CHAPTER FIVE

Transaction Cycle and Accounting Application

The Revenue Cycle

The revenue cycle is a recurring set of business activities and related information processing
operations associated with providing goods and services to customers and collecting their cash
payments. The primary external exchange of information is with customers with a primary
objective of providing the right product in the right place at the right time for the right price.
Four basic business activities are performed in the revenue cycle:

 Sales order entry  Billing

 Shipping  Cash collection

1. Sales order entry

Sales order entry is performed by the sales order department. The sales order department
typically reports to the VP of Marketing. The steps in the sales order entry process include:

– Take the customer’s order. – Check inventory availability.

– Check the customer’s credit. – Respond to customer inquiries

(may be done by customer
service or sales order entry).
1.1
Customer Orders Take Customer
Order
Response
Inquiries

Orders
1.2
Approve DFD for
Customer Credit
1.3
Approved Sales Order
1.4 Check
Orders
Resp. to Sales Order Inv.
Entry
Inventory
Cust. Inq. Avail.
Sales Sales Packing
Order Ware- Purchas-
Shipping Billing
Order List
house ing
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i. Take customer orders
Order data are received on a sales order document which may be completed and received in the
store by mail, by phone, on a website and by a salesperson in the field. The sales order (paper or
electronic) indicates item numbers, ordered quantities, prices and salesperson. To reduce human
error, customers should enter data themselves as much as possible on websites, on OCR (optical
character reader/ recognition) forms and via phone menus

ii. Check the customer’s credit

There are two types of credit authorization: General authorization: - for existing customers
below their credit limit who don’t have past-due balances. Credit limits vary by customer based
on past history and ability to pay. General authorization involves checking the customer master
file to verify the account and status. Specific authorization: - for customers who are new, have
past-due balances and are placing orders that would exceed their credit limit. Specific
authorization is done by the credit manager who reports to the treasurer.

iii. Check inventory availability

When the order has been received and the customer’s credit approved, the next step is to ensure
there is sufficient inventory to fill the order and advise the customer of the delivery date. The
sales order clerk can usually reference a screen displaying quantity on hand, quantity on order
and quantity already committed to others. If there are enough units to fill the order; complete the
sales order, update the quantity available field in the inventory file and notify the following
departments of the sale: Shipping, Inventory, Billing and Send an acknowledgment to the
customer. If there’s not enough to fill the order, initiate a back order. For manufacturing
companies, notify the production department that more should be manufactured and for retail
companies, notify purchasing that more should be purchased.

iv. Respond to customer inquiries

Another step in the sales order entry process is responding to customer inquiries: May occur
before or after the order is placed. The quality of this customer service can be critical to company
success. Many companies use Customer Relationship Management (CRM) systems to support
this process: Organizes customer data to facilitate efficient and personalized service and provides
data about customer needs and business practices so they can be contacted proactively about the
need to reorder.
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2. Shipping
The second basic activity in the revenue cycle is filling customer orders and shipping the
desired merchandise. The process consists of two steps: Picking and packing the order, and
Shipping the order. The warehouse department typically picks the order and the shipping
departments packs and ships the order. Both functions include custody of inventory and
ultimately report to the VP of Manufacturing.

Sales 2.1
Order Picking List Pick & Shipping
Entry Pack
Goods &
Sales
2.2
Packing
Sales Order
Order
Ship
List Inventory
Billing &Bill of
Goods
Accts. Lading & Goods, Shipments
Packing Slip Packing Slip,
Rec.
Carrier
& Bill of Lading

A picking ticket is printed by sales order entry and triggers the pick-and-pack process. The
picking ticket identifies: Which products to pick and what quantity. Warehouse workers record
the quantities picked on the picking ticket, which may be a paper or electronic document. The
picked inventory is then transferred to the shipping department. The shipping department
compares the following quantities: Physical count of inventory, quantities indicated on picking
ticket and quantities on sales order. Discrepancies can arise if: Items weren’t stored in the
location indicated and perpetual inventory records were inaccurate. If there are discrepancies, a
back order is initiated. The clerk then records online: The sales order number, the item numbers
ordered and the quantities shipped. This process:

– Updates the quantity-on-hand field in the inventory master file.

