AIS Information in Business
CHAPTER 1  Information is a business resource that:
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 is accountable for the short-
term planning and coordination of activities necessary to
accomplish organizational objectives. Top management is
responsible for longer-term
Internal & External planning and setting
Information Flows
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.
 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 problems rather than routine
operations. The information
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.
 A subsystem is considered a system when it
is the focus of 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
 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 by 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  Data Storage - excessive storage costs of paper
performed by one or more large computers housed documents and/or magnetic form
at a central site that serves users throughout the  Data Updating - changes or additions must be
organization. Primary areas database administration performed multiple times
data processing systems development systems  Currency of Information - potential problem of failing
maintenance. to update all affected files
 Task-Data Dependency - user’s inability to obtain
 DATABASE ADMINISTRATION. Centrally
additional information as needs change
organized companies maintain their data
 Data Integration - separate files are difficult to
resources in a central location that is shared by
integrate across multiple users
all end users
THE DATABASE MODEL
 DATA PROCESSING. The data processing group
 An organization can overcome the problems
manages the computer resources used to
associated with flat files by implementing the
perform the day-to-day processing of
database model to data management.
transactions. It may consist of the following
REA Model
functions: data control, data conversion,
 The REA model is an accounting framework for
computer operations, and the data library.
modeling an organization’s
 SYSTEMS DEVELOPMENT AND MAINTENANCE.
a. economic resources; e.g., assets
The information needs of users are met by two
b. economic events; i.e., affect changes in
related functions: systems development and
resources
systems maintenance
c. economic agents; i.e., individuals and
Potential Advantages of DDP departments that participate in an economic
 Cost reductions in hardware and data entry tasks event
 Improved cost control responsibility d. Interrelationships among resources, events
 Improved user satisfaction since control is closer to and agents
the user level  Entity-relationship diagrams (ERD) are often used to
 Backup of data can be improved through the use of model these relationships.
multiple data storage sites
Accountants as Information System Users
Potential Disadvantages of DDP  Accountants must be able to clearly convey their
 Loss of control needs to the systems professionals who design the
 Mismanagement of company resources system.
 Hardware and software incompatibility  The accountant should actively participate
 Redundant tasks and data in systems development projects to ensure
 Consolidating tasks usually segregated appropriate systems design.
 Difficulty attracting qualified personnel
Accountants as System Designers
 Lack of standards
 The accounting function is responsible for the
Manual Process Model conceptual system, while the computer function is
 Transaction processing, information processing, and responsible for the physical system.
accounting are physically performed by people,  The conceptual system determines the nature of the
usually using paper documents. information required, its sources, its destination, and
 Useful to study because: the accounting rules that must be applied.
a. helps link AIS courses to other accounting
Accountants as System Auditors
courses
 External Auditors
b. often easier to understand business
 attest to fairness of financial statements
processes when not shrouded in technology
 assurance service: broader in scope than
c. facilitates understanding internal controls
traditional attestation audit
 The Flat-File Model - The flat-file model describes an
 IT Auditors
environment in which individual data files are not related
 evaluate IT, often as part of external audit
to other files. End users in this environment own their data
 Internal Auditors
files rather than share them with other users. Thus, stand-
 in-house IS and IT appraisal services
alone applications rather than integrated systems perform
CHAPTER 2
data processing.
TRANSACTION PROCESSING
Data Redundancy Problems
A Financial Transaction is...
  an economic event that affects the assets and  Fixed asset system. A firm’s fixed asset system
equities of the firm, is reflected in its accounts, and processes transactions pertaining to the
is measured in monetary terms. acquisition, maintenance, and disposal of its fixed
 similar types of transactions are grouped together assets.
into three transaction cycles:  Conversion Cycle:
 the expenditure cycle  the production system (planning, scheduling,
 the conversion cycle and control of the physical product through
 the revenue cycle the manufacturing process)
The most common financial transactions are economic  the cost accounting system (monitors the
exchanges with external parties. flow of cost information related to
Financial transactions also include certain internal events production)
such  Revenue Cycle: time lag between the two due to
as the depreciation of fixed assets; the application of labor, credit relations with customers:
raw materials, and overhead to the production  physical component (sales order processing)
process; and the transfer of inventory from one department  financial component (cash receipts)
to another.  Sales order processing. The majority of business
Relationship between Transaction Cycles 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
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.
 Product Documents - the result of transaction
 Cash disbursements system. When the obligation
processing
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.
  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
  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

