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ETHICS, FRAUD, INTERNAL CONTROL, AND EXPENDITURE CYCLE

Ethical Issues in Business
Ethics pertains to the principles of conduct that individuals use in making choices and guiding their behavior
in situations that involve the concepts of right and wrong. More specifically, business ethics involves finding
the answers to two (2) questions (Hall, 2016):
• How do managers decide what is right in conducting their business?
• How do they achieve it?
Ethical issues can be divided into four (4) areas: equity, rights, honesty, and the exercise of corporate power.
The table below identifies some of the business practices and decisions in each area with ethical implications.

Table 1. Four (4) Main Areas of Business Ethics

Source: https://images.slideplayer.com/36/10608490/slides/slide_5.jpg

Computer Ethics - It is the analysis of computer technology's nature and social impact and the
corresponding formulation and justification of policies for the ethical use of such technology. There are
three (3) levels of computer ethics. These are (Hall, 2016):
o Pop computer ethics - It is the exposure to stories and reports found in popular media regarding
the good or bad ramifications of computer technology. This level covers several engagements in
newspapers, magazines, and news programs, where these platforms inform the public with
information (e.g., computer-aided robbery, viruses, computerized weapons, etc.) that computer
technology can threaten human values.
o Para computer ethics - It involves taking a real interest in computer ethics cases and acquiring
some skills and knowledge in the field. The person involved in this level is named a “para”

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computer ethicist. By comparison with a paramedic – who is not a physician but who does have
some medical knowledge to administer first aid or basic medical assistance – a para computer
ethicist is not a professional ethicist but does have distinctive knowledge that does not aim to
provide some output like any professional philosopher or lawyer (e.g., information to solve any
computer ethic cases). Rather, it only makes preliminary assessments and identification of
computer ethics cases just for comparisons and possible analysis.
o Theoretical computer ethics - This involves multidisciplinary researchers who apply the theories
of philosophy, sociology, and psychology to computer science to bring some new understanding
to the field. Since it incorporates certain disciplines, this is usually exercised in schools and
normally taught in subjects like computer ethics, computers, society, etc.

Fraud and Accountants

Fraud denotes a false representation of a material fact made by one (1) party to another party intending
to deceive and induce the other party to rely on the fact to their detriment justifiably. According to common
law, a fraudulent act must meet the following five (5) conditions (Hall, 2016):
1. False representation. There must be a false statement or a nondisclosure.
2. Material fact. A fact must be a substantial factor in inducing someone to act.
3. Intent. There must be the intent to deceive or the knowledge that one’s statement is false.
4. Justifiable reliance. The representation must have been a substantial factor on which the injured
party relied.
5. Injury or loss. The deception must have caused injury or loss to the victim of the fraud.
To clearly understand the above conditions, refer to the following:
Gio, the controller of Seasons Company, intentionally reduces the bad debt reserves to increase their
profits, thereby triggering a bonus for the management.
There is fraud involved in the previous example because Gio met all the conditions, which are explained
as follows:
(1) There is false representation because Gio does not present the correct bad debt reserves of Seasons
Company for that particular period;
(2) The material fact is that this misrepresentation will benefit Gio by receiving a higher bonus;
(3) The intent is to deceive the management and misstate the profits for that period;
(4) This misrepresentation can substantiate all the possible damages once it was identified by the
management or any regulatory agencies such as the Bureau of Internal Revenue (BIR);
(5) This act may cause the company to suffer higher bonus expenses. Also, the transaction may entail
higher tax liability for seasons company.
Conversely, assuming that the profit increase was caused by a mistake made by Gio in compiling certain
information, then it is not fraud but only triggers the issue of incompetence since there was no intent
to misstate the financial statement.
Fraud in a business environment has a more specialized meaning. It is an intentional deception,
misappropriation of a company’s assets, or manipulation of a company’s financial data to the perpetrator's
advantage. In accounting literature, fraud is commonly known as white-collar crime, defalcation,

