materials store-room or finished goods warehouse for safekeeping. Another copy is filed in the open/closed PO file toclose out the PO. A third copy of the receiving report is sent to the AP department, where it is filed in theAP pending file. A fourth copy of the receiving report is sent to inventory control for updating the inven-tory records. Finally, a copy of the receiving report is placed in the receiving report file.

F I G U R E

5-4 BLIND COPY PURCHASE ORDER

Hampshire Supply Co.Purchase Order

No. 23591

To : Jones and Harper Co.1620 North Main St.Bethlehem PA 18017

Please show theabove number on allshipping documentsand invoices.

Date Ordered

DateNeeded

PurchasingAgent

TermsVendorNumber4001 8/15/09 9/1/09 J. Buell 2/10, n/30

PurchaseReq. No.


896318983489851

863292067145218


PreparedBy :

ApprovedBy :

TotalAmountBKG RMS

C H A P T E R 5 The Expenditure Cycle Part I: Purchases and Cash Disbursements Procedures 221

UPDATE INVENTORY RECORDS. Depending on the inventory valuation method in place, the in-ventory control procedures may vary somewhat among firms. Organizations that use a standard cost sys-tem carry their inventories at a predetermined standard value regardless of the price actually paid to thevendor. Figure 5-6 presents a copy of a standard cost inventory ledger.

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

F I G U R E

5-5 RECEIVING REPORT

Hampshire Supply Co.Receiving Report

No. 62311

Vendor VendorShipped Via :Jones and Harper Co.

Purchase Order No. 23591 Date Received 9/1/09

Part No. Quantity Description Condition

863292067145218

200100

10


GoodGoodEar on one unit bent

Received By: Inspected By: Delivered To:

RTS LEW DYT

F I G U R E

5-6 INVENTORY SUBSIDIARY LEDGER USING STANDARD COST

HAMPSHIRE MACHINE CO.

Perpetual Inventory Record—Item #86329

Qnty Total

Item Units Units on Reorder Qnty on Vendor Standard Inven.

Description Received Sold Hand Point Order EOC Number Cost Cost

Engine Block Core

Plug 200 200 30 200 4001 1.10 220

30 170 187

20 150 165


SET UP ACCOUNTS PAYABLE. During the course of this transaction, the set up AP function hasreceived and temporarily filed copies of the PO and receiving report. The organization has receivedinventories 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 invoice2 containing thefinancial 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 record-ing process, during which time the firm’s liabilities are technically understated. As a practical matter, thismisstatement is a problem only at period-end when the firm prepares financial statements. To close thebooks, the accountant will need to estimate the value of the obligation until the invoice arrives. If the esti-mate is materially incorrect, an adjusting entry must be made to correct the error. Because the receipt ofthe invoice typically triggers AP procedures, accountants need to be aware that unrecorded liabilities mayexist at period-end closing.

When the invoice arrives, the AP clerk reconciles the financial information with the receiving reportand PO in the pending file. This is called a three-way match, which verifies that what was ordered wasreceived and is fairly priced. Once the reconciliation is complete, the transaction is recorded in the pur-chases journal and posted to the supplier’s account in the AP subsidiary ledger. Figure 5-7 shows therelationship between these accounting records.

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

After recording the liability, the AP clerk transfers all source documents (PO, receiving report, andinvoice) to the open AP file. Typically, this file is organized by payment due date and scanned daily toensure that debts are paid on the last possible date without missing due dates and losing discounts. Weexamine cash disbursements procedures later in this section. Finally, the AP clerk summarizes the entriesin the purchases journal for the period (or batch) and prepares a journal voucher for the general ledgerfunction (see Figure 5-7). Assuming the organization uses the perpetual inventory method, the journalentry will be:

DR CRInventory—Control 6,800.00

Accounts Payable—Control 6,800.00

If the periodic inventory method is used, the entry will be:

DR CRPurchases 6,800.00

Accounts Payable—Control 6,800.00

Vouchers Payable SystemRather than using the AP procedures described in the previous section, many firms use a vouchers pay-able system. Under this system, the AP department uses cash disbursement vouchers and maintains avoucher register. After the AP clerk performs the three-way match, he or she prepares a cash disburse-ment voucher to approve payment. Vouchers provide improved control over cash disbursements andallow firms to consolidate several payments to the same supplier on a single voucher, thus reducing thenumber of checks written. Figure 5-8 shows an example of a voucher.

Each voucher is recorded in the voucher register, as illustrated in Figure 5-9. The voucher registerreflects the AP liability of the firm. The sum of the unpaid vouchers in the register (those with no checknumbers 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 openAP file discussed earlier and also is organized by due date. The DFD in Figure 5-1 illustrates both liabil-ity recognition methods.

2 Note that the supplier’s invoice in the buyer’s expenditure cycle is the sales invoice of the supplier’s revenue cycle.


POST TO GENERAL LEDGER. The general ledger function receives a journal voucher from the APdepartment and an account summary from inventory control. The general ledger function posts from thejournal voucher to the inventory and AP control accounts and reconciles the inventory control accountand the inventory subsidiary summary. The approved journal vouchers are then posted to the journalvoucher file. With this step, the purchases phase of the expenditure cycle is completed.

F I G U R E

5-7RELATIONSHIP BETWEEN PURCHASE JOURNAL, AP SUBSIDIARY LEDGER, AND JOURNAL VOUCHER

Date InvoiceNumber

Inven ControlAcct # 150

PostRef

AP Control(# 400)

9/4

9/5

9/6

9/7

9/8

2484

4117

2671

9982

2690

1,500.00

3,600.00

1,000.00

200.00

500.00

6,800.00

Hampshire Supply Co.Accounts Payable Subsidiary Ledger

Vendor

Debit

AP SubAcct #

4001

4002

4001

4005

4001

Date

1,500.00

3,600.00

1,000.00

200.00

500.00

6,800.00


Ozment Supply


Superior Machine


Transaction DEBIT CREDIT BALANCE

9/4

9/6

9/8

9/12

Credit Purchases

Credit Purchase

Credit Purchase

Cash Payment 3,000.00

1,500.00

1,000.00

500.00

1,500.00

2,500.00

3,000.00

0

Date Transaction DEBIT CREDIT BALANCE

9/5 Credit Purchase 3,600.00 3,600.00

4002 -- Ozment Supply

4001 -- Jones and HarperJournal Voucher

InventoryControl

Acct PayControl 6,800.00

DR. CR.

6,800.00

PurchasesReturns # 500

General Ledger

Hampshire Supply Co.Purchases Journal

Credit


THE CASH DISBURSEMENTS SYSTEMSThe 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 thatamounts paid are timely and correct. If the system makes payments early, the firm forgoes interest incomethat it could have earned on the funds. If obligations are paid late, however, the firm will lose purchasediscounts or may damage its credit standing. Figure 5-10 presents a DFD conceptually depicting the in-formation flows and key tasks of the cash disbursements system.

F I G U R E

5-8 CASH DISBURSEMENT VOUCHER

9/4/092484 $1,5002671 9/6/09 $1,0002690 9/8/09 $525 $25

$1,500$1,000

$500

RJK JAN $3,000 4001

Hampshire Supply Co.Cash Disbursement Voucher

No. 1870Date__________

Disburse Check to:

PreparedBy:

ApprovedBy:

TotalAmount

AccountDebited

InvoiceNumber

InvoiceAmount

DiscountAmount

InvoiceDate

NetAmount

9/12/09

Jones and Harper Co.1620 North Main St.Bethlehem Pa. 18017

F I G U R E

5-9 VOUCHER REGISTER

Hampshire Supply Co. Voucher Register

Date VoucherNo.

Paid

Check No. Date

VoucherPayable(Credit)

Merchandise Debit Supplies DebitSelling

Expense Debit

Fixed AssetsDebit

Administrative Expense Debit

Misc. Debits

Acct. No. Amount

9/12/09 1870 104 9/14 3,000 3,000

3,600

500

9/13/09 1871 3,600

9/14/09 1872 105 9/15 500


F I G U R E

5-10 DFD FOR CASH DISBURSEMENTS SYSTEM

Supplier

PaymentDetail

JournalVoucher File General Ledger

Check Register

PrepareCashDisbursement

Post toGeneralLedger

IdentifyLiabilitiesDue

Open AP File(Voucher Payable)

UpdateAPRecord

AP Sub Ledger(Voucher Register)

Closer VoucherFile

CheckVoucher Packet

Due Date,Amount Due

Check Copy

Journal Voucher

APSummary

J VPosting Detail

ApprovedJournal Voucher

Voucher Packet,Check Copy

Check Number,Payment Date

226P

AR

TI

IT

ransactionC

yclesand

BusinessProcesses

IDENTIFY LIABILITIES DUE. The cash disbursements process begins in the AP department byidentifying items that have come due. Each day, the AP function reviews the open AP file (or voucherspayable file) for such items and sends payment approval in the form of a voucher packet (the voucherand/or supporting documents) to the cash disbursements department.

PREPARE CASH DISBURSEMENT. The cash disbursements clerk receives the voucher packet andreviews the documents for completeness and clerical accuracy. For each disbursement, the clerk preparesa check and records the check number, dollar amount, voucher number, and other pertinent data in thecheck register, which is also called the cash disbursements journal. Figure 5-11 shows an example of acheck register.

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

DR CRAccounts Payable XXXX.XX

Cash XXXX.XX

UPDATE AP RECORD. Upon receipt of the voucher packet, the AP clerk removes the liability by deb-iting the AP subsidiary account or by recording the check number and payment date in the voucher regis-ter. The voucher packet is filed in the closed voucher file, and an account summary is prepared and sentto the general ledger function.

POST TO GENERAL LEDGER. The general ledger function receives the journal voucher from cashdisbursements and the account summary from AP. The voucher shows the total reductions in the firm’sobligations and cash account as a result of payments to suppliers. These numbers are reconciled with theAP summary, and the AP control and cash accounts in the general ledger are updated accordingly. Theapproved journal voucher is then filed. This concludes the cash disbursements procedures.

F I G U R E

5-11 CASH DISBURSEMENTS JOURNAL (CHECK REGISTER)

Cash Disbursements Journal

Date Check

No.

DescriptionCredit

Cash Purch.

Disc.

GL / Subsidiary

Account Debited

Vouch Pay

401

Freight-in

516

Op Expen

509

Other Posted

9/4/09

9/4/09

9/12/09

9/14/09

101

102

103

104

Martin Motors

Pen Power

Acme Auto

Jones and Harper

500

100

500

3,000

Auto

Utility

Purchases

3,000

100

500

500

PostedVoucher

No.

1867

1868

1869

1870


EXPENDITURE CYCLE CONTROLSThis section describes the primary internal controls in the expenditure cycle according to the controlprocedures specified in Statement on Auditing Standards No. 78. The main points are summarized inTable 5-1.

Transaction AuthorizationPURCHASES SUBSYSTEM. The inventory control function continually monitors inventory levels. Asinventory levels drop to their predetermined reorder points, inventory control formally authorizes replen-ishment with a purchase requisition.

Formalizing the authorization process promotes efficient inventory management and ensures the legiti-macy of purchases transactions. Without this step, purchasing agents could purchase inventories at theirown discretion, being in a position both to authorize and to process the purchase transactions. Unautho-rized purchasing can result in excessive inventory levels for some items, while others go out of stock. Ei-ther situation is potentially damaging to the firm. Excessive inventories tie up the organization’s cashreserves, and stock-outs cause lost sales and manufacturing delays.

CASH DISBURSEMENTS SUBSYSTEM. The AP function authorizes cash disbursements via thecash disbursement voucher. To provide effective control over the flow of cash from the firm, the cash dis-bursements function should not write checks without this explicit authorization. A cash disbursementsjournal (check register) containing the voucher number authorizing each check (see Figure 5-11) providesan audit trail for verifying the authenticity of each check written.

Segregation of DutiesSEGREGATION OF INVENTORY CONTROL FROM THE WAREHOUSE. Within the pur-chases subsystem, the primary physical asset is inventory. Inventory control keeps the detailed records ofthe asset, while the warehouse has custody. At any point, an auditor should be able to reconcile inventoryrecords to the physical inventory.

T A B L E

5-1 SUMMARY OF EXPENDITURE CYCLE CONTROLS

Control Activity Purchases Processing System Cash Disbursements System

Transactions authorization Inventory control. AP authorizes payment.

Segregation of duties Inventory control separate from

purchasing and inventory custody. AP

subsidiary ledger separate from the

general ledger.

Separate AP subsidiary ledger, cash

disbursements, and general ledger

functions.

Supervision Receiving area.