– Produces a packing slip.

– Multiple copies of the bill of lading: - The bill of lading is a legal contract that defines
responsibility for goods in transit.
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The shipment is accompanied by: The packing slip, a copy of the bill of lading and the freight
bill. What happens to other copies of the bill of lading? One is kept in shipping to track and
confirm delivery; one is sent to billing to trigger an invoice and one is retained by the freight
carrier. A major shipping decision is the choice of delivery methods: Some companies maintain a
fleet of trucks or companies increasingly outsource to commercial carriers which reduces costs
and allows company to focus on core business. Selecting best carrier means collecting and
monitoring carrier performance data for: on-time delivery and condition of merchandise
delivered. Another decision relates to the location of distribution centers. Many customers want
suppliers to deliver products only when needed.

3. Billing
• The third revenue cycle activity is billing customers. This activity involves two tasks:
Invoicing and updating accounts receivable. Accurate and timely billing is crucial.

Sales
Order Sales Order
3.1 Shipping
Entry Billing
Invoice
Sales
General
Ledger & Customer Sales Customer
Rept. Sys. 3.2
Maintain Mailroom
Billing Accts. Remittance
and Rec. List
Accoun
Billing is an information processing activity that repackages and summarizes information from
ts and shipping activities. It requires information from: Shipping Department
the sales order entry
on items Receiv
and quantities shipped and Sales on prices and other sales terms. The basic document
created is the sales invoice. The invoice notifies the customer of: The amount to be paid and
able
where to send payment. Invoices may be sent/received in paper form or By EDI. Updating
accounts receivable: The accounts receivable function reports to the controller. This function performs
two basic tasks: Debits customer accounts for the amount the customer is invoiced and Credits
customer accounts for the amount of customer payments. There are two basic ways to maintain
accounts receivable: Open-invoice method and Balance forward method. Open-invoice method:
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Customers pay according to each invoice and two copies of the invoice are typically sent to the
customer. Customer is asked to return one copy with payment. This copy is a turnaround
document called a remittance advice. Advantages of open-invoice method: Conducive to
offering early-payment discounts and results in more uniform flow of cash collections.
Disadvantages of open-invoice method: More complex to maintain. Balance forward method:
Customers pay according to amount on their monthly statement, rather than by invoice. Monthly
statement lists transactions since the last statement and lists the current balance. The tear-off
portion includes pre-printed information with customer name, account number, and balance.
Customers are asked to return the stub, which serves as the remittance advice. Remittances are
applied against the total balance rather than against a specific invoice. Advantages of balance-
forward method: It’s more efficient and reduces costs because you don’t bill for each individual
sale and it’s more convenient for the customer to make one monthly remittance. Cycle billing is
commonly used with the balance-forward method. Monthly statements are prepared for subsets
of customers at different times. EXAMPLE: Bill customers according to the following schedule:

• 1st week of month—Last names beginning with A-F

• 2nd week of month—Last names beginning with G-M

• 3rd week of month—Last names beginning with N-S

• 4th week of month—Last names beginning with T-Z

Advantages of cycle billing: Produces more even cash flow, produces more even workload and
doesn’t tie up computer for several days to print statements. If there’s a return, the credit
manager: Receives confirmation from the receiving dock that the goods were actually returned to
inventory and then issues a credit memo which authorizes the crediting of the customer’s
account. If goods are slightly damaged, the customer may agree to keep them for a price
reduction and credit manager issues a credit memo to reflect that reduction. Distribution of credit
memos: One copy to accounts receivable to adjust the customer account, one copy to the
customer. If repeated attempts to collect payment fail, the credit manager may issue a credit
memo to write off an account and a copy will not be sent to the customer
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NOTE: Because accounts receivable handles the customer accounts, why does someone else
have to issue the credit memos? Example: An accounts receivable employee could allow a
relative or friend (or even himself) to run up an account with the company and then simply write
the account off or credit it for returns and allowances. Having the credit memos issued by the
credit manager is good segregation of duties between: Authorizing a transaction (write-off) and
Recording the transaction.

