Accounting is classified by underlying business processes, called “accounting cycles”. These processes include revenue and receipts, purchases and payments, payroll, fixed assets, financing, and general ledger.
Several cycles are basically variations of others, thus the core accounting cycles of revenue, expenditures, and general ledger discussed in this post.
Revenue and Receipts Cycle
The revenue and receipts (sales) cycle includes all systems that record the sale of goods and services, and receive and record customer remittances (see chart below.) The details of a product sold for a price, or of professional services rendered for a fee, are set out in a document called a sales invoice (or just “invoice”.) Details of all sales invoices are listed in the sales journal.
When the customer pays, the company records the payment on a deposit slip ultimately listed in the cash receipts journal or receives notification of an electronic funds transfer (EFT) payment.
Companies keep a list of those customers who owe money, produced by comparing the sales journal and the cash receipts journal.
For customers who purchase on credit terms, transactions are recorded in the accounts receivable journal. It is usually prepared monthly, for each customer listed, the balance owed and the aging of the receivable—that is, if the customer has owed the money for 30, 60, 90, or more than 90 days.
Customer ledgers are used to depict a specific customer’s sales and payment transactions and are often analyzed for critical customers or customers whose account is significantly aged (especially over 90 days past due).
The system of sales, receipts, and receivables constitutes the revenue cycle of any company. The primary documents are the sales invoice (evidence of the sale to the customer) and the deposit slip (evidence of the customer’s payment to the company). The best evidence of payment is a customer’s cancelled check. With the advent of electronic check clearing, checks are truncated at some point of the banking system and not physically returned to the payer.
Purchases and Payables
The purchases and payables cycle (also known as the expenditures or disbursements cycle) includes all systems that record the acquisition of goods and services for use in exchange for payment or promises to pay. See the next chart:
In order to produce its product for sale, a company makes various types of expenditures. These may be for acquiring land, buildings, and equipment; purchasing materials and supplies; and paying company employees. Purchases are made from many different suppliers. A supplier’s invoice is evidence of a transaction.
This invoice is sent to the company and sets out the details of the transaction. The company lists certain details of the supplier’s invoice in the purchase journal.
If the company has the funds available, the supplier usually is paid within 30 or 60 days (according to payment terms set by agreement or in the invoice). This payment is evidenced by the company’s cancelled check. All checks are recorded in the company’s check disbursements journal when they are issued. This journal is simply a list of the checks paid to the various suppliers and other creditors and individuals doing business with the company.
Most companies attempt to keep track of what they owe suppliers. The company prepares an accounts payable listing by comparing what is recorded in the purchases journal with what is recorded as paid in the check disbursements journal. This list may detail how long various suppliers have been owed (e.g., 30, 60, or 90 days). Accounts payable listings for specific vendors are known as vendor ledgers.
Auditors often watch the most common group of asset misappropriation frauds is fraudulent disbursements. Therefore, this cycle is ripe with possibilities of fraud detection in the average organization, if a fraud occurs. These frauds often involve collusion or override of controls, so monitoring and supervision are key to control.
General Ledger and Financial Reporting
Transactions listed in each of the four journals (sales, receipts, purchases, and disbursements) are totaled and entered into the general ledger. General ledger reports can be organized in a variety of ways: by journal totals, by primary accounts (assets, liabilities, and equity) and in total, by month or other cross-sections.
More important than the form is the fact that adjusting journal entries and other transactions are sometimes made directly to the general ledger account or directly to the financial statements and not through the applicable journal.
Nearly all systems have a way to place a journal entry into the general ledger through the general journal during the financial reporting process.
Mistakes and errors do occur in accounting and to correct them, an entry is made in the general journal. Even if no mistakes are made, the nature of certain transactions or the design of accounting processes lend themselves more efficiently to journal entries. For example, estimate transactions, such as the allowance for bad debt and associated expense, are often calculated based on data from the general ledger, prevailing market conditions, and other judgmental factors, which can be difficult to automate or due to dependencies lend themselves to journal entries.
An example of business process design around journal entries are outsourced payroll where the entity receives a detailed report of payroll expenses, but for various reasons including efficiency, records the total payroll expense through a journal entry.
Traditionally, the general ledger served as the complete set of financial statements for financial reporting. However, statements are more complex today and many companies produce their financial statements by extracting data from the general ledger and entering additional transactions in spreadsheets or other methods outside the system.
The risks associated with edits to financial statements outside the general ledger are similar to journal entries.
While most entries made in these manners are perfectly legitimate, such entries potentially bypass several steps in the accounting process. Normally, sales occur that will be related to receipts; those receipts and the process of matching sales to receipts provide a paper trail. The sale gives credibility to the receipt and vice versa.
The process and credibility of general journal entries is dependent on the effectiveness of the controls for adjusting entries.
Adjusting entries should set out a documented explanation for the correction, supporting evidence, and normally evidence of management approval. A list of recurring journal entries and other typical transactions to record during the ‘‘close’’ (financial statement production) process should be documented and approved.
The next two exhibit (“Documents in Revenue Cycle” and “Documents in Expenditures Cycle”) illustrate the components and end product of the general ledger:
Documents in Revenue Cycle
Documents in Expenditures Cycle
Due to the critical role the general ledger plays in producing financial statements and other reports, entries to the general ledger present a significant fraud risk for auditors. Financial statement frauds often employ journal entries either to create fictitious revenues or assets or to cover up the fraud.
Normally, valid and invalid adjusting entries occur at the end of fiscal years or other time periods (months, quarters, etc.). Frauds have been discovered many times when managers, especially executives, booked fictitious revenues in the last quarter of the year to increase the profits of the organization.
From an internal perspective, controls over all adjusting general ledger entries should be strong and firmly in place.
Cash Flow and Reconciliations
Reconciliations are comparisons of two sources of data and subsequent resolution of any differences. Reconciliations occur in many places in the accounting information system. Typically entities reconcile sub-ledgers with the general ledger to ensure complete and accurate entry and processing of data occurred. The reconciliations most understood and most closely related to fraud are bank reconciliations.
The cash the company receives (as recorded in the cash receipts journal) and the monies the company pays out (as recorded in the check disbursements journal) are processed through the company’s bank account.
To ensure that the transactions recorded in these journals agree with those shown on the bank statement, a monthly bank reconciliation is prepared.
The bank reconciliation accounts for the transactions processed by the bank and those executed by the entity but not processed by the bank as of the statement date (for example, un-cashed checks sent to vendors) in the comparison of the entity’s bank balance according to the bank statement and the bank balance according to the accounting information system. Below chart shows this process:
The bank reconciliation is one of the more important functions management can oversee, because in the end, frauds typically involve monetary transactions, the money must go somewhere, and it always leaves a trail in the accounting system. The most common frauds are disbursement frauds, and the bank reconciliation can often reveal the fraud.
Too often, however, the bank reconciliation is not performed, is performed by the perpetrator, or goes unmonitored by management. Management should consider segregating the bank reconciliation step from other steps in the disbursement cycle, or personally reviewing the bank reconciliation.
In regard to fraud, the asset misappropriation type of fraud (generally perpetrated by employees) is almost always associated with cash coming in or cash going out of the business. Theft of inventory or other ‘‘liquid’’ (easily convertible to cash) assets is a small percentage of asset misappropriation frauds. Therefore, the positions that employees hold along the trail of cash coming in and going out are key positions and critical control points to prevent and detect fraud. The employees who hold these positions generally are believed to be trustworthy. Organizations should continuously consider if adequate controls are in place over cash (background checks, bank reconciliations, secondary approvals of wire transfers, etc.)