The Expense Cycle: Purchasing to Cash Payments

1. The Expense Cycle: Purchasing to Cash Payments Chapter 11 FOSTER School of Business Acctg.320

2. Questions Addressed • What are the basic business activities and data processing operations that are performed in the expenditure cycle? • What decisions need to be made in the expenditure cycle, and what information is needed to make these decisions? • What are the major threats in the expenditure cycle and the controls related to those threats? FOSTER School of Business Acctg.320

3. Introduction The expense cycleis a recurring set of business activities and related information processing operations associated with the purchase of and or payment for good and services. Primary external exchange of information is with suppliers. FOSTER School of Business Acctg.320

4. Expense Cycle Objective The expense cycle’s primary objective is to minimize the total cost of acquiring and maintaining inventories, supplies, and the various services the organization needs to function To accomplish that objective, management must make many key decisions: FOSTER School of Business Acctg.320

5. Key Decisions: Expense Cycle • What is the optimal levelof 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 usedto improve both the efficiency and accuracy of the inbound logistics function? • Is sufficient cash available to take advantage of any discounts suppliers offer? • How can payments to vendors be managed to maximize cash flow? FOSTER School of Business Acctg.320

6. AIS basic functions There are 3 basic functions of the AIS in the expense cycle: (same for all cycles) (1) capturing and processing data about business activities, (2) storing and organizing that data to support decision making, (3) providing controls: ensure reliability of data & safeguard resources. FOSTER School of Business Acctg.320

7. Expense Cycle Business Activities Three basic business activities performed in the expense cycle: • Ordering goods, supplies and services; • Receiving and storing goods, supplies and services; • Paying for goods, supplies and services. FOSTER School of Business Acctg.320

8. Order Goods The first major business activity in the expenditure cycle 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. • inaccurate inventory records and • inventory shorts resulting in production delays caused by late delivery or substandard components delivered FOSTER School of Business Acctg.320

9. Order Goods: Alternative Inventory Control Methods We consider three alternate approachesto inventory control: • economic order quantity (EOQ); • materials requirements planning(MRP); and • just in time inventory (JIT). FOSTER School of Business Acctg.320

10. EOQ • Economic Order Quantity (EOQ) is the traditional approach to managing inventory. The goal is to maintain enough stock so that production doesn’t get interrupted. An optimal order sizeis calculated by minimizing the sum of ordering costs, carrying costs, and stockout costs. A reorder pointis also calculated. • Ordering Costsincludes all expenses associated with processing purchase transaction. • Carrying Costsare those associated with holding inventory. • Stockout Costsare those cost that result from inventory shortages, such as lost sales or production delays. • The Reorder Pointis when to order based on delivery time and safety stock levels. • Optimal Order Size : EOQ = (2DP / C) ^1/2 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. FOSTER School of Business Acctg.320

11. Materials Requirement Planning (MRP) (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. FOSTER School of Business Acctg.320

12. Just-in-Time (JIT) (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 JITis the production scheduling. • MRPsystems 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. FOSTER School of Business Acctg.320

13. 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 is received by a purchasing agent in the purchasing department, who typically performs the purchasing activity. The purchasing agent next makes a purchase order (PO). FOSTER School of Business Acctg.320

14. 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 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 orderis a commitment to buy specified items at specified prices from a particular supplier for a set time period. FOSTER School of Business Acctg.320

15. Improving Efficiency and Effectiveness of Purchasing The major cost driveris the number of purchase orders processed. Ways to reduce costs: • 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. • Vendor-managedinventory programs provide anther means of reducing purchase and inventory costs. • Reverse auctions, suppliers compete with one another to meet demand at the lowest price. • conduct a pre-award audit, normally involving large purchases that involve bids, the internal auditor verifies the accuracy of the bids. • RFID allows for specific identification method for inventories. FOSTER School of Business Acctg.320

16. Receiving and Storing Goods The two major responsibilities of the receiving department are: (1) deciding whether to accept delivery (based on whether there is a valid purchase order) and (2) verifying the quantity and quality of delivered goods. The receiving reportis the primary document used in this process. The receiving reportincludes 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. FOSTER School of Business Acctg.320

17. Receiving Goods 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. If items are damaged, defective, or missing the purchasing department must resolve the situation with the supplier. In the case of damaged or poor quality goods, a debit memois prepared after the supplier agrees to take back the goods or grant a price reduction. FOSTER School of Business Acctg.320

