CHAPTER 11

THE EXPENDITURE CYCLE: PURCHASING TO CASH DISBURSEMENTS

Instructors Manual

Learning Objectives:

1. Describe the basic business activities and related information

processing operations performed in the expenditure cycle.

2. Discuss the key decisions to be made in the expenditure cycle,

and identify the information needed to make those decisions.

3. Document an understanding of the expenditure cycle.

4. Identify major threats in the expenditure cycle, and evaluate the

adequacy of various control procedures for dealing with those
threats.

Questions to be addressed in this chapter include:

 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?

Introduction
The expenditure cycle is a recurring set of business activities and
related data processing operations associated with the purchase of and
payment for goods and services.

Figure 11-1 on page 418 provides a context diagram of the expenditures

cycle. Note that the expenditures cycle involves the revenue cycle,
inventory cycle, various departments involved in requesting items be
order and receiving the items and the production cycle.

This chapter focuses on the purchase of raw materials, finished goods,

supplies and services. Chapters 12 and 13 will cover fixed assets and
labor services respectively.

Primary objective of the expenditure cycle is to minimize the total

cost of acquiring and maintaining inventories, supplies and the various
services the organization needs to function.

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 Learning Objective Two

Part One: Discuss the key decisions to be made in

the expenditure cycle.

To achieve this objective management must make the following key

decisions:

 What is the optimal level of inventory and supplies to carry?

 Which suppliers provide the best quality and service at the best
prices?

 Where should inventories and supplies be held?

 How can the organization consolidate purchases across units to

obtain optimal prices?

 How can IT be used to improve both the efficiency and accuracy of

the inbound logistics function?

 Is sufficient cash available to take advantage of any discounts

suppliers offer?

 How can payments to vendors be managed to maximize cash flow?

Learning Objective One

Describe the basic business activities and

related information processing operations
performed in the expenditure cycle.

Learning Objective Three

Document an understanding of the expenditure

cycle.

Expenditure Cycle Business Activities

Figure 11-12 on page 419 provides a level 0 data flow diagram for
the expenditure cycle.

Three basic business activities in the expenditure cycle:

1) Ordering goods, supplies and services;

2) Receiving and storing goods, supplies and services;

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 3) Paying for goods, supplies and services

Figure 11-2 on Page 419 provides a level 0 data flow diagram for the
expenditure cycle in Figure 11-2).

Order Goods

The first major business activity in the expenditure cycle (circle 1.0
in Figure 11-2) is ordering inventory or supplies.

Key decisions in this process involve identifying what, when, and

how much to purchase and from whom. Weaknesses in inventory control
can create significant problems with this process as demonstrated in
the introductory AOE case:

 inaccurate inventory records and

 inventory shorts resulting in production delays caused by late

delivery or substandard components delivered

Alternative Inventory Control Methods

One of the key factors affecting the ordering process is the

inventory control method to be used.

We will consider three alternate approaches to inventory control:

economic order quantity (EOQ); just in time inventory (JIT); and
materials requirements planning (MRP).

Economic Order Quantity (EOQ) is the traditional approach to

managing inventory. The goal is to maintain enough stock so that
production doesn’t get interrupted. An optimal order size is
calculated by minimizing the sum of ordering costs, carrying
costs, and stockout costs. A reorder point is also calculated.

 Ordering Costs includes all expenses associated with

processing purchase transaction.

 Carrying Costs are those associated with holding

inventory

 Stockout Costs are those cost that result from inventory

shortages, such as lost sales or production delays.

 The Reorder Point is when to order based on delivery

time and safety stock levels.

 Optimal Order Size

2 DP
EOQ =
C
D = Demand in units for a specified period
P = Relevant ordering cost per purchase order

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 C = Relevant carrying cost of one unit in stock for
the time period used for D.

Materials Requirement Planning (MRP) seeks to reduce inventory

levels by improving the accuracy of forecasting techniques to
better schedule purchases to satisfy production needs. This
schedule identifies the quantities of raw materials, parts and
supplies needed in production and the point in time when they
will be needed.

