Transaction Cycles and Internal Controls

• This chapter discusses transaction cycles and key controls for each cycle.
• The goal is to describe transaction cycle categories, identify associated business process elements, identify used forms/documents, identify department functions, and identify possible controls.
• There are no official standards for transaction cycles; they vary across industries and entities.

Introduction

• An accounting system consists of interrelated structured activities that create value and contribute to business objectives.
• Business process execution involves a logical sequence that might require employees, external parties, resources, data, documents and machines.
• These processes are triggered by transactions with starting and ending points.
• A transaction is an agreement between two entities to exchange goods or services, measurable in economic terms.

Definition

• Businesses have financial transactions during operations.
• Transaction cycle reports determine a process or product's profitability.
• These transactions can be aggregated into a small number of transaction cycles.
• Transaction cycles process related activities, such as sales to customers, acquiring merchandise/paying vendors, producing for sale, and paying employees.

Categories

• To understand transaction cycles, five interrelated major cycles are explored:
• Order to Cash (Revenue and Receipt) includes receiving orders, examining creditworthiness, shipping goods/providing services, invoicing, and collecting payment.
• Purchase to Pay (Expenditure and Disbursement) includes issuing purchase orders, receiving goods/services, recording liabilities, and paying suppliers.
• Hire to Retire (Human Resources and Payroll) includes acquiring services from employees, monitoring/recording employee time, verifying overtime, calculating pay/deductions/net pay, and paying employees.
• Plan to Inventory (Production or Conversion) includes monitoring/recording the production of entity's product for sale
• Financing and Investing includes generating capital from investors and investing capital into profitable activities.

Entity's Responsibility

• An entity’s key role via its management and those charged with governance, is to design and implement policies, procedures, forms and integrated controls minimizing fraudulent activities in transaction cycles.

Auditor's Objective

• The auditor should obtain an understanding of these transation cycles to develop an effective and efficient audit approach.
• The auditor should determine the reliability of financial reporting functions and the fairness of presentation in accordance with financial reporting framework of the accounts.

Understanding the Transaction Cycles

• For a better understanding of transaction cycles, basic concepts for each cycle should be known.
• General objectives of transaction cycles include to promote adequate segregation of incompatible duties and to provide safeguards to entity's resources.
• Basic concepts to understand include departments involved (functions, objective, possible controls) and forms/documents initiated and processed.
• Important concepts for forms/documents include the initiating department approving the form, being accountable for unused forms, and retaining a copy.
• Form notification does not require a hard copy, it can be done electronically.

Major Assumptions

• Entities operate under normal operating cycle conditions, accounting for sales and purchases on account.
• Entities are using imprest and voucher systems.

Revenue and Receipt Cycle

• The revenue and receipt cycle includes sale and collection transactions, starting with a customer order and ending when the related receivable is collected.
• It may also be known as a sale and collection cycle.
• The objective is proper valuation of accounts (receivables, sales, cash, bad debts, and allowances) and assurance that resources from goods or services are received.
• Business functions include resources distributed to customers for future payments and customers paying cash for those resources.
• Accounts affected include sales, returns/allowances/discounts, receivables, bad debts expense and cash.

Departments Involved (Revenue Cycle)

• Revenue: Sales/Customer Order, Credit, Inventory Control/Warehouse, Shipping, Billing, Accounting (inventory, receivable, and general).
• Receipt: Mail Room/Receptionist, Treasury, Accounting (receivable and general).

Forms or Documents (Revenue Cycle)

• Sales Order: Details goods ordered (quantity, prices, payment terms); initiated by the sales department; distributed to customers, credit, shipping, and billing.
• Shipping Document: Describes goods to be shipped, serves as contract; initiated by shipping department; distributed to carrier, customers and billing.
• Sales Invoice: Describes goods sold, amount due, payment terms; initiated by billing department; distributed to customers and accounting.
• Remittance Advice: Facilitates accounting for cash collection; actioned by the billing department; distributed to customers.
• Daily Summaries: Summarizes transactions recorded during the day; actioned by receivable/treasury and mailroom (receipts); distributed to general acconting, treasury, and receivables.
• Mail Room: Forwards mail received to treasury and receivables.

Sales Department

• Primary Objective: To increase entity's sales.
• Activities: Locates buyers, negotiates, accepts orders, prepares/distributes sales orders, retains copy, monitors status, updates customers.
• Possible Controls: Exclusive customer communication, authorized customer list, and range of selling prices.

Credit Department

• Primary Objective: To minimize exposure to high-risk customers.
• Activities: Receives/reviews sales orders, investigates credit, approves requests, notifies sales, forwards approved orders to inventory control.
• Possible Controls: Independent credit department, and authorized customer list.

