AC330 Instructor Outline

CHAPTER 11 THE EXPENDITURE CYCLE: PURCHASING TO CASH DISBURSEMENTS

This chapter focuses on the purchase of raw materials, finished goods, supplies and services. Chapters 12 and 13 will cover fixed assets and labor services respectively. As a result of your study of this chapter, you should be able to: 1. Describe the basic business activities and related information processing operations performed in the expenditure cycle. 2. Discuss the key decisions to be made in the expenditure cycle, and identify the information needed to make those decisions. 3. Document an understanding of the expenditure cycle. 4. Identify major threats in the expenditure cycle, and evaluate the adequacy of various control procedures for dealing with those threats. The Expenditure Cycle: The expenditure cycle is a recurring set of business activities and related data processing operations associated with the purchase of and payment for goods and services. Figure 11-1 on page 418 provides a context diagram of the expenditures cycle. Note that the expenditures cycle involves the revenue cycle, inventory cycle, various departments involved in requesting items be order and receiving the items, and the production cycle. Primary objective of the expenditure cycle is to minimize the total cost of acquiring and maintaining inventories, supplies and the various services the organization needs to function. To achieve this objective management must make the following key decisions:
What is the optimal level of inventory and supplies to carry? Which suppliers provide the best quality and service at the best

prices? Where should inventories and supplies be held? How can the organization consolidate purchases across units to obtain optimal prices? How can IT be used to improve both the efficiency and accuracy of the inbound logistics function? Is sufficient cash available to take advantage of any discounts
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suppliers offer? How can payments to vendors be managed to maximize cash flow? Expenditure Cycle Business Activities Figure 11-2 on page 419 provides a level 0 data flow diagram for the expenditure cycle. Three basic business activities in the expenditure cycle:
1) Ordering goods, supplies and services; 2) Receiving and storing goods, supplies and services; 3) Paying for goods, supplies and services

Order Goods The first major business activity in the expenditure cycle (circle 1.0 in Figure 11-2) is ordering inventory or supplies. Key decisions in this process involve identifying what, when, and how much to purchase and from whom. Weaknesses in inventory control can create significant problems with this process as demonstrated in the introductory AOE case: inaccurate inventory records and inventory shorts resulting in production delays caused by late delivery or substandard components delivered Alternative Inventory Control Methods One of the key factors affecting the ordering process is the inventory control method to be used. We will consider three alternate approaches to inventory control: economic order quantity (EOQ); just in time inventory (JIT); and materials requirements planning (MRP). Economic Order Quantity (EOQ) is the traditional approach to managing inventory. The goal is to maintain enough stock so that production doesnt get interrupted. An optimal order size is calculated by minimizing the sum of ordering costs, carrying costs, and stockout costs. A reorder point is also calculated.

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Ordering Costs includes all expenses associated with processing purchase transaction. Carrying Costs are those associated with holding inventory Stockout Costs are those cost that result from inventory shortages, such as lost sales or production delays. The Reorder Point is when to order based on delivery time and safety stock levels. Optimal Order Size EOQ =
2 DP C

D = Demand in units for a specified period P = Relevant ordering cost per purchase order C = Relevant carrying cost of one unit in stock for the time period used for D. Materials Requirement Planning (MRP) seeks to reduce inventory levels by improving the accuracy of forecasting techniques to better schedule purchases to satisfy production needs. This schedule identifies the quantities of raw materials, parts and supplies needed in production and the point in time when they will be needed. Just-in-Time (JIT) systems attempt to minimize, if not totally eliminate, carrying inventory by only purchasing and producing goods in response to actual sales. These systems have frequent, small deliveries of materials, parts, and supplies directly to the location where production will occur. A major difference between MRP and JIT is the production scheduling.

MRP systems schedule production to meet forecasted sales; thereby creating a stock of finished goods inventory. JIT systems schedule production in response to customer demands; thereby virtually eliminating finished goods inventory.

