AIS problems rather than routine operations.
CHAPTER 1 The information
THE INFORMATION ENVIRONMENT
The pyramid shows the business organization
divided horizontally into several levels of
activity. Business operations form the base of
the pyramid. These activities consist of the
product-oriented work of the organization, such
as manufacturing, sales, and distribution.
Operations management is directly
responsible for controlling day-to-day
operations. Middle management
accountable for the short-term planning and
coordination
Internal & Externalof activities
Information Flows necessary
accomplish organizational objectives. Top
management is responsible for longer-term
planning and setting organizational objectives.
Internal Information Flows
 Horizontal flows of information used
primarily at the operations level to
capture transaction and operations data.
Horizontal flow supports operations-level
tasks with highly detailed information
about the many business transactions
affecting the firm. This includes
information about events such as the sale
and shipment of goods, the use of labor
and materials in the production process,
and internal transfers of resources from
one department to another.
 Vertical flows of information
 downward flows — instructions,
quotas, and budgets
 upward flows — aggregated
transaction and operations data
 External users fall into two groups:
trading partners and stakeholders.
 Exchanges with trading partners include
customer sales and billing information,
purchase information for suppliers, and
inventory receipts information.
Information Requirements
 Each user group has unique information
requirements.
 The higher the level of the organization,
the greater the need for more aggregated
information and less need for detail.
Information in Business
 Information is a business resource that:
 needs to be appropriately managed
 is vital to the survival of
contemporary businesses
 Management information is thus more
summarized and oriented toward
reporting on overall performance and
must identify potential problems in time for
management to take corrective action.
What is a System?
 A group of interrelated multiple
components or subsystems that serve a
common purpose
 System or subsystem?
 A system is called a subsystem
when it is viewed as a component
of a larger system.
is
 A subsystem is considered a
system when it is the focus of
to
attention.
Elements of a System
 MULTIPLE COMPONENTS. A system
must contain more than one part.
 RELATEDNESS. A common purpose
relates the multiple parts of the
system.
 SYSTEM VERSUS SUBSYSTEM.
 PURPOSE. A system must serve at
least one purpose, but it may serve
several.
System Decomposition versus System
Interdependency
 System Decomposition
 the process of dividing the system
into smaller subsystem parts
 System Interdependency
 distinct parts are not self-contained
 they are reliant upon the
functioning of the other parts of the
system
 all distinct parts must be
functioning or the system will fail
What is an Information System?
An information system is the set of formal
procedures by which data are collected,
processed into information, and distributed to
users.
Transactions
 A transaction is a business event.
 Financial transactions
 economic events that affect the
assets and equities of the
organization
 e.g., purchase of an airline ticket
 Nonfinancial transactions
 all other events processed by the
organization’s information system
 e.g., an airline reservation — no
commitment by the customer
What is an Accounting Information
System?
 Accounting is an information system.
 It identifies, collects, processes,
and communicates economic
information about a firm using a
wide variety of technologies.
  It captures and records the
financial effects of the firm’s
transactions.
 It distributes transaction
information to operations personnel
to coordinate many key tasks.
AIS versus MIS
 Accounting Information Systems (AIS)
process
 financial transactions; e.g., sale of
goods
 nonfinancial transactions that
directly affect the processing of
financial transactions; e.g., addition
of newly approved vendors
 Management Information Systems
(MIS) process
 nonfinancial transactions that are
not normally processed by
traditional AIS; e.g., tracking
customer complaints
AIS Subsystems
 Transaction processing system (TPS)
- supports daily business operations. central
to the overall function of the information
system by converting economic events into
financial transactions, recording financial
transactions in the accounting records
(journals and ledgers), and distributing
essential financial information to operations
personnel to support their daily operations.
The TPS consists of three transaction cycles:
the revenue cycle, the expenditure cycle,
and the conversion cycle. Each cycle
captures and processes different types of
financial transactions.
 General Ledger/ Financial
Reporting System (GL/FRS) - produces
financial statements and reports. Summaries
of transaction cycle activity are processed
by the GLS to update the general ledger
control accounts.
 Management Reporting System
(MRS) - produces special-purpose reports
for internal use. This type of reporting is
called discretionary reporting because the
organization can choose what information to
report and how to present it.
General Model for AIS
The elements of the general model:
 End Users - External users include
creditors, stockholders, potential investors,
regulatory agencies, tax authorities,
suppliers, and customers. Internal users
include management at every level of the
organization, as well as operations
personnel.
 Data are facts, which may or may not be
processed (edited, summarized, or refined)
and have no direct effect on the user. By
contrast, information causes the user to
take an action that he or she otherwise
could not, or would not, have taken.
Information is often defined simply as
processed data.
 Data Processing
 Database Management - The
organization’s database is its physical
repository for financial and nonfinancial
data. We use the term database in the
generic sense. It can be a filing cabinet or a
computer disk.
 DATA ATTRIBUTE - The data attribute is
the most elemental piece of potentially
useful data in the database. An attribute is a
logical and relevant characteristic of an
entity about which the firm captures data.
 RECORD - A record is a complete set of
attributes for a single occurrence within an
entity class.
 FILES. A file is a complete set of records of
an identical class.
Data Sources
 Data sources are financial transactions
that enter the information system from
internal and external sources.
 External financial transactions
are the most common source of data
for most organizations.
• E.g., sale of goods and
services, purchase of inventory,
receipt of cash, and disbursement
of cash (including payroll)
 Internal financial transactions
involve the exchange or movement
of resources within the organization.
• E.g., movement of raw
materials into work-in-process
(WIP), application of labor and
overhead to WIP, transfer of WIP
into finished goods inventory, and
depreciation of equipment
Transforming the Data into Information
Functions for transforming data into
information according to the general AIS
model:
1. Data Collection
 Capturing transaction data
 Recording data onto forms
• Merging
• Calculating
• Summarizing
• Comparing
  Validating and editing the data
2. Data Processing
 Classifying  Merging
 Transcribing  Calculating
 Sorting  Summarizing
 Batching  Comparing
3. Data Management
 Storing - task assigns keys to new
records and stores them in their proper
location in the database
 Retrieving - the task of locating and
extracting an existing record from the
database for processing. After processing
is complete, the storage task restores the
updated record to it place in the
database.
 Deleting - the task of permanently
removing obsolete or redundant records
from the database.
4. Information Generation
 Compiling
 Arranging
 Formatting
 Presenting
Characteristics of Useful Information
 Regardless of physical form or
technology, useful information has the
following characteristics:
 Relevance: serves a purpose
 Timeliness: no older than the time
period of the action it supports
 Accuracy: free from material
errors
 Completeness: all information
essential to a decision or task is
present
 Summarization: aggregated in
accordance with the user’s needs
 Feedback is a form of output that is sent
back to the system as a source of data.
Feedback may be internal or external and is
used to initiate or alter a process.
Information System Objectives in a
Business Context
 The goal of an information system is to
support
 the stewardship function of
management
 management decision making
 the firm’s day-to-day operations
Organizational Structure
 The structure of an organization helps to
allocate
 responsibility
 authority
 accountability
 Segmenting by business function is a
very common method of organizing.
Functional Areas
 Inventory/Materials Management - The
objective of materials management is to
plan and control the materials inventory of
the company.
 Purchasing - responsible for ordering
inventory from vendors when inventory
levels fall to their reorder points.