Just-in-Time (JIT) systems attempt to minimize, if not totally

eliminate, carrying inventory by only purchasing and producing
goods in response to actual sales. These systems have frequent,
small deliveries of materials, parts, and supplies directly to
the location where production will occur.

A major difference between MRP and JIT is the production

scheduling.

MRP systems schedule production to meet forecasted

sales; thereby creating a stock of finished goods
inventory.

JIT systems schedule production in response to customer

demands; thereby virtually eliminating finished goods
inventory.

Purchase Requests

Whatever the inventory control system, the order processing

typically begins with a purchase request followed by the
generation of a purchase order. The purchase requisition is
triggered by the inventory control function or an employee
noticing a shortage. Advanced inventory control systems
automatically initiate purchase requests when quantity falls
below the reorder point.

The purchase requisition (Figure 11-3 on page 422) is a

paper or electronic form that identifies who is requesting
the goods; where they should be delivered; when they’re
needed; item numbers, descriptions, quantities, and prices;
a suggested supplier; and the department number and account
number to be charged.

The purchase requisition is received by a purchasing agent in the

purchasing department, who typically performs the purchasing
activity. The purchase requisition shown in Figure 11-3 on page
422 is a document, or electronic form, that identifies the
requisitioner, specifies the delivery location and date needed;
identifies the item numbers, descriptions, quantity and price of
each item requested; and may suggest a supplier.

Figure 11-4 on page 422 shows a typical purchase requisition data

entry screen used in ERP systems.

Generating Purchase Orders

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A crucial decision is the selection of supplier for inventory
items. Several factors should be considered in making this
decision:

 Price
 Quality of materials
 Dependability in making deliveries

Once a supplier has been selected for a product, their identity

should become part of the product inventory master file. It’s
important to track and periodically evaluate supplier
performance. The purchasing function should be evaluated and
rewarded based on how well it minimizes total costs, not just the
costs of purchasing the goods.

A purchase order (PO), shown in Figure 11-5 on page 423 is a

document or electronic form that formally requests a supplier to
sell and deliver specified products at specified prices. The PO
is both a contract and a promise to pay. Multiple purchase orders
may be completed for one purchase requisition if multiple vendors
will fill the request. A blanket purchase order is a commitment
to buy specified items at specified prices from a particular
supplier for a set time period.

Improving Efficiency and Effectiveness

The major cost driver is the number of purchase orders processed.

Using EDI is one way to improve the purchasing process. EDI

reduces costs by eliminating the clerical work associated with
printing and mailing paper documents.

The time between recognizing the need to reorder an item and

subsequently receiving it also is reduced.

Vendor-managed inventory programs provide anther means of

reducing purchase and inventory costs.

Vendor-managed inventory essentially outsources much of the

inventory control and purchasing.

Suppliers are given access to point-of-sales and inventory

data and are authorized to automatically replenish
inventory.

Reverse auctions provide another technique to reduce purchasing-

related expenses. In reverse auctions, suppliers compete with one
another to need demand at the lowest price.

On other way to reduce purchasing-related costs is to conduct a

pre-award audit, normally involving large purchases that involve
bids.

The internal auditor verifies the accuracy of the bids.

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Receiving and Storing Goods

The Receiving Department accepts deliveries from suppliers. The

Receiving Department normally reports to the Warehouse Manager,
who reports to Vice President of Manufacturing. The Inventory
Stores Department, which also reports to the Warehouse Manager,
is responsible for the storage of the goods.

The receipt of goods must be communicated to the inventory

control function to update inventory records.

Figure 11-6 on page 425 provides a Level 1 DFD of the Receiving

Function. The two major responsibilities of the receiving
department are deciding whether to accept delivery (based on
whether there is a valid purchase order) and verifying the
quantity and quality of delivered goods.