Inventory Control (or Warehouse) Department

• Primary Objective: To control transfers of inventory in/out of storage, monitor levels, and report slow-moving/damaged items.
• Activities: Reviews approved sales orders, monitors availability, authorizes goods issuance, forwards orders to shipping.
• Possible Controls: Restricted access to inventory levels, and inventory management concepts

Shipping Department

• Primary Objective: To provide reasonable assurance that all shipments are authorized and customers are billed.
• Activities: Compares sales orders with goods/approved orders, completes shipping documents, releases goods to carrier (obtaining receipt), notifies sales, forwards documents to billing.
• Possible Controls: Pre-numbered shipping documents.

Billing Department

• Primary Objective: To provide reasonable assurance that all billings are shipped
• Activities: Compares sales order, approved sales order and shipping document, prepares/sends invoice, and Prepares remittance advice/ sends copy to customers.
• Possible Controls: Ensure sales invoices are pre-numbered and prior to preparation, ensure a shipping document is present.

Accounting Department

• Inventory: Provides cost information on the goods sold to be forwarded to general accounting.
• General: Records the sale and forwards sales invoice and documents to Accounts receivable.
• Accounts receivable: Updates subsidiary ledger related to customer's account.

Mail Room/Receptionist

• Receives remittance advises and customer checks from customers
• Prepares list of receipts
• Endorses checks/list of receipts to the treasury department and endorses remittance advices/list of receipts to accounts receivable department

Treasury Department

• Updates cash records.
• Prepares deposit slips.
• Prepares cash summaries to Accounts receivable and general accounting, retain a copy.
• Deposits cash collection to the bank.

Accounting Department

• Accounts receivable: Compares remittance advice from mailroom/cash summaries from treasury, updates ledgers, prepares daily summaries (general accounting).
• General: Compares daily summaries from treasury accounts receiveable, and updates general ledgers.

Uncollected Accounts

• Accounts receivable: Review customer accounts against credit limits periodically and prepare monthly trial balances.
• Authorized personnel independent of credit department: Review/age receivables periodically.
• Authorized personnel reporting to the treasurer/independent of recording functions: Authorize write-offs, such account should be reviewed, and written authorization should be sent to accounts receivable or general accounting.

Sales Returns and Allowances

• Sales department: Reviews customer requests for returns/allowances, grants sales returns/allowances, prepares credit memo for customer and forwards it for recording to accounts receivable and returns to inventory control.
• Inventory control: Compares received goods (receiving department) and credit memo.
• Accounting: Updates inventory records (goods receipt) and prepares summaries; A/R updates records (credit memo) and prepares accounts, then compares inventory and accounts recievable and updates general ledgers.

Expenditure and Disbursement Cycle

• This cycle covers acquisition and disbursement transactions, starting when an entity orders from a supplier and ending when the payable is paid.
• This cycle is also known as the acquisition and disbursement cycle.
• The objectives are proper valuation of payables, cash, and assets, and assurance that payment represents goods/services received.
• Functions include resources acquired from vendors for obligations to pay and the entity paying vendors and employees.
• Significant departments include user (any department within the entity), purchasing, receiving, accounts payable, and accounting (inventory and general).

Forms and Documents (Expenditure and Disbursement)

• Requisition Slip: Details the user department's request, initiated by the user department, sent to purchasing.
• Purchase Order: Describes goods to be acquired (quantity and description); initiated by Purchasing; sent to the vendor, user, receiving, and accounts payable.
• Receiving Report: Describes goods received (quantity, description, condition); Receiving Department initiates; sent to Purchasing and Accounts Payable.
• Shipping Document: Describes the goods to be shipped; Vendor initiates; sent to Receiving (thru the carrier).
• Vendors Invoice: Describes goods sold, amount due, payment terms; Vendor initiates; sent to Accounts Payable.
• Daily Summaries: Summarizes transactions recorded; actioned by accounts payable/treasury; distributed to the general accounting.

User Department

• Prepares requisition to be forwarded to purchasing.

Purchasing Department

• Primary Objective: to meet user department's needs at the lowest price.
• Activities: Receives/approves purchase requisition slip, locates/negotiates vendors, prepares/distributes purchase orders, monitors status, updates users.
• Possible Controls: Purchasing communicates solely with vendors, authorized vendor list, and purchase price is reviewed and compares to market prices.

Receiving Department

• Primary Objective: Provides assurance that received goods are based on an approved purchase order.
• Activities: Files purchase orders until goods arrive, counts/checks goods, reviews/compares purchase orders and shipping documents, prepares receiving reports to be forwarded with supporting documents.
• Possible Controls: The receiving department will count and check goods received, the purchasing department sends a blank purchase order.