 Receiving - the task of accepting the
inventory previously ordered
purchasing. Receiving activities include
counting and checking the physical
condition of these items.
 Stores - takes physical custody of the
inventory received and releases these
resources into the production process as
needed.
 Production - production planning, quality
control, and maintenance
 Marketing - The marketing
function deals with the strategic problems of
product promotion, advertising, and market
research.
 Distribution - the activity of getting the
product to the customer after the sale. This
is a critical step.
 Personnel - Competent and reliable
employees are a valuable resource to a
business. The objective of the personnel
function is to effectively manage this
resource.
 Finance - The finance function manages
the financial resources of the firm through
banking and treasury activities, portfolio
management, credit evaluation, cash
disbursements, and cash receipts.
 Accounting - manages the financial
information resource of the firm. In this
regard, it plays two important roles in
transaction processing. First, accounting
captures and records the financial effects of
the firm’s transactions. Second, the
accounting function distributes transaction
information to operations personnel to
coordinate many of their key tasks.
 Computer Services
Accounting Independence
 Information reliability requires
accounting independence.
 Accounting activities must be
separate and independent of the
functional areas maintaining
resources.
 Accounting supports these
functions with information but does
not actively participate.
 Decisions makers in these functions
require that such vital information
be supplied by an independent
source to ensure its integrity.
The Computer Services Function
1. Distributed Data Processing -
Reorganizing the computer services
function into small information processing
units that are distributed to end users and
placed under their control
2. Centralized Data Processing - All data
processing is performed by one or more
large computers housed at a central site
that serves users throughout the
organization. Primary areas database
administration data processing systems
development systems maintenance.
 DATABASE ADMINISTRATION.
Centrally organized companies
maintain their data resources in a
by
 central location that is shared by all
end users
 DATA PROCESSING. The data
processing group manages the
computer resources used to perform
the day-to-day processing of
transactions. It may consist of the
following functions: data control, data
conversion, computer operations, and
the data library.
 SYSTEMS DEVELOPMENT AND
MAINTENANCE. The information
needs of users are met by two related
functions: systems development and
systems maintenance
Potential Advantages of DDP
 Cost reductions in hardware and data
entry tasks
 Improved cost control responsibility
 Improved user satisfaction since control is
closer to the user level
 Backup of data can be improved through
the use of multiple data storage sites
Potential Disadvantages of DDP
 Loss of control
 Mismanagement of company resources
 Hardware and software incompatibility
 Redundant tasks and data
 Consolidating tasks usually segregated
 Difficulty attracting qualified personnel
 Lack of standards
Manual Process Model
 Transaction processing, information
processing, and accounting are physically
performed by people, usually using paper
documents.
 Useful to study because:
a. helps link AIS courses to other
accounting courses
b. often easier to understand business
processes when not shrouded in
technology
c. facilitates understanding internal
controls
 The Flat-File Model - The flat-file model
describes an environment in which individual
data files are not related to other files. End
users in this environment own their data files
rather than share them with other users.
Thus, stand-alone applications rather than
integrated systems perform data processing.
Data Redundancy Problems
 Data Storage - excessive storage costs
of paper documents and/or magnetic form
 Data Updating - changes or additions
must be performed multiple times
 Currency of Information - potential
problem of failing to update all affected
files
 Task-Data Dependency - user’s inability
to obtain additional information as needs
change
 Data Integration - separate files are
difficult to integrate across multiple users
THE DATABASE MODEL
 An organization can overcome the
problems associated with flat files by
implementing the database model to
data management.
REA Model
 The REA model is an accounting
framework for modeling an
organization’s
a. economic resources; e.g., assets
b. economic events; i.e., affect
changes in resources
c. economic agents; i.e., individuals
and departments that participate in
an economic event
d. Interrelationships among
resources, events and agents
 Entity-relationship diagrams (ERD)
are often used to model these
relationships.
Accountants as Information System Users
 Accountants must be able to clearly
convey their needs to the systems
professionals who design the system.
 The accountant should actively
participate in
systems development projects to ensure
appropriate systems design.
Accountants as System Designers
 The accounting function is responsible for
the conceptual system, while the
computer function is responsible for the
physical system.
 The conceptual system determines the
nature of the information required, its
sources, its destination, and the
accounting rules that must be applied.
Accountants as System Auditors
 External Auditors
 attest to fairness of financial
statements
 assurance service: broader in
scope than traditional attestation
audit
 IT Auditors
 evaluate IT, often as part of
external audit
 Internal Auditors
 in-house IS and IT appraisal
services
CHAPTER 2
TRANSACTION PROCESSING
A Financial Transaction is...
  an economic event that affects the assets
and equities of the firm, is reflected in its
accounts, and is measured in monetary
terms.
 similar types of transactions are grouped
together into three transaction cycles:
 the expenditure cycle
 the conversion cycle
 the revenue cycle
The most common financial transactions are
economic exchanges with external parties.
Financial transactions also include certain
internal events such
as the depreciation of fixed assets; the
application of labor, raw materials, and
overhead to the production
process; and the transfer of inventory from one
department to another.
Relationship between Transaction Cycles
Each Cycle has Two Primary Subsystems
 Expenditure Cycle: time lag between
the two due to credit relations with
suppliers:
 physical component
(acquisition of goods)
 financial component (cash
disbursements to the supplier)
 Purchases/accounts payable
system. This system recognizes the
need to acquire physical inventory
(such as raw materials) and places an
order with the vendor.
 Cash disbursements system.
When the obligation created in the
purchases system is due, the cash
disbursements system authorizes the
payment, disburses the funds to the
vendor, and records the transaction by
reducing the cash and accounts
payable accounts.
 Payroll system. The payroll
system collects labor usage data for
each employee, computes the payroll,
and disburses paychecks to the
employees. Conceptually, payroll is a
special-case purchases and cash
disbursements system.
 Fixed asset system. A firm’s
fixed asset system processes
transactions pertaining to the
acquisition, maintenance, and disposal
of its fixed assets.
 Conversion Cycle:
 the production system
(planning, scheduling, and control
of the physical product through the
manufacturing process)
 the cost accounting system
(monitors the flow of cost
information related to production)
 Revenue Cycle: time lag between the
two due to credit relations with
customers:
 physical component (sales order
processing)
 financial component (cash
receipts)
 Sales order processing. The
majority of business sales are made
on credit and involve tasks such as
preparing sales orders, granting
credit, shipping products (or rendering
of a service) to the customer, billing
customers, and recording the
transaction in the accounts (accounts
receivable, inventory, expenses, and
sales).
 Cash receipts. Cash receipts
processing includes collecting cash,
depositing cash in the bank, and
recording these events in the
accounts (accounts receivable and
cash).
Manual System Accounting Records
A document provides evidence of an economic
event and may be used to initiate transaction
processing. Some documents are a result of
transaction processing
 Source Documents - used to capture
and formalize transaction data needed for
transaction processing
 Product Documents - the result of
transaction processing
 Turnaround Documents - a product
document of one system that becomes a
source document for another system
 Journals - a record of chronological entry
  special journals - specific classes
of transactions that occur in high
frequency
 general journal - nonrecurring,
infrequent, and dissimilar transactions
 REGISTER. The term register is often
used to denote certain types of special
journals. For example, the payroll
journal is often called the payroll
register.