Verifying the quantity of delivered goods is important so the

company only pays for goods received and inventory records are
updated accurately. The receiving report, shown in Figure 11-7
on page 426 is the primary document used in this process. The
receiving report includes the date received, shipper, supplier
and purchase order number. For each item received, it shows the
item number, description, unit of measure and quantity. It also
provides space for signature and comments by the person who
receives and inspects the goods.

A receiving report is not typically used for receipt of services.

Receipt of services is typically documented by supervisory
approval of the supplier’s invoice.

When goods arrive, a receiving clerk compares the PO number on

the packing slip with the open PO file to verify the goods were
ordered. The receiving clerk counts the goods, and examines them
for damage before routing to warehouse or factory.

Three possible exceptions to this process are

(1) receiving a quantity of goods different from the amount

ordered,

(2) receiving damaged goods, or

(3) receiving goods of inferior quality that fail

inspection.

In all three cases, the purchasing department must resolve the

situation with the supplier.

In the case of damaged or poor quality goods, a debit memo is

prepared after the supplier agrees to take back the goods or
grant a price reduction.

Improve Efficiency and Effectiveness

One way to improve the efficiency of the receiving process is to

require suppliers to bar-code their products.

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 Bar-coding enables 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 technology provide another way to improve the

efficiency of inbound logistics. EDI advance shipping notices
inform companies when products have been shipped.

Finally, audits may identify opportunities to cut freight costs.

For example, many companies have negotiated significant savings
with specific carriers.

Paying For Goods And Services

The third main activity in the expenditure cycle is paying vendors

as shown in Figure 11-8 on page 427.

There are two basic sub-processes involved in the payment process:

 approval of vendor invoices and

 actual payment of the invoices.

Approve Vendor Invoices for Payment

Approval of vendor invoices is done by the accounts payable

department, which reports to the controller. The legal obligation
to pay arises when goods are received; but most companies pay only
after receiving and approving the invoice. This timing difference
may necessitate adjusting entries at the end of a fiscal period.

The objective of accounts payable is to authorize payment only for

goods and services that were ordered and actually received. This
requires information from purchasing about the existence of a valid
purchase order and from receiving for a report that goods were
received

There are two basic approaches to processing vendor invoices:

– Non-voucher system--Each approved invoice is posted in the

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.

– In a voucher system--A disbursement voucher is also

prepared which identifies the supplier, lists outstanding
invoices and net amount to be paid after discounts and
allowances. The disbursement voucher effectively shows

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 which accounts will be debited and credited, along with the
account numbers. Figure 11-9 on page 428 shows the voucher
data entry screen.

There are three advantages from using disbursement vouchers:

 several invoices may be paid at once (reducing number of

checks);

 vouchers can be pre-numbered, which simplify tracking all

payables; and

 the voucher provides a record that a vendor invoice has been

approved for payment and facilitates invoice approval separate
from invoice payment. This makes it easier to schedule both
activities to maximize efficiency.

Accounting approves the invoice for payment by comparing the invoice

to the purchase order and receiving report. A voucher package, which
contains the approved invoice, and supporting purchase order and
receiving report, is sent to the cashier. This voucher package
authorizes issuance of a check or EFT to the supplier.

Pay Approved Invoices

The final activity in the expenditure cycle is the payment of

approved invoices (circle 3.2 in Figure 11-8 on page 427).

The cashier reviews the voucher package, approves the payment,

prepares the check for payment and signs the check.

Note to Instructor: Before discussing the threats and internal

controls, power point slides #61 through #65 provides organizational
charts depicting who does what and who they report to.

Improving Efficiency and Effectiveness

The accounts payable process, which matches vendor invoices to

purchase orders and receiving reports, is a prime candidate for
automation.

Processing efficiency can be improved by: requiring suppliers to

submit invoices by EDI and having the system automatically match
invoices to purchase orders and receiving reports.

Another option is to eliminate vendor invoices. This “invoiceless”

approach is called evaluated receipt settlement (ERS). ERS replaces
the traditional three-way matching process with a two-way match of
the purchase order and receiving report (refer to Figure 11-10 on
page 430).

