Chapter 4 - Transaction Cycles investors «investment of capital funds to other profitable activities REVENUE AND RECEIPT CYCLE / ORDER TO CASH (OTC) Business ‘Two major business functions are functions * Resources are distributed to customers in exchange for promises of future payments Customers pay cash for resources distributed to them Accounts Accounts affected include the following: affected © Sales and related sales returns, allowances and discount © Receivable, allowance for bad debts and bad debts expense Cash Departments | Significant departments affecting the cycle are: involved Revenue © Sales or customer order © Credit * Inventory control or warehouse © Shipping « Billing # Accounting (inventory, receivable and general) Receipt © Mail room or receptionist ° Treasury # Accounting (receivable and general) Forms or documents received, initiated and processed Form Description Initiated by: Distributed to: Sales order Contains the details | Sales * Customers (order slip or of goods ordered | department © Credit customer order) | (quantity, prices and © Shipping payment terms) « Billing Shipping Describes the goods | Shipping * Carrier document (bill | to be shipped and | department Customers of lading or serves as contract « Billing delivery receipt) | between the entity and carrier Sales invoice Describes the goods | Billing Customers (billing sold, amount due and | department * Accounting statement) the terms of payment Remittance A document sent bya | Customer thru | « General advice customer to a seller, | the mail room accounting: informing the seller | department Receivable that their invoice has department been paid. 50Chapter 4 - Transaction Cycles Daily Summarizes Receivable (for | © General summaries transactions sales) accounting recorded during the | Treasury (for * Treasury anc day by the different | collection) Receivable departments. Mail room (for mail received) Important notes to forms or documents processed 1, The department that initiated the processing approves the form. 2, The department that initiated the processing is accountable for unused forms. Also, access to those forms shall be limited to the said department. 3. The notification of forms does not necessarily mean a hard copy shall be forwarded. Notification can be done thru electronic mail. 4. The department that initiated, received or processed a form shall retain a copy (hard or electronic copy) for filing. Summary of Functions of Departments in the Revenue Cycle A. Sales department Primary objective: To increase entity's sales Activities Possible controls 1. Locates and encourages buyers 2. Negotiates terms with buyers 3. Accepts customer orders 4. Prepares sales order and distribute copies to customers, credit, shipping and billing 5, Retains copy in unfilled order file 6. Monitors the status of the order 7. Updates customers as to the status of the order Common controls adopted _ by different entities in this department include: © Sales department has an exclusive function to communicate with the customers © Entity maintains list of authorized customers to minimize exposure to high-risk customers © Entity maintains range of selling prices for its products B. Credit department Primary objective: To minimize exposure to high-risk customers Activities Possible controls 1. Receives and review sales order from sales department 2,Conducts credit investigation 3. Approves credit request by preparing a memo’ or placing an “approved” mark in the sales order 4.Notifies sales department as to the approval/disapproval of the credit request 5, Forwards the approved sales order to inventory control Common controls adopted by different entities in this department include: * Entities establish a credit department that is independent with the sales department * Credit department issues list of authorized customers: 51Chapter 4 - Transaction Cycles C. Inventory control department Primary objective: To control transfers of inventory in and out of storage areas, monitor inventory levels, and report slow-moving or damaged items. Activities Possible controls T.Reviews approved sales order | Common controls adopted _ by received from credit department 2Monitors the availability of goods ordered 3.Authorizes the issuance of goods to the shipping department 4. Forwards the approved sales order to shipping department different entities in this department include: © Inventory control that provides access to sales department to inventory levels © Different inventory management concepts which are applied to provide reasonable assurance the availability of goods when needed D. Shipping department Primary objective: To provide reasonable assurance that all shipments are authorized. approved sales order from inventory control 2.Completes shipping documents and prepares goods for shipment 3.Release goods to carrier and obtains receipt 4.Notifies sales department that goods have been shipped 5.Forwards the shipping documents and approved sales order to billing department Activities Possible controls T.Compares sales order from sales|Common controls adopted by department with goods __and | different entities in this department include: © Shipping documents that are pre- _ numbered and accounted for ¢ Ensure related billings are made on a periodic basis E. Billing department are billed. Primary