 Ledger - a book of financial accounts
 general ledger - shows activity
for each account listed on the chart of
accounts
 subsidiary ledger - shows activity
by detail for each account type
Flow of Information from Economic Event
into the General Ledger
Audit Trail
The accounting records described previously
provide an audit trail for tracing transactions
from source documents to the financial
statements. Of the many purposes of the audit
trail, most important to accountants is the year-
end audit. Although the study of financial
auditing falls outside the scope of this text, the
following thumbnail sketch of the audit process
will demonstrate the importance of the audit
trail. The external auditor periodically evaluates
the financial statements of publicly held
business organizations on behalf of its
stockholders and other interested parties.
Example of Tracing an Audit Trail
Verifying Accounts Receivable
Computer-Based Systems
 The audit trail is less observable in
computer-based systems than traditional
manual systems.
 The data entry and computer programs
are the physical trail.
 The data are stored in magnetic files.
Computer Files
 Master File - generally contains account
data (e.g., general ledger and subsidiary file)
 Transaction File - a temporary file
containing transactions since the last update
 Reference File - contains relatively
constant information used in processing
(e.g., tax tables, customer addresses)
 Archive File - contains past transactions
for reference purposes
Documentation Techniques
 Documentation in a CB environment is
necessary for many reasons.
 Five common documentation
techniques:
 Entity Relationship Diagram
 Data Flow Diagrams
 Document Flowcharts
 System Flowcharts
 Program Flowcharts
Entity Relationship Diagram (ERD)
 A documentation technique to represent
the relationship between entities in a
system.
 The REA model version of ERD is widely
used in AIS. REA uses 3 types of entities:
 resources (cash, raw materials)
 events (release of raw materials
into the production process)
 agents (inventory control clerk,
vendor, production worker)
Cardinalities
 Represent the numerical mapping
between entities:
 one-to-one
 one-to-many
 many-to-many
Data Flow Diagrams (DFD)…
 use symbols to represent the processes,
data sources, data flows, and entities in a
system
 represent the logical elements of the
system
 do not represent the physical system
Data Flow Diagram Symbols
System Flowcharts…
 illustrate the relationship among
processes and the documents that flow
between them
 contain more details than data flow
diagrams
 clearly depict the separation of functions
in a system
Symbol Set for Representing
Manual Procedures
System Flowcharts…
 are used to represent the relationship
between the key elements--input sources,
programs, and output products--of computer
systems
 depict the type of media being used
(paper, magnetic tape, magnetic disks, and
terminals)
 in practice, not much difference between
document and system flowcharts
Symbol Set for Representing Computer
Processes
Program Flowcharts…
 illustrate the logic used in
programs
Program Flowchart Symbols
Modern Systems versus Legacy Systems
 Modern systems characteristics:
 client-server based and process
transactions in real time
 use relational database tables
 have high degree of process
integration and data sharing
 some are mainframe based and
use batch processing
 Some firms employ legacy systems
for certain aspects of their data
processing.
 Accountants need to understand
legacy systems.
 Legacy systems characteristics:
 mainframe-based applications
 batch oriented
 early legacy systems use flat files
for data storage
 later legacy systems use
hierarchical and network databases
 data storage systems promote a
single-user environment that
discourages information integration
Computer-Based Accounting Systems
 Two broad classes of systems:
 batch systems
 real-time systems
Batch Processing
 A batch is a group of similar transactions
that are accumulated over time and then
processed together.
 The transactions must be independent of
one another during the time period over
which the transactions are accumulated
in order for batch processing to be
appropriate.
 A time lag exists between the event and
the processing.
Steps in Batch Processing/Sequential File
 Keystroke - source documents are
transcribed by clerks to magnetic tape for
processing later
 Edit Run - identifies clerical errors in the
batch and places them into an error file
 Sort Run - places the transaction file in
the same order as the master file using a
primary key
 Update Run - changes the value of
appropriate fields in the master file to
reflect the transaction
 Backup Procedure - the original master
continues to exist and a new master file is
created
Advantages of Batch Processing
 Organizations can increase efficiency
by grouping large numbers of
 transactions into batches rather than
processing each event separately.
 Batch processing provides control over
the transaction process via control
figures.
Real-Time Systems…
 process transactions individually at
the moment the economic event occurs
 have no time lag between the economic
event and the processing
 generally, require greater resources
than batch processing since they require
dedicated processing capacity; however,
these cost differentials are decreasing
 oftentimes have longer systems
development time
=============================
====================
CHAPTER 3
Ethics, Fraud and Internal Control
Ethical Standards
Ethical standards are derived from societal
mores and deep-rooted personal beliefs about
issues of right and wrong that are not
universally agreed upon.
Business Ethics
Ethics pertains to the principles of conduct
that individuals use in making choices and
guiding their behavior in situations that involve
the concepts of right and wrong.
Why should we be concerned about ethics in the
business world?
 Ethics are needed when conflicts arise—
the need to choose
 In business, conflicts may arise between:
 employees
 management
 stakeholders
 Litigation
Business ethics involves finding the answers to
two questions:
 How do managers decide on what is right
in conducting their business?
 Once managers have recognized what is
right, how do they achieve it?
Four Main Areas of Business Ethics
PROPORTIONALITY. The benefit from a
decision must outweigh the risks. Furthermore,
there must be no alternative decision that
provides the same or greater benefit with less
risk.
 Justice. The benefits of the decision
should be distributed fairly to those who
share the risks. Those who do not benefit
should not carry the burden of risk.
 Minimize risk. Even if judged acceptable
by the principles, the decision should be
implemented so as to minimize all of the
risks and avoid any unnecessary risks.
Computer Ethics
 The analysis of the nature and social
impact of computer technology and the
corresponding formulation and
justification of policies for the ethical use
of such technology.… [This includes]
concerns about software as well as
hardware and concerns about networks
connecting computers as well as
computers themselves.’’
 concerns the social impact of computer
technology (hardware, software, and
telecommunications).
 Three levels of computer ethics: pop,
para, and theoretical.4
 Pop computer ethics is simply the
exposure to stories and reports found in
the popular media regarding the good or
bad ramifications of computer
technology.
 Para computer ethics involves taking
a real interest in computer ethics cases
and acquiring some level of skill and
knowledge in the field.
 The third level, theoretical computer
ethics, is of interest to multidisciplinary
researchers who apply the theories of
philosophy, sociology, and psychology to
computer science with the goal of
bringing some new understanding to the
field.
What are the main computer ethics
issues?
 Privacy - The creation and maintenance
of huge, shared databases make it
necessary to protect people from the
potential misuse of data.
 Security—accuracy and confidentiality -
Computer security is an attempt to avoid
such undesirable events as a loss of
confidentiality or data integrity. Security
systems attempt to prevent fraud and
other misuse of computer systems; they
act to protect and further the legitimate
interests of the system’s constituencies.
 Ownership of property - Laws designed
to preserve real property rights have been
extended to cover what is referred to as
intellectual property, that is, software.
 Equity in access
 Environmental issues
 Artificial intelligence
 Unemployment and displacement -
Many jobs have been and are being
changed as a result of the availability of
computer technology. People unable or
unprepared to change are displaced.
