CHAPTER 13

THE EXPENDITURE CYCLE: PURCHASING TO CASH DISBURSEMENTS

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. 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:
1. What must be done to ensure that AOEs inventory records are
current and accurate to avoid unexpected components shortages like
those experienced at the Wichita plant?
2. How could the problems at the Dayton plant be avoided in the
future? What can be done to ensure timely delivery of quality
components?
3. Is it possible to reduce AOEs investment in materials
inventories?
4. How could the information system provide better information to
guide planning and production?
5. How could IT be used to further reengineer expenditure cycle
activities?

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 to be
ordered, 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.
The 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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Expenditure Cycle Business Activities

Figure 13-2 on page 373 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
3. Paying for goods, supplies, and services

Order Goods

The first major business activity in the expenditure cycle (circle 1.0
in Figure 13-2) 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:
1. Inaccurate inventory records
2. 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 doesnt 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.
1. Ordering Costs include all expenses associated with
processing purchase transaction.
2. Carrying Costs are those associated with holding
inventory.
3. Stockout Costs are those cost that result from inventory
shortages, such as lost sales or production delays.
4. The Reorder Point is when to order based on delivery time
and safety stock levels.

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5. Optimal Order Size

EOQ =
D =
P =
C =
the

2 DP
C
Demand in units for a specified period
Relevant ordering cost per purchase order
Relevant carrying cost of one unit in stock for
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.
1. MRP systems schedule production to meet forecasted sales;
thereby creating a stock of finished goods inventory.
2. 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 13-4 on page 379) is a
paper or electronic form that identifies who is requesting
the goods; where they should be delivered; when theyre
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 13-4 on page
379 is a document, or electronic form, that identifies the
requisitioner, specifies the delivery location and date needed,

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identifies the item numbers, descriptions, quantity and price of

each item requested; and may suggest a supplier.
Figure 13-4 on page 379 shows a typical purchase requisition data
entry screen used in ERP systems.
Generating Purchase Orders
A crucial decision is the selection of supplier for inventory
items. Several factors should be considered in making this
decision:
1. Price
2. Quality of materials
3. Dependability in making deliveries
Once a supplier has been selected for a product, their identity
should become part of the product inventory master file. Its
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 13-5 on page 381 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 another 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.

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Reverse auctions provide another technique to reduce purchasingrelated expenses. In reverse auctions, suppliers compete with one
another to need demand at the lowest price.
One 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.

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.
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 13-6 on
page 385 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 suppliers 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 the 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
3. Receiving goods of inferior quality that fail inspection
In all three cases, the purchasing department must resolve the
situation with the supplier.

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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.
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 companys 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

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

1. Approval of vendor invoices

2. 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:
1. Non-Voucher systemEach approved invoice is posted in the
suppliers records in accounts payable, filed, and is
then stored in an open invoice file.

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When a check is written, the invoice is removed from the

open invoice file, marked paid and then stored in a
paid invoice file.
2. Voucher systemA 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
which accounts will be debited and credited, along with
the account numbers.
There are three advantages for using disbursement vouchers:

1. Several invoices may be paid at once (reducing number of

checks).

2. Vouchers can be pre-numbered, which simplifies tracking all

payables.

3. 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.
The cashier reviews the voucher package, approves the payment,
prepares the check for payment, and signs the check.

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.
Procurement cards provide one way to eliminate the need for accounts
payable to process many small noninventory invoices. A procurement

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card is a corporation credit card that employees can use only at

designated suppliers to purchase specific kinds of items.
Using corporate credit cards for travel expenses further reduces the
number of invoices that need to be processed.
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 percent 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 13-2 on page 389 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.
Medtronics application of process improvement techniques yielded
a dramatic improvement in the efficiency and effectiveness of its
Accounts Payable function:
1. The time required to open the mail, sort, process, and
record vendor invoices dropped from 3 days to 1 day.
2. The number of invoices for which discounts for prompt
payment were taken increased by 15 percent.
3. Payment processing times were cut by 50 percent.

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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

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.

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.
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.
8. All disclosures are full and fair.

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Order Goods
Threat 1Stock-outs 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; barcoding inventory; and periodic physical counts.
Threat 2Ordering 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 3Purchasing 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 highcost and specialized products; review of purchase orders;
budgetary controls and responsibility accounting; and
performance review.
Threat 4Purchasing Goods of Inferior Quality
Sometimes purchasing goods at the lowest possible price
sacrifices quality of the goods.
Controls: Use of approved supplier list; review of purchase
orders; tracking of supplier performance; purchasing
accountability for rework and scrap.
Threat 5Purchasing 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 6Kickbacks

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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
companys POS system to automatically manage inventory:
1. At what point in the process can the order be
canceled?
2. Which party is responsible for the cost of return
freight if contract terms are not followed?

3. Which party is responsible for errors in bar codes,

RFID tags, and labels?

4. What happens if errors in the purchasing companys

POS system cause additional errors in the amount of

goods that suppliers provide?

5. 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.

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 7Receiving Unordered Goods
Controls: Accept goods only when theres an approved purchase
order.
Threat 8Errors in Counting Received Goods
Controls: Bar-coding of ordered goods; quantities blanked out
on receiving forms; signature of receiving clerks; bonuses for

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catching discrepancies; re-counting of items by inventory

control.
Threat 9Stealing 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:
1. Pay only for goods and services that were ordered and
received.
2. Safeguard cash.
Threat 10Failing 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 11Paying for Goods not Received
Controls: Compare invoice quantities to quantities reported by
receiving and inventory control; use tight budgetary controls.
Threat 12Failing to Take Available Purchase Discounts
Controls: File and track invoices by due date; prepare cash
flow budgets.
Threat 13Paying the Same Invoice Twice
Controls: Approve invoices only with complete voucher package;
pay only on original invoices; cancel invoices once paid; use
internal audit to detect and recover overpayments; control
access to accounts payable master file.
Threat 14Recording and Posting Errors in Accounts Payable
Controls: Data entry and processing controls; reconcile
supplier balances with control accounts.
Threat 15Misappropriation 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 or positive pay; provide strict logical and access
controls for EFT; log, encrypt, stamp, and number all EFT

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transactions; monitor EFT transactions; and use embedded audit

modules.
General Control Issues
Threat 16Loss, 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 17Performing Poorly
Controls: Performance reports.

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