4. Cash collections
The final activity in the revenue cycle is collecting cash from customers. The cashier, who
reports to the treasurer, handles customer remittances and deposits them in the bank. Because
cash and checks are highly vulnerable, controls should be in place to discourage theft. Accounts
receivable personnel should not have access to cash (including checks). Possible approaches to
collecting cash:

 Turnaround documents forwarded to accounts receivable. The mailroom opens

customer envelopes and forwards to accounts receivable either: Remittance advices.
Photocopies of remittance advices. A remittance list prepared in the mailroom.
 Lockbox arrangements: Customers remit payments to a bank P.O. box. The bank sends
the company: Remittance advices, an electronic list of the remittances and copies of the
checks.
 Electronic lockboxes: Upon receiving and scanning the checks, the bank immediately sends
electronic notification to the company, including: Customer account number and amount
remitted.
 Electronic funds transfer and bill payment: Customers remit payment electronically to
the company’s bank. This eliminates mailing delays.
 Accept credit cards or procurement cards from customers: Speeds collection because
credit card issuer usually transfers funds within two days.
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 PARTIAL ORGANIZATION
CHART FOR UNITS
INVOLVED IN REVENUE CEO

CYCLE
VP of Marketing VP of M anufacturing CFO

Sales Custom er W arehouse Shipping Controller Treasurer

O rder Service

Billing Accounts Credit Cashier

Takes customer orders Dept. Receivable M anager
Authorizes credit for
existing customers in
Customer service: Responds to customer inquiries. Ware house: Picks the order. Shipping: Packs
good standing
the order and Ships the order. Billing department: Invoices the customer. Account receivable:
Checks inventory
Maintains the customer’s account (Increases customer account when sales are made and
availability
Decreases account when cash is collected). Credit manager: Approves credit for new customers
or existing customers with issues and authorizes credits to customer accounts for returns,
allowances, and write-offs. Cashier: Deposits cash received from customers.