  Misuse of computer
Legal Definition of Fraud
 False representation - false statement
or disclosure
 Material fact - a fact must be substantial
in inducing someone to act
 Intent to deceive must exist
 The misrepresentation must have resulted
in justifiable reliance upon information,
which caused someone to act
 The misrepresentation must have caused
injury or loss
Enron, WorldCom, Adelphia - Underlying
Problems
Lack of Auditor Independence: auditing firms
also engaged by their clients to perform non
accounting activities
Lack of Director Independence: directors who
also serve on the boards of other companies,
have a business trading relationship, have a
financial relationship as stockholders or have
received personal loans, or have an operational
relationship as employees
Questionable Executive Compensation
Schemes: short-term stock options as
compensation result in short-term strategies
aimed at driving up stock prices at the expense
of the firm’s long-term health
Inappropriate Accounting Practices: a
characteristic common to many financial
statement fraud schemes
 Enron made elaborate use of special
purpose entities.
 WorldCom transferred transmission line
costs from current expense accounts to
capital accounts.
Sarbanes-Oxley Act of 2002 - Its principal
reforms pertain to:
 Creation of the Public Company
Accounting Oversight Board (PCAOB)
 Auditor independence—more
separation between a firm’s attestation
and non-auditing activities
 Corporate governance and
responsibility—audit committee
members must be independent and the
audit committee must oversee the
external auditors
 Disclosure requirements—
increase issuer and management
disclosure
 New federal crimes for the
destruction of or tampering with
documents, securities fraud, and actions
against whistleblowers
Employee Fraud
 Committed by non-management
personnel
 Usually consists of: an employee taking
cash or other assets for personal gain by
circumventing a company’s system of
internal controls
Management Fraud
 Perpetrated at levels of management
above the one to which internal control
structure relates
 Frequently involves using financial
statements to create an illusion that an
entity is healthier and prosperous than it
actually is
 Involves misappropriation of assets, it
frequently is shrouded in a maze of
complex business transactions
Fraud Schemes
Three categories of fraud schemes according to
the Association of Certified Fraud Examiners:
A. fraudulent statements - are associated
with management fraud.
B. corruption - involves an executive,
manager, or employee of the organization in
collusion with an outsider.
C. asset misappropriation - The most
common fraud schemes involve some form of
asset misappropriation in which assets are
either directly or indirectly diverted to the
perpetrator’s benefit.
A. Fraudulent Statements
 Misstating the financial statements to
make the copy appear better than it is
 Usually occurs as management fraud
 May be tied to focus on short-term
financial measures for success
 May also be related to management
bonus packages being tied to financial
statements
B. Corruption
 BRIBERY. Bribery involves giving,
offering, soliciting, or receiving things of
value to influence an official in the
performance of his or her lawful duties
 ILLEGAL GRATUITIES. An illegal
gratuity involves giving, receiving,
offering, or soliciting something of value
because of an official act that has been
taken. This is similar to a bribe, but the
transaction occurs after the fact
 CONFLICTS OF INTEREST. Every
employer should expect that his or her
employees will conduct their duties in a
way that serves the interests of the
employer. A conflict of interest occurs
when an employee acts on behalf of a
third party during the discharge of his or
her duties or has self-interest in the
activity being performed
 ECONOMIC EXTORTION. Economic
extortion is the use (or threat) of force
(including economic sanctions) by an
individual or organization to obtain
 something of value. The item of value
could be a financial or economic asset,
information, or cooperation to obtain a
favorable decision on some matter under
review.
 Foreign Corrupt Practice Act of 1977:
 indicative of corruption in business
world
 impacted accounting by requiring
accurate records and internal
controls
C. Asset Misappropriation
 Skimming involves stealing cash from an
organization before it is recorded on the
organization’s books and records.
 Cash larceny involves schemes in which
cash receipts are stolen from an
organization after they have been
recorded in the organization’s books and
records. An example of this is lapping, in
which the cash receipts clerk first steals
and cashes a check from Customer A.
 Check tampering involves forging or
changing in some material way a check
that the organization has written to a
legitimate payee.
 Payroll fraud is the distribution of
fraudulent paychecks to existent and/or
nonexistent employees. Most common
type of fraud and often occurs as
employee fraud
 Examples:
 making charges to expense
accounts to cover theft of asset
(especially cash)
 lapping: using customer’s check
from one account to cover theft
from a different account
 transaction fraud: deleting,
altering, or adding false
transactions to steal assets
Internal Control Objectives According to
AICPA SAS
1. Safeguard assets of the firm
2. Ensure accuracy and reliability of
accounting records and information
3. Promote efficiency of the firm’s
operations
4. Measure compliance with management’s
prescribed policies and procedures
Modifying Assumptions to the Internal
Control Objectives
 Management Responsibility
The establishment and maintenance of a
system of internal control is the responsibility of
management.
 Reasonable Assurance
The cost of achieving the objectives of internal
control should not outweigh its benefits.
 Methods of Data Processing
The techniques of achieving the objectives will
vary with different types of technology.
Limitations of Internal Controls
 Possibility of honest errors
 Circumvention via collusion
 Management override
 Changing conditions--especially in
companies with high growth
Exposures of Weak Internal Controls (Risk)
 Destruction of an asset
 Theft of an asset
 Corruption of information
 Disruption of the information system
Preventive, Detective, and Corrective
Controls
SAS 78 / COSO
Describes the relationship between the firm’s…
 internal control structure,
 auditor’s assessment of risk, and
 the planning of audit procedures
How do these three interrelate?
The weaker the internal control structure, the
higher the assessed level of risk; the higher the
risk, the more auditor procedures applied in the
audit.
Five Internal Control Components: SAS 78 /
COSO
1. Control environment
2. Risk assessment
3. Information and communication
4. Monitoring
5. Control activities
1: The Control Environment
 Integrity and ethics of management
 Organizational structure
 Role of the board of directors and the
audit committee
 Management’s policies and philosophy
 Delegation of responsibility and authority
 Performance evaluation measures
 External influences—regulatory agencies
 Policies and practices managing human
resources
2: Risk Assessment
 Identify, analyze and manage risks
relevant to financial reporting:
 changes in external environment
 risky foreign markets
 significant and rapid growth that
strain internal controls
 new product lines
 restructuring, downsizing
 changes in accounting policies
3: Information and Communication
 The AIS should produce high quality
information which:
 identifies and records all valid
transactions
 provides timely information in
appropriate detail to permit proper
classification and financial
reporting
 accurately measures the financial
value of transactions
  accurately records transactions in
the time period in which they
occurred
Information and Communication
 Auditors must obtain sufficient knowledge of
the IS to understand:
 the classes of transactions that are
material
 how these transactions are initiated
[input]
 the associated accounting records and
accounts used in processing [input]
 the transaction processing steps involved
from the initiation of a transaction to its
inclusion in the financial statements
[process]
 the financial reporting process used to
compile financial statements, disclosures,
and estimates [output]
[red shows relationship to the general AIS
model]
4: Monitoring
The process for assessing the quality of internal
control design and operation
[This is feedback in the general AIS model.]