Accounting records AP subsidiary ledger, general ledger,

purchases requisition file, purchase

order file, receiving report file.

Voucher payable file, AP subsidiary

ledger, cash disbursements journal,

general ledger cash accounts.

Access Security of physical assets. Limit access

to the accounting records above.

Proper security over cash. Limit access

to the accounting records above.

Independent verification AP reconciles source documents before

liability is recorded. General ledger

reconciles overall accuracy of process.

Final review by cash disbursements.

Overall reconciliation by general ledger.

Periodic bank reconciliation by

controller.


SEGREGATION OF THE GENERAL LEDGER AND ACCOUNTS PAYABLE FROM CASHDISBURSEMENTS. The asset subject to exposure in the cash disbursements subsystem is cash. Therecords controlling this asset are the AP subsidiary ledger and the cash account in the general ledger. Anindividual with the combined responsibilities of writing checks, posting to the cash account, and main-taining AP could perpetrate fraud against the firm. For instance, an individual with such access couldwithdraw cash and then adjust the cash account accordingly to hide the transaction. Also, he or she couldestablish fraudulent AP (to an associate in a nonexistent vendor company) and then write checks to dis-charge the phony obligations. By segregating these functions, we greatly reduce this type of exposure.

SupervisionIn the expenditure cycle, the receiving department is the area that most benefits from supervision. Large quan-tities of valuable assets flow through this area on their way to the warehouse. Close supervision here reducesthe chances of two types of exposure: (1) failure to properly inspect the assets and (2) the theft of assets.

INSPECTION OF ASSETS. When goods arrive from the supplier, receiving clerks must inspect itemsfor proper quantities and condition (damage, spoilage, and so on). For this reason, the receiving clerkreceives a blind copy of the original PO from purchasing. A blind PO has all the relevant informationabout the goods being received except for the quantities and prices. To obtain quantities information,which is needed for the receiving report, the receiving personnel are forced to physically count andinspect the goods. If receiving clerks were provided with quantity information via an open PO, they maybe tempted to transfer this information to the receiving report without performing a physical count.

Inspecting and counting the items received protect the firm from incomplete orders and damagedgoods. Supervision is critical at this point to ensure that the clerks properly carry out these importantduties. A packing slip containing quantity information that could be used to circumvent the inspectionprocess often accompanies incoming goods. A supervisor should take custody of the packing slip whilereceiving clerks count and inspect the goods.

THEFT OF ASSETS. Receiving departments are sometimes hectic and cluttered during busy periods.In this environment, incoming inventories are exposed to theft until they are securely placed in the ware-house. Improper inspection procedures coupled with inadequate supervision can create a situation that isconducive to the theft of inventories in transit.

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

Access ControlsDIRECT ACCESS. In the expenditure cycle, a firm must control access to physical assets such as cashand inventory. These control concerns are essentially the same as in the revenue cycle. Direct access con-trols include locks, alarms, and restricted access to areas that contain inventories and cash.

INDIRECT ACCESS. A firm must limit access to documents that control its physical assets. For exam-ple, an individual with access to purchase requisitions, purchase orders, and receiving reports has theingredients to construct a fraudulent purchase transaction. With the proper supporting documents, a fraud-ulent transaction can be made to look legitimate to the system and could be paid.


Independent VerificationINDEPENDENT VERIFICATION BY ACCOUNTS PAYABLE. The AP function plays a vital rolein the verification of the work others in this system have done. Copies of key source documents flow intothis department for review and comparison. Each document contains unique facts about the purchase trans-action, which the AP clerk must reconcile before the firm recognizes an obligation. These include:

1. The PO, which shows that the purchasing agent ordered only the needed inventories from a validvendor.3 This document should reconcile with the purchase requisition.

2. The receiving report, which is evidence of the physical receipt of the goods, their condition, and thequantities received. The reconciliation of this document with the PO signifies that the organizationhas a legitimate obligation.

3. The supplier’s invoice, which provides the financial information needed to record the obligation asan account payable. The AP clerk verifies that the prices on the invoice are reasonable comparedwith the expected prices on the PO.

INDEPENDENT VERIFICATION BY THE GENERAL LEDGER DEPARTMENT. The generalledger function provides an important independent verification in the system. It receives journal vouchersand summary reports from inventory control, AP, and cash disbursements. From these sources, the gen-eral ledger function verifies that the total obligations recorded equal the total inventories received and thatthe total reductions in AP equal the total disbursements of cash.

Physical SystemsIn this section we examine the physical system. This begins with a review of manual procedures and thenmoves on to deal with several forms of computer-based systems. As mentioned in the previous chapter,manual systems are covered here as a visual training aid to promote a better understanding of the conceptspresented in the previous section. From this point, therefore, the reader may continue with the review ofmanual systems or, without loss of technical content, bypass this material and go directly to computer-based purchases and cash disbursements applications located on page 234.

A MANUAL SYSTEMThe purpose of this section is to support the conceptual treatment of systems presented in the previoussection. This should help you envision the relationships between organizational units, the segregation ofduties, and the information flows essential to operations and effective internal control. In addition, wewill highlight inefficiencies intrinsic to manual systems, which gave rise to improved technologies andtechniques used by modern systems. The following discussion is based on Figure 5-12, which presents aflowchart of a manual purchases system.

Inventory ControlWhen inventories drop to a predetermined reorder point, the clerk prepares a purchase requisition. Onecopy of the requisition is sent to the purchasing department, and one copy is placed in the open purchaserequisition file. Note that to provide proper authorization control, the inventory control department is seg-regated from the purchasing department, which executes the transaction.

Purchasing DepartmentThe purchasing department receives the purchase requisitions, sorts them by vendor, and prepares a mul-tipart PO for each vendor. Two copies of the PO are sent to the vendor. One copy of the PO is sent to

3 Firms often establish a list of valid vendors with whom they do regular business. Purchasing agents must acquire inventories onlyfrom valid vendors. This technique deters certain types of fraud, such as an agent buying from suppliers with whom he or she has arelationship (a relative or friend) or buying at excessive prices from vendors in exchange for a kickback or bribe.


F I G U R E

5-12 MANUAL PURCHASE SYSTEM

A

B

C

D

A

B

C

D

C

Vendor Purchasing Department Inventory Control Receiving Accounts Payable General Ledger

PackingSlip

Invoice

ReceivingReport

PreparePurchase

Order

PurchaseRequisition

InventoryLedger

PR

PO

ReceivingReport

UpdateRecords

InventoryLedger

Summary

PRPO

RR

PO BlindCopy

PackingSlip

PrepareReceiving

Report

PO

PackingSlip

Stores

RR

ReceivingReport

Invoice

PO

ReceivingReport

VoucherRegister

Invoice(Copy)

PurchasesJournal

JournalVoucher

PO

ReceivingReport

Invoice

JournalVoucher Summary

GeneralLedger

Post andReconcile

Summary

JournalVoucher

PO

PO

ReviewRecords

Cash DisbursementVoucher

PostLiability

PurchaseRequisition

POPO

PO

PO

PO

PR

RRRR

RR

Accounts PayableSub Ledger

APPending File

PO

Voucher Payor Open AP

File

File

File

File

File

OpenPO

Reconcileand File

PurchaseRequisition

PurchaseOrder

ClosedPO

PurchaseReport

ReceivingReport

PurchaseRequisition

CH

AP

TE

R5

The

ExpenditureC

yclePartI:Purchases

andC

ashD


231

inventory control, where the clerk files it with the open purchase requisition. One copy of the PO is sentto 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 requisi-tion in the open PO file.

ReceivingGoods arriving from the vendor are reconciled with the blind copy of the PO. Upon completion of thephysical count and inspection, the receiving clerk prepares a multipart receiving report stating the quan-tity and condition of the inventories. One copy of the receiving report accompanies the physical invento-ries to the storeroom. Another copy is sent to the purchasing department, where the purchasing clerkreconciles it with the open PO. The clerk closes the open PO by filing the purchase requisition, the PO,and the receiving report in the closed PO file.

A third copy of the receiving report is sent to inventory control where (assuming a standard cost sys-tem) the inventory subsidiary ledger is updated. A fourth copy of the receiving report is sent to the APdepartment, where it is filed in the AP pending file. The final copy of the receiving report is filed in thereceiving department.

AP DepartmentWhen the invoice arrives, the AP clerk reconciles the financial information with the documents in thepending file, records the transaction in the purchases journal, and posts it to the supplier’s account in theAP subsidiary ledger (voucher register). After recording the liability, the AP clerk transfers the sourcedocuments (PO, receiving report, and invoice) to the open vouchers payable (APOK) file.

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

THE CASH DISBURSEMENTS SYSTEMSA detailed system flowchart of a manual cash disbursements system is presented in Figure 5-13. Thetasks performed in each of the key processes are discussed in the following section.

AP DepartmentEach day, the AP clerk reviews the open vouchers payable (AP) file for items due and sends the vouchersand supporting documents to the cash disbursements department.

Cash Disbursements DepartmentThe cash disbursements clerk receives the voucher packets and reviews the documents for completenessand clerical accuracy. For each disbursement, the clerk prepares a three-part check and records the checknumber, dollar amount, voucher number, 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. Theclerk returns the voucher 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 thegeneral ledger department.

AP DepartmentUpon receipt of the voucher packet, the AP clerk removes the liability by recording the check number inthe voucher register and filing the voucher packet in the closed voucher file. Finally, the clerk sends anAP summary to the general ledger department.


General Ledger DepartmentBased on the journal voucher from cash disbursements and the account summary from AP, the generalledger clerk posts to the general ledger control accounts and files the documents. This concludes the cashdisbursements procedures.

Concluding RemarksWe conclude our discussion of manual systems with two points of observation. First, notice how manualexpenditure cycle systems generate a great deal of paper documentation. Buying, preparing, transporting,and filing physical documents add considerably to the cost of system operation. As we shall see in thenext section, their elimination or reduction is a primary objective of computer-based systems design.

Second, for purposes of internal control, many functions such as the inventory control, purchasing,AP, cash disbursements, and the general ledger are located in physically separate departments. Theselabor-intensive activities also add greatly to the cost of system operation. In computer-based systems,computer programs perform these clerical tasks, which is much cheaper and far less prone to error.Although the classic department structure may still exist in computer-based environments, personnelresponsibilities are refocused. Rather than being involved in day-to-day transaction processing, thesedepartments are now involved with financial analysis and exception-based problem solving. As a result,these departments are smaller and more efficient than their manual system counterpart.

F I G U R E

5-13 CASH DISBURSEMENTS SYSTEM

Supplier

Cash Disb.Voucher

PurchaseOrder

ReceivingReport

Invoice

Cash Disb.Voucher

Cash Disb.Voucher

VoucherRegister

Cash Disb.Voucher

Cash Disb.Voucher

CloseVoucherand File

ClosedVoucherFile

Check(Copy)

Post to GLfrom JournalVoucher andReconcile GLto Summary

Check1

23

Check

SignChecks

PrepareChecks

CheckRegister

JournalVoucher

Summary JournalVoucher

GeneralLedgerSummary

JournalVoucher

A

Accounts Payable Cash Disbursements General Ledger

Check(Copy)

PORR

Invoice

PORR

InvoiceCD

Voucher

OpenVoucher

File

PORR

Invoice

PORR

Invoice

Check(Copy)

File

File

PORR

InvoiceSearch Open

Voucher File forItems Due

Summary

A


Computer-Based Purchases and CashDisbursements ApplicationsNow that we have covered the fundamental operational tasks and controls that constitute the expenditurecycle, let’s examine the role of computers. In Chapter 4 we presented a technology continuum with auto-mation at the low end and reengineering at the high end. Recall that automation involves using technol-ogy to improve the efficiency and effectiveness of a task, while the objective of reengineering is toeliminate nonvalue–added tasks. Reengineering involves replacing traditional procedures with innovativeprocedures that are often very different from those previously in place. In this section we see how bothautomation and reengineering techniques apply in purchases and cash disbursement systems.

AUTOMATING PURCHASES PROCEDURES USINGBATCH PROCESSING TECHNOLOGYThe automated batch system presented in Figure 5-14 has many manual procedures similar to those pre-sented in Figure 5-12. The principal difference is that accounting (bookkeeping) tasks are now automated.The following section describes the sequence of events as they occur in this system.

Data Processing Department: Step 1The purchasing process begins in the data processing department, where the inventory control function isperformed. When inventories are reduced by sales to customers or usage in production, the system deter-mines if the affected items in the inventory subsidiary file have fallen to their reorder points.4 If so, a re-cord is created in the open purchase requisition file. Each record in the requisition file defines a separateinventory item to be replenished. The record contains the inventory item number, a description of theitem, the quantity to be ordered, the standard unit price, and the vendor number of the primary supplier.The information needed to create the requisition record is selected from the inventory subsidiary record,which is then flagged ‘‘On Order’’ to prevent the item from being ordered again before the current orderarrives. Figure 5-15 shows the record structures for the files used in this system.