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embezzlement, and irregularities. Auditors encounter fraud at two (2) levels. These are as follows (Hall,
2016):
a. Employee Fraud – It is generally designed to directly convert cash or other assets to the employee’s
personal benefit. This type of fraud usually involves three (3) steps (Hall, 2016):
1. Stealing something of value (an asset)
2. Converting the asset to a usable form (cash)
3. Concealing the crime to avoid detection
b. Management Fraud - It is considered more deceptive than employee fraud because it often escapes
detection until the organization has suffered irreparable damage or loss. The following are the three
(3) defining characteristics of management fraud (Hall, 2016):
1. The fraud is perpetrated at the upper level of management.
2. The fraud frequently involves using financial statements to create an illusion that an entity
is healthier and more prosperous than it is.
3. If the fraud involves the misappropriation of assets, it frequently is shrouded in a maze of
complex business transactions, often involving related third parties.
The Fraud Triangle - It consists of three (3) factors that contribute to or are associated with management
and employee fraud. These are (Hall, 2016):
• Situational pressure, which includes personal or job-related stresses that could coerce an individual
to act dishonestly;
• Opportunity, which involves direct access to assets and/or access to information that controls
assets; and
• Ethics, which pertains to one’s character and degree of moral opposition to acts of dishonesty.
Fraud Schemes - It can be classified in several different ways. However, three (3) broad categories are
defined by the Association of Certified Fraud Examiners (ACFE). These are the following (Hall, 2016):
a. Fraudulent statements - Under this fraud scheme, the misrepresentation of the financial
statement must bring direct or indirect financial benefit to the perpetrator.
b. Corruption - It involves an executive, manager, or employee of the organization in collusion with
an outsider. The ACFE study identifies four (4) principal types of corruption: bribery, illegal
gratuities, conflict of interest, and economic extortion.
o Bribery - It involves giving, offering, soliciting, or receiving things of value to influence an
official in the performance of his or her lawful duties.
o Illegal gratuities - It involves giving, receiving, offering, or soliciting something of value
because of an official act that has been taken. For example, DKI Company gave Robert Ali, the
Revenue Commissioner of Turkey, a sports car to lower the company's tax payable by almost
half a billion dollars. This is considered an illegal gratuity because the gift was given after the
illegal act. On the other hand, if DKI gave the sports car to induce Ali to reduce tax payable,
then it is now considered bribery.
o Conflict of interest - It occurs when an employee acts on behalf of a third party during the
discharge of his or her duties or has self-interest in the activity being performed. An example
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of conflict interest is when an employee works part-time in a company that offers services
that compete with the services of his full-time employer.
o Economic extortion - It is the use (or threat) of force (including economic sanctions) by an
individual or organization to obtain something of value. For example, AB Company, the sole
supplier of raw materials for DC Company’s major product, asks the latter to pay a specific
amount, which is not included in their contract. The purpose of AB Company is to increase its
sales revenue for the year, thereby providing the company with a good image to attract future
investors. In addition, AB Company warns DC that if they refuse to pay that amount, they will
cut immediately all the shipments of raw materials. This is economic extortion because DC’s
refusal to pay that specific amount will cause their business to fail since AB is the sole supplier
of their raw materials.
c. Asset Misappropriation - It involves some form of asset misuse in which assets are either directly
or indirectly diverted to perpetrator’s benefit.
The following are examples of this fraud scheme (Hall, 2016):
o Skimming - It involves stealing cash from an organization before it is recorded on the
organization’s books and records. An example of skimming is an employee who accepts
payment from a customer but does not record the sale.
o Cash larceny - It involves schemes in which cash receipts are stolen from an organization after
they have been recorded in the organization’s books and records. An example is lapping, where
the cash receipts clerk first steals and cashes a check from Customer A. To conceal the
accounting imbalance caused by the loss of the asset, Customer A’s account is not credited.
Later (the next billing period), the employee uses a check received from Customer B and applies
it to Customer A’s account. Funds received in the next period from Customer C are then applied
to Customer B's account, and so on.
o Billing scheme - It is also known as vendor fraud. These are perpetrated by employees who
cause their employer to issue a payment of a false supplier (vendor) by submitting invoices for
fictitious goods or services, inflated invoices, or invoices for personal purchases.
Three (3) examples of billing schemes:
1. Shell company fraud - At first, it requires that the perpetrator establish a false supplier
on the books of the victim company. The fraudster then manufactures false purchase
orders, receives reports and invoices in the vendor's name, and submits them to the
accounting system, creating the illusion of a legitimate transaction.