 Separate procedures—test of controls by
internal auditors
 Ongoing monitoring:
 computer modules integrated into
routine operations
 management reports which
highlight trends and exceptions
from normal performance
[red shows relationship to the general AIS
model]
5: Control Activities
 Policies and procedures to ensure that the
appropriate actions are taken in response
to identified risks
 Fall into two distinct categories:
 IT controls—relate specifically to
the computer environment
 Physical controls—primarily pertain
to human activities
Two Types of IT Controls
 General controls—pertain to the entity
wide computer environment
 Examples: controls over the data
center, organization databases,
systems development, and
program maintenance
 Application controls—ensure the integrity
of specific systems
 Examples: controls over sales order
processing, accounts payable, and
payroll applications
Six Types of Physical Controls
 Transaction Authorization
 Segregation of Duties
 Supervision
 Accounting Records
 Access Control
 Independent Verification
Physical Controls
Transaction Authorization
 used to ensure that employees are
carrying out only authorized transactions
 general (everyday procedures) or specific
(non-routine transactions) authorizations
Segregation of Duties
 In manual systems, separation between:
 authorizing and processing a
transaction
 custody and recordkeeping of the
asset
 subtasks
 In computerized systems, separation
between:
 program coding
 program processing
 program maintenance
Supervision
 a compensation for lack of segregation;
some may be built into computer systems
Accounting Records
 provide an audit trail
Access Controls
 help to safeguard assets by restricting
physical access to them
Independent Verification
 reviewing batch totals or reconciling
subsidiary accounts with control accounts
Physical Controls in IT Contexts
Transaction Authorization
 The rules are often embedded within
computer programs.
 EDI/JIT: automated re-ordering of
inventory without human
intervention
Segregation of Duties
 A computer program may perform many
tasks that are deemed incompatible.
 Thus the crucial need to separate
program development, program
operations, and program maintenance.
Supervision
 The ability to assess competent
employees becomes more challenging
due to the greater technical knowledge
required.
Accounting Records
 ledger accounts and sometimes source
documents are kept magnetically
 no audit trail is readily apparent
Access Control
 Data consolidation exposes the
organization to computer fraud and
excessive losses from disaster.
Independent Verification
 When tasks are performed by the
computer rather than manually, the need
for an independent check is not
necessary.
 However, the programs themselves are
checked.
  credit reference file (may not be
needed)
 salesperson file (may be a master
file)
 Sales history file
 cash receipts history file
 accounts receivable reports file
Sales Order Processing
Sales order procedures include the tasks
involved in receiving and processing a customer
order, filling the order and shipping products to
the customer, billing the customer at the proper
time, and correctly accounting for the
transaction.
RECEIVE ORDER
 Begins with a customer placing an order
 The sales department captures the
CHAPTER 4 essential details on a sales order
The Revenue Cycle form.
 Sales Order - captures vital information
such as the customer’s name, address,
and account number; the name, number,
and description of the items sold; and the
quantities and unit prices of each item
sold
 After creating the sales order, a copy of it
is placed in the customer open order
file for future reference. The open order
file thus enables customer service
employees to respond promptly and
accurately to customer questions.
CHECK CREDIT
 The transaction is authorized by obtaining
credit approval by the credit department.
 The credit approval process is an
Journal Vouchers/Entries (How do we get authorization control and should be
them?) performed as a function separate from
 Billing Department prepares a journal the sales activity. In our conceptual
voucher: system, the receive-order task sends the
Accounts Receivable sales order (credit copy) to the check-
DR credit task for approval.
Sales  Sales information is released to:
CR  Billing
 Inventory Control Dept. prepares a journal  Warehouse (stock release or
voucher: picking ticket)
Cost of Goods Sold DR  Shipping (packing slip and
Inventory CR shipping notice)
 Cash Receipts prepares a journal voucher: PICK GOODS
Cash DR  The receive order activity forwards the
Accounts Receivable stock release document (also called the
CR picking ticket) to the pick goods function, in
the warehouse.
Revenue Cycle Databases  The merchandise is picked from the
Warehouse and sent to Shipping. After
 Master files picking the stock, the order is verified for
 customer master file accuracy and the goods and verified stock
 accounts receivable master file release document are sent to the ship
 merchandise inventory master file goods task.
 Transaction and Open Document  Stock records are adjusted.
Files SHIP GOODS
 sales order transaction file  The merchandise, packing slip, and
• open sales order transaction bill of lading are prepared by Shipping
file and sent to the customer.
 sales invoice transaction file  Shipping reconciles the merchandise
 cash receipts transaction file received from the Warehouse with the
 Other Files sales information on the packing slip.
 shipping and price data reference  Shipping information is sent to Billing.
file BILL CUSTOMER
 The billing function awaits notification
from shipping before it bills. The bill-
customer function receives the sales order
(invoice copy) from the receive order task.
This document is placed in an S.O. pending
file until receipt of the shipping notice,
which describes the products that were
actually shipped to the customer. Upon
arrival, the items shipped are reconciled
with those ordered and unit prices, taxes,
and freight charges are added to the invoice
copy of the sales order. The completed
sales invoice is the customer’s bill, which
formally depicts the charges to the
customer.
 Billing compiles and reconciles the
relevant facts and issues an invoice to the
customer and updates the sales journal.
Information is transferred to:
 Accounts Receivable (A/R)
 Inventory Control
 A/R records the information in the
customer’s account in the accounts
receivable subsidiary ledger.
 Inventory Control adjusts the inventory
subsidiary ledger.
 Billing, A/R, and Inventory Control submits
summary information to the General
Ledger dept., which then reconciles this
data and posts to the control accounts in
the G/L.
 The sales journal is a special journal
used for recording completed sales
transactions. The details of sales invoices
are entered in the journal individually. At the
end of the period, these entries are
summarized into a sales journal voucher,
which is sent to the general ledger task for
posting.
 The AR summary figures should equal the
total debits to AR reflected in the journal
vouchers for the transaction period. By
reconciling these figures, the general ledger
function can detect many types of errors.
Sales Return Procedures
PREPARE RETURN SLIP.
When items are returned, the receiving
department employee counts, inspects, and
prepares a return slip describing the items.
The goods, along with a copy of the return slip,
go to the warehouse to be restocked. The
employee then sends the second copy of the
return slip to the sales function to prepare a
credit memo.
PREPARE CREDIT MEMO.
Upon receipt of the return slip, the sales
employee prepares a credit memo. This
document is the authorization for the customer
to receive credit for the merchandise returned.
APPROVE CREDIT MEMO.
The credit manager evaluates the
circumstances of the return and makes a
judgment to grant (or disapprove) credit. The
manager then returns the approved credit
memo to the sales department.
UPDATE SALES JOURNAL.
Upon receipt of the approved credit memo,
the transaction is recorded in the sales journal
as a contra entry. The credit memo is then
forwarded to the inventory control function for
posting. At the end of the period, total sales
returns are summarized in a journal voucher and
sent to the general ledger department.
UPDATE INVENTORY AND AR RECORDS.
The inventory control function adjusts the
inventory records and forwards the credit memo
to accounts receivable, where the customer’s
account is also adjusted.
UPDATE GENERAL LEDGER.
Sales Return Journal Entry
G/L posts the following to control accounts:
Inventory—Control DR
Sales Returns and Allowances DR
Cost of Goods Sold CR
Accounts Receivable—Control CR
Cash Receipts Processes
Involve receiving and securing the cash;
depositing the cash in the bank; matching the
payment with the customer and adjusting the
correct account; and properly accounting for and
reconciling the financial details of the
transaction.
OPEN MAIL AND PREPARE REMITTANCE
ADVICE.