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

Program Flowcharts…
 illustrate the logic used in programs
Program Flowchart 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

Modern Systems versus Legacy Systems

 Modern systems characteristics:
 client-server based and process transactions in
real time
Symbol Set for Representing
 use relational database tables
Manual Procedures
 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
System Flowcharts… Computer-Based Accounting Systems
 Two broad classes of systems:
  batch systems Why should we be concerned about ethics in the business
 real-time systems world?
Batch Processing  Ethics are needed when conflicts arise—the need to
 A batch is a group of similar transactions that are choose
accumulated over time and then processed together.  In business, conflicts may arise between:
 The transactions must be independent of one another  employees
during the time period over which the transactions are  management
accumulated in order for batch processing to be  stakeholders
appropriate.  Litigation
 A time lag exists between the event and the Business ethics involves finding the answers to two
processing. questions:
 How do managers decide on what is right in
Steps in Batch Processing/Sequential File
conducting their business?
 Keystroke - source documents are transcribed by
 Once managers have recognized what is right, how
clerks to magnetic tape for processing later do they achieve it?
 Edit Run - identifies clerical errors in the batch and  Four Main Areas of Business Ethics
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 PROPORTIONALITY. The benefit from a decision must
 have no time lag between the economic event and outweigh the risks. Furthermore, there must be no
the processing alternative decision that provides the same or greater
 generally, require greater resources than batch benefit with less risk.
processing since they require dedicated processing  Justice. The benefits of the decision should be
capacity; however, these cost differentials are distributed fairly to those who share the risks. Those
decreasing who do not benefit should not carry the burden of
 oftentimes have longer systems development time 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.
CHAPTER 3
Computer Ethics
Ethics, Fraud and Internal Control
 The analysis of the nature and social impact of
Ethical Standards
computer technology and the corresponding
Ethical standards are derived from societal mores and
formulation and justification of policies for the ethical
deep-rooted personal beliefs about issues of right and wrong
use of such technology.… [This includes] concerns
that are not universally agreed upon.
about software as well as hardware and concerns
Business Ethics
about networks connecting computers as well as
Ethics pertains to the principles of conduct that individuals
computers themselves.’’
use in making choices and guiding their behavior in situations
 concerns the social impact of computer technology
that involve the concepts of right and wrong.
(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- Independent Verification
routine transactions) authorizations  When tasks are performed by the computer rather
Segregation of Duties than manually, the need for an independent check is
 In manual systems, separation between: not necessary.
 authorizing and processing a transaction  However, the programs themselves are checked.
 custody and recordkeeping of the asset
 subtasks
 In computerized systems, separation between: CHAPTER 4
 program coding The Revenue Cycle
 program processing
 program maintenance
Supervision Sales Order
 a compensation for lack of segregation; some may 1
be built into computer systems Credit / Customer
Accounting Records Service REVENUE CYCLE
2
 provide an audit trail (SUBSYSTEM)
Cash Receipts/
Access Controls Collections

 help to safeguard assets by restricting physical 6

access to them Shipping

Independent Verification 3
 reviewing batch totals or reconciling subsidiary
accounts with control accounts Billing/ Accounts
Receivable
4/5

Journal Vouchers/Entries (How do we get them?)