Procurement cards provide one way to eliminate the need for accounts
payable to process many small noninventory invoices. A procurement
card is a corporation credit card that employees can use only at
designated suppliers to purchase specific kinds of items.

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 Using corporate credit cards for travel expenses further reduces the
number of invoices that need to be processed.

Preparing careful short-term cash budgets is useful in taking

advantage of early-payment discounts.

For example, if the corporation purchased an item for $100,000

with the terms 2/10, n/30; the amount of the discount that could
be realized by paying within ten days is $2,000. Even more
important, if the corporation did not pay within the ten days;
the 2% discount represents an annual interest rate of 18 percent
(2% X 360/20).

Finally, financial data electronic interchange (FEDI) can cut the

costs associated with paying suppliers by eliminating the need to
prepare and mail checks.

Focus 11-2 on page 431 shows dramatic improvements can often be made
simply by reengineering the accounts payable and cash disbursements
processes.

Medtronic had successfully used both Six Sigma and Lean

principles to streamline its work-flow activities and improve
product quality.

Six Sigma is a philosophy that focuses on improving quality

by reducing mistakes.

Lean analysis seeks to improve efficiency by eliminating

bottlenecks and redundancies.

Medtronic initiated a series of intensive 5-day projects, called

kaizen, to apply Six Sigma and Lean principles to improve
accounts payable.

Medtronic’s application of process improvement techniques

yielded a dramatic improvement in the efficiency and
effectiveness of its Accounts Payable function:

- The time required to open the mail, sort, process and

record vendor invoices dropped from 3 days to 1 day.

- The number of invoices for which discounts for prompt

payment were taken increased by 15%

- Payment processing times were cut by 50%

Information Processing Procedures

Figure 11-11 on page 432 depicts the portion of AOE’s new ERP system
that supports its expenditure cycle activities.

Major suppliers send electronic notification of coming deliveries. When

a shipment arrives, the receiving dock workers use the inquiry
processing system to verify that an order is expected from that
supplier.

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Receiving dock workers also inspect the goods and use an online
terminal to enter the inventory item numbers, count and purchase order
number.

Upon transfer of the goods to the warehouse, the inventory stores

department verifies the count of the items placed into inventory and
enters that data in the system.

Most companies use batch processing to pay its suppliers. Each day, the
treasurer uses the inquiry processing to review the vouchers that are
due and approves them for payment.

When an EFT payment is authorized or a check is printed, the system

updates the accounts payable, open-invoice and general ledger files.

After reviewing checks against the voucher package, the cashier signs
them.

In summary, AOE’s ERP system improves the efficiency and effectiveness

of its expenditure cycle activities in the following ways:

1) The quantity of paper documents processed is reduced

2) More timely and accurate information enables AOE to take
advantage of discounts for prompt payment vendor invoices
3) Inventory records are more accurate and timely
4) The warehouse and receiving departments can better plan
activities
5) The system compares data the receiving department entered to
the purchase order file, thereby detecting and facilitating
correction of any errors on a timely basis
6) Reports and performance measures are timelier, which enhances
management’s ability to monitor and improve efficiency and
effectiveness

Multiple Choice 1

The EOQ calculation that considers loss sales or production

delays is:

a. Carrying costs
b. Stockout costs
c. Reorder point
d. Ordering costs

Multiple Choice 2

The approach to managing inventory that is based on forecasted

sales to schedule production is:

a. IBM
b. EOQ
c. MRP
d. JIT

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Multiple Choice 3

Crucial operating decisions when selecting suppliers for

inventory items includes:

a. Price
b. Quality of materials
c. Dependability of making decisions
d. All of the above

Multiple Choice 4

The document used to request that an item be ordered is the

a. Purchase order
b. Purchase requisition
c. Purchase advice
d. Purchase auction

Multiple Choice 5

The major cost driver in the purchasing function is

a. The number of purchase orders processed

b. The price of the items purchased
c. The reputation of the supplier
d. None of the above.