At the end of the day, the system sorts the open purchase requisition file by vendor number and con-solidates multiple items from the same vendor onto a single requisition. Next, vendor mailing informationis retrieved from the valid vendor file to produce hard copy purchase requisition documents, which go tothe purchasing department.

Purchasing DepartmentUpon receipt of the purchase requisition, the purchasing department prepares a multipart PO. Copies aresent to the vendor, AP, receiving, data processing, and the purchasing department’s file.

The system in Figure 5-14 employs manual procedures as a control over the ordering process. A com-puter program identifies inventory requirements and prepares traditional purchase requisitions, but thepurchasing agent reviews the requisitions before placing the order. Some firms do this to reduce therisk of placing unnecessary orders with vendors because of a computer error. Such manual interven-tion, however, does create a bottleneck and delays the ordering process. If sufficient computer controlsare in place to prevent or detect purchasing errors, then more efficient ordering procedures can beimplemented.

Before continuing with our example, we need to discuss alternative approaches for authorizing andordering inventories. Figure 5-16 illustrates three common methods.

In alternative one, the system takes the procedures shown in Figure 5-14 one step further. This systemautomatically prepares the PO documents and sends them to the purchasing department for review and

4 This may be batch or real time, depending on the revenue and conversion cycle systems that interface with the expenditure cycle.The raw materials and finished goods inventory files link these three transaction cycles together. The design of one systeminfluences the others. For example, if sales processing (revenue cycle) reduces inventories in real time, the system will naturallyidentify inventory requirements in real time also. This is true even if the purchases system is batch oriented.


F I G U R E

5-14 BATCH PURCHASES SYSTEM

Vendor

Vendor

Stores

Sales Procedures

Update Inventory andIdentify Items at theirreorder points. Thisprogram creates an openpurchase requisition file.

Sort by Vendorand Prepare

PurchaseRequisitions

Open PurchaseRequisition File

Close OutOpen PO

Voucher(Batch)

VoucherFile

OpenAP File

PR

PO

RR

Invoice

Voucher

ReceivingReport

PurchaseOrder

Voucher

Vendor

SupplierInvoice

Match Invoice withAP Pending File

and Prepare CashDisbursement

Voucher

Open Voucher File

Step 1

Step 2

Step 3

Step 4

Purchases Receiving Accounts Payable

PurchaseRequisition

PurchaseOrder

PurchaseOrder

PackingSlip

InventorySub File

UpdateProgram

OpenPO File

ClosedRequisition File

GL BatchTotals

RecordVoucher

in Register

VendorFile

VoucherRegister

GL BatchTotals

OpenPO File

UpdateInventory

InventorySub Ledger

UpdatedInventory

ClosedPO File

Receiving Report File

Receiving Report File

Accounts PayPending File

PurchaseOrder

PurchaseRequisition

ReceivingReport

PurchaseOrder(Batch)

ReceivingReport

ReceivingReport

ReceivingReport

Vendor File

Open PurchaseRequisition File

Enter PO

UpdateProgram

PreparePO

POPO

POPO

PrepareRR

RR

RR

Enter RecReport

EnterVoucher

B

A

D

EA

D

EE

B

File

Data Processing Purchases System

PR

continued

CH

AP

TE

R5

The

ExpenditureC

yclePartI:Purchases

andC

ashD


235

F I G U R E

5-14 BATCH PURCHASES SYSTEM (Continued)

VoucherRegister

CheckRegister

ClosedAP File

GL BatchTotals

TransactionListing

Check

CopyCopy

Search Voucher Filefor Items Due. WriteChecks, Record inCheck Register

End-of-Day Procedures: General Ledger Update

Batch Totals

Inventory

Open AP

Closed AP

Cash Disbursements

Update GL fromBatch Totals

Updated

Closed Voucher File

Check

VoucherInvoice

RRPO

PR

Voucher

InvoiceRR

POPR Check

Copy

Match Check withSupport Documentsin Open Voucher File

Check

CopyCopy

A

Match

TransactionListing

TransactionListing

Check

CopyCopy

SignChecks

Check

File

Vendor

A

(Cash DisbursementsJournal)

GeneralLedger

Accounts Payable Cash DisbursementsData Processing Cash Disbursements System

OpenVoucher

File

236P

AR

TI

IT

ransactionC

yclesand

BusinessProcesses

signing. The purchasing agent then mails the approved POs to the vendors and distributes copies to otherinternal users.

Alternative two expedites the ordering process by distributing the POs directly to the vendors and in-ternal users, thus bypassing the purchasing department completely. Instead, the system produces a trans-action list of items ordered for the purchasing agent’s review.

Alternative three represents a reengineering technology called electronic data interchange. Theconcept was introduced in Chapter 4 to illustrate its application to the revenue cycle. This methodproduces no physical POs. Instead, the computer systems of both the buying and selling companiesare connected via a dedicated telecommunications link. The buyer and seller are parties to a tradingpartner arrangement in which the entire ordering process is automated and unimpeded by humanintervention.

In each of the three alternatives, the tasks of authorizing and ordering are integrated within the com-puter system. Because physical purchase requisitions have no purpose in such a system, they are not pro-duced. Digital requisition records, however, would still exist to provide an audit trail.

F I G U R E

5-15 RECORD STRUCTURES FOR EXPENDITURE CYCLE FILES

InvenNum

Description Qnty on Hand

EOQ VendorNumber

Standard Cost

Total Inven.Cost

Pur ReqNumber

InvenNum

Qnty on Order

VendorNumber

Unit StandardCost

Open (and Closed)Purchase Requisition File

Inventory Master File

VendorNumber

Address Terms ofTrade

Date of Last Order

Vendor File

PO Num

Pur ReqNumber

InvenNum

Qnty OnOrder

VendorNumber

Address StandardCost

ExpectedInvoiceAmount

RecFlag

Open (and Closed)Purchase Order File

VoucherNumber

CheckNum

InvoiceNum

AcctCr

AcctDR

OpenDate

CloseDate

Voucher Register (Open AP File)

InvoiceAmount

ReorderPoint

LeadTime

VendorNumber

DueDate

Rec RptNumber

PONum

CarrierCode

ConditionCode

DateReceived

A value in this field is a "flag" to prevent the system from ordering the item a second time. When inventories are received,the flag is removed by changing this value to zero.

Rec Report File

Qnty OnOrder


F I G U R E

5-16 ALTERNATIVE INVENTORY ORDERING PROCEDURES

Purchases

Acct Pay CopyBlind Copy

File Copy

PurchaseOrder


File Copy

PurchaseOrder

Reviewand

Distribute

Vendor

Open PurchaseOrder File

PurchaseRequisition File

PreparePurchaseOrders Vendor File


File Copy

PurchaseOrder

Blind Copy Acct Pay Copy

Data Processing Department Receiving Accounts Payable

Purchases





Purchase Order

TransactionList

Blind Copy Acct Pay Copy

Data Processing Department Receiving Accounts Payable

ALTERNATIVE ONE

TransactionList

ReviewandFile

TransactionList

Vendor

ALTERNATIVE TWO




Vendor

Data Processing Department

Electronic Transfer of Purchase OrderDirect to Vendor's Computer System

ALTERNATIVE THREE

File

File


Data Processing Department: Step 2As explained in Figure 5-14, a copy of the PO is sent to data processing and used to create a record in theopen PO file. The associated requisitions are then transferred from the open purchase requisition file tothe closed purchase requisition file.

Receiving DepartmentWhen the goods arrive from vendors, the receiving clerk prepares a receiving report and sends copies tothe stores (with the goods), purchasing, AP, and data processing.

Data Processing Department: Step 3The data processing department creates the receiving report file from data provided by the receivingreport documents. Then a batch program updates the inventory subsidiary file from the receiving reportfile. The program removes the ‘‘On Order’’ flag from the updated inventory records and calculates batchtotals of inventory receipts, which will later be used in the general ledger update procedure. Finally, theassociated records in the open PO file are transferred to the closed PO file.

Accounts PayableWhen the AP clerk receives the supplier’s invoice, he or she reconciles it with the supporting documentsthat were previously placed in the AP pending file. The clerk then prepares a voucher, files it in the openvoucher file, and sends a copy of the voucher to data processing.

Data Processing Department: Step 4The voucher file is created from the voucher documents. A batch program validates the voucher recordsagainst the valid vendor file and adds them to the voucher register (open AP subsidiary file). Finally,batch totals are prepared for subsequent posting to the AP control account in the general ledger.

CASH DISBURSEMENTS PROCEDURESData Processing DepartmentEach day, the system scans the DUE DATE field of the voucher register (see Figure 5-15) for items due.Checks are printed for these items, and each check is recorded in the check register (cash disbursementsjournal). The check number is recorded in the voucher register to close the voucher and transfer the itemsto the closed AP file. The checks, along with a transaction listing, are sent to the cash disbursementsdepartment. Finally, batch totals of closed AP and cash disbursements are prepared for the general ledgerupdate procedure.

At the end of the day, batch totals of open (unpaid) and closed (paid) AP, inventory increases, andcash disbursements are posted to the AP control, inventory control, and cash accounts in the generalledger. The totals of closed AP and cash disbursements should balance.

Cash Disbursements DepartmentThe cash disbursements clerk reconciles the checks with the transaction listing and submits the negotiableportion of the checks to management for signing. The checks are then mailed to the suppliers. One copyof each check is sent to AP, and the other copy is filed in cash disbursements, along with the transactionlisting.

Accounts Payable DepartmentUpon receipt of the check copies, the AP clerk matches them with open vouchers and transfers these nowclosed items to the closed voucher file. This concludes the expenditure cycle process.


REENGINEERING THE PURCHASES/CASH DISBURSEMENTS SYSTEMThe automated system described in the previous section simply replicates many of the procedures in amanual system. In particular, the AP task of reconciling supporting documents with supplier invoices islabor-intensive and costly. The following example shows how reengineering this activity can produceconsiderable 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 discrepan-cies among supplier invoices, receiving reports, and POs. The first step in solving the problem was tochange the business environment. Ford initiated trading partner agreements with suppliers in which theyagreed in advance to terms of trade such as price, quantities to be shipped, discounts, and lead times. Withthese sources of discrepancy eliminated, Ford reengineered the work flow to take advantage of the newenvironment. The flowchart in Figure 5-17 depicts the key features of a reengineered system.

Data ProcessingThe following tasks are performed automatically.

1. The inventory file is searched for items that have fallen to their reorder points.

2. A record is entered in the purchase requisition file for each item to be replenished.

3. Requisitions are consolidated according to vendor number.

F I G U R E

5-17 REENGINEERED PURCHASES/CASH DISBURSEMENTS SYSTEM

Scan Inventoryand Prepare

Purchase Orders

Vendor

Purchasing

Vendor

File

File

PurchaseOrders

TransactionListing

Purch. Req.File

Open POFile

InventoryFile

GLControl

ReceivingReport File

TransactionListing

PackingSlip

ReceivingReport

GoodsArrive

TransactionListing

Checks

ValidVendors

Open APFile

CashDisbursements

Inventory

GL ControlAccts

Closed APFile

Check Register

Data Processing Receiving Accounts Payable

PrepareRec Report

Print Report

Update Inventory File and Flag Items Received

in the Open PO File. Update GL File.

Transfer the Closed POto the Open AP file.

A Batch Program atthe End of the Day

Selects AP Due, WritesChecks, and Records

These in Register


4. Vendor mailing information is retrieved from the valid vendor file.

5. Purchase orders are prepared and added to the open PO file.

6. A transaction listing of POs is sent to the purchasing department for review.

Receiving DepartmentWhen the goods arrive, the receiving clerk accesses the open PO file in real time by entering the PO num-ber taken from the packing slip. The receiving screen, illustrated in Figure 5-18, then prompts the clerk toenter the quantities received for each item on the PO.

Data ProcessingThe following tasks are performed automatically by the system.

1. Quantities of items received are matched against the open PO record, and a Y value is placed in alogical field to indicate the receipt of inventories.

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

3. The inventory subsidiary records are updated to reflect the receipt of the inventory items.

4. The general ledger inventory control account is updated.

5. The record is removed from the open PO file and added to the open AP file, and a due date for pay-ment is established.

Each day, the DUE DATE fields of the AP records are scanned for items due to be paid. The followingprocedures are performed for the selected items.