 Billing Department prepares a journal voucher:
Accounts Receivable DR
Sales CR
 Inventory Control Dept. prepares a journal voucher:
Cost of Goods Sold DR
Inventory CR
 Cash Receipts prepares a journal voucher:
Physical Controls in IT Contexts
Cash DR
Transaction Authorization
Accounts Receivable CR
 The rules are often embedded within computer
programs.
Revenue Cycle Databases
 EDI/JIT: automated re-ordering of inventory
without human intervention
 Master files
Segregation of Duties
 customer master file
 A computer program may perform many tasks that
 accounts receivable master file
are deemed incompatible.
 merchandise inventory master file
 Thus the crucial need to separate program
 Transaction and Open Document Files
development, program operations, and program
 sales order transaction file
maintenance.
• open sales order transaction file
Supervision
 sales invoice transaction file
 The ability to assess competent employees becomes
 cash receipts transaction file
more challenging due to the greater technical
 Other Files
knowledge required.
 shipping and price data reference file
Accounting Records
 credit reference file (may not be needed)
 ledger accounts and sometimes source documents
 salesperson file (may be a master file)
are kept magnetically
 Sales history file
 no audit trail is readily apparent
 cash receipts history file
Access Control
 accounts receivable reports file
 Data consolidation exposes the organization to
Sales Order Processing
computer fraud and excessive losses from disaster.
 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 essential
details on a sales order 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 authorization
control and should be performed as a function
separate from the sales activity. In our conceptual
system, the receive-order task sends the sales order
(credit copy) to the check-credit task for approval.
 Sales information is released to:
 Billing
 Warehouse (stock release or picking ticket)
 Shipping (packing slip and shipping notice)
PICK GOODS
 The receive order activity forwards the stock release
document (also called the picking ticket) to the pick
goods function, in the warehouse.
 The merchandise is picked from the Warehouse and sent
to Shipping. After picking the stock, the order is verified
for accuracy and the goods and verified stock release
document are sent to the ship goods task.
 Stock records are adjusted.
SHIP GOODS
 The merchandise, packing slip, and bill of lading are
prepared by Shipping and sent to the customer.
 Shipping reconciles the merchandise received from
the Warehouse with the sales information on the
packing slip.
 Shipping information is sent to Billing.
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
Purchase Requisition Purchasing
1 2
PROCUREMENT CYCLE
(SUBSYSTEM)
Receiving/
Cash Disbursements Inspection
3
5
Accounts Payable
4
Goals of the Expenditure Cycle
 The goal of providing needed resources to
organization can be broken down into several
objectives:
 purchase from reliable vendors
 purchase high quality items
 obtain best possible price
 purchase only items that are properly
authorized
 have resources available when they are
needed
 receive only those items ordered
 ensure items are not lost, stolen,
or broken
 pay for the items in a timely manner
A Purchase System
 Begins in Inventory Control when inventory levels
drop to reorder levels
 A purchase requisition (PR) is prepared and copies to
be sent to Purchasing and Accounts Payable (A/P)
 Purchasing prepares a purchase order (PO) for each
vendor and sends copies to Inventory Control, A/P,
and Receiving
 Upon receipt, Receiving counts and inspects the
goods.
 A blind copy of the PO is used to force
workers to count the goods.
 A receiving report is prepared and copies sent to the
raw materials storeroom, Purchasing, Inventory
Control, and A/P.
 A/P eventually receives copies of the PR, PO,
receiving report, and the supplier’s invoice.
 A/P reconciles these documents, posts to the
purchases journal, and records the liability in the
accounts payable subsidiary ledger.
 A/P periodically summarizes the entries in the
purchases journal as a journal voucher which is sent
to the General Ledger (G/L) department.
 Inv-Control or Purchases DR
Accts Payable-Control CR
 A/P also prepares a cash disbursements voucher and
posts it in the voucher register.
 G/L department:
 posts from the accounts payable journal voucher to
the general ledger
 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 register
(cash disbursements journal)
 returns paid vouchers to accounts payable,
mails the check to the supplier
 sends a journal voucher to G/L:
Accounts Payable DR
Cash CR
 G/L department receives:
 the journal voucher from cash
disbursements
 a summary of the accounts payable
subsidiary ledger from A/P
 The journal voucher is used to update the general
ledger.
 The accounts payable control account is reconciled
with the subsidiary summary.
AP & CASHDISBURSEMENT (Departments Involved)
Inventory Control
Note that to provide proper authorization control, the
inventory control department is segregated from the