2. Pass through fraud - It is similar to shell company fraud, except that a transaction occurs.
Again, the perpetrator creates a false vendor and issues purchase orders to it for
inventory or supplies. The false vendor then purchases the needed inventory from a
legitimate vendor. The false vendor charges the victim company a much higher than
market price for that item but pays only the market price to the legitimate vendor. The
difference is the profit that the perpetrator pockets.

3. Pay-and-return – This scheme involves a check-writing authority who intentionally pays

a vendor twice for the same invoice for purchasing inventory or supplies.

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o Check Tampering - It is forging or changing in some material way a check that the organization
has written to a legitimate payee.
o Payroll fraud – It is the distribution of fraudulent paycheck to existent and/or nonexistent
employees.
o Expense reimbursement fraud – It is a scheme in which an employee claims reimbursement of
fictitious or inflated business expenses.
o Theft of cash - It is a scheme that involves the direct theft of cash on hand in the organization.
o Non-cash fraud - It involves the theft or misuse of the victim organization’s non-cash assets.

Internal Control Concepts and Techniques

The internal control system comprises policies, practices, and procedures employed by the organization to
achieve four (4) objectives (Hall, 2016):
1. To safeguard the assets of the firm;
2. To ensure the accuracy and reliability of accounting records and information;
3. To promote efficiency in the firm’s operations; and
4. To measure compliance with management’s prescribed policies and procedures.
Inherent in these control objectives are four (4) modifying assumptions that guide designers and auditors of
internal controls. These are as follows (Hall, 2016):
1. Management Responsibility. This concept holds that establishing and maintaining a system of
internal control is a management responsibility.
2. Reasonable Assurance. The internal control cost system should provide reasonable assurance that
the four (4) broad internal control objectives are met cost-effectively. This means that no internal
control system is perfect, and the cost of achieving improved control should not outweigh its
benefits.
3. Methods of Data Processing. Internal controls should achieve four (4) broad objectives regardless
of the data processing methods used.
4. Limitations. Every system of internal control has limitations on its effectiveness. These include (1)
the possibility of error – no system is perfect, (2) circumvention – personnel may circumvent or
bypass the system through collusion/conspiracy or other means, (3) management override –
management is in a position to set aside control procedures by personally distorting transactions or
by directing a subordinate to do so, and (4) changing conditions – conditions may change over time
and render existing controls ineffective.
Preventive-Detective-Corrective (PDC) Internal Control Model – These are internal control lines of defense
used to block, uncover, and correct any deviations caused by undesirable events.
• Preventive Controls - These are passive techniques designed to reduce the frequency of occurrence of
undesirable events. Preventive controls force compliance with prescribed or desired actions and thus
screen out abnormal events. When designing internal control systems, an ounce of prevention is most
certainly worth a pound of cure. The vast majority of undesirable events can be blocked at this first level.
A well-designed source document is one (1) classic example of preventive control (Hall, 2016).
• Detective Controls - These are the second line of defense for errors or deviations. These devices,
techniques, and procedures are designed to identify and expose undesirable events that elude
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preventive controls.
• Corrective Controls - These are actions taken to reverse the effects of errors detected in the previous
step. There is an important distinction between detective controls and corrective controls. Detective
controls identify and draw attention to anomalies; corrective controls fix the problem.
Sarbanes-Oxley and Internal Control. Sarbanes- Oxley legislation requires the management of public
companies to implement an adequate system of internal controls over their financial reporting process. This
entails providing an annual report addressing the following points (Hall, 2016):
1. A statement of management’s responsibility for establishing and maintaining adequate internal
control;
2. An assessment of the effectiveness of the company’s internal controls over financial reporting;
3. A statement that the organization’s external auditors have issued an attestation report on
management’s assessment of the company’s internal controls;
4. An explicit written conclusion as to the effectiveness of internal control over financial reporting; and
5. A statement identifying the framework used in the assessment of internal controls.
The SAS 78/COSO Internal Control Framework
The Statement on Auditing Standards (SAS) No. 78, which is based on the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) Framework, was developed for auditors and describes
the complex relationship between a firm’s internal controls, the auditor’s assessment of risk, and the
planning of audit procedures. This framework consists of five (5) components: control environment, risk
assessment, information and communication, monitoring, and control activities (Hall, 2016).
• Control Environment - It is the foundation for the other four (4) control components. The control
environment sets the tone for the organization and influences the control awareness of its
management and employees. Important elements of the control environment are as follows
(Hall, 2016):
o Integrity and ethical values of management
o Structure of the organization
o Participation of the organization’s board of directors and the audit committee, if one exists
o Management’s philosophy and operating style
o Procedures for delegating responsibility and authority
o Management’s methods for assessing performance
o External influences, such as examinations by regulatory agencies
o Organization’s policies and practices for managing its human resources
• Risk Assessment - This aims to identify, analyze, and manage risks relevant to financial reporting.
Risks can arise or change from circumstances such as (Hall, 2016):
o Changes in the operating environment that impose new or changed competitive pressures
on the firm
o New personnel who have a different or inadequate understanding of internal control
o New or reengineered information systems that affect transaction processing
o Significant and rapid growth that strains existing internal controls