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Purchase Requests Whatever the inventory control system, the order processing typically begins with a purchase request followed by the generation of a purchase order. The purchase requisition is triggered by the inventory control function or an employee noticing a shortage. Advanced inventory control systems automatically initiate purchase requests when quantity falls below the reorder point. The purchase requisition (Figure 11-3 on page 422) is a paper or electronic form that identifies who is requesting the goods; where they should be delivered; when theyre needed; item numbers, descriptions, quantities, and prices; a suggested supplier; and the department number and account number to be charged. The purchase requisition is received by a purchasing agent in the purchasing department, who typically performs the purchasing activity. Figure 11-4 on page 422 shows a typical purchase requisition data entry screen used in ERP systems. Generating Purchase Orders A crucial decision is the selection of supplier for inventory items. Several factors should be considered in making this decision:

Price Quality of materials Dependability in making deliveries

Once a supplier has been selected for a product, their identity should become part of the product inventory master file. Its important to track and periodically evaluate supplier performance. The purchasing function should be evaluated and rewarded based on how well it minimizes total costs, not just the costs of purchasing the goods. A purchase order (PO), shown in Figure 11-5 on page 423 is a document or electronic form that formally requests a supplier to sell and deliver specified products at specified prices. The PO is both a contract and a promise to pay. Multiple purchase orders may be completed for one purchase requisition if multiple vendors will fill the request. A blanket purchase order is a commitment to buy specified
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items at specified prices from a particular supplier for a set time period. Improving Efficiency and Effectiveness The major cost driver is the number of purchase orders processed. Using EDI is one way to improve the purchasing process. EDI reduces costs by eliminating the clerical work associated with printing and mailing paper documents. The time between recognizing the need to reorder an item and subsequently receiving it also is reduced. Vendor-managed inventory programs provide anther means of reducing purchase and inventory costs. Vendor-managed inventory essentially outsources much of the inventory control and purchasing. Suppliers are given access to point-of-sales and inventory data and are authorized to automatically replenish inventory. Reverse auctions provide another technique to reduce purchasingrelated expenses. In reverse auctions, suppliers compete with one another to meet demand at the lowest price. One other way to reduce purchasing-related costs is to conduct a preaward audit, normally involving large purchases that involve bids. The internal auditor verifies the accuracy of the bids. Receiving and Storing Goods The Receiving Department accepts deliveries from suppliers. The Receiving Department normally reports to the Warehouse Manager, who reports to Vice President of Manufacturing. The Inventory Stores Department, which also reports to the Warehouse Manager, is responsible for the storage of the goods. The receipt of goods must be communicated to the inventory control function to update inventory records. Figure 11-6 on page 425 provides a Level 1 DFD of the Receiving Function. The two major responsibilities of the receiving department are deciding whether to accept delivery (based on whether there is a valid purchase order) and verifying the quantity and quality of delivered goods.

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Verifying the quantity of delivered goods is important so the company only pays for goods received and inventory records are updated accurately. The receiving report, shown in Figure 11-7 on page 426 is the primary document used in this process. The receiving report includes the date received, shipper, supplier, and purchase order number. For each item received, it shows the item number, description, unit of measure and quantity. It also provides space for signature and comments by the person who receives and inspects the goods. A receiving report is not typically used for receipt of services. Receipt of services is typically documented by supervisory approval of the suppliers invoice. When goods arrive, a receiving clerk compares the PO number on the packing slip with the open PO file to verify the goods were ordered. The receiving clerk counts the goods, and examines them for damage before routing to warehouse or factory. Three possible exceptions to this process are (1) receiving a quantity of goods different from the amount ordered, (2) receiving damaged goods, or (3) receiving goods of inferior quality that fail inspection. In all three cases, the purchasing department must resolve the situation with the supplier. In the case of damaged or poor quality goods, a debit memo is prepared after the supplier agrees to take back the goods or grant a price reduction. Improve Efficiency and Effectiveness One way to improve the efficiency of the receiving process is to require suppliers to bar-code their products. Bar-coding enables receiving clerks to scan in the product number, description and quantity of all items received, eliminating data errors.