objective; To provide reasonable assurance that all shipments Activities Possible controls 1. Compares the following documents: a. sales order from sales department b.approved sales order and shipping document from shipping department 2,Prepares sales invoice and send copies to customer (thru the carrier) and to inventory accounting _ Common controls adopted by different entities in this department include: © Pre-numbered sales invoice Shipping document must be present before preparation of sales invoice, 52Chapter 4 - Transaction Cycles F. Accounting department Inventory: Provides cost information on the goods sold to be forwarded to general accounting and records transaction related to the cost of goods sold. * General: Records the sale and forward sales invoice and related documents to accounts receivable Accounts Receivable: Updates subsidiary ledger related to customer’s account, Summary of Functions of Departments in the Receipt Cycle Collections A. Mailroom or Receptionist Receives remittance advices and customer checks from customers © Prepares list of receipts Endorses checks and list of receipts to the treasury department * Endorses remittance advices and list of receipts to the accounts receivable department B. Treasury department Updates cash records © Prepares deposit slips * Prepares collection summaries, sends copy to accounts receivable and general accounting and retains a copy © Deposits collection to the bank C.. Accounting department * Accounts receivable: compares remittance advice from mail room and cash summaries from treasury, updates subsidiary ledgers, and prepares daily summaries to be forwarded to general accounting. ° General: compares daily summaries from treasury and accounts receivable, then updates general ledgers. Other activities in the revenue and receipt cycle Uncollected accounts 1. Accounts receivable Review individual customer accounts periodically and compare against credit limits ¢ Prepare monthly accounts receivable trial balances for reconciliation with the general ledgers (i.e, SL-GL reconciliation) 2. Authorized personnel independent of credit department © Review and age accounts receivable balances periodically : 3, Authorized personnel who reports to the treasurer and independent of recording functions or Treasurer to authorize the write-off © Incase of delinquent account, such account should be reviewed 53Chapter 4 - Transaction Cycles « Ifjudged to be uncollectible, written authorization to write-off shoulg be sent to accounts receivable and general accounting Sales returns and allowances 1. Sales department « Reviews customer's request for returns and allowances ¢ Grants sales returns and allowances and prepares credit memo which is forwarded to customer, accounts receivable (for recording), ang inventory control (for returns) 2. Receiving department Receives returned goods ¢ Prepare receiving report 3, Inventory control Compares goods received through the receiving department and credit memo 4, Accounting © Inventory: updates inventory records based on receiving report and prepare daily summaries to be forwarded to general accounting Accounts receivable: update records based on the credit memo received and prepares daily summaries to be forwarded to general accounting. General: compares daily summaries from inventory and accounts receivable, then, updates general ledgers. PURCHASE TO PAY (P2P) Business ‘Two major business functions are functions © Resources are acquired from vendors in exchange for obligations to pay « Entity pays cash to vendors and employees ‘Accounts ‘Accounts affected inchide the following: affected « Purchases (e.g. inventory and supplies) « Purchase returns, allowances and discount « Payables © Cash Departments _| Significant departments affecting the cycle are: involved Expenditure User (any department within the entity) © Purchasing or procurement Receiving * Accounting (accounts or vouchers payable) ¢ Accounting (Inventory and general) Disbursement Treasury « Accounting (receivable and general) 54Chapter 4 - Transaction Cycles Forms or documents received, initiated and processed Form Description Initiated by: Distributed to: Requisition | Contains the details of the | User © Purchasing slip user department's request | department (purchase requisition) Purchase Describes the goods to be | Purchasing ‘ Vendor order acquired (quantity and | department * User + description) © Receiving * Accounts payable Receiving Describes the goods | Receiving Purchasing report received (quantity, | department * Accounts description and condition) _payable Shipping Describes the goods to be | Vendor (thru | Receiving document shipped and serves as | the carrier) department contract between the vendor and carrier Vendors Describes the goods sold, | Vendor © Accounts invoice amount due and the terms payable of payment Remittance | A document sent by the | Treasury * Vendor advice entity to the seller, informing the seller that their invoice has been paid. Daily Summarizes transactions | Accounts © General summaries | recorded during the day | payable (for | accounting by the different | purchases) department Treasury (for payment) Summary of Functions of Departments in P2P Process Cycle A. User department Prepares requisition slip to be forwarded to purchasing and accounts payable departments B, Purchasing