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The Expenditure Cycle

The primary external exchange of information is with suppliers (vendors). The primary objective
of the expenditure cycle is to minimize the total cost of acquiring and maintaining inventory,
supplies, and services. The three basic activities performed in the expenditure cycle are:
 Ordering goods, supplies, and services.
 Receiving and storing these items.
 Paying for these items.
These activities mirror the activities in the revenue cycle.
1. Ordering goods, supplies, and services
Key decisions in this process involve identifying what, when, and how much to purchase and
from whom. Weaknesses in inventory control can create significant problems with this process:
Inaccurate records cause shortages. One of the key factors affecting this 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)
• Materials Requirements Planning (MRP)
EOQ is the traditional approach to managing inventory. The goal is to maintain enough stock so
that production doesn’t get interrupted. Under this approach, an optimal order size is calculated
by minimizing the sum of several costs: Ordering costs, Carrying costs and Stockout costs. MRP
seeks to reduce inventory levels by improving the accuracy of forecasting techniques and
carefully scheduling production and purchasing around that forecast. JIT systems attempt to
minimize or eliminate inventory by purchasing or producing only in response to actual (as
opposed to forecasted) sales. These systems have frequent, small deliveries of materials, parts,
and supplies directly to the location where production will occur. A factory with a JIT system
will have multiple receiving docks for their various work centers.
Whatever the inventory control system, the order processing typically begins with a purchase
request followed by the generation of a purchase order. A request to purchase goods or supplies
is triggered by either: 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 need to purchase goods typically results in the creation of a
purchase requisition.
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The purchase requisition is a paper document 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, possibly a suggested supplier and department number and
account number to be charged. Most of the detail on the suppliers and the items purchased can be
pulled from the supplier and inventory master files. The purchase requisition is received by a
purchasing agent (aka, buyer) in the purchasing department, who typically performs the
purchasing activity. In manufacturing companies, this function usually reports to the VP of
Manufacturing. A crucial decision is the selection of supplier. Key considerations are: Price,
Quality and Dependability. It is especially important in JIT systems because late or defective
deliveries can bring the whole system to a halt. Consequently, certification that suppliers meet
ISO 9000 quality standards is important. This certification recognizes that the supplier has
adequate quality control processes.
Once a supplier has been selected for a product, their identity should become part of the product
inventory master file so that the selection process does not have to be carried out for every
purchase. A list of potential alternates should also be maintained. For products that are seldom
ordered, the selection process may be repeated every time. It’s important to track and
periodically evaluate supplier performance, including data on: Purchase prices, Rework and
scrap costs and Supplier delivery 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 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. It
includes: Names of supplier and purchasing agent, Order and requested delivery dates, Delivery
location, Shipping method and Details of the items ordered. Multiple purchase orders may be
completed for one purchase requisition if multiple vendors will fill the request. The ordered
quantity may also differ from the requested quantity to take advantage of quantity discounts. A
blanket order is a commitment to buy specified items at specified prices from a particular
supplier for a set time period. It reduces buyer’s uncertainty about reliable material sources,
Helps supplier plan capacity and operations
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2. Receiving and storing goods
The receiving department accepts deliveries from suppliers. Normally, reports to warehouse
manager, who reports to VP of Manufacturing. Inventory stores typically stores the goods and
also reports to warehouse manager. The receipt of goods must be communicated to the inventory
control function to update inventory records. The two major responsibilities of the receiving
department are: Deciding whether to accept delivery and verifying the quantity and quality of
delivered goods. The first decision is based on whether there is a valid purchase order. Accepting
un-ordered goods wastes time, handling and storage. 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 is the primary document used in this process:
– It documents the date goods received, shipper, supplier, and PO number.
– Shows item number, description, unit of measure, and quantity for each item.
– Provides space for signature and comments by the person who received and inspected.
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. Then counts the goods and examines for damage before
routing to warehouse or factory. Three possible exceptions in this process:
– The quantity of goods is different from the amount ordered;
– The goods are damaged; and
– The goods are of inferior quality.
If one of these exceptions occurs, the purchasing agent resolves the situation with the supplier.
Supplier typically allows adjustment to the invoice for quantity discrepancies. If goods are
damaged or inferior, a debit memo is prepared after the supplier agrees to accept a return or grant
a discount. One copy goes to supplier, who returns a credit memo in acknowledgment, one copy
to accounts payable to adjust the account payable and one copy to shipping to be returned to
supplier with the actual goods.

3. Paying for goods and services

There are two basic sub-processes involved in the payment process: Approval of vendor
invoices and actual payment of the invoices. 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
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 the invoice. This timing difference may necessitate adjusting entries at the end of a fiscal
period. Objective of accounts payable: Authorize payment only for goods and services that
were ordered and actually received. It requires information from: Purchasing—about
existence of valid purchase order and receiving—for receiving report indicating goods were
received. There are two basic approaches to processing vendor invoices:

Non-voucher system: Each invoice is stored in an open invoice file. When a check is
written, the invoice is marked “paid” and then stored in a paid invoice file.
Voucher system: A disbursement voucher is prepared which lists: Outstanding invoices
for the supplier and net amount to be paid after discounts and allowances. The
disbursement voucher effectively shows which accounts will be debited and credited,
along with the account numbers.
Payment of the invoices is done by the cashier, who reports to the treasurer. The cashier
receives a voucher package, which consists of the vendor invoice and supporting
documentation, such as purchase order and receiving report. This voucher package authorizes

PARTIAL ORGANIZATION CHART

issuance of a check or EFT to the supplier.

FOR UNITS INVOLVED IN

EXPENDITURE CYCLE
CEO

V P o f M a nu fa c tu r ing CFO

P u r c ha s ing R e c e iv ing In v e n to r y C o n tr o lle r T re as u rer

S to r e s

A c c o u n ts C a s h ie r
Selects suitable P a ya b le

suppliers
Receiving: Decides whether to accept deliveries, and Counts and inspects deliveries. Inventory
Issues
stores: purchase
Stores goods that haveorders
been delivered and accepted. Accounts payable: Approves
invoices for payment. Cashier: Issues payment to vendors.
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The Production Cycle

The production cycle is a recurring set of business activities and related data processing
operations associated with the manufacture of products. The four basic activities in the
production cycle are:

 Product design
 Planning and scheduling
 Production operations
 Cost accounting
Accountants are primarily involved in the fourth activity (cost accounting) but must understand
the other processes well enough to design an AIS that provides needed information and supports
these activities.