1. Checks are automatically printed, signed, and distributed to the mail room for mailing to vendors.EDI vendors receive payment by electronic funds transfer (EFT). EFT is discussed in the appendix toChapter 12.

2. The payments are recorded in the check register file.

3. Items paid are transferred from the open AP file to the closed AP file.

4. The general ledger AP and cash accounts are updated.

5. Reports detailing these transactions are transmitted via terminal to the AP and cash disbursementsdepartments for management review and filing.

Because the financial information about purchases is known in advance from the trading partner agree-ment, the vendor’s invoice provides no critical information that cannot be derived from the receiving

F I G U R E

5-18 RECEIVING SCREEN

DATE: 12/15/09 CLERK ID

ITEM # QTY RECVD

45-709

Displays after Qty Recvdhas been entered

Discrepancy

MANUAL ENTRY =

55 5

QTY ORDER

MDPURCH. ORDER # 567

50


report. By eliminating this source of potential discrepancy, Ford was able to eliminate the task of recon-ciling vendor invoices with the supporting documents for the majority of purchase transactions. As aresult of its reengineering effort, Ford was able to reduce its AP staff from 500 to 125.

CONTROL IMPLICATIONSThe general control issues raised in Chapter 4 pertain also to the expenditure cycle and are not revisitedhere. A full treatment of this material is provided in Chapters 15 through 17. In the following section weexamine only the issues specific to the expenditure cycle by focusing on the differences between an auto-mated and a reengineered system.

The Automated SystemIMPROVED INVENTORY CONTROL. The greatest advantage of the automated system over itsmanual counterpart is improved ability to manage inventory needs. Inventory requirements are detectedas they arise and are processed automatically. As a result, the risks of accumulating excessive inventoryor of running out of stock are reduced. With this advantage, however, comes a control concern. Authori-zation rules governing purchase transactions are embedded within a computer program. Program errorsor flawed inventory models can cause firms to find themselves suddenly inundated with inventories ordesperately short of stock. Therefore, monitoring automated decisions is extremely important. A well-controlled system should provide management with adequate summary reports about inventory pur-chases, inventory turnover, spoilage, and slow-moving items.

BETTER CASH MANAGEMENT. The automated system promotes effective cash management byscanning the voucher file daily for items due, thus avoiding early payments and missed due dates. In addi-tion, by writing checks automatically, the firm reduces labor cost, saves processing time, and promotesaccuracy.

To control against unauthorized payments, all additions to the voucher file should be validated bycomparing the vendor number on the voucher against the valid vendor file. If the vendor number is noton file, the record should be diverted to an error file for management review.

In this system, a manager in the cash disbursements department physically signs the checks, thus pro-viding control over the disbursement of cash. Many computer systems, however, automate check signing,which is more efficient when check volume is high. This, naturally, injects risk into the process. To offsetthis exposure, firms set a materiality threshold for check writing. Checks in amounts below the thresholdare signed automatically, while those above the threshold are signed by an authorized manager or thetreasurer.

TIME LAG. A lag exists between the arrival of goods in the receiving department and recording inven-tory receipts in the inventory file. Depending on the type of sales order system in place, this lag may neg-atively affect the sales process. When sales clerks do not know the current status of inventory, sales maybe lost.

PURCHASING BOTTLENECK. In this automated system, the purchasing department is directlyinvolved in all purchase decisions. For many firms this creates additional work, which extends the time lagin the ordering process. A vast number of routine purchases could be automated, thus freeing purchasingagents from routine work such as preparing POs and mailing them to the vendors. Attention can then befocused on problem areas (such as special items or those in short supply), and the purchasing staff can bereduced.

EXCESSIVE PAPER DOCUMENTS. The automated system is laden with paper documents. All opera-tions departments create documents, which are sent to data processing, and which data processing must thenconvert to magnetic media. Paper documents add costs because they must be purchased, stored, prepared,handled by internal mail carriers, and converted by data processing personnel. Organizations with high vol-umes of transactions benefit considerably from reducing or eliminating paper documents in their systems.


The Reengineered SystemThe reengineered system addresses many of the operational weaknesses associated with the automatedsystem. Specifically, the improvements in this system are that (1) it uses real-time procedures and directaccess files to shorten the lag time in record keeping, (2) it eliminates routine clerical procedures by dis-tributing terminals to user areas, and (3) it achieves a significant reduction in paper documents by usingdigital communications between departments and by digitally storing records. These operational improve-ments, however, have the following control implications.

SEGREGATION OF DUTIES. This system removes the physical separation between authorizationand transaction processing. Here, computer programs authorize and process POs as well as authorize andissue checks to vendors. To compensate for this exposure, the system provides management with detailedtransaction listings and summary reports. These documents describe the automated actions taken by thesystem and allow management to spot errors and any unusual events that warrant investigation.

ACCOUNTING RECORDS AND ACCESS CONTROLS. Advanced systems maintain accountingrecords on digital storage media, with little or no hard-copy backup. Sarbanes-Oxley legislation requiresorganization management to implement adequate control security measures to protect accounting recordsfrom unauthorized access and destruction.

SummaryThe chapter examined procurement procedures involving theacquisition of raw materials and finished goods. Because mostorganizations conduct these activities on a credit basis, the in-formation system needs to be designed to properly recognizeand record obligations as they arise and to discharge themwhen they come due. Two expenditure cycle subsystems ac-complish these tasks: the purchases system and the cash dis-bursements system. This chapter focused on the followingareas:

1. The processes of each subsystem and the flow of infor-mation between them.

2. The documents, journals, and accounts needed to pro-vide audit trails, maintain historical records, and supportinternal decision making and financial reporting.

3. The areas of exposure and the control techniques thatreduce these risks.

The chapter examined the impact of technology on items1, 2, and 3 in the preceding list. From this perspective, we sawthat automated systems use computers to replicate traditionalmanual tasks. Reengineered systems, however, involve andrequire new and innovative ways of dealing with traditionalproblems. Any technological solution carries control implica-tions. Computers remove a fundamental separation of func-tions between authorizing and processing transactions. Also atrisk is the integrity of accounting records. To control theserisks, systems must be designed to provide users with docu-ments and reports that permit independent verification andsupport audit trail needs.

Key Termsactual cost inventory ledgers (222)AP pending file (221)AP subsidiary ledger (223)blind copy (221)cash disbursement vouchers (223)cash disbursements journal (227)check register (227)closed AP file (239)closed purchase order (PO) file (218)closed voucher file (227)inventory subsidiary file (234)

open AP file (223)open purchase order (PO) file (218)open purchase requisition file (230)open vouchers payable (AP) file (232)purchase order (218)purchase requisition (218)receiving report (221)receiving report file (221)standard cost system (222)supplier’s invoice (223)valid vendor (218)


valid vendor file (234)vendor’s invoice (241)voucher packet (227)

voucher register (223)vouchers payable file (223)vouchers payable system (223)

Review Questions1. Differentiate between a purchase requisition and a

purchase order.

2. What purpose does a purchasing departmentserve?

3. Distinguish between an accounts payable file and avouchers payable file.

4. What are the three logical steps of the cash dis-bursements system?

5. What general ledger journal entries does the pur-chases system trigger? From which departmentsdo these journal entries arise?

6. What two types of exposures can close supervi-sion of the receiving department reduce?

7. How can a manual purchases cash disbursementssystem be reengineered to reduce discrepancies,be more accurate, and reduce processing costs?

8. What steps of independent verification does thegeneral ledger department perform?

9. What is (are) the purpose(s) of maintaining a validvendor file?

10. How do computerized purchasing systems help toreduce the risk of purchasing bottlenecks?

11. What is the purpose of the blind copy of a pur-chase order?

12. Give one advantage of using a vouchers payablesystem.

Discussion Questions1. What three documents must accompany the pay-

ment of an invoice? Discuss where these threedocuments originate and the resulting controlimplications.

2. Are any time lags in recording economic eventstypically experienced in cash disbursements sys-tems? If so, what are they? Discuss the accountingprofession’s view on this matter as it pertains to fi-nancial reporting.

3. Discuss the importance of supervision controls inthe receiving department and the reasons behindblind fields on the receiving report, such as quan-tity and price.

4. Why do the inventory control and general ledgerdepartments seem to disappear in computer-basedpurchasing systems (Figure 5-14)? Are these func-tions no longer important enough to have theirown departments?

5. How does the procedure for determining inventoryrequirements differ between a basic batch-process-ing system and batch processing with real-time data

input of sales and receipts of inventory? What aboutfor the procedures the receiving department uses?

6. What advantages are achieved in choosing

a. a basic batch computer system over a manualsystem?

b. a batch system with real-time data input over abasic batch system?

7. Discuss the major control implications of batchsystems with real-time data input. What compen-sating procedures are available?

8. Discuss some specific examples in which informa-tion systems can reduce time lags and how thefirm is positively affected by such time lags.

9. You are conducting an end-of-year audit. Assumethat the terms of trade between a buyer and aseller are free on board (FOB) destination. Whatdocument provides evidence that a liability existsand may be unrecorded?

10. Describe a three-way match.


Multiple-Choice Questions1. Which document helps to ensure that the receiv-

ing clerks actually count the number of goodsreceived?

a. packing list

b. blind copy of purchase order

c. shipping notice

d. invoice

2. When the goods are received and the receivingreport has been prepared, which ledger may beupdated?

a. standard cost inventory ledger

b. inventory subsidiary ledger

c. general ledger

d. accounts payable subsidiary ledger

3. Which statement is NOT correct for anexpenditure system with proper internalcontrols?

a. Cash disbursements maintain the checkregister.

b. Accounts payable maintains the accounts pay-able subsidiary ledger.

c. Accounts payable is responsible for payinginvoices.

d. Accounts payable is responsible for authoriz-ing invoices.

4. Which duties should be segregated?

a. matching purchase requisitions, receivingreports, and invoices and authorizingpayment

b. authorizing payment and maintaining the checkregister

c. writing checks and maintaining the checkregister

d. authorizing payment and maintaining theaccounts payable subsidiary ledger

5. Which documents would an auditor mostlikely choose to examine closely to ascertainthat all expenditures incurred during theaccounting period have been recorded asa liability?

a. invoices

b. purchase orders

c. purchase requisitions

d. receiving reports

6. Which task must still require human interventionin an automated purchases/cash disbursementssystem?

a. determination of inventory requirements

b. preparation of a purchase order

c. preparation of a receiving report

d. preparation of a check register

7. Which one of the following departments does nothave a copy of the purchase order?

a. the purchasing department

b. the receiving department

c. accounts payable

d. general ledger

8. Which document typically triggers the process ofrecording a liability?

a. purchase requisition

b. purchase order

c. receiving report

d. supplier’s invoice

9. Which of the following tasks should the cash dis-bursement clerk NOT perform?

a. review the supporting documents for com-pleteness and accuracy

b. prepare checks

c. approve the liability

d. mark the supporting documents paid

10. Which of the following is true?

a. The cash disbursement function is part ofaccounts payable.

b. Cash disbursements is an independentaccounting function.

c. Cash disbursements is a treasury function.

d. The cash disbursement function is part of thegeneral ledger department.


Problems1. UNRECORDED LIABILITIESYou are auditing the financial statements of a New YorkCity company that buys a product from a manufacturerin Los Angeles. The buyer closes its books on June 30.Assume the following details:

Terms of trade FOB shipping point

June 10, buyer sends purchase order to seller

June 15, seller ships goods

July 5, buyer receives goods

July 10, buyer receives seller’s invoice

Requireda. Could this transaction have resulted in an

unrecorded liability in the buyer’s financialstatements?

b. If yes, what documents provide audit trail evidenceof the liability?

c. On what date did the buyer realize the liability?

d. On what date did the buyer recognize the liability?

New assumption:

Terms of trade free on board destination

e. Could this transaction have resulted in anunrecorded liability in the buyer’s financialstatements?

f. If yes, what documents provide audit trail evidenceof the liability?

g. On what date did the buyer realize the liability?

h. On what date did the buyer recognize the liability?

2. INVENTORY ORDERINGALTERNATIVESRefer to Figure 5-16 in the text, which illustrates threealternative methods of ordering inventory.

Requireda. Distinguish between a purchase requisition and a

purchase order.

b. Discuss the primary advantage of alternative twoover alternative one. Be specific.

c. Under what circumstances can you envision man-agement using alternative one rather than alterna-tive two?