Multiple Choice 6

A receiving report is typically not used for

a. Low cost supply items

b. Items ordered on blanket purchase orders
c. Receipt of services
d. Reoccurring items

Learning Objective Four

Identify major threats in the expenditure cycle,

and evaluate the adequacy of various control
procedures for dealing with those threats.

Control Objectives, Threats, And Procedures

In the expenditure cycle (or any cycle), a well-designed AIS should
provide adequate controls to ensure that the following objectives
are met:

(1) All transactions are properly authorized;

(2) All recorded transactions are valid;

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 (3) All valid and authorized transactions are recorded;

(4) All transactions are recorded accurately;

(5) Assets are safeguarded from loss or theft;

(6) Business activities are performed efficiently and

effectively;

(7) The company is in compliance with all applicable laws and

regulations; and

(8) All disclosures are full and fair.

Order Goods

The six threats for ordering goods are listed at the beginning of
Table 11-1 on page 435.

Threat No. 1 — Stock-outs and/or Excess Inventory

Stockouts result in lost sales; excess inventory incurs

higher than necessary carrying costs.

Controls: Accurate inventory control and sales forecasting;

use of perpetual inventory method; supplier performance
reports; recording of inventory changes in real time; bar-
coding inventory; and periodic physical counts.

Threat No. 2 — Ordering Unnecessary Items

Companies must also beware of purchasing items that are not

currently needed.

Controls: Integrate databases of various divisions and

produce reports that link item descriptions to part numbers
to allow consolidation of orders.

Threat No. 3 — Purchasing Goods at Inflated Prices

The cost of purchased components represents a substantial

portion of the total cost of many manufactured products.

Controls: Price lists for frequently-purchased items; use

of catalogs for low-cost items; solicitation of bids for
high-cost and specialized products; review of purchase
orders; budgetary controls and responsibility accounting;
and performance review.

Threat No. 4 — Purchasing Goods of Inferior Quality

Sometimes purchasing goods at the lowest possible price

sacrifices quality of the goods.

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 Controls: Use of approved supplier list; review of
purchase orders; tracking of supplier performance;
purchasing accountability for rework and scrap.

Threat No. 5 — Purchasing from Unauthorized Suppliers

Purchasing from unauthorized suppliers can result in

numerous problems. Items may be of inferior quality or
overpriced.

Controls: review of purchase orders; restriction of access

to supplier list; periodic review of supplier list; and
coordination with procurement card providers to restrict
acceptance of cards.

Threat No. 6 — Kickbacks

Kickbacks are gifts from suppliers to purchasing agents for

the purpose of influencing their choice of suppliers.

Controls: “No gift” policy for buyers; employee training

on gift handling; job rotation and mandatory vacation;
audits of buyers; review of conflict of interest
statements; vendor audits.

EDI-Related Threats

Controls: Restriction of EDI access; verification and

authentication of EDI transactions; acknowledgment of EDI
transactions; log and review EDI of transactions;
encryption; digital signatures; EDI agreements with
suppliers.

Types of issues that occur when suppliers are linked to the

company’s POS system to automatically manage inventory:

 At what point in the process can the order be

canceled?
 Which party is responsible for the cost of return
freight if contract terms are not followed?
 Which party is responsible for errors in bar
codes, RFID tags and labels?
 What happens if errors in the purchasing company’s
Pos system cause additional errors in the amount
of goods that suppliers provide?
 Can suppliers ship more inventory than ordered if
doing so reduces total freight costs by having a
full, rather than partial, truckload?

Purchases of Services

Controls: Hold supervisors accountable for costs; compare

actual to budgeted expenses; review and audit contracts for
services.

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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.

Threat No. 9 — Stealing Inventory

Controls: Secure storage locations for inventory;

documentation of intra-company transfers; periodic physical
counts; segregation of duties.