A mail room employee opens envelopes
containing customers’ payments and remittance
advices. Remittance advices contain information
needed to service individual customers’
accounts. This includes payment date, account
number, amount paid, and customer check
number. Mail room personnel route the checks
and remittance advices to an administrative
clerk who endorses the checks ‘‘For Deposit
Only’’ and reconciles the amount on each
remittance advice with the corresponding check.
The clerk then records each check on a form
called a remittance list (or cash prelist), where
all cash received is logged.
 A mail room clerk prepares a cash
prelist and sends the prelist and the
checks to Cash Receipts.
 The cash prelist is also sent to A/R
and the Controller.
RECORD AND DEPOSIT CHECKS.
 Cash Receipts:
 verifies the accuracy and
completeness of the checks
 updates the cash receipts journal
 prepares a deposit slip
 prepares a journal voucher to send
to G/L
 A/R posts from the remittance advices to
the accounts receivable subsidiary ledger.
 Periodically, a summary of the
postings is sent to G/L.
 G/L department:
 reconciles the journal voucher from
Cash Receipts with the summaries
from A/R
 updates the general ledger control
accounts
 The Controller reconciles the bank
accounts.
SALES ORDER PROCESSING (Departments
Involved)
Sales Department
 The sales process begins with a customer
contacting the sales department by telephone,
mail, or in person. The sales department records
the essential details on a sales order.
Credit Department Approval
To provide independence to the credit
authorization process, the credit department is
organizationally and physically segregated from
the sales department. When credit is approved,
the sales department clerk pulls the various
copies of the sales orders from the pending file
and releases them to the billing, warehouse, and
shipping departments.
Warehouse Procedures
The next step is to ship the merchandise,
which should be done as soon after credit
approval as possible. The warehouse clerk
receives the stock release copy of the sales
order and uses this to locate the inventory. The
inventory and stock release are then sent to the
shipping department. Finally, the warehouse
clerk records the inventory reduction in the
stock records.
The Shipping Department
The shipping clerk reconciles the products
received from the warehouse with the shipping
notice copy of the sales order received earlier.
When the order is correct, a bill of lading is
prepared, and the products are packaged and
shipped via common carrier to the customer.
The clerk then enters the transaction into the
shipping log and sends the shipping notice and
stock release to the billing department.
The Billing Department
The shipping notice is proof that the product
has been shipped and is the trigger document
that initiates the billing process. Upon receipt of
the shipping notice and stock release, the billing
clerk compiles the relevant facts about the
transaction (product prices, handling charges,
freight, taxes, and discount terms) and bills the
customer. The billing clerk then enters the
transaction into the sales journal and distribute
documents to the AR and inventory control
departments. Periodically, the clerk summarizes
all transactions into a journal voucher and sends
this to the general ledger department.
Accounts Receivable, Inventory Control,
and General Ledger Departments
Upon receipt of sales documents from the
billing department, the AR and inventory control
clerks update their respective subsidiary
ledgers. Periodically they prepare journal
vouchers and account summaries, which they
send to the general ledger department for
reconciliation and posting to the control
accounts.
SALES RETURN PROCEDURES
Receiving Department
The sales return process begins in the
receiving department, where personnel receive,
count, inspect for damage, and send returned
products to the warehouse. The receiving clerk
prepares a return slip, which is forwarded to the
sales department for processing.
Sales Department
Upon receipt of the return slip, the clerk
prepares a credit memo. Depending on the
materiality and circumstance of the return,
company policy will dictate whether credit
department approval (not shown) is required.
Processing the Credit Memo
The objective of the sales return system is to
reverse the effects of the original sales
transaction. Billing records a contra entry into
sales return, and allowance journal inventory
control debits the inventory records to reflect
the return of goods. The AR clerk credits the
customer account
CASH RECEIPTS PROCEDURES
Mail Room
Customer payments and remittance advices
arrive at the mail room, where the envelopes are
opened. The checks are sent to the cashier in
the cash receipts department, and the
remittance advices are sent to the AR
department.
Cash Receipts
The cashier records the checks in the cash
receipts journal and promptly sends them to the
bank, accompanied by two copies of the deposit
slip. Periodically, the employee prepares a
journal voucher and sends it to the general
ledger department.
Controller’s Office
In this case, someone from the controller’s
office periodically performs a bank reconciliation
by comparing deposit slips returned from the
bank, account summaries used to post to the
accounts, and journal vouchers.
Summary of Internal Controls
Authorization Controls
 Proper authorization of transactions
(documentation) should occur so that only
valid transactions get processed.
 Within the revenue cycle, authorization
should take place when:
 a sale is made on credit
(authorization)
 a cash refund is requested
(authorization)
 posting a cash payment received to
a customer’s account (cash pre-list)
Segregation of Functions (Three Rules)
1. Transaction authorization should be
separate from transaction processing.
 2. Asset custody should be separate from
asset record-keeping.
3. The organization should be so structured
that the perpetration of a fraud requires
collusion between two or more
individuals.
 Sales Order Processing
 credit authorization separate from
SO processing
 inventory control separate from
warehouse
 accounts receivable sub-ledger
separate from general ledger
control account
 Cash Receipts Processing
 cash receipts separate from
accounting records
 accounts receivable sub-ledger
separate from general ledger
Supervision
 Often used when unable to enact
appropriate segregation of duties.
 Supervision of employees serves as a
deterrent to dishonest acts and is
particularly important in the mailroom.
Accounting Records
 With a properly maintained audit trail, it is
possible to track transactions through the
systems and to find where and when errors
were made:
 pre-numbered source documents -
(sales orders, shipping notices,
remittance advices, and so on) are
sequentially numbered by the printer and
allow every transaction to be identified
uniquely. This permits the isolation and
tracking of a single event (among many
thousands) through the accounting
system.
 special journals - By grouping similar
transactions together into special
journals, the system provides a concise
record of an entire class of events.
 subsidiary ledgers - These subsidiary
records provide links back to journal
entries and to the source documents that
captured the events.
 general ledger - he general
ledger control accounts are the basis
for financial statement preparation.
 Files - The revenue cycle employs
several temporary and permanent files
that contribute to the audit trail. The
following are typical examples:
 Open sales order file shows the
status of customer orders.
 Shipping log specifies orders shipped
during the period.
 Credit records file provides customer
credit data.
 Sales order pending file contains open
orders not yet shipped or billed.
 Back-order file contains customer
orders for out-of-stock items.
 b is a compilation of all journal
vouchers posted to the general ledger.
Access Controls
 Access to assets and information
(accounting records) should be limited.
 Within the revenue cycle, the assets to
protect are cash and inventories and
access to records such as the accounts
receivable subsidiary ledger and cash
journal should be restricted.
Independent Verification
 Physical procedures as well as record-
keeping should be independently
reviewed at various points in the system
to check for accuracy and completeness:
 shipping verifies the goods sent
from the warehouse are correct in
type and quantity
 warehouse reconciles the stock
release document (picking slip) and
packing slip
 billing reconciles the shipping
notice with the sales invoice
 general ledger reconciles journal
vouchers from billing, inventory
control, cash receipts, and
accounts receivable
Automating the Revenue Cycle
 Authorizations and data access can be
performed through computer screens.
 There is a decrease in the amount of
paper.
 The manual journals and ledgers are
changed to disk or tape transaction and
master files.
 Input is still typically from a hard copy
document and goes through one or more
computerized processes.