3. DOCUMENT PREPARATIONCreate the appropriate documents (purchase requisition,purchase order, receiving report, inventory record, anddisbursement voucher), and prepare any journal entriesneeded to process the following business events forJethro’s Boot & Western Wear Manufacturing Com-pany (this is a manual system).

a. On October 28, 2005, the inventory subsidiaryledger for Item 2278, metal pins, indicates that thequantity on hand is 4,000 units (valued at $76), thereorder point is 4,750, and units are on order. Theeconomic order quantity is 6,000 units. The sup-plier is Jed’s Metal Supply Company (vendor num-ber 83682). The customer number is 584446. Thecurrent price per unit is $0.02. Inventory recordsare kept at cost. The goods should be delivered toInventory Storage Room 2.

b. On November 8, the goods were received (thescales indicated that 4,737 units were received).

c. On November 12, an invoice (number 9886) wasreceived for the above units, which included freightof $6. The terms were 1/10, net 30. Jethro’s likes tokeep funds available for use as long as possiblewithout missing any discounts.

4. FLOWCHART ANALYSISExamine the diagram for Problem 4 and indicate anyincorrect initiation and/or transfer of documentation.What problems could this cause?

5. ACCOUNTING RECORDSAND FILESIndicate which department—accounts payable, cash dis-bursements, data processing, purchasing, inventory, orreceiving—has ownership over the following files andregisters:

a. open purchase order file

b. purchase requisition file

c. open purchase requisition file

d. closed purchase requisition file

e. inventory

f. closed purchase order file

g. valid vendor file


PROBLEM 4: FLOWCHART ANALYSIS

PurchaseRequisition

32

1

PurchaseOrder

Packing Slip

Invoice ReceivingReport

PurchaseOrder

InventoryLedger

ReceivingReport

Inventory Ledger

JournalVoucher

Stores

ReceivingReport

RR

PackingSlip

PackingSlip

PO

PO

Invoice

ReceivingReport

PO

PurchaseRequisition

PurchaseRequisition

PO

ReceivingReport

VoucherRegister

PO

ReceivingReport

PurchaseRequisition

PR

POJournalVoucher

JournalVoucher

GeneralLedger

JournalVoucher

General LedgerAccounts Payable Cash DisbursementsReceivingInventory ControlVendor Purchases

Clerk Compare

Packing Slipwith PO and Prepare RR

PreparePurchase

Requisitionand PO

Update InventoryLedgers

File and PrepareJournal Voucher

Record Liability inVoucher Register and

Prepare Journal Voucher

UpdateGeneralLedger

32

1

32

1

JournalVoucher

JournalVoucher

A

B

E

C

PRPO

RR

C

D

A

32

1

E

B

D

Cash DisbVoucher

Invoice

CH

AP

TE

R5

The

ExpenditureC

yclePartI:Purchases

andC

ashD


247

h. voucher register

i. open vouchers payable file

j. receiving report file

k. closed voucher file

l. check register (cash disbursements journal)

6. SOURCE DOCUMENTSIDENTIFICATIONExplain, in detail, the process by which the informationis obtained and the source of information for each of thefields in the expenditure cycle files. (See Figure 5-15for a complete listing of files and fields.)

7. DATA PROCESSINGExplain how the processing procedures would differ, ifat all, for the transactions listed in Problem 6 if a com-puter-based system with

a. a basic batch-processing system were implemented.

b. a batch-processing system with real-time data inputwere used.

8. INTERNAL CONTROLUsing the flowchart for Problem 8 of a purchases sys-tem, identify six major control weaknesses in the sys-tem. Discuss and classify each weakness in accordancewith SAS 78/COSO.

9. PURCHASE DISCOUNTS LOSTEstimate the amount of money accounts payable andcash disbursements departments could save if a basicbatch-processing system were implemented. Assumethat the clerical workers cost the firm $12 per hour, that13,000 vouchers are prepared, and that 5,000 checks arewritten per year. Assume that total cash disbursementsto vendors amount to $5 million per year. Because ofsloppy bookkeeping, the current system takes advantageof only about 25 percent of the discounts vendors offerfor timely payments. The average discount is 2 percentif payment is made within 10 days. Payments are cur-rently made on the 15th day after the invoice isreceived. Make your own assumptions (and state them)regarding how long specific tasks will take. Also dis-cuss any intangible benefits of the system. (Don’t worryabout excessive paper documentation costs.)

PROBLEM 8: INTERNAL CONTROL

PurchasingPrepares ThreeCopies of PO

32

Goods Arrive from Vendor

with Packing Slip

AP Ledger

Invoice

Check

Invoice

Invoice

A

A

12

Vendor Purchases Inventory Control Receiving Accounts Payable Cash Disbursments General Ledger

Check1

2

PurchaseOrder

PurchaseOrder

PurchaseOrder

1 3

InventoryLedger

ReceivingReport

PackingSlip

CashDisbursement

Voucher

CheckCopy

CheckCopy

CheckCopy

CashDisbursement

Voucher

CashDisbursement

Voucher

GeneralLedger

PurchaseOrder

3


10. DATA PROCESSING OUTPUTUsing the information provided in Problem 9, discuss alltransaction listings and summary reports that would benecessary for a batch system with real-time input of data.

11. INTERNAL CONTROLThe following is a description of manufacturing com-pany’s purchasing procedures. All computers in the com-pany are networked to a centralized accounting system sothat each terminal has full access to a common database.

The inventory control clerk periodically checks in-ventory levels from a computer terminal to identifyitems that need to be ordered. Once the clerk feels in-ventory is too low, he chooses a supplier and creates apurchase order from the terminal by adding a record tothe purchase order file. The clerk prints a hard copy ofthe purchase order and mails it to the vendor. An elec-tronic notification is also sent to accounts payable andreceiving, giving the clerks of each department accessto the purchase order from their respective terminals.

When the raw materials arrive at the unloading dock,a receiving clerk prints a copy of the purchase orderfrom his terminal and reconciles it to the packing slip.The clerk then creates a receiving report on a computersystem. An electronic notification is sent to accountspayable and inventory control, giving the respectiveclerks access to the receiving report. The inventory con-trol clerk then updates the inventory records.

When the accounts payable clerk receives a hard-copy invoice from the vendor, she reconciles theinvoice with the digital purchase order and receivingreport and prepares a paper cash disbursements voucher.The cash disbursements voucher and invoice are placedin the open accounts payable file in a filing cabinet until

the due date. The clerk also updates the accounts pay-able subsidiary ledger and records the liability amount inthe purchase journal from the department computer ter-minal. The accounts payable clerk periodically reviewsthe cash disbursement file for items due and, when theyare identified, prepares a check for the amount due.Finally, using the department terminal, the clerk removesthe liability from the accounts payable subsidiary file andposts the disbursement to the cash account.

Requireda. Create a system flowchart of the system.

b. Analyze the internal control weaknesses in the sys-tem. Model your response according to the six cate-gories of physical control activities specified inSAS 78/COSO.

12. ACCOUNTING DOCUMENTS

RequiredAnswer the following questions.

a. Which department is responsible for initiating thepurchase of materials?

b. What is the name of the document generated bythe department identified in (a) above?

c. Typically, multiple copies of a purchase order areprepared. One copy should go to the vendor, andone is retained in the purchasing department. Toachieve proper control, which other departmentsshould receive copies of the purchase order?

d. What documents does the accounts payable clerkreview before setting up a liability?

e. Which document transfers responsibility for goodssold to a common carrier?

Internal Control Cases1. Smith’s Market (Small Business CashSales Accounting System)In 1989 Robert Smith opened a small fruit and vegeta-ble market in Bethlehem, Pennsylvania. OriginallySmith sold only produce grown on his family farmand orchard. As the market’s popularity grew, however,he added bread, canned goods, fresh meats, and a lim-ited supply of frozen goods. Today Smith’s Market is afull-range farmers’ market with a strong local customerbase. Indeed, the market’s reputation for low prices andhigh quality draws customers from other Pennsylvaniacities and even from the neighboring state of NewJersey. Currently Smith’s has 40 employees. These

include sales staff, shelf stockers, farm laborers, shiftsupervisors, and clerical staff. Recently Smith hasnoticed a decline in profits and sales, while his pur-chases of products for resale have continued to rise.Although the company does not prepare auditedfinancial statements, Robert Smith has commissionedyour public accounting firm to assess his company’ssales procedures and internal controls. Smith’s Marketexpenditure cycle procedures are described below:

Expenditure CycleThe expenditure cycle begins in the warehouse adjacentto the market where Smith’s keeps their inventory of


nonperishable goods such as canned goods and paperproducts. They also maintain a one-day inventory of pro-duce and other perishable products in the warehousewhere they can quickly restock the shelves when neces-sary. At close of business each evening the warehouseclerk reviews the market shelves for items that need to bereplenished. The clerk restocks the shelves and adjuststhe digital stock records accordingly from the warehousePC. At this time the clerk takes note of what needs to bereordered from the suppliers and prints purchase ordersfrom the PC. Depending upon the nature of the productand urgency of the need, the clerk either mails the pur-chase order to the supplier or orders by phone. Phoneorders are followed up by faxing the purchase order tothe supplier.

When the goods arrive from the vendor the ware-house clerk reviews the packing slip, restocks the ware-house shelves, and updates the stock records from thePC. At the end of the day the clerk prepares a hard-copypurchases summary from the PC and sends it to thetreasury clerk for posting to general ledger.

The vendor’s invoice is sent to the accounting clerk.She examines it for correctness and files it in a tempo-rary file until it is due to be paid. The clerk reviews thetemporary file daily looking for invoices to be paid.Using the accounting department PC, the clerk prints acheck and records it in the digital check register. Shethen files the invoice and mails the check to the supplier.At the end of the day she prints a hard-copy journalvoucher from the PC, which summarizes the day’s cashdisbursements, and sends it to the treasury clerk for post-ing to the general ledger.

Using the department PC, the treasury clerk posts thejournal voucher and purchases summary information tothe appropriate general ledger accounts.

Requireda. Create a data flow diagram of the current system.

b. Create a system flowchart of the current system.

c. Analyze the internal control weaknesses in thesystem. Model your response according to the sixcategories of physical control activities specified inSAS 78/COSO.

2. Spice Is Right Imports (Stand-Alone PC-Based Accounting System)Spice Is Right was established in 1990 in Boston wherethey began importing exotic spices and cooking saucesfrom India and China. They distribute these specialtyfoods to ethnic food shops, cafes, and restaurants acrossthe country. In addition to their Boston headquartersand warehouse, the company has a distribution center in

Elizabeth, New Jersey. Spice Is Right currently employsover 100 people, has dozens of suppliers, and trades inhundreds of ethnic and exotic foods from all over theworld.

Recently, Spice Is Right has been receiving com-plaints from customers and suppliers about billing, ship-ping, and payment errors. Management believes thatthese complaints stem, in part, from an antiquated com-puter system. Spice’s current information systemincludes manual procedures supported by independent(non-networked) PC in each department, which cannotcommunicate with each other. Document flows betweenthe departments is entirely in hard-copy form. The fol-lowing is a description of their expenditure cycle at theBoston headquarters office.

Purchasing ProcessThe purchasing agent monitors the inventory levelsby reviewing the inventory subsidiary ledger fromhis department computer. He decides which items needto be replenished and selects a supplier. He then entersthis information into the computer terminal to createa digital purchase order. The computer terminal gener-ates three hard copies of the purchase order. The pur-chasing agent sends one copy to the supplier, one copyto the accounts payable department where it is filedtemporarily, and files the third copy in the purchasingdepartment.

When the goods are received, the receiving depart-ment inspects and verifies them using the packing slip,which is attached to the goods. The receiving clerkmanually prepares two hard copies of a receiving report.One copy accompanies the goods to the warehouse forstorage. The receiving clerk sends the second copy tothe purchasing agent who uses it to update the inventorysubsidiary ledger and to close the open purchase order.The purchase agent then files the receiving report in thedepartment.

Accounts Payable and CashDisbursements ProceduresThe accounts payable clerk receives the supplier’sinvoice and reconciles it with the purchase order in thetemporary file. From her computer terminal the clerkrecords the purchase in the purchases journal andrecords the liability by creating a cash disbursementvoucher. The clerk then updates the inventory controland accounts payable control accounts in the generalledger. The purchases order and invoice are then filedin the department.


Each day, the clerk visually searches the cash dis-bursements voucher file from her terminal for openinvoices that are due to be paid. From her computer ter-minal, the clerk prepares the check and records it in thecheck register. The negotiable portion of the check ismailed to the vendor, and a check copy is filed. The clerkthen closes the voucher register and updates the accountspayable control and cash accounts in the general ledger.


b. Create a system flowchart of the existing system.


d. Prepare a system flowchart of a redesigned computer-based system that resolves the control weaknessesyou identified. Explain your solution.