purchasing department, which executes the transaction.
Purchasing Department
The purchasing department receives the purchase
requisitions, sorts them by vendor, and prepares a multipart
PO for each vendor.
Receiving Department
Goods arriving from the vendor are reconciled with the
blind copy of the PO. Upon completion of the physical count
and inspection, the receiving clerk prepares a multipart
receiving report stating the quantity and condition of the
inventories. One copy of the receiving report accompanies
the physical inventories to the storeroom. Another copy is
sent to the purchasing department, where the purchasing
clerk reconciles it with the open PO.
AP Department
When the invoice arrives, the AP clerk reconciles the
financial information with the documents in the pending file,
records the transaction in the purchases journal, and posts it
to the supplier’s account in the AP subsidiary ledger (voucher
register)
General Ledger Department
The general ledger department receives a journal voucher
from the AP department and an account summary from
inventory control. The general ledger clerk reconciles these
and posts 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 The personnel department prepares and submits
 segregation of duties personnel action forms to the prepare payroll function. These
 Documentation documents identify employees authorized to receive a
 Asset Accountability Controls paycheck and are used to reflect changes in hourly pay rates,
 Management Practices payroll deductions, and job classification. Personnel action
 Data Center Operations Controls form is used to advise payroll of an increase in an employee’s
 Authorization Controls salary.
 Access Controls Production Department
Authorization Controls Production employees prepare two types of time records:
 Purchases of inventory should be authorized by the job tickets and time cards. Job tickets capture the time that
Inventory Control department, not by purchasing individual workers spend on each production job. Cost
agents accounting uses these documents to allocate direct labor
 Accounts Payable authorizes the payments of bills, charges to work-in-process (WIP) accounts. Time cards
not the cash disbursements clerk, who writes the capture the time the employee is at work. These are sent to
checks the prepare payroll function for calculating the amount of the
Traditional Segregation of Duties employee’s paycheck.
 Warehouse (stores) Update WIP Account (Cost Accounting Department)
 Inventory control After cost accounting allocates labor costs to the WIP
 Accounts payable accounts, the charges are summarized in a labor distribution
 General ledger summary and forwarded to the general ledger function.
 Requisitioning Prepare Payroll
 Purchases The payroll department receives pay rate and withholding
 Purchases returns and allowances data from the personnel department and hours worked data
 Cash disbursements from the production department. A clerk in payroll then
Supervision performs the following tasks.
 Within the expenditure cycle, supervision is of 1. Prepares the payroll register showing gross pay,
highest importance in the Receiving department, deductions, overtime pay, and net pay.
where the inventory arrives and is logged in by a 2. Enters this information into the employee payroll
receiving clerk. Need to minimize: records
 failures to properly inspect the assets 3. Prepares employee paychecks .
 theft of the assets 4. Sends the paychecks to the distribute paycheck function.
Access Controls 5. Files the time cards, personnel action form, and copy of
 Access to: the payroll register (not shown).
 inventories (direct) Distribute Paycheck
 cash (direct) A form of payroll fraud involves submitting time cards for
 accounting records (indirect) nonexistent employees. To prevent this, many companies use
Independent Verification a paymaster to distribute the paychecks to employees. This
 A/Payable dept. verifies much of the work done individual is independent of the payroll process—not involved
within the expenditure cycle. in payroll authorization or preparation tasks. If a valid
 PR, PO, receiving reports, and suppliers’ employee does not claim a paycheck, the paymaster returns
invoices must be checked and verified by the check to payroll. The reason the check went unclaimed
A/P. can then be investigated.
 G/Ledger dept. verifies: Prepare Accounts Payable (Accounts Payable Department)
 the total obligations recorded equal the The accounts payable (AP) clerk reviews the payroll register
total inventories received for correctness and prepares copies of a cash disbursement
 the total reductions in accounts payable voucher for the amount of the payroll. The clerk records the
equal the total disbursements of cash 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
CHAPTER 6 ledger function.
Payroll Processing and Fixed Asset Procedures Prepare Cash Disbursement (Cash Disbursement Department)
Upon receipt of the voucher packet, the cash
(Departments Involved) disbursements function prepares a single check for the entire
Personnel Department 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.