 Processes store data in electronic files
(the tape or disk) or prepare data in the
form of a hardcopy report.
 Revenue cycle programs can include:
 formatted screens for collecting
data
 edit checks on the data entered
 instructions for processing and
storing the data
 security procedures (passwords or
user IDs)
 steps for generating and displaying
output
 To understand files, you must consider the
record design and layout.
 The documents and the files used as
input sources must contain the data
necessary to generate the output reports.
CHAPTER 5
Purchases and Cash Disbursements
Procedures
  reconciles the inventory amount with the
account summary received from
inventory control
DFD for Cash Disbursements System
Cash Disbursements System
 Periodically, A/P searches the open
vouchers payable file for items with
payments due:
 A/P sends the voucher and
supporting documents to Cash
Disbursements
 A/P updates the accounts payable
subsidiary ledger
 Cash Disbursements:
 prepares the check
 records the information in a check
Goals of the Expenditure Cycle
register (cash disbursements
 The goal of providing needed resources to
journal)
organization can be broken down into
 returns paid vouchers to accounts
several objectives:
payable, mails the check to the
 purchase from reliable vendors
supplier
 purchase high quality items
 sends a journal voucher to G/L:
 obtain best possible price
Accounts Payable DR
 purchase only items that are
Cash CR
properly authorized
 G/L department receives:
 have resources available when they
 the journal voucher from cash
are needed
disbursements
 receive only those items ordered
 a summary of the accounts payable
 ensure items are not lost, stolen,
subsidiary ledger from A/P
or broken
 The journal voucher is used to update the
 pay for the items in a timely
general ledger.
manner
 The accounts payable control account is
reconciled with the subsidiary summary.
AP & CASHDISBURSEMENT (Departments
A Purchase System
Involved)
 Begins in Inventory Control when
inventory levels drop to reorder levels
Inventory Control
 A purchase requisition (PR) is prepared
Note that to provide proper authorization
and copies to be sent to Purchasing and
control, the inventory control department is
Accounts Payable (A/P)
segregated from the purchasing department,
 Purchasing prepares a purchase order
which executes the transaction.
(PO) for each vendor and sends copies to
Purchasing Department
Inventory Control, A/P, and Receiving
The purchasing department receives the
 Upon receipt, Receiving counts and
purchase requisitions, sorts them by vendor,
inspects the goods.
and prepares a multipart PO for each vendor.
 A blind copy of the PO is used to
Receiving Department
force workers to count the goods.
Goods arriving from the vendor are
 A receiving report is prepared and copies
reconciled with the blind copy of the PO. Upon
sent to the raw materials storeroom,
completion of the physical count and inspection,
Purchasing, Inventory Control, and A/P.
the receiving clerk prepares a multipart
 A/P eventually receives copies of the PR,
receiving report stating the quantity and
PO, receiving report, and the supplier’s
condition of the inventories. One copy of the
invoice.
receiving report accompanies the physical
 A/P reconciles these documents, posts to
inventories to the storeroom. Another copy is
the purchases journal, and records the
sent to the purchasing department, where the
liability in the accounts payable
purchasing clerk reconciles it with the open PO.
subsidiary ledger.
AP Department
 A/P periodically summarizes the entries in
When the invoice arrives, the AP clerk
the purchases journal as a journal
reconciles the financial information with the
voucher which is sent to the General
documents in the pending file, records the
Ledger (G/L) department.
transaction in the purchases journal, and posts it
Inv-Control or Purchases DR
to the supplier’s account in the AP subsidiary
Accts Payable-Control CR
ledger (voucher register)
 A/P also prepares a cash disbursements
General Ledger Department
voucher and posts it in the voucher
The general ledger department receives a
register.
journal voucher from the AP department and an
 G/L department:
account summary from inventory control. The
 posts from the accounts payable journal
general ledger clerk reconciles these and posts
voucher to the general ledger
to the inventory and AP control accounts. With
this step, the purchases phase of the
expenditure cycle is completed.
THE CASH DISBURSEMENTS SYSTEMS
(Departments involved)
AP Department
Each day, the AP clerk reviews the open
vouchers payable (AP) file for items due and
sends the vouchers and supporting documents
to the cash disbursements department.
Cash Disbursements Department
The cash disbursements clerk receives the
voucher packets and reviews the documents for
completeness and clerical accuracy. For each
disbursement, the clerk prepares a three-part
check and records the check number, dollar
amount, 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. The clerk 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 the
general ledger department.
General Ledger Department
Expenditure Cycle Database
 Master Files
 supplier (vendor) master file
 accounts payable master file
 merchandise inventory master file
 Transaction and Open Document
Files
 purchase order file
 open purchase order file
 supplier’s invoice file
 open vouchers file
 cash disbursements file
 Other Files
 supplier reference and history file
 buyer file
 accounts payable detail file
Summary of Internal Controls
General Internal Controls
 Organization controls
 segregation of duties
 Documentation
 Asset Accountability Controls
 Management Practices
 Data Center Operations Controls
 Authorization Controls
 Access Controls
Authorization Controls
 Purchases of inventory should be
authorized by the Inventory Control
department, not by purchasing agents
 Accounts Payable authorizes the
payments of bills, not the cash
disbursements clerk, who writes the
checks
Traditional Segregation of Duties
 Warehouse (stores)
 Inventory control
 Accounts payable
 General ledger
 Requisitioning
 Purchases
 Purchases returns and allowances
 Cash disbursements
Supervision
 Within the expenditure cycle,
supervision is of highest importance
in the Receiving department, where
the inventory arrives and is logged in
by a receiving clerk. Need to
minimize:
 failures to properly inspect the
assets
 theft of the assets
Access Controls
 Access to:
 inventories (direct)
 cash (direct)
 accounting records (indirect)
Independent Verification
 A/Payable dept. verifies much of the work
done within the expenditure cycle.
 PR, PO, receiving reports, and
suppliers’ invoices must be
checked and verified by A/P.
 G/Ledger dept. verifies:
 the total obligations recorded equal
the total inventories received
 the total reductions in accounts
payable equal the total
disbursements of cash
CHAPTER 6
Payroll Processing and Fixed Asset
Procedures
(Departments Involved)
Personnel Department
The personnel department prepares and
submits personnel action forms to the prepare
payroll function. These documents identify
employees authorized to receive a paycheck
and are used to reflect changes in hourly pay
rates, payroll deductions, and job classification.
Personnel action form is used to advise payroll
of an increase in an employee’s salary.
Production Department
 Production employees prepare two types of
time records: job tickets and time cards. Job
tickets capture the time that individual workers
spend on each production job. Cost accounting
uses these documents to allocate direct labor
charges to work-in-process (WIP) accounts. Time
cards capture the time the employee is at work.
These are sent to the prepare payroll function
for calculating the amount of the employee’s
paycheck.
Update WIP Account (Cost Accounting
Department)
After cost accounting allocates labor costs to
the WIP accounts, the charges are summarized
in a labor distribution summary and
forwarded to the general ledger function.
Prepare Payroll
The payroll department receives pay rate
and withholding data from the personnel
department and hours worked data from the
production department. A clerk in payroll then
performs the following tasks.
1. Prepares the payroll register showing gross
pay, deductions, overtime pay, and net pay.
2. Enters this information into the employee
payroll records
3. Prepares employee paychecks .
4. Sends the paychecks to the distribute
paycheck function.