1. Product design
The objective of product design is to design a product that strikes the optimal balance of:
Meeting customer requirements for quality, durability, and functionality; and minimizing
production costs. Simulation software can improve the efficiency and effectiveness of product
design. Key documents and forms in product design:

– Bill of Materials: Lists the components that are required to build each product, including part
numbers, descriptions, and quantity.

– Operations List: Lists the sequence of steps required to produce each product, including the
equipment needed and the amount of time required.

2. Planning and scheduling

The objective of the planning and scheduling activity is to develop a production plan that is
efficient enough to meet existing orders and anticipated shorter-term demand while minimizing
inventories of both raw materials and finished goods. There are two common approaches to
production planning: Manufacturing Resource Planning (MRP-II) and lean manufacturing. MRP-
II is an extension of MRP inventory control systems: Seeks to balance existing production
capacity and raw materials needs to meet forecasted sales demands. It often referred to as push
manufacturing. Lean manufacturing is an extension of the principles of just-in-time inventory
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systems: Seeks to minimize or eliminate inventories of raw materials, work in process, and
finished goods. Theoretically, produces only in response to customer orders, but in reality, there
are short-run production plans. It is often referred to as pull manufacturing.

Key documents and forms:

I. Master production schedule

Specifies how much of each product is to be produced during the period and when. It uses
information about customer orders, sales forecasts, and finished goods inventory levels to
determine production levels. Although plans can be modified, production plans must be frozen a
few weeks in advance to provide time to procure needed materials and labor. Scheduling
becomes significantly more complex as the number of factories increases. Raw materials needs
are determined by exploding the bill of materials to determine amount needed for current
production. These amounts are compared to available levels to determine amounts to be
purchased.

i. Production order
Authorizes production of a specified quantity of a product: It lists:

a. Operations to be performed
b. Quantity to be produced
c. Location for delivery
Also collects data about these activities
ii. Materials requisition
Authorizes movement of the needed materials from the storeroom to the factory floor: This
document indicates:
a. Production order number
b. Date of issue
c. Part numbers and quantities of raw materials needed (based on data in bill of
materials)
iii. Move ticket
Documents the transfer of parts and materials throughout the factory:
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3. Production operations
Production operations vary greatly across companies, depending on the type of product and
the degree of automation. The use of various forms of IT, such as robots and computer-
controlled machinery is called computer-integrated manufacturing (CIM). It can
significantly reduce production costs. Accountants aren’t experts on CIM, but they must
understand how it affects the AIS. One effect is a shift from mass production to custom-order
manufacturing and the need to accumulate costs accordingly. In a lean manufacturing
environment, a customer order triggers several actions: System first checks inventory on
hand for sufficiency and calculates labor needs and determines whether overtime or
temporary help will be needed. Based on bill of materials, determines what components need
to be ordered. Necessary purchase orders are sent via EDI. The master production schedule is
adjusted to include the new order. Sharing information across cycles helps companies be
more efficient by timing purchases to meet the actual demand.

Although the nature of production processes and the extent of CIM vary, all companies need data
on:

– Raw materials used

– Labor hours expended
– Machine operations performed
– Other manufacturing overhead costs incurred
4. Cost accounting
Types of cost accounting systems:

i. Job order costing: Assigns costs to a specific production batch or job. Used when the
product or service consists of discretely identifiable items. Example: Houses.
ii. Process costing: Assigns costs to each process or work center in the production cycle.
Calculates the average cost for all units produced. Used when similar goods or services are
produced in mass quantities and discrete units can’t be easily identified. Example: Paint.
Both require that data be accumulated about:

– Raw materials – Machinery and equipment usage

– Direct labor – Manufacturing overhead

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The choice of method does not affect how data are collected and does affect how costs are
assigned to products

Raw material usage data:

When production is initiated, the issuance of a materials requisition triggers a debit (increase) to
work in process and a credit (decrease) to raw materials inventory. Work in process is credited
and raw materials are debited for any amounts returned to inventory. Many raw materials are bar
coded so that usage data is collected by scanning.