or procurement department Primary objective: To meet the specific needs of the user department at the least possible cost 1.Receives approved requisition slip from the user department 2.Locates vendor and negotiates with terms Activities 55 Possible controls Common controls different entities in this department include: « Purchasing department _has_an adopted byChapter 4 - Transaction Cycles and user, 3.Prepares purchase orders distributes copies to vendor, receiving and accounts payable 4.Monitors the status of the order 5.Updates customers as to the status of the order exclusive function to communicay) with the vendor * Entity maintains list of authorizeg vendors Entity compares purchase price ty market prices C. Receiving department Primary objective: To provide reas onable assurance that received good; are based on approved purchase order Activities Possible controls 1. Files purchase orders until goods are received 2.Upon receipt, counts and checks the goods for appropriate quantity and condition 3.Reviews and compares purchase orders and shipping document from the carrier 4,Prepares receiving reports to be forwarded to purchasing and accounts payable accompanied by purchase order from purchasing and shipping document from the carrier Common controls adopted by different entities in this departmen, include: *To ensure that the receiving department will count and check the goods received, the purchasing department sends a blank purchase order D. Accounts or vouchers payable department Primary objective: To provide reasonable assurance that payments will only be made to shipments received Activities Possible controls Reviews and compares purchase order, receiving report and vendors invoice (ie. 3-way match) 2.Prepares voucher 3.Prepares voucher _ package {requisition slip, purchase order, receiving report, vendors invoice, and voucher) and daily summary to be forwarded to the treasury and general accounting, respectively E, Treasury department (Disbursement) Activities 1. Reviews voucher package received 2. Prepares check and have it signed by authorized signatories 3.Forwards checks and remittance 56 Common controls adopted by different entities in this department include: * Voucher should be supported by purchase order, receiving report and suppliers sales invoice or any other supporting documents * Accounts payable department files voucher package by due date so as to pay liability on time and take | advantage of discounts, ifany __ Possible controls Common controls adopted by different entities in this department include; « The person last signing the checkChapter 4 - Transaction Cycles advice to vendors cancels the voucher package by 4.Prepares daily summary which is to | placing a mark such as “paid”, be forwarded to general accounting “cancelled” or writing the check number. * Entity may adopt any of the following in relation to issuance of checks - Check over a certain amount should have an identified payee - No checks shall be issued without an identified payee - Checks should be signed by at least two authorized persons HUMAN RESOURCES AND PAYROLL CYCLE Human resource and payroll cycle are part of the expenditure and disbursement cycle. This cycle covers the entity’s acquisition of services from its employees or personnel. The following are main reasons why the auditor is concerned with this cycle. a. Payroll include different categories of employee benefits (short- term; post-employment, other long-term and retirement) that could significantly affect major elements of financial statements; and b._For most entities, significant amount of resources is incurred Business Two major business functions are functions © Services are received from employees in exchange for obligations to pay Entity pays cash to employees Accounts Accounts affected include, but not limited to the following: affected © Salaries and wages expense and payable « Premiums expense and payable © Withholding taxes payable « Inventories (for inventoriable salaries and wages) © Cash Departments _| Significant departments affecting the cycle are: involved Expenditure © User (any department within the entity) ¢ Human resources (HR) or personnel ¢ Payroll ¢ Accounting (inventory and general) Disbursement and distribution © Treasury Ls © Accounting (general) 57Chapter 4 - Transaction Cycles Forms or documents received, initiated and processed Form Description Initiated by: | Distributed t; HRrecords | It contains all information | HR * Payroll (Personnel | related to _entity’s | department (limited 4, records or | employees from time they payroll 201 file) are hired up to their related eventual termination. It information documents all —_ actions only) taken by the employees or management on behalf of an employee. Commonly, it also documents — salary rates, deductions, and other payroll related information Daily time Describes the number of | User ° Payroll record hours worked by an | department (DTR) employee during =a particular day covered by a pay period Payroll Shows all related payroll | Payroll * Treasury register information (gross pay, all © General deductions, and net pay) accounting for each pay period Labor cost _ | Shows payroll information | Payroll * Inventory summary | which is capitalizable or accounting can be attributed to a particular job or customer order