3. ABE Plumbing, Inc. (Centralized SmallBusiness Accounting System)ABE Plumbing, Inc., opened its doors in 1979 as awholesale supplier of plumbing equipment, tools, andparts to hardware stores, home-improvement centers,and professional plumbers in the Allentown-Bethlehem-Easton metropolitan area. Over the years they haveexpanded their operations to serve customer across thenation and now employ over 200 people as technicalrepresentatives, buyers, warehouse workers, and salesand office staff. Most recently ABE has experiencedfierce competition from the large online discount storessuch as Harbor Freight and Northern Supply. Inaddition the company is suffering from operational inef-ficiencies related to its archaic information system.ABE’s expenditure cycle procedures are described inthe following paragraphs.

Expenditure CycleABE uses a centralized accounting system for managinginventory purchases and recording transactions. Thesystem is almost entirely paperless. Each departmenthas a computer terminal that is networked to the ‘‘Pur-chases/Accounts Payable System’’ that is run from asmall data processing department. All accountingrecords are maintained on centralized computer filesthat are stored on a file server in the data processingdepartment.

PurchasingThe process begins in the purchasing department. Eachmorning the purchasing agent reviews the inventory lev-

els from his department terminal and searches for itemsthat have fallen to their reorder points and need to bereplenished. The purchasing agent then selects the ven-dors and creates digital purchase orders in the purchaseorder file. He then prints two hard copies of each pur-chase order and sends them to the respective vendors.

ReceivingWhen the items are received, the receiving departmentclerk reconciles the goods with the attached packing slipand the digital purchase order, which he accesses fromhis computer terminal. The clerk then creates a digitalreceiving report, stating the condition of the materialsreceived. The system automatically closes the purchaseorder previously created by the purchasing agent. Inaddition, the receiving clerk prints a hard copy of thereceiving report, which he sends with the inventory tothe warehouse where the items are stored.

WarehouseUpon receipt of the inventory, the warehouse clerk rec-onciles the items with the receiving report and updatesthe inventory subsidiary ledger. The accounting systemautomatically and immediately updates the inventorycontrol account in the general ledger.

Accounts PayableOnce the accounts payable clerk receives the vendor’sinvoice, she reconciles it with the purchase order andreceiving report from her terminal. The clerk then cre-ates a digital cash disbursement voucher record and setsa due date for payment. The system automaticallyupdates the AP control account in the general ledger.Daily, the accounts payable clerk reviews the open cashdisbursement voucher records from her terminal lookingfor items that need to be paid. The clerk then creates arecord for the payment in the digital check register andcloses the open cash disbursement voucher. Finally, theclerk prints a hard copy of the check and sends it to thevendor. The system automatically updates the accountspayable and cash general ledger accounts.



c. Identify the internal control weaknesses in thesystem. Model your response according to the sixcategories of physical control activities specified inSAS 78/COSO.



4. Walker Books, Inc. (Manual System withMinimal PC Support)(Prepared by Matt Wisser, Lehigh University)

Walker Books, Inc., is one of the fastest-growing bookdistributors in the United States. Established in 1981 inPalo Alto, California, Walker Books was originally aside project of founder and current president CurtisWalker, who at the time was employed by a local lawfirm. Because reading was much more than just a hobbyof his, he decided to use some of his savings to buy anabandoned restaurant and convert it into a neighbor-hood bookstore, mainly selling used books that weredonated and obtained from flea markets. When thedoors first opened, Walker’s wife, Lauren, was the onlyemployee during the week and Curtis worked week-ends. At the end of the first fiscal year, Walker Bookshad grossed $20,000 in sales.

As the years passed, Curtis Walker quit the lawfirm and began concentrating fully on his bookstore.More employees were hired, more books were tradedin, and more sales were attained each year that passed.During the mid-1990s, however, Walker was facedwith two problems: many large, upscale bookstoreswere being built in the area, and the use of the Internetfor finding and ordering books was becoming cheaperand more popular for current customers. In 1995,Walker’s sales started to decline. Deciding to take arisk because of the newfound competition, he closedhis doors to the neighborhood, invested more moneyto expand the current property, and transformed hiscompany from simply selling used books to being adistributor of new books. His business model was toobtain books from publishers at a discount, store themin his warehouse, and resell them to large bookstorechains.

Walker Books, Inc., has rapidly become one of thelargest book distributors in the country. Although theyare still at their original location in Palo Alto, California,they distribute books to all 50 states and because of that,the company now sees gross sales of about $105,000,000per year. When Mr. Walker is asked about his fondestmemory, he always responds that he will never forgethow the little bookstore, with two employees, hasexpanded to now have more than 145 employees.

Under his current business model, all of Walker’scustomers are large-chain bookstores who themselvessee many millions of dollars in revenue per year. Someof these customers, however, are now experiencingproblems with Walker Books that threaten their busi-ness relationship. Such problems as books being or-dered but not sent, poor inventory management byWalker causing stock-outs, and the inability of Walker

to provide legitimate documentation of transactionshave become common.

One potential source of these problems rests withWalker’s antiquated accounting system, which is a com-bination of manual procedures supported by stand-alonePC workstations. These computers are not networkedand cannot share data between departments. All interde-partmental communication takes place through hard-copy documents.

You have been hired as an independent expert toexpress an opinion on the appropriateness of WalkerBooks’ business processes and internal controls. Theexpenditure cycle is described next.

Expenditure CyclePurchases SystemThe purchases process begins with the purchasingagent, who monitors the levels of books available via acomputer terminal listing current inventory. Upon notic-ing deficiencies in inventory levels, the agent manuallygenerates four hard copies of a purchase order: one issent to accounts payable, one is sent to the vendor, oneis sent to the receiving department, and the last is filedwithin the department.

Vendors will generally ship the products within fivebusiness days of the order. When goods arrive in thereceiving department, the corresponding packing slipalways accompanies them. The receiving departmentclerk unloads the goods and then reconciles the packingslip with the purchase order. After unloading the goods,the clerk manually prepares three hard copies of thereceiving report. One copy goes with the goods to thewarehouse, another is sent to the purchasing depart-ment, and the final copy is filed in the receiving depart-ment. In the warehouse, the copy is simply filed oncethe goods are stored on the shelves. In the purchasingdepartment, the clerk receives this copy of the receivingreport and files it with the purchase order.

When the accounts payable department receives thepurchase order, it is temporarily filed until the respec-tive invoice arrives from the vendor. Upon receipt ofthe invoice, the accounts payable clerk removes the pur-chase order from the temporary file and reconciles thetwo documents. The clerk then manually records theliability in the hard copy accounts payable subsidiaryledger. Finally, the clerk files the purchase order andinvoice in the open accounts payable file in the depart-ment. At the end of the day, the clerk prepares a hard-copy journal voucher and sends it to the general ledgerdepartment.

Once the general ledger department receives thejournal voucher, the clerk examines it for any obvious


errors and then enters the relevant data into the depart-ment PC to update the appropriate digital general ledgeraccounts.

Cash Disbursements SystemThe accounts payable clerk periodically reviews theopen accounts payable file for liabilities that are due. Tomaximize returns on invested cash yet still take advan-tage of vendor discounts, the clerk will pull the invoicetwo days before its applicable due date. Upon findingan open accounts payable file in need of payment, theclerk manually prepares a check for the amount due asper the invoice. The hard copy accounts payable ledgeris also updated by the accounts payable clerk. Thecheck number, dollar amount, and other pertinent dataare manually recorded in the hard-copy check register.The check is then sent to the cash disbursements depart-ment. Finally, the invoice is discarded as it no longerhas any relevant information that hasn’t already beenrecorded elsewhere.

When the cash disbursements clerk receives theunsigned check, she examines it to ensure that no onehas tampered with any of the information and that noerrors have been made. Because she is familiar with allof the vendors with whom Walker deals, she can iden-tify any false vendors or any payment amounts thatseem excessive. Assuming everything appears in order,she signs the check using a signature block that displaysthe name of the assistant treasurer, Tyler Matthews.Only Matthews’ signature can validate a vendor check.The cash disbursements clerk then photocopies thecheck for audit trail purposes.

Once the check is signed, it is sent directly to the sup-plier. The photocopy of the check is marked as paid andthen filed in the cash disbursements department. Theclerk then creates a journal voucher, which is sent to thegeneral ledger department. Once the general ledgerdepartment receives the journal voucher, the clerk exam-ines it for any obvious errors and then enters the relevantdata into the department PC to update the appropriatedigital general ledger accounts.



c. Analyze the internal control weaknesses in thesystem. Model your response according to thesix categories of physical control activities specifiedin SAS 78/COSO.


5. A&V Safety, Inc. (Manual and Stand-Alone Computer Processing)(Prepared by Adam Johnson and Aneesh Varma,Lehigh University)A&V Safety, Inc., is a growing company specializing inthe sales of safety equipment to commercial entities.It currently employs 200 full-time employees all ofwhom work out of their headquarters in San Diego,California. During the summer, the company expandsto include about 10 summer interns who are delegatedsmaller jobs and other errands. A&V currently com-petes with Office Safety, Inc., and X-Safe, who leadthe industry. Suppliers for A&V include Halotron Extin-guishers, Kadelite, and Exit Signs, Inc. A&V attempts tomaintain inventory levels sufficient to service two weeksof sales. This level has shown to avoid stock-outs, andthe excess inventory is held in a warehouse in a suburbof San Diego.

A&V has a legacy accounting system that employs acombination of manual procedures supported by stand-alone PC in the various departments. Recently theyhave experienced business inefficiencies that have beenlinked to their antiquated accounting system. You havebeen retained by A&V management to review their pro-cedures for compliance with the Sarbanes-Oxley Actand to provide recommendations for improvement. TheA&V expenditure cycle is presented in the followingparagraphs.

Expenditure CycleThe company purchases safety devices such as fireextinguishers, exit signs, and sensors from many differ-ent suppliers. When the quantity on hand of a particularproduct falls to a low level, the warehouse clerk selectsa vendor and manually prepares three hard copies of apurchase order. The clerk sends one copy of the pur-chase order to the vendor, one copy to the generalledger department, and the third to the receiving depart-ment to be used to verify the goods when they arrive.When the goods arrive from the vendor, they first go tothe receiving department. The receiving clerk matchesthe packing slip in the shipment to the purchase orderthat the warehouse clerk had previously sent. Aftercomparing the quantities and products on the packingslip to those specified on the purchase order, the receiv-ing clerk signs the purchase order and sends it to theaccounting department. The receiving clerk then man-ually prepares a hard-copy receiving report, which hesends with the goods to the warehouse. From his depart-ment PC, the warehouse clerk uses the receiving reportto update the inventory subsidiary ledger to reflect thereceipt of the goods.


Subsequently, the accounting department’s accountspayable clerk receives the supplier’s invoice, which shematches and reconciles to the previously received purchaseorder from the receiving clerk. From her departmentPC the accounts payable clerk then updates the digitalaccounts payable subsidiary ledger to reflect the new liabil-ity and records the event in the digital purchases journal.

Cash Disbursements ProceduresThe accounts payable clerk in the accounting departmentreviews the liabilities that are due by searching theaccounts payable subsidiary ledger from the departmentPC. The clerk then prints out a hard-copy cash disburse-ment voucher for each item due for payment. The clerkthen sends cash disbursements voucher to the cash dis-bursements department for payment. At the end of theday the clerk prints a hard-copy accounts payable sum-mary from the department PC and sends it to the generalledger department.

From his department PC, the cash disbursement clerkuses the cash disbursement voucher to record the pay-ment in the digital check register and then prints athree-part check. The clerk signs the negotiable portionof the check and sends it to the vendor. One check copyis filed in the department and the clerk sends the secondcheck copy, along with the original cash disbursementvoucher, to the accounting department accounts payableclerk. At the end of the day the clerk prints a hard-copysummary of the check register and sends it to the gen-eral ledger department.

From the accounting department PC, the accountspayable clerk uses the check copy and cash disburse-ment voucher to record the payment in the digital checkregister and to close out the liability in the digitalaccounts payable subsidiary ledger. The clerk then filesthe hard-copy cash disbursement voucher and checkcopy in the department.

From the department PC, the general ledger clerk poststhe summaries received from the accounting and cash dis-bursement departments to the appropriate general ledgeraccounts. The clerk files the hard copy summaries in thegeneral ledger department.