Direct labor costs:

Historically, job time tickets were used to record the time a worker spent on each job task.
Currently, workers may: Enter the data on online terminals and use coded ID badges, which are
run through a badge reader at the beginning and end of each job.

Machinery and equipment usage:

Machinery costs make up an ever-increasing proportion of production costs. Data about

machinery and equipment are collected at each production step, often with data about labor costs.
Until recently, data was collected by wiring the factory so all equipment was linked to the
computer system.

Manufacturing overhead costs:

It includes costs that can’t be easily traced to jobs or processes, such as utilities, depreciation,
supervisory salaries. Most of these costs are collected in the expenditure cycle. An exception is
supervisory salaries, which are collected in the HRM/payroll cycle.
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The Human Resources Management and Payroll Cycle

The HRM/payroll cycle is a recurring set of business activities and related data processing
operations associated with effectively managing the employee workforce. The more important
tasks performed in the HRM/payroll cycle are:

– Recruiting and hiring new employees

– Training
– Job assignment
– Compensation (payroll)
– Performance evaluation
– Discharge of employees (voluntarily or involuntarily)
Payroll costs are also allocated to products and departments for use in product pricing and mix
decisions. The payroll system handles compensation and comes under the purview of the
controller. The HRM system handles the other five tasks and comes under the purview of the
director of human resources. The design of the HRM system is also important because the
knowledge and skills of employees are valuable assets, so HRM systems should: Help assign
these assets to appropriate tasks; and help monitor their continuous development. There are five
major sources of input to the payroll system:

 HRM department provides information about hiring, terminations, and pay-rate changes.
 Employees provide changes in discretionary deductions (e.g., optional life insurance).
 Various departments provide data about the actual hours worked by employees.
 Government agencies provide tax rates and regulatory instructions.
 Insurance companies and other organizations provide instructions for calculating and
remitting various withholdings.
Employee morale is also important. Bad morale leads to high turnover. Employee attitudes affect
customer interactions and are positively correlated with profitability. To effectively track
intellectual capital and human resources, the AIS must do more than just record time and
attendance and prepare paychecks. Payroll should be integrated with HRM so management can
access data about employee-related costs and employee skills and knowledge. The payroll
application is processed in batch mode because: Paychecks are issued periodically and most
employees are paid at the same time.
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The seven basic activities in the payroll cycle are:

 Update payroll master file

 Update tax rates and deductions
 Validate time and attendance data
 Prepare payroll
 Disburse payroll
 Calculate employer-paid benefits and taxes
 Disburse payroll taxes and miscellaneous deductions
1. Update payroll master file
The HRM department provides information on new hires, terminations, changes in pay rates,
and changes in discretionary withholdings. Appropriate edit checks, such as validity checks
on employee number and reasonableness tests are applied to all change transactions. Changes
must be entered in a timely manner and reflected in the next pay period. Records of
terminated employees should not be deleted immediately as some year-end reports.

2. Update tax rates and deductions

The payroll department receives notification of changes in tax rates and other payroll
deductions from government agencies, insurers, unions, etc. These changes occur
periodically

3. Validate time and attendance data

Information on time and attendance comes in various forms depending on the employee’s
pay scheme. Most employees are paid either on an hourly basis or a fixed salary. Many
companies use a time card to record their arrival and departure time. This document typically
includes total hours worked during a pay period. Manufacturing companies may use job time
tickets to record not only time present but also time dedicated to each job. Employees that
earn a fixed salary, e.g., managers and professional staff: Usually don’t record their time, but
supervisors informally monitor their presence. Professionals in accounting, law, and
consulting firms must track their time on various assignments to accurately bill clients. Sales
staffs are often paid on a straight commission or base salary plus commission. Some may
also receive bonuses for surpassing sales targets. Increasingly, laborers may be paid partly on
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 productivity. Some management and employees may receive stock to motivate them to cut
costs and improve service.