Employee | Shows the cumulative, | Payroll * Accounts earnings year-to-date summary of payable record earnings and deductions of every employee Daily Summarizes transactions | Payroll (for | General summaries | recorded during the day by | liability accounting the different department _| recognition) Inventory (for inventoriable labor costs) Treasury (for payment) _ 58Chapter 4 - Transaction Cycles Summary of Functions of Departments in Human Resource and Payroll cycle A. User department Primary objective: To ensure that time records prepared by employees represent actual hours worked during a pay period Activities Possible controls [.Monitors and approves daily time records *Note: However, due to introduction of computerized human resources systems, time records are commonly tracked through biometrics and access devices. Common controls adopted _ by different entities in this department include: * Appropriate review activities shall be made to ensure the validity of daily time records prepared by employees * In case of computerized systems, approval of any exceptions shall be made by the user department head B. HR department Primary objective: To ensure employees included in the payroll are rendering services to the entity Activities Possible controls 1. Initiates, updates and maintains HR records 2. Forwards payroll related information to payroll department (e.g. salary and wage rates, bonuses, overtime pays, and payroll deductions) 3.Determines terms of settlement (lump-sum or installment) in case of termination of employee/s 4.Immediately notify payroll department of terminated employee to avoid inclusions of these employees in the subsequent payroll calculations Common controls adopted by different entities in this department include: © Access, including initiating changes, to HR records shall be limited only to the HR department ‘ Information not relevant to payroll calculation shall not be shared to other departments C. Payroll department Primary objective: To provide reasonable assurance that the payroll calculation in every pay period is valid Activities Possible controls 1.Receives and reviews relevant Payroll related information from HR and user departments 2.Considers any update on employees’ pay rates and deductions 3. Prepares payroll register Common controls adopted by different entities in this department include: # Appropriate level of management (preferably a member who is not {_ involved_in_payroll_preparation) | 59Chapter 4 - Transaction Cycles 4.Updates cumulative earnings records 5.Identifies and submits to inventory accounting capitalizable payroll in case of servicing and manufacturing companies with inventoriable labor costs employee reviews the payroll register joy accuracy and reasonableness © To assure adequacy of segregation of duties, payroll departmen, should be segregated form HR Treasury, and some —_ user departments. D. Treasury department - disbursement Primary objective: To provide re asonable assurance that all payrol| disbursement is based on actual services rendered by employees Activities Possible controls 1. Reviews payroll register received 2, Prepares check and have it signed by authorized signatories* 3. Distributes checks to employees 4, Prepares daily summary which is to be forwarded to general accounting ‘Note: Most companies disburse payroll through bank fund transfers from company’s payroll fund to individual employees payroll account. In this case, the treasury department should be the one authorizing the bank Common controls adopted by different entities in this department include: * Separate bank account should be maintained exclusively for payroll disbursements On a surprise basis, an employee independent from payroll and user departments may distribute paychecks. The purpose of this is to identify whether or not fictitious employees exist © Unclaimed payroll checks shall be transfer. te-deposited to the bank E. Accounting department Primary objective: To provide reasonable assurance that items related to payroll are appropriately -classified and recorded in correct accounting period at appropriate amounts Inventory: Records inventoriable labor costs to appropriate jobs or customers account and forward a daily summary to general accounting. * General: Reviews daily summaries and documents received from payroll, treasury and inventory departments. It records the recognition of payroll related expenses and liabilities in the general journal. PRODUCTION OR CONVERSION CYCLE Production or conversion cycle covers the production of entity's product for sale, It is where materials, labor and overhead are converted into finished goods. The primary objective of this cycle is the proper valuation of inventories. Such objective encompasses the proper allocation of costs to each run made 60Chapter 4 - Transaction Cycles by the production department. In order to attain this, the production department uses inputs from the expenditure and disbursement cycle and provides resources and information to revenue and receipt cycle. The details of the processes used in this cycle have been discussed in Cost Accounting course. The focus of this discussion note will be purely on controls over custody of resources involved, authorization of activities, and recording of transactions. As for the substantive test, you may refer