18. Improve Efficiency and Effectiveness: Receiving • Require suppliers to bar-code their products. • Bar-codingenables receiving clerks to scan in the product number, description and quantity of all items received, eliminating data errors. • 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 company’s warehouse unit can read. • EDI and satellite technologyprovide another way to improve the efficiency of inbound logistics. EDIadvance shipping notices inform companies when products have been shipped. • Finally, auditsmay identify opportunities to cut freight costs. For example, many companies have negotiated significant savings with specific carriers. FOSTER School of Business Acctg.320

19. Paying For Goods And Services There are two basic sub-processesinvolved in the payment process: • Accounts payable department approves vendor invoices and • Cashier makes actual payment of the invoices. FOSTER School of Business Acctg.320

20. Approve Vendor Invoices for payment Most companies record A/P only after receipt and approval—means the EoP adj. JEs need to be made. Objective of A/P is to approve payment only for goods that actually were ordered and receives. Two ways to process vendor invoices: (1) non-voucher system, and (2) voucher system--prepare a disbursement voucher. FOSTER School of Business Acctg.320

21. Non-voucher system In a Non-voucher systemeach approved invoice is posted in the supplier’s records in accounts payable, filed and is then stored in an open invoice file. When a check is written, the invoice is removed from the open invoice file, marked “paid” and then stored in a paid invoice file. FOSTER School of Business Acctg.320

22. Voucher System 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. There are three advantagesfrom 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 approvalseparate from invoice payment. This makes it easier to schedule both activities to maximize efficiency. FOSTER School of Business Acctg.320

23. Pay Approved Invoices 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. The cashier reviews the voucher package, approves the payment, prepares the check for payment and signs the check. Sends check on its way. FOSTER School of Business Acctg.320

24. Improving Efficiency and Effectiveness 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 two-way match of the purchase order and receiving report. • Procurement cardsprovide 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. FOSTER School of Business Acctg.320

25. Improving Efficiency and Effectiveness • 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 36 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. • Medtronic example on page 431 shows dramatic improvements can often be made simply by reengineering the accounts payable and cash disbursements processes. FOSTER School of Business Acctg.320

26. Information Processing Procedures Many companies are (have) replacing their AIS systems with ERP systems. New ERP systems allow sharing of data (better communication) between activities and increase integration. FOSTER School of Business Acctg.320

27. ERP efficiencies ERP systems improve the efficiency and effectiveness of its expenditure cycle activities in the following ways: • Reduced amount of paper documents processed. • More timely and accurate information enables company to take advantage of discounts. • Inventory records are more accurate and timely. • The warehouse and receiving departments can better plan activities. • Reports and performance measures are timelier. FOSTER School of Business Acctg.320

28. Control Objectives, Threats, And Procedures The six threats for ordering goods are: Threat No. 1 — Stock-outs and/or Excess InventoryStockoutsresult 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. FOSTER School of Business Acctg.320

29. Control Objectives, Threats, And Procedures Threat No. 2 — Ordering Unnecessary Items 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 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. FOSTER School of Business Acctg.320

30. Control Objectives, Threats, And Procedures Threat No. 4 — Purchasing Goods of Inferior Quality 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 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 Controls: “no-gift” policy, vendor audit, rotate. FOSTER School of Business Acctg.320

31. Control Objectives, Threats, And Procedures Receive and Store Goods 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 there’s an approved purchase order. Threat No. 8 — Errors in Counting Received Goods Controls: Bar-coding of ordered goods; quantities blanked out on receiving forms; signature of receiving clerks; bonuses for catching discrepancies; re-counting of items by inventory control. FOSTER School of Business Acctg.320

32. Control Objectives, Threats, And Procedures Receive and Store Goods (continued) Threat No. 9 — Stealing Inventory Controls: Secure storage locations for inventory; documentation of intra-company transfers; periodic physical counts; segregation of duties. FOSTER School of Business Acctg.320

33. Control Objectives, Threats, And Procedures Approve and Pay Vendor Invoices 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. 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 FOSTER School of Business Acctg.320

34. Control Objectives, Threats, And Procedures 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. FOSTER School of Business Acctg.320

35. Control Objectives, Threats, And Procedures 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. FOSTER School of Business Acctg.320

36. Expense Cycle Information Needs The following information is needed for the expenditure cycle: • 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. FOSTER School of Business Acctg.320

37. Expense Cycle Information Needs 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 financialandoperating data. FOSTER School of Business Acctg.320

38. Inventory Turnover 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. Inventory Turnover = CoGs / ending inventory FOSTER School of Business Acctg.320