4. Prepare payroll
The employee’s department provides data about hours worked. A supervisor confirms the data.
Pay rate information is obtained from the payroll master file. Procedures:

• The payroll transaction file is sorted by employee number (same sequence as master file).
• For each transaction, the payroll master file is read for pay rates, etc., and gross pay is calculated.
• Hourly employees: Gross pay = (hours worked x wage rate) + Overtime + Bonuses
• Salaried employees: Gross pay = Annual salary x Fraction of year worked
Payroll deductions are summed and subtracted from gross pay to obtain net pay. There are two
types of deductions: Payroll tax withholdings and Voluntary deductions. Year-to-date totals for
gross pay, deductions, and net pay are calculated, and the master file is updated. The following
are printed: Paychecks for employees—often accompanied by an earnings statement, which lists
pay detail, current and year-to-date. A payroll register, which lists each employee’s gross pay,
deductions, and net pay in a multi-column format: Is used to authorize the transfer of funds to the
company’s payroll bank account and may be accompanied by a deduction register, listing
miscellaneous voluntary deductions for each employee.

As payroll transactions are processed, labor costs are accumulated by general ledger accounts
based on codes on the job time tickets. The totals for each account are used as the basis for a
summary journal entry to be posted to the general ledger. Other payroll reports and government
reports are produced.

5. Disburse payroll
Most employees are paid either by: Check or direct deposit. In some industries, such as
construction, cash payments may still be made, but does not provide good documentation
Procedures: When paychecks have been prepared, the payroll register is sent to accounts payable
for review and approval. A disbursement voucher is prepared to authorize transfer of funds from
checking to the payroll bank account. For control purposes, checks should not be drawn on the
company’s regular bank account. A separate account is created for this purpose. This will limit
2
the company’s loss exposure and makes it easier to reconcile payroll and detect paycheck
forgeries.

The approved disbursement voucher and payroll register are sent to the cashier. The cashier:

–
Reviews the documents.
–
Prepares and signs the payroll check to transfer the funds.
–
Reviews, signs, and distributes employee paychecks
–
Re-deposits unclaimed checks in the company’s bank account.
–
Sends a list of these paychecks to internal audit for investigation.
–
Returns the payroll register to payroll department, where it is filled with time cards and
job time tickets.
– Sends the disbursement voucher to accounting clerk to update general ledger.
6. Calculate employer-paid benefits and taxes
The employer pays some payroll taxes and employee benefits directly. The employer withholds
federal and state taxes from employee paycheck, along with Medicare tax, and the employee’s
share of Social Security. It may also withhold voluntary deductions such as union dues, United
Way contributions, credit union savings, retirement contributions, etc. In addition, the employer
pays:

– A matching amount of Social Security.

– Federal and state unemployment taxes.
– The employer share of health, disability, and life insurance premiums, as well as
pension contributions.
Some companies offer flexible benefit plans, sometimes called cafeteria-style benefit plans.
Benefit programs increase the demands on the HRM/payroll system for gathering employee data,
disbursing payments and information, etc. Providing access to payroll/HRM information through
a company intranet can help reduce costs.

7. Disburse payroll taxes and miscellaneous deductions

The company must periodically prepare checks or EFT to pay tax and other liabilities.

General Ledger and Reporting System

The general ledger and reporting system (GLARS) include the processes in place to update
general ledger accounts and prepare reports that summarize results of the organization’s
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 activities. One of the primary functions of GLARS is to collect and organize data from: Each of
the accounting cycle subsystems, which provide summary entries related to the routine activities
in those cycles, the treasurer, who provides entries with respect to non-routine activities such as
transactions with creditors and investors, the budget department which provides budget numbers
and The controller, who provides adjusting entries. The information must be organized to meet
the needs of internal and external users. Again, the system must be designed to produce regular
periodic reports and to support real-time inquiries.

The basic activities in the GLARS are:

– Update the general ledger

– Post adjusting entries
– Prepare financial statements
– Produce managerial reports
The first three represent the basic steps in the accounting cycle.