Accounts Payable Department

• Primary Objective: payments made only for shipments received.
• Activities: Reviews requisition slip, purchase order, receiving report, and invoices; prepares voucher and voucher package and daily summary.
• Possible Controls: Voucher packages are filed by due date, vendors involices should be accompanied by a receiving report.

Treasury Department (Disbursement)

• Activities: Reviews voucher packages, prepares/signs checks, forwards checks to vendors, prepares daily journal entries to be forwarded to general accounting.
• The person signing the check must cancel the voucher package, entity may adopt policies for issuance of checks (identified payee, signatures).

Human Resources and Payroll Cycle

• This cycle covers the entity's acquisition of services from its employees or personnel.
• The reasons auditors should be concerned with this cycle is because payroll includes employee benefits which significantly affect financial statements and for most entities, a significant amount of resources are incurred.
• Functions include services received from employees in exchange for obligations to pay, and the entity paying cash to employees.
• Departments:
• Expenditure: User (any department within the entity), HR/ Personnel, Payroll, Accounting (inventory & general).
• Disbursement and distribution: Treasury, Accounting (general).

Forms or documents (Human Resources and Payroll)

• HR records: Contains all information related to entity's employees from time they are hired to eventual termination; initiated by the HR department; sent to payroll (limited to payroll related information):
• Daily Time Record (DTR): Describes hours worked by an employee on a particular day; User department initiates, and the sent to payroll.
• Payroll Register: Shows all related payroll information for each pay period; Prepared by payroll to treasury/general accounting.
• Labor Cost Summary: Shows payroll information; Prepared by payroll to inventory accounting.
• Employee Earnings Record: Shows the cumulative, year-to-date summary of earnings and deductions of every employee.Prepared by payroll to accounts payable,.
• Daily Payroll Summaries: Summary of transactions recorded; Payroll intiates, the to liability recognition, Capitalizable labor costs, and treasury.

User Department (Payroll)

• Objective: Time records prepared by employees represent actual hours in a pay period.
• Activities: Monitors and approves daily time records.
• Control: Review validation of daily time records and approve payroll exceptions.

HR Department (Payroll)

• Objective: To ensure employees included in the payroll are rendering services to the entity.
• Initiates, updates, and maintains HR records, forwards payroll related data, determines settlement terms, and immediately notify payroll about terminated employees.
• Possible Controls: access to HR records should be limited and information no shared.

Payroll Department (Payroll)

• Objective: Payroll calculation is valid every pay period.
• Activities: Receives and reviews relevant payroll related from HR and User departments, considers any updates on employees' pay rates and deductions, prepares payroll register and updates cumulative earnings, identifies and submits inventory accounting capitalizable payroll.
• Objective: an appropriate level of management reviews payroll register for accuracy and reasonableness, Payroll department segregation of duties.

Treasury Department (Disbursement)

• Objective: Payroll cash disbursements are based on a recognized liability.
• Activities: Reviews payroll register, prepares /authorized, distributes checks to employees, prepares daily summary.
• Bank accounts are seperate for payroll disbursements and unclaimed payroll checks are re-deposited to the bank.

Accounting Department (Payroll)

• Objective: Ensure that items related to payroll are appropriately classified.
• Inventory: records inventoriable labor costs and forwards it to general accounting.
• General: Reviews daily summaries and documents to recognize payroll related expenses and liabilities.

Production or Conversion Cycle

• This cycle covers the production of an entity's product for sale ( labor materials and overhead converted to finished goods)
• Proper cost accounting and allocation is the primary objective.
• Focus is purely on the controls over the involved custody of resourced, authorization, and recording of transactions.

Summary of Control Related Duties and Responsibilities (Production Cycle)

• Custody: Production Department have physicals, auditor observes physical count and reconciles.
• Authorization: The production department authorized to make normal production run, auditor reviews production orders and related documents.
• Recording: Cost Accounting records all transactions, auditor reviews making journial entries, and reconcilation of general ledger.

Finance and Investment Cycle

• This cycle generally involves investments, long-term debts, and shareholders' equity.
• Few but significant amounts of resources are normally used.
• Auditor commonly employs substantive testing to gather evidence, however, control-related duties are critical.
• Focus: custody, authorization, and recording over the different covered transactions.

Summary of Control-Related Duties and Responsibilities (Finance Cycle)

• Custody: Unissued certificates must be kept by officer or independent custodian, auditor inquires regarding accounting .
• Authorization: Transactions approved by the board, auditor review board meeting mintues.
• Recording: Transactions recorded and the general journal, auditor revieews individuals making general entries.
• Investment cycle: auditor determines certificates and accounts.