to Chapter 11. Summary of control-related duties and responsibilities Duties and Person/s assigned to perform Procedures responsibilities the function performed by auditor Custody Physical custody of materials | Auditor observes and labor documents is normally | physical count and held by the —_ production | reconciles the result of department. such count to entity’s | Since most of the assets here are | T@Cords. highly susceptible to | If held by other parties, misappropriation, adequate | auditor may send physical controls must be | confirmation requests implemented. to the custodian (eg. | consignees, agents, or branches) Authorization | The production department is | Auditor reviews authorized to make normal | production orders and production runs. related documents supporting production runs made by the department to determine whether it bears the necessary authorization. However, in case of special runs (to meet a special order), authorization must come from the board of directors or its authorized representative. Recording Transactions are recorded by the | Auditor normally cost accounting. Daily summaries | reviews the are then prepared and | competency of the forwarded to general accounting | individuals making for recording and posting in the journal entries. general journal and ledger, | ¥ reconciliation of the respectively. general ledger FINANCE AND INVESTMENT CYCLE Finance and investment cycle generally involves three major categories of transactions: investments, long-term debts, and shareholders’ equity. It covers complicated processes such as accounting for investments, mergers, long-term liabilities, and equity transactions, 61Chapter 4 - Transaction Cycles This cycle normally involves few but significant amounts of resources. Thus, auditor commonly employs substantive testing to gather sufficient appropriate evidence. However, it must be noted that prior to designing of substantive test procedures, control-related duties and responsibilities is one of the major consideration of the auditor. With this, similar with the production or conversion cycle, the focus of this discussion note will be on the different controls over custody, authorization, and recording of the different transactions covered by this cycle. As for the substantive tests, you may refer to Chapters 14, 25 and 31. Summary of control-related duties and responsibilities Finance cycle Duties and Person/s assigned to perform Procedures responsibilities the function | performed by auditor Custody Unissued equity and debt | Auditor inquires certificates must be kept by | directly to assigned appropriate internal official (e.g. | custodians. Corporate Secretary) or independent external custodian, If held internally, auditor observes the accounting of unissued certificates Authorization | As previously mentioned, | Auditor reviews transactions covered in this cycle | minutes of the board of involve large amounts of cash or | directors’ meetings. other resources. With _ this, transactions shall be approved by the board of directors. Recording Transactions are recorded in the | Auditor normally general journal by personnel in | reviews the the general accounting. ¥ competency of the individuals making journal entries. Y reconciliation of the subsidiary and general ledgers Important notes; 1, In case of settlement of equity or debt securities previously issued, the certificate is cancelled thru perforation (e.g. the certificate is shredded). The purpose of this is to avoid duplicate payments, The supporting records and documents are then kept as audit trail of the transactions. 2. In case of debt instruments, the general accounting shall appropriately monitor any accruing interests from the liabilities. 62Chapter 4 - Transaction Cycles Investment cycle Duties and responsibilities Person/s assigned to perform the function Procedures performed by auditor Custody Generally, investment certificates are kept as follows: * Negotiable certificates - brokerage account « Titles to real estate - may be kept in a safe with the entity or bank safe deposit box Auditor inquires directly to assigned custodians thru sending of confirmation requests. If held internally, the auditor observes the accounting for certificates held. Authorization ‘As previously mentioned, transactions covered in this cycle involve large amounts of cash or other resources. With this, transactions shall be approved by the board of directors or by an investment committee of the BOD. ‘Auditor reviews minutes of the board of directors meetings. Recording Transactions are recorded in the general journal by personnel in the general accounting. Moreover, most companies monitor transactions in the investment cycle through a subsidiary ledger/s maintained by the treasury department. ‘Auditor normally reviews the ¥ competency of the individuals making journal entries. Y periodic reconciliation of subsidiary and general ledgers Important notes: 1. Regardless of the manner of safekeeping, access to these certificates is given to at least two high-ranking officers (e.g. President, Treasurer, CEO, COO, CFO, or Chairman of the board). This control is sometimes called dual control or joint custody. 2. The auditor normally requests for the conduct of securities count in the financial institutions holding the client's certificates. 63