1. Update the general ledger

Updating the general ledger consists of posting journal entries from two sources: Summary
journal entries of routine transactions from the accounting subsystems and individual journal
entries for non-routine transactions from the treasurer. Examples: Issuances or payment of debt
and the associated interest, issuances or repurchases of company stock and paying dividends on
that stock. Journal entries are often documented on a form called a journal voucher. After
updating the general ledger (GL), journal entries are stored in a journal voucher file.

2. Post adjusting entries

Adjusting entries originate in the controller’s office at the end of each accounting period (month,
quarter, year, etc.) and after the initial trial balance has been prepared. The trial balance lists the
balances for all of the GL accounts. If properly recorded, the total of all debit balances equal the
total of all credit balances. There are five types of adjusting entries:

Accruals: An accrual involves an event that has occurred for which the related cash flow has not
yet taken place. Accrued revenue—The Company has delivered a product or service to a
customer but has not yet been paid. Accrued expense—The Company has used up a good or
service but not yet paid for it.
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Deferrals: A deferral involves a situation where the cash flow takes place before the related
revenue is earned or the expense is incurred. Deferred revenue—The Company received
payment for a product or service that was not yet been completely delivered to the customer
(aka, “unearned revenue”). Deferred expense—The Company paid for a good or service which
they had not yet completely used up (aka, “prepaid expense”).
Estimates: Estimates are used to recognize expenses that cannot be directly attributed to a
related revenue and must be allocated in a more subjective or systematic manner. Examples:
Depreciation expense and bad debt expense.
Re-evaluations: Re-evaluations result from: Reconciling actual and recorded values of assets.
Example: Making a lower-of-cost-or-market adjustment to inventory, recording asset
impairment, recording changes in accounting principles.
Error corrections: Error corrections involve correction of errors previously made in the general
ledger.
Journal vouchers for adjusting entries should be stored in the journal voucher file. Once
adjusting entries have been recorded, an adjusted trial balance is prepared from the new balances
in the general ledger. The adjusted trial balance serves as the input for the next step—
preparation of the financial statements.

3. Prepare financial statements

Activities in the preparation of financial statements are as follows:

 Prepare an income statement: The income statement is prepared using the balances in the
revenue, expense, gain, and loss accounts listed on the adjusted trial balance.
 Prepare closing entries: After preparation of the income statement, the revenue, expense,
gain, and loss accounts are closed. Their balances are transferred to retained earnings, so
that this account will have the correct ending balance. If a separate account is kept for
dividends, that account is also closed to retained earnings. Most companies perform
monthly and annual closes.
 Prepare a statement of stockholders’ equity: Reconciles the changes in the stockholder’s
equity accounts (paid-in capital and retained earnings) for the year.
 Prepare a balance sheet: Presents the balances in the permanent accounts: Assets,
Liabilities and Owners’ Equity
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  Prepare a statement of cash flows: Presents changes in cash for the period categorized
by: Operating activities, investing activities and Financing activities.
4. Produce managerial reports
The final step is preparing of reports for internal purposes, including:

 Reports to verify the accuracy of the posting process. Examples: Lists of journal
vouchers by numerical sequence, account number, or date. Lists of general ledger
account balances
 Budgets for planning and evaluating performance. Operating budget: Depicts planned
revenues and expenses for each unit. Capital expenditure budget: Shows planned cash
inflows and outflows for each project. Cash flow budget: Shows anticipated cash inflows
and outflows for use in determining borrowing needs. Budgets and performance reports
should be developed on the basis of responsibility accounting, i.e., reporting results on
the basis of the manager responsible:
 Breaks down financial results by sub-unit. Shows actual costs and variances for
current month and year-to-date for items the subunit controls. The cost of a sub-unit is
displayed as a single line item on the report for the next level up. Contents of the
budgetary performance reports should be tailored to the nature of the unit being
evaluated.
 Cost centers: Examples: Production, service, and administrative departments. Present
actual vs. budgeted costs, focusing only on controllable costs.
 Revenue centers: Example: Sales department. Present actual vs. forecasted sales by
product, geographical category, etc.
 Profit centers: Examples: IT and utilities that charge other units for their services. It
compares actual vs. budgeted revenues, expenses, and profits.
 Investment centers: Examples: Plants, divisions, and other autonomous operating units.
Provide calculations of return on investment.
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