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• Information and Communication - It consists of records and methods used to initiate, identify,
analyze, classify, and record the organization’s transactions and to account for the related assets
and liabilities. An effective accounting information system will (Hall, 2016):
o Identify and record all valid financial transactions
o Provide timely information about transactions in sufficient detail to permit proper
classification and financial reporting
o Accurately measure the financial value of transactions so their effects can be recorded in
financial statements
o Accurately record transactions in the period in which they occurred
• Monitoring - It is the process by which the quality of internal control design and operation can be
assessed. This may be accomplished by separate procedures or by ongoing activities (Hall, 2016).
• Control Activities - These are policies and procedures used to ensure that appropriate actions are
taken to deal with the organization’s identified risks. Control activities can be grouped into two (2)
distinct categories: information technology (IT) controls, which relate specifically to the computer
environment; and physical controls, which relate to human activities employed in accounting
systems (Hall, 2016).

Expenditure Cycle: Conceptual, Physical, and Computerized Accounting Systems

The objective of the expenditure cycle is to convert the organization’s cash into the physical materials and
the human resources it needs to conduct business.
1. The Conceptual System - This system focuses on information about what needs to be done, not how it
is accomplished. The tasks described in this section may be performed manually or by computer.
Using data flow diagrams (DFDs) as a guide, Figure 1 traces the sequence of activities through two (2)
processes that constitute the expenditure cycle for most retail, wholesale, and manufacturing
organizations. These are purchase processing and cash disbursement procedures (Hall, 2016).

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Figure 1. DFD for Purchase System

Source: Accounting Information System (9th ed.), 2016, p. 211

A. Purchase Processing Procedures

Purchase procedures include the tasks involved in identifying inventory needs, placing the order,
receiving the inventory, and recognizing the liability. The relationships between these tasks are
presented with the DFD in Figure 1. In general, these procedures are applicable both in manufacturing
and retailing firms.

1. Monitor Inventory Records. Firms deplete their inventories by transferring raw materials into the
production process (the conversion cycle) and selling finished goods to customers (revenue cycle).
When inventories drop to a predetermined reorder point, a purchase requisition is prepared and
sent to the prepare purchase order function to initiate the purchase process. The figure below
presents an example of a purchase requisition (Hall, 2016).

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Figure 2. Purchase Requisition

Source: Accounting Information System (9th ed.), 2016, p. 212

2. Prepare Purchase Order. The prepare purchase order function receives the purchase requisitions,
sorted by the vendor if necessary. Next, a purchase order (PO) is prepared for each vendor, as
illustrated in Figure 3. A copy of the PO is sent to the vendor. In addition, a copy is sent to the set-
up accounts payable (AP) function for temporary filing in the AP pending file, and a blind copy is
sent to the receive goods function, where it is held until the inventories arrive. The last copy is
filed in the open/closed purchase order file (Hall, 2016).

Figure 3. Purchase Order

Source: Accounting