Approve and Pay Vendor Invoices

The primary objectives of this process are to:

– Pay only for goods and services that were ordered and
received.
– Safeguard cash.

Threat No. 10 — Failing to Catch Errors in Vendors Invoices

Controls: Check mathematical accuracy; verify procurement

card charges; adopt Evaluated Receipt Settlement; train staff
on freight terminology; use common carrier to take advantage
of discounts.

Threat No. 11 — Paying for Goods Not Received.

Controls: Compare invoice quantities to quantities reported

by receiving and inventory control; use tight budgetary
controls.

Threat No. 12 — Failing to Take Available Purchase Discounts

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

flow budgets.

Threat No. 13 — Paying the Same Invoice Twice

Controls: Approve invoices only with complete voucher

package; pay only on original invoices; cancel invoices once
paid; use internal audit to detect and recover overpayments;
control access to accounts payable master file.

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 Threat No. 14 — Recording and Posting Errors in Accounts Payable

Controls: Data entry and processing controls; reconcile

supplier balances with control accounts.

Threat No. 15 — Misappropriation of Cash, Checks, or EFT

Controls: Restrict access to cash, checks, and check signing

machines; use sequentially numbered checks and reconcile;
segregate duties; two signatures on checks over a certain
limit; restrict access to supplier list; cancel all documents;
have independent bank reconciliation; use check protection
measures and/or positive pay; provide strict logical and
access controls for EFT; log, encrypt, stamp and number all
EFT transactions; monitor EFT transactions; and use embedded
audit modules.

General Control Issues

Threat No. 16 — Loss, Alteration, or Unauthorized Disclosure of

Data

Controls: File backups, use of file labels; strict access

controls; alter default settings on ERP modules; encrypt data;
and use message acknowledgment techniques.

Threat No. 17 — Performing Poorly

Controls: Performance reports.

Multiple Choice 7

Which of the following statements is not true?

a. Kickbacks are the most expensive form of employee

corruption.
b. RFID technology is more efficient that bar codes.
c. The Bureau of Industry and Security maintains lists of
individuals and companies with whom it is illegal to
transact business.
d. Competitive written bids should be solicited for high-
cost and specialized products.
e. All of the above

Multiple Choice 8

The following is(are) a red flag(s) that would identify suppliers

likely to represent potential problems:

a. The supplier’s address is on the invoices.

b. Entertainment expenses are high in terms of a percentage
of the supplier’s gross sales.
c. A large percentage of the supplier’s gross sales was to
one company.
d. A and B
e. B and C

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Multiple Choice 9

It is difficult to prevent fraudulent billing for services. One

of the most effective techniques is for the _______ _____
function to periodically conduct detailed reviews of contracts
for services.

a. CPA firms
b. Internal audit
c. Internal control
d. Accounts payable

Learning Objective Two

Part Two: Identify the information needed to make

those key business decisions.

Expenditure Cycle Information Needs

The following information is needed for the following operational
tasks in the expenditure cycle:

1) Determine when and how much additional inventory to order

2) Select the appropriate suppliers from whom to order

3) Verify the accuracy of vendor invoices

4) Decide if purchase discounts should be taken

5) Monitor cash flow needs to pay outstanding obligations

The AIS needs to provide information to evaluate the following:

1) purchasing efficiency and effectiveness;

2) supplier performance;

3) time taken to move goods from receiving to production; and

4) percent of purchase discounts taken.

Notice that these decisions require both financial and operating

data.

Because inventory represents a sizable investment of working

capital, reports that help manage inventory are especially valuable.
A key inventory measure is the inventory turnover.

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 Multiple Choice 10

The formula for the inventory turnover is ______ ______ divided

by the _______.

a. Net sales; inventory

b. Cost of goods sold; inventory
c. Gross margin; inventory
d. None of the above

Answer to Multiple Choice Questions:

Multiple Choice Question Answers

Number Answer Number Answer
1 B 6 C
2 C 7 E
3 D 8 E
4 B 9 B
5 A 10 B

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