6. Premier Sports Memorabilia (NetworksComputer System with ManualProcedures)(Prepared by Chris Polchinski, Lehigh University)Premier Sports Memorabilia is a medium-sized, rapidlygrowing online and catalogue-based retailer centered inBrooklyn, New York. The company was founded in1990 and specializes in providing its customers withauthentic yet affordable sports memorabilia from theirfavorite players and teams, past and present. Tradition-ally the company’s customers were located in the north-east region of the United States. Recently, however,Premier launched a successful ad campaign to expandits customer base. This has increased sales, whichhas in turn placed a strain on the organization’s opera-tional resources. The company currently employs 205employees who are spread out among its three ware-houses and two offices in the tri-state area.

The firm purchases from a large number of manufac-turers and memorabilia dealers around the country andis always looking for additional contacts who have newor rare items to offer.

The company has a computer network installed, which,until recently, has served it well. The firm is now, how-ever, experiencing operational inefficiencies and account-ing errors. Your firm has been hired to evaluate Premier’sbusiness processes and internal controls. The expenditurecycle is described in the following paragraphs.

Purchase System ProceduresPremier’s purchase transactions are initiated when itsinventory levels for a certain item falls below the desig-nated reorder point. This is electronically monitoredthrough Premier’s inventory requisition system that isdirectly linked to the inventory file. Once an item fallsbelow the reorder point, an open requisition record isautomatically created. A valid vendor file is used bothto retrieve stored vendor information and to check thatitems are being ordered through a preapproved vendorwith which the company has done business in the past.Digital purchase requisitions are made available to theclerks in the inventory control department and the pur-chasing department via the computer terminal.

When the purchasing department clerk views the dig-ital requisition, she prepares and prints five hard copiesof the purchase order. One copy is filed in the depart-ment. A second copy is sent to the receiving department.A third copy is sent to the accounts payable department.A fourth copy is sent to the inventory control depart-ment. A final copy is sent to the vendor as placement ofthe order.


Upon receiving the purchase order, the inventory con-trol clerk uses a terminal to access the open requisitionfile and closes the record. In addition, the program auto-matically creates a digital pending open purchase record.

Shortly after receiving the purchase order, the vendorwill send out both the goods and a packing slip to Pre-mier’s receiving department. After the receiving clerkhas both the purchase order and the packing slip, hephysically inspects the condition of the goods andchecks that both the type and quantity received are cor-rect. Upon completion of the inspection, the clerk man-ually creates three hard copies of a receiving report.One copy is filed in the department. The second copy issent to accounts payable for reconciliation. The thirdcopy is sent to the inventory control department.

When the inventory control department obtains thereceiving report, the clerk uses the purchase update pro-gram to access the pending open purchase record andcloses it out. In addition, the clerk updates the inventoryfile by posting the amounts received to the various in-ventory records affected.

When the accounts payable department clerkreceives the invoice from the supplier, he matches it tothe supporting purchase order and receiving reportreceived from the purchasing and receiving depart-ments, respectively. The clerk manually reconciles allthree documents and prepares an accounts payablerecord from the department terminal.

Finally, at the end of each day, the inventory controldepartment and the accounts payable department create ahard-copy inventory summary and accounts payable jour-nal voucher, respectively, reflecting the effects of all of theday’s transactions. These documents are sent to the generalledger department, where they are reconciled and posted totheir specific control accounts within the general ledger file.





7. Bait ’n Reel Superstore (CombinationNetworked Computers and ManualSystem)(Prepared by Matt Wisser, Lehigh University)Bait ’n Reel was established in 1983 by Jamie Roberts,an avid fisherman and environmentalist. Growing up in

Pennsylvania’s Pocono Mountains region, Roberts waslucky enough to have a large lake right down the road,where he found himself fishing throughout the year.Unfortunately, he had to drive more than 15 miles topurchase his fishing supplies, such as lines, hooks, andbait, among other things. Throughout his early adult-hood, Jamie frequently overheard other fishermenvocalizing their displeasure at not having a local fishingstore to serve their needs. Because of this, Robertsvowed to himself that he would open his own store if hecould ever save up enough money.

By 1983, he had sufficient funds and the opportunityarose when a local grocery store went up for sale. Hepurchased the building and converted it into the ‘‘Bait ’nReel’’ fishing store. His early business involved cash-only transactions with local fishermen. By the mid-1990s, however, the building expanded into a superstorethat sold a wide range of sporting products and campinggear. People from all over the county shopped at Bait ’nReel as Roberts increased his advertising efforts, empha-sizing his ability to provide excellent service and thewide range of products. Roberts moved away from acash-only business and began offering store credit cardsto consumers and became a regional wholesaler to manysmaller sporting goods stores.

With the help of a friend, Roberts also installed acomputer network. Even though these computers didhelp to automate the company’s business processes andfacilitated the sharing of data between departments,much interdepartmental communication continued to bevia hard-copy documents.

Revenue increased sharply during the four years afterthe implementation of the computer system. In spite ofthis, Roberts had some questions about the quality of pro-cesses, as many of the subsidiary accounts did not matchthe general ledger control accounts. This didn’t prove tobe a material problem, however, until recently when thecomputers began listing supplies on hand that were notactually on the shelves. This created problems as custom-ers became frustrated by stock-outs. Roberts knew some-thing was wrong, but he couldn’t put his finger on it.

You have been hired by Roberts to evaluate Bait ’nReel’s processes and internal controls and make recom-mendations for improvement. Bait ’n Reel’s expendi-ture cycle is described in the following paragraphs.

Expenditure CyclePurchases SystemThe process begins when the purchasing managerchecks the inventory subsidiary ledger on his computerterminal each morning. When inventory is deemed tobe too low, he reviews the valid vendor file, also from


his terminal, to select vendors for items to be purchased.Once a vendor is found, he prepares an electronic ver-sion of the purchase order, in addition to two hard cop-ies of the purchase order. One hard copy is sent to thevendor immediately, while the other is filed in thedepartment. Immediately after this event, the electronicversion of the purchase order is sent out to two termi-nals: one in the receiving department and one in theaccounts payable department.

When the clerk in the receiving department receivesthe electronic purchase order, he reads over it once tomake sure it seems correct. When the goods arrive, hemakes a detailed inspection of them and reconciles thegoods to the corresponding information contained in theelectronic purchase order. If everything looks correct,the clerk manually prepares two hard copies of thereceiving report. One of these copies accompanies thegoods to the inventory control/storage department,where the clerk updates the inventory subsidiary accountfrom his terminal; it is then filed after the goods areplaced on the shelves. The other copy of the receivingreport is sent to the accounts payable department.

Upon receipt of the receiving report, the accountspayable clerk matches it to the respective electronic pur-chase order on his terminal. He then updates theaccounts payable subsidiary ledger from his terminal toreflect the transaction. The clerk temporarily files thereceiving report until the invoice arrives from the ven-dor. Typically, vendors provide a photocopy of the orig-inal purchase order along with the invoice so anydiscrepancies can immediately be identified. When theaccounts payable clerk receives the invoice and purchaseorder copy, he pulls the receiving report from the tempo-rary file and reconciles the three documents. At thistime, the clerk updates the accounts payable control andthe inventory control accounts in the general ledger onhis terminal. The clerk the sends the invoice, receivingreport, and the purchase order copy to the cash disburse-ments department.

Cash Disbursements SystemUpon receipt of the documents from the accounts pay-able department, the cash disbursements clerk pre-pares a check for the invoiced amount. Once this iscompleted, he updates the check register, accountspayable subsidiary account, and the general ledgerfrom his terminal. The three documents, along withthe check, are then passed on to the assistant treasurer.As an additional control, the assistant treasurerreviews the supporting documents and makes a photo-copy of the check for record-keeping purposes. Thetreasurer then signs the check, which is immediately

sent to the vendor for payment. The invoice, purchaseorder copy, receiving report, and check copy are filedin the department.



c. Analyze the internal control weaknesses in thesystem. Model your response according to the sixcategories of physical control activities specifiedin SAS 78/COSO.


8. Green Mountain Coffee Roasters, Inc.(Manual Procedures and Stand-Alone PC)(Prepared by Ronica Sharma, Lehigh University)Green Mountain Coffee Roasters, Inc., was founded in1981 and began as a small cafe in Waitsfield, Vermont,roasting and serving premium coffee on the premises.Green Mountain blends and distributes coffee to a vari-ety of customers, including cafes, delis, and restaurants,and currently has about 6,700 customer accounts reach-ing states across the nation. As the company has grown,several beverages have been added to their product line,including signature blends, light and heavy roasts,decaffeinated coffee and teas, and herbal teas. GreenMountain Coffee Roasters, Inc., has been publiclytraded since 1993.

Green Mountain Coffee has a warehouse and manu-facturing plant located in Wilton, Vermont, where it pres-ently employees 250 full-time and part-time workers.The company receives its beans in bulk from a selectgroup of distributors located across the world, with theirlargest supplier being Columbia Beans Co. Green Moun-tain Coffee also sells accessories that complement theirproducts, including mugs, thermoses, and coffee contain-ers that they purchase from their supplier, Coffee Lovers,Inc. In addition, Green Mountain purchases paper prod-ucts such as coffee bags, coffee cups, and stirrers, whichthey distribute to their customers.

Green Mountain’s accounting system consists ofmanual procedures supported by stand-alone PC locatedin various departments. Because these computers arenot networked they cannot share data digitally, and allinterdepartmental communication is through hard-copydocuments.

Green Mountain is a new audit client for your CPAfirm and as manager on the assignment you are examin-ing their internal controls. The expenditure cycle isdescribed in the following paragraphs.


Purchases SystemGreen Mountain Coffee purchases beans and blendsfrom manufactures and then sells them to customerstores. Sara is in charge of inventory management in thewarehouse. From her PC, she reviews the inventoryledger to identify inventory needs. When items fall totheir pre-established reorder point, she prepares a pur-chase requisition. She keeps a copy in her departmentfor use later, files one in the open purchase requisitionfile, and sends a copy to accounts payable. At the endof the day, she uses the purchase requisitions to preparea four-part purchase order. One copy is filed, two copiesare sent to the supplier, and one copy is sent to Fayth inthe accounts payable department. When the goodsarrive, Sara inspects and counts them and sends thepacking slip to accounts payable. Using a PC, Saraupdates the inventory subsidiary ledger and, at the endof day, sends an account summary to Vic in the generalledger department.

After checking that the purchase requisition and pur-chase order exist to support the packing slip, Fayth filesthe documents in the accounts payable pending file. Thesupplier’s invoice is mailed directly to Fayth, whochecks it against the documents in the pending file.Using a computer system, she updates the accounts pay-able subsidiary ledger and records the transaction in thepurchases journal. She then files the purchase requisition,purchase order, packing slip, and invoice in the openaccounts payable file. At the end of the day, she preparesa journal voucher, which is sent to Vic in the generalledger department. Using a separate computer system,Vic updates the control accounts affected by the transac-tions and files the summary and journal vouchers.

Cash Disbursements System SummaryFayth reviews the open accounts payable file for itemsdue for payment, waiting until the last date to make apayment and still take advantage of the discount.From her PC, she then updates (closes) the appropriateaccounts payable subsidiary record, prints a two-partcheck, and records the payment in the check registerfile. At the close of day, Fayth mails the check to thesupplier, files a copy, and prepares a journal voucher,which goes to Vic. Vic records the transaction in theaffected general ledger accounts and files the journalvoucher.



c. Analyze the internal control weaknesses in thesystem. Model your response according to the six

categories of physical control activities specified inSAS 78/COSO.


9. USA Cycle Company (ManualProcedures and Stand-Alone PCs(Prepared by Kim Hancy, Lehigh University)USA Cycle Company is one of the fastest-growingbicycle distributors in the United States, with headquar-ters in Chicago, Illinois. Their primary business is dis-tribution of bicycles assembled in China, but they alsohave a smaller, custom-order business for which theybuild bicycles from parts purchased from various sup-pliers. Their product line includes mountain, road, andcomfort bikes as well as a juvenile line with up to 24-inch frames. They also distribute BMX bicycles as wellas tricycles and trailer bikes. In addition, they distributevarious bicycle accessories such as helmets, clothing,lights, and spare parts for all of the models they carry.

Established in 1985, the company’s first warehouseswere in Illinois and Wisconsin and supplied retail bicycleoutlets primarily in the Midwest. One year ago, USACycle Company expanded, adding two additional facili-ties in Sacramento, California, and Redmond, Washing-ton, to meet the growing demand for their bicycles. Theynow also sell customized bicycles direct to retailersthrough the Internet as well as by conventional means.

The company’s expansion to the West Coast wascoupled with a planned increase in reliance on suppliersin China. Although this resulted in decreased costs,some problems regarding inventory levels arosebecause of unexpected delays in shipping, primarily at-tributable to miscommunication and shipping condi-tions. Because the company does not want to carryexcess inventory, they are sometimes forced to seeklocal suppliers at an increased cost.