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Radio frequency identification (RFID) tags are attached to each crate of goods and emit a signal that a receiving unit embedded in the gates near a companys warehouse unit can read. EDI and satellite technology provide another way to improve the efficiency of inbound logistics. EDI advance shipping notices inform companies when products have been shipped. Finally, audits may identify opportunities to cut freight costs. For example, many companies have negotiated significant savings with specific carriers. Paying For Goods and Services The third main activity in the expenditure cycle is paying vendors as shown in Figure 11-8 on page 427. There are two basic sub-processes involved in the payment process: approval of vendor invoices and actual payment of the invoices. Approve Vendor Invoices for Payment Approval of vendor invoices is done by the accounts payable department, which reports to the controller. The legal obligation to pay arises when goods are received; but most companies pay only after receiving and approving the invoice. This timing difference may necessitate adjusting entries at the end of a fiscal period. The objective of accounts payable is to authorize payment only for goods and services that were ordered and actually received. This requires information from purchasing about the existence of a valid purchase order and from receiving for a report that goods were received There are two basic approaches to processing vendor invoices:

Non-voucher system--Each approved invoice is posted in the suppliers records in accounts payable, filed and is then stored in an open invoice file. When a check is written, the invoice is

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removed from the open invoice file, marked paid and then stored in a paid invoice file.

In a voucher system--A disbursement voucher is also prepared which identifies the supplier, lists outstanding invoices and net amount to be paid after discounts and allowances. The disbursement voucher effectively shows which accounts will be debited and credited, along with the account numbers. Figure 11-9 on page 428 shows the voucher data entry screen. There are three advantages from using disbursement vouchers: several invoices may be paid at once (reducing number of checks); vouchers can be pre-numbered, which simplify tracking all payables; and the voucher provides a record that a vendor invoice has been approved for payment and facilitates invoice approval separate from invoice payment. This makes it easier to schedule both activities to maximize efficiency. Accounting approves the invoice for payment by comparing the invoice to the purchase order and receiving report. A voucher package, which contains the approved invoice, and supporting purchase order and receiving report, is sent to the cashier. This voucher package authorizes issuance of a check or EFT to the supplier.

Pay Approved Invoices The final activity in the expenditure cycle is the payment of approved invoices (circle 3.2 in Figure 11-8 on page 427). The cashier reviews the voucher package, approves the payment, prepares the check for payment and signs the check. Improve Efficiency and Effectiveness