5. Files the time cards, personnel action form,
and copy of the payroll register (not shown).
Distribute Paycheck
A form of payroll fraud involves submitting
time cards for nonexistent employees. To
prevent this, many companies use a paymaster
to distribute the paychecks to employees. This
individual is independent of the payroll process
—not involved in payroll authorization or
preparation tasks. If a valid employee does not
claim a paycheck, the paymaster returns the
check to payroll. The reason the check went
unclaimed can then be investigated.
Prepare Accounts Payable (Accounts
Payable Department)
The accounts payable (AP) clerk reviews the
payroll register for correctness and prepares
copies of a cash disbursement voucher for the
amount of the payroll. The clerk records the
voucher in the voucher register and submits the
voucher packet (voucher and payroll register) to
cash disbursements. A copy of the disbursement
voucher is sent to the general ledger function.
Prepare Cash Disbursement (Cash
Disbursement Department)
Upon receipt of the voucher packet, the cash
disbursements function prepares a single check
for the entire amount of the payroll and deposits
it in the payroll imprest account. The employee
paychecks are drawn on this account, which is
used only for payroll. Funds must be transferred
from the general cash account to this imprest
account before the paychecks can be cashed.
The clerk sends a copy of the check along with
the disbursement voucher and the payroll
register to the AP department, where they are
filed (not shown). Finally, a journal voucher is
prepared and sent to the general ledger
function.
Update General Ledger
The general ledger function receives the
labor distribution summary from cost
accounting, the disbursement voucher from AP,
and the journal voucher from cash
disbursements. With this information, the
general ledger clerk makes the following
accounting entries:
From the Labor Distribution Summary
Work-in-Process (Direct labor)
XXX.XX
Factory Overhead (Indirect labor)
XXX.XX
Wages Payable
XXX.XX
Transaction Authorization
A form of payroll fraud involves submitting
time cards for employees who no longer work
for the firm. To prevent this, the personnel
action form helps payroll keep the employee
records current. This document describes
additions, deletions, and other changes to the
employee file and acts as an important
authorization control to ensure that only the
time cards of current and valid employees are
processed.
Segregation of Duties
The time-keeping function and the personnel
function should be separated. Segregating key
aspects of the payroll transaction between AP
and cash disbursement functions returns control
to the process. AP reviews the work done by
payroll (payroll register) and approves payment.
Cash disbursements then writes the check to
cover the total payroll. None of the employee
paychecks is a negotiable instrument until the
payroll check is deposited into the imprest
account.
Supervision
Sometimes employees will clock in for
another worker who is late or absent.
Supervisors should observe the time-keeping
process and reconcile the time cards with actual
attendance.
Accounting Records
The audit trail for payroll includes the following
documents:
1. Time cards, job tickets, and disbursement
vouchers.
2. Journal information, which comes from the
labor distribution summary and the payroll
register.
3. Subsidiary ledger accounts, which contain the
employee records and various expense
accounts.
4. The general ledger accounts: payroll control,
cash, and the payroll clearing (imprest) account.
Access Controls
The assets associated with the payroll
system are labor and cash. Both can be
misappropriated through improper access to
accounting records. Similarly, control over
access to all journals, ledgers, and source
documents in the payroll system is important, as
it is in all expenditure cycle systems.
Independent Verification
The following are examples of independent
verification controls in the payroll system:
1. Verification of time. Before sending time cards
to payroll, the supervisor must verify their
accuracy and sign them.
2. Paymaster. The use of an independent
paymaster to distribute checks (rather than the
normal supervisor) helps verify the existence of
the employees. The supervisor may be party to
a payroll fraud by pretending to distribute
paychecks to nonexistent employees.
3. Accounts payable. The AP clerk verifies the
accuracy of the payroll register before creating a
disbursement voucher that transfers funds to
the imprest account.
4. General ledger. The general ledger
department provides verification of the overall
process by reconciling the labor distribution
summary and the payroll disbursement voucher.
FIXED ASSETS are the property, plant, and
equipment used in
the operation of a business. These are relatively
permanent items that often collectively
represent the largest financial investment by the
organization. Examples of fixed assets include
land, buildings, furniture, machinery, and motor
vehicles. A firm’s fixed asset system processes
transactions pertaining to the acquisition,
maintenance, and disposal of its fixed assets.
Asset Acquisition
Usually begins with the departmental
manager (user) recognizing the need to obtain a
new asset or replace an existing one.
Authorization and approval procedures over the
transaction will depend on the asset’s value.
Department managers typically have authority
to approve purchases below a certain
materiality limit. Capital expenditures above the
limit will require approval from the higher
management levels. This may involve a formal
cost-benefit analysis and the formal solicitation
of bids from suppliers. Once the request is
approved and a supplier is selected, the fixed
asset acquisition task is similar to the
expenditure cycle procedures described in
Chapter 5, with two noteworthy differences.
First, the receiving department delivers the
asset into the custody of the user/manager
rather than a central store or warehouse.
Second, the fixed asset department, not
inventory control, performs the record-keeping
function.
Asset Maintenance
Involves adjusting the fixed asset subsidiary
account balances as the assets (excluding land)
depreciate over time or with usage. The method
of depreciation and the period used should
reflect, as closely as possible, the asset’s actual
decline in utility to the firm. The depreciation of
fixed assets used to manufacture products is
charged to manufacturing overhead and then
allocated to WIP. Depreciation charges from
assets not used in manufacturing are treated as
expenses in the current period.
Depreciation calculations are transactions
that the fixed asset system must be designed to
anticipate internally when no external event
(source document) triggers the action. An
important record used to initiate this task is the
depreciation schedule. Each subsidiary record
should indicate the current location of the asset.
The ability to locate and verify the physical
existence of fixed assets is an important
component of the audit trail.
Asset Disposal
When an asset has reached the end of its
useful life or when management decides to
dispose of it, the asset must be removed from
the fixed asset subsidiary ledger. It begins when
the responsible manager issues a request to
dispose of the asset. Like any other transaction,
the disposal of an asset requires proper
approval. The disposal options open to the firm
are to sell, scrap, donate, or retire the asset in
place. A disposal report describing the final
disposition of the asset is sent to the fixed asset
accounting department to authorize its removal
from the ledger.
Authorization Controls
Fixed asset acquisitions should be formal and
explicitly authorized. Each transaction should be
initiated by a written request from the user or
department. In the case of high-value items,
there should be an independent approval
process that evaluates the merits of the request
on a cost-benefit basis.
Supervision Controls
Because capital assets are widely distributed
throughout the organization, they are more
susceptible to theft and misappropriation than
inventories that are secured in a warehouse.
Therefore, management supervision is an
important element in the physical security of
fixed assets. Supervisors must ensure that fixed
assets are being used in accordance with the
organization’s policies and business practices.
Independent Verification Controls
Periodically, the internal auditor should
review the asset acquisition and approval
procedures to determine the reasonableness of
factors used in the analysis. These include the
useful life of the asset, the original financial
cost, the proposed cost savings as a result of
acquiring the asset, the discount rate used, and
the capital budgeting method used in the
analysis. The internal auditor should verify the
location, condition, and fair value of the
organization’s fixed assets against the fixed
asset records in the subsidiary ledger. In
addition, the automatic depreciation charges
calculated by the fixed asset system should be
reviewed and verified for accuracy and
completeness.