Initially, USA Cycle Company was a family-ownedbusiness. In need of capital, however, the companywent public when they added the two facilities on theWest Coast. The number of employees rose from 100 to200 during the expansion.

USA Cycle Company uses limited computer technol-ogy to process business transactions and recordaccounting data. Each of its facilities is similarly config-ured: The various departments in the facility employmanual procedures that are supported by non-networkedPC. Because this type of configuration does not permitdepartments to share data digitally, most interdepart-mental communication is accomplished via hard-copydocuments.


Since the expansion, USA Cycle has been plaguedby inefficiency, and accounting errors. You have beenhired to evaluate their processes and internal controlsfor compliance with the Sarbanes-Oxley Act. The ex-penditure cycle of one of its facilities is described in thefollowing paragraphs.

Description of Purchases ProceduresThe purchases process begins when a clerk in the ware-house reviews the inventory subsidiary ledger from hisPC. When inventory is needed, the clerk creates a digitalrecord in the purchase order file. Four copies of the pur-chase order are printed. One copy is filed in the open pur-chase order file, two copies are sent to the supplier, andone copy is forwarded to the accounts payable depart-ment and filed in the accounts payable pending file.

When the goods are received in the warehouse, thepurchase order is pulled from the open purchase orderfile and a clerk inspects, counts, and reconciles thegoods to the packing slip and what was ordered. Theclerk places the goods on the warehouse shelves anduses the computer to prepare the receiving report. Theinformation is saved in the digital receiving record file,and two hard copies of the receiving report are printed.One copy is forwarded to the accounts payable depart-ment. The second copy, along with the purchase orderand packing slip, is used to update the digital inventorysubsidiary records from the department PC. The pur-chase order, packing slip, and receiving report are thenfiled in the closed purchase order file.

When the receiving report is received in the accountspayable department, it is filed in the accounts payablepending file with the purchase order. Upon receipt ofthe invoice from the supplier, the accounts payableclerk pulls the receiving report and purchase order fromthe accounts payable pending file. The clerk uses thesedocuments to add a digital record to the purchases jour-nal and to post the liability to the accounts payable sub-sidiary ledger from the department PC. The accountspayable computer system automatically updates theappropriate accounts in the general ledger. The purchaseorder, receiving report, and invoice are then filed in theopen accounts payable file.

Description of Cash DisbursementsProcessUsing the open accounts payable file, in which the sourcedocuments are arranged by payment date, a clerk in theaccounts payable department searches for accounts com-ing due. When payments are due, the clerk removes thepurchase order, receiving report, and invoice from the fileto manually prepare the vendor check and check copy.

Using these documents, the clerk updates the digitalcheck register and accounts payable subsidiary ledgerfrom the department PC. The general ledger is automati-cally updated by the system. The check is signed andmailed to the supplier. The check copy along with thepurchase order, receiving report, and invoice are filed inthe closed accounts payable file.




d. Prepare a system flowchart of a redesignedcomputer-based system that resolves the controlweaknesses you identified. Explain your solution.

10. New Born Candy Company(Comprehensive Case—Revenue andExpenditure—Manual and BatchComputer Processes)(Prepared by Gaurav Mirchandani and MatthewDemko, Lehigh University)New Born Candy Company is the manufacturer and mar-keter of a premier line of candies. James Born, the cur-rent CEO of New Born Candy Company, took control ofthe family-run business in the 1970s, although New BornCandy Company has been in existence since the mid-1930s. The company has grown to two plants on the EastCoast and 209 employees across the country.

As of the fiscal year ended 2008, New Born CandyCompany experienced gross sales of almost $100 mil-lion. In spite of its success, the CEO and managementteam are concerned about recent cost overruns and pro-duction problems. For example, the rate of increase incost of goods sold has been disproportionate with growthin sales. Additionally, they have experienced raw mate-rial stock-outs that have occasionally shut down produc-tion lines or prevented them from producing to capacity.

To get to the bottom of these issues James Born andhis management team have hired GMD ConsultingGroup to review New Born’s business processes andaccounting system. The following describes the relevantbusiness cycles under review.

Revenue Cycle DescriptionNew Born Candy Company receives orders from one oftwo places: they are delivered to the mail room wherethey are received and sorted, or the sales personnel receivethem directly. After the mail is received and sorted by the


mail room, sales orders are passed to the sales personnel.GMD Consulting looked further into mail room proce-dures and operations and made some interesting findings.Jonathan, the supervisor of the mail room, explained toGMD Consulting that there are so many orders (due tothe rapid growth of the business and the 6,000-plus cus-tomers) that they have trouble sorting through all of themail and getting it to the appropriate department. Jonathanexplained that people in the mail room have been workingconsiderable overtime to process the mail, but they stillfrequently fall behind. In talking with Suzanne, a veteransalesperson for New Born Candy Company, it was dis-covered that sales orders often take several days to getfrom the mail room to the sales department. She also toldGMD Consulting that during busy times, it is very diffi-cult to process all of the daily orders.

After receiving the customer order, the sales person-nel manually prepare several copies of a sales order andperform a credit check. When completed, the creditcopy of the sales order is filed along with the customerorder. The billing copy of the sales order is sent to thecomputer department, and the stock release, packingslip, shipping notice, and file copy are sent to the ware-house. The goods are picked and sent to shipping alongwith the supporting documents. Shipping then recon-ciles the file copy, shipping notice, packing slip, andstock release with the goods. The shipping clerk signsthe shipping notice, and manually prepares three hardcopies of a bill of lading. Two copies of the bill of lad-ing, along with a packing slip, are given to the carrierfor shipment to the customer. The file copy, stockrelease copy, and a copy of the bill of lading are placedin a shipping file. It is important to note that in examin-ing the shipping department, it was found that they havebeen receiving an increasing number of complaintsfrom customers. Some key documents (found on pages260–263) shed some light on this issue.

The billing copy that was generated by the salesdepartment is now in the computer department. Here, viaa keystroke operation, a clerk produces a digital salesorder file. The sales order file is then processed by a batchedit program to identify errors. After the edit run, thebatch sales application posts the sales orders to the salesjournal, accounts receivable subsidiary file, the inventorysubsidiary file, and the control accounts in the generalledger file. The system then prepares various managementreports including sales and shipping reports. Also, thecustomer invoice is printed and sent to the customer.

Expenditure Cycle DescriptionTwice each week, a computer program in New BornCandy Company’s computer department reviews the dig-ital inventory file. From this review the computer prints a

requisition list of items that need to be replenished. Thelist is sent to the purchasing department and used to man-ually prepare hard-copy purchase orders. Two purchaseorders are sent to the vendor, and one is filed in thedepartment along with the requisition list.

When the vendor receives the order from purchasing,it ships the goods along with a copy of New Born’soriginal purchase order and a formal packing slip to thereceiving department. There the purchase order andpacking slip are used to assist the receiving clerk inmanually preparing three hard copies of a receivingreport. The purchase order and packing slip are thenfiled in the department. One copy of the receiving reportis sent to the purchasing department, where it is filed;another copy is sent to accounts payable, where it isfiled until the vendor’s invoice arrives. The third copyaccompanies the good to the stores area.

When accounts payable receives the vendor’s invoice,the accounts payable clerk matches it to the filed copy ofthe receiving report. The clerk then manually prepares acash disbursement voucher to authorize payment andfiles the invoice in the accounts payable department. Thedisbursement voucher is sent to the computer depart-ment, where it is used in a keystroke operation to createan accounts payable record. Once the digital accountspayable is created the hard-copy cash disbursementvoucher is destroyed in the computer center.

At the end of the day the accounts payable clerk pre-pares a hard-copy journal voucher that is sent to thecomputer department and used to update the generalledger computer file. The journal voucher is filed in thecomputer department.

Cash Disbursements ProcessAt the end of the week the cash disbursement system (abatch computer application) scans the accounts payablefile for items that need to be paid. The system closes theopen accounts payable record and adds a new record tothe check register to record the payment. The systemthen prints the check, which is sent to the vendor,and prepares a cash disbursement report that goes tomanagement.

Requireda. Create data flow diagrams of the revenue and

expenditure procedures.

b. Create system flowcharts of the current revenueand expenditure procedures.

c. Analyze the internal control and operationalweaknesses in the system.

d. Prepare system flowcharts of a redesigned systemthat resolves the control and operational weaknessesyou have identified. Explain your solution.


PROBLEM 10: CASH DISBURSEMENTS REPORT FOR MONTHS MAY AND JUNE

CheckAmount

002,5$002,5$121106ynapmoCraguSllaH90/1/5

$1,020

578,1$578,1$25306slacimehCnworB90/51/5

003,2$003,2$221406sbaLrialcniS90/61/5

599,1$543$

$180

003,2$231506sbaLrialcniS90/32/5

527,1$572,1$888606.cnI,sreilppuSraguS90/03/5

272,5$572,5$212706ynapmoCraguSseillaH90/03/5

000,1$000,1$222806.cnI,seidnaCroloC90/1/6

002,5$002,5$121906ynapmoCraguSllaH90/8/6

051,1$051,1$787016.oC&srepparWydnaC90/51/6

5/8/09 Ray Packaging 602 782 $1,200

Invoice Invoice Payment Date Vendor Name No No Amount Discount


PROBLEM 10: SHIPPING REPORT FOR MONTHS ENDED MAY AND JUNE

etaDeciovnI

deppihS tnemyaP sserddA eciovnI oNsserddA gnippihS remotsuC emaN remotsuCetaD

11/2/09 James McGuire 12 Maple Avenue, Englewood, NJ 07631 556 12 Maple Avenue, Englewood, NJ 07631 $850 11/2/09

11/2/09 The Hall Candy Store 72 E.4th Street, Easton, PA 18042 233 72 E.4th Street, Easton, PA 18042 $1,975 11/2/09

11/2/09 Smiles Candies & Co. 112 Packard Circle, Easton, PA 18042 428 112 Packard Circle, Easton, PA 18042 $1,290 11/12/09

11/2/09 The Candy Guy, Inc. 47 Cresent Avenue, Allentown, PA 18103 166 47 Cresent Avenue, Allentown, PA 18103 $2,895 11/2/09

11/9/09 Candies & Treats 104 W. 48th Street, New York, NY 10017 983 1694 Corporate Way, Clifton, NJ 07014 $6,800 11/9/09

11/9/09 Kathleen Hallaway 118 Cordes Street, Bedford, NH 03110 108 118 Cordes Street, Bedford, NH 03110 $925 11/9/09

11/10/09 Lehigh University 39 University Drive, Bethlehem, PA 18015 191 39 University Drive, Bethlehem, PA 18015 $11,200 11/10/09

11/10/09 Philadelphia Candy Company 100 Mulbury Street, Philadelphia, PA 19103 333 100 Mulbury Street, Philadelphia, PA 19103 $2,650 11/10/09

11/10/09 Timothy Klienman 18 Heatherspoon Way, Bethlehem, PA 18015 445 18 Heatherspoon Way, Bethlehem, PA 18015 $750 11/10/09

11/16/09 The Candy Store At the Hilton 1810 Beach Way, Boca Raton, FL 33432 972 1810 Beach Way, Boca Raton, FL 33432 $8,200 11/16/09

CH

AP

TE

R5

The

ExpenditureC

yclePartI:Purchases

andC

ashD


261

PROBLEM 10: INVOICE

INVOICESugar Suppliers, Inc.

Billing Department

181 Sugar Plant Way

Allentown, PA 18103

To: New Born Candy Company Date: 8/28/09

1332 Rockaway Avenue Invoice #: 888

24th Floor

Bethlehem, PA 18015

Order Number Quantity Description Total Price

1234 1000 Lbs. Sugar Qty Code SJRT $1,275.00

Total Amount Due $1,275.00

Prepared by: SKM

Approved by: JAH

Please make payment immediately. Please DO NOT SEND CASH.

Failure to pay within 30 days results in additional late charges.

For additional billing questions please contact us at 1-888-NewBorn


PROBLEM 10: INVOICE

INVOICENew Born Candy Company

Billing Department

1332 Rockaway Avenue

Bethlehem, PA 18015

To: Customer Shipping Address: Invoice #: 983

Date of Invoice: 11/30/09

Candies & Treats

1694 Corporate Way

Clifton, NJ 07014

Customer Name Customer No. Shipping Date Amount Due

Candies & Treats 1234 11/09/09 $6,800.00

Total Amount Due $6,800.00

Prepared by: SKM

Approved by: JAH

Please make payment immediately. Please DO NOT SEND CASH.

Failure to pay within 30 days results in additional late charges.

For additional billing questions please contact us at 1-888-NewBorn