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The accounts payable process, which matches vendor invoices to purchase orders and receiving reports, is a prime candidate for automation. Processing efficiency can be improved by: requiring suppliers to submit invoices by EDI and having the system automatically match invoices to purchase orders and receiving reports. Another option is to eliminate vendor invoices. This invoiceless approach is called evaluated receipt settlement (ERS). ERS replaces the traditional three-way matching process with a twoway match of the purchase order and receiving report (refer to Figure 11-10 on page 430). Procurement cards provide one way to eliminate the need for accounts payable to process many small noninventory invoices. A procurement card is a corporation credit card that employees can use only at designated suppliers to purchase specific kinds of items. Using corporate credit cards for travel expenses further reduces the number of invoices that need to be processed. Preparing careful short-term cash budgets is useful in taking advantage of early-payment discounts. For example, if the corporation purchased an item for $100,000 with the terms 2/10, n/30; the amount of the discount that could be realized by paying within ten days is $2,000. Even more important, if the corporation did not pay within the ten days; the 2% discount represents an annual interest rate of 18 percent (2% X 360/20). Finally, financial data electronic interchange (FEDI) can cut the costs associated with paying suppliers by eliminating the need to prepare and mail checks. Focus 11-2 on page 431 shows dramatic improvements can often be made simply by reengineering the accounts payable and cash disbursements processes. Medtronic had successfully used both Six Sigma and Lean principles to streamline its work-flow activities and improve product quality. Six Sigma is a philosophy that focuses on improving quality by reducing mistakes. Lean
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analysis seeks to improve efficiency by eliminating bottlenecks and redundancies. Medtronic initiated a series of intensive 5-day projects, called kaizen, to apply Six Sigma and Lean principles to improve accounts payable. Medtronics application of process improvement techniques yielded a dramatic improvement in the efficiency and effectiveness of its Accounts Payable function: - The time required to open the mail, sort, process and record vendor invoices dropped from 3 days to 1 day. - The number of invoices for which discounts for prompt payment were taken increased by 15% - Payment processing times were cut by 50% Information Processing Procedures Figure 11-11 on page 432 depicts the portion of AOEs new ERP system that supports its expenditure cycle activities. Major suppliers send electronic notification of coming deliveries. When a shipment arrives, the receiving dock workers use the inquiry processing system to verify that an order is expected from that supplier. Receiving dock workers also inspect the goods and use an online terminal to enter the inventory item numbers, count and purchase order number. Upon transfer of the goods to the warehouse, the inventory stores department verifies the count of the items placed into inventory and enters that data in the system. Most companies use batch processing to pay its suppliers. Each day, the treasurer uses the inquiry processing to review the vouchers that are due and approves them for payment. When an EFT payment is authorized or a check is printed, the system updates the accounts payable, openinvoice and general ledger files. After reviewing checks against the voucher package, the cashier signs them. In summary, AOEs ERP system improves the efficiency and effectiveness of its expenditure cycle activities in the following ways: 1) The quantity of paper documents processed is reduced 2) More timely and accurate information enables AOE to take advantage of discounts for prompt payment vendor invoices 3) Inventory records are more accurate and timely
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4) The warehouse and receiving departments can better plan activities 5) The system compares data the receiving department entered to the purchase order file, thereby detecting and facilitating correction of any errors on a timely basis 6) Reports and performance measures are timelier, which enhances managements ability to monitor and improve efficiency and effectiveness Control Objectives, Threats, and Procedures In the expenditure cycle (or any cycle), a well-designed AIS should provide adequate controls to ensure that the following objectives are met: (1) All transactions are properly authorized; (2) All recorded transactions are valid; (3) All valid and authorized transactions are recorded; (4) All transactions are recorded accurately; (5) Assets are safeguarded from loss or theft; (6) Business activities are performed efficiently and effectively; (7) The company is in compliance with all applicable laws and regulations; and (8) All disclosures are full and fair. Order Goods The six threats for ordering goods are listed at the beginning of Table 111 on page 435. Threat No. 1 Stock-outs and/or Excess Inventory Stockouts result in lost sales; excess inventory incurs higher than necessary carrying costs. Controls: Accurate inventory control and sales forecasting; use of perpetual inventory method; supplier performance reports; recording of inventory changes in real time; bar-coding inventory; and periodic physical counts. Threat No. 2 Ordering Unnecessary Items
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Companies must also beware of purchasing items that are not currently needed. Controls: Integrate databases of various divisions and produce reports that link item descriptions to part numbers to allow consolidation of orders. Threat No. 3 Purchasing Goods at Inflated Prices The cost of purchased components represents a substantial portion of the total cost of many manufactured products. Controls: Price lists for frequently-purchased items; use of catalogs for low-cost items; solicitation of bids for high-cost and specialized products; review of purchase orders; budgetary controls and responsibility accounting; and performance review. Threat No. 4 Purchasing Goods of Inferior Quality Sometimes purchasing goods at the lowest possible price sacrifices quality of the goods. Controls: Use of approved supplier list; review of purchase orders; tracking of supplier performance; purchasing accountability for rework and scrap. Threat No. 5 Purchasing from Unauthorized Suppliers Purchasing from unauthorized suppliers can result in numerous problems. Items may be of inferior quality or overpriced. Controls: review of purchase orders; restriction of access to supplier list; periodic review of supplier list; and coordination with procurement card providers to restrict acceptance of cards. Threat No. 6 Kickbacks

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Kickbacks are gifts from suppliers to purchasing agents for the purpose of influencing their choice of suppliers. Controls: No gift policy for buyers; employee training on gift handling; job rotation and mandatory vacation; audits of buyers; review of conflict of interest statements; vendor audits. EDI-Related Threats Controls: Restriction of EDI access; verification and authentication of EDI transactions; acknowledgment of EDI transactions; log and review EDI of transactions; encryption; digital signatures; EDI agreements with suppliers. Types of issues that occur when suppliers are linked to the companys POS system to automatically manage inventory: At what point in the process can the order be canceled? Which party is responsible for the cost of return freight if contract terms are not followed? Which party is responsible for errors in bar codes, RFID tags and labels? What happens if errors in the purchasing companys Pos system cause additional errors in the amount of goods that suppliers provide? Can suppliers ship more inventory than ordered if doing so reduces total freight costs by having a full, rather than partial, truckload? Purchases of Services Controls: Hold supervisors accountable for costs; compare actual to budgeted expenses; review and audit contracts for services. Receive and Store Goods

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The primary objectives of this process are to verify the receipt of ordered inventory and safeguard the inventory against loss or theft. Threat No. 7 Receiving Unordered Goods Controls: Accept goods only when theres an approved purchase order. Threat No. 8 Errors in Counting Received Goods Controls: Bar-coding of ordered goods; quantities blacked out on receiving forms; signature of receiving clerks; bonuses for catching discrepancies; re-counting of items by inventory control. Threat No. 9 Stealing Inventory Controls: Secure storage locations for inventory; documentation of intra-company transfers; periodic physical counts; segregation of duties. Approve and Pay Vendor Invoices The primary objectives of this process are to: Pay only for goods and services that were ordered and received. Safeguard cash. Threat No. 10 Failing to Catch Errors in Vendors Invoices Controls: Check mathematical accuracy; verify procurement card charges; adopt Evaluated Receipt Settlement; train staff on freight terminology; use common carrier to take advantage of discounts. Threat No. 11 Paying for Goods Not Received. Controls: Compare invoice quantities to quantities reported by receiving and inventory control; use tight budgetary controls. Threat No. 12 Failing to Take Available Purchase Discounts

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Controls: File and track invoices by due date; prepare cash flow budgets.

Threat No. 13 Paying the Same Invoice Twice Controls: Approve invoices only with complete voucher package; pay only on original invoices; cancel invoices once paid; use internal audit to detect and recover overpayments; control access to accounts payable master file. Threat No. 14 Recording and Posting Errors in Accounts Payable Controls: Data entry and processing controls; reconcile supplier balances with control accounts. Threat No. 15 Misappropriation of Cash, Checks, or EFT Controls: Restrict access to cash, checks, and check signing machines; use sequentially numbered checks and reconcile; segregate duties; two signatures on checks over a certain limit; restrict access to supplier list; cancel all documents; have independent bank reconciliation; use check protection measures and/or positive pay; provide strict logical and access controls for EFT; log, encrypt, stamp and number all EFT transactions; monitor EFT transactions; and use embedded audit modules. General Control Issues Threat No. 16 Loss, Alteration, or Unauthorized Disclosure of Data Controls: File backups, use of file labels; strict access controls; alter default settings on ERP modules; encrypt data; and use message acknowledgment techniques. Threat No. 17 Performing Poorly Controls: Performance reports.
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Expenditure Cycle Information Needs The following information is needed for following operational tasks in the expenditure cycle: 1) 2) 3) 4) 5) Determine when and how much additional inventory to order Select the appropriate suppliers from whom to order Verify the accuracy of vendor invoices Decide if purchase discounts should be taken Monitor cash flow needs to pay outstanding obligations

The AIS needs to provide information to evaluate the following: 1) purchasing efficiency and effectiveness; 2) supplier performance; 3) time taken to move goods from receiving to production; and 4) percent of purchase discounts taken. Notice that these decisions require both financial and operating data. Because inventory represents a sizable investment of working capital, reports that help manage inventory are especially valuable. A key inventory measure is the inventory turnover. Accountants should also design other reports to help management better manage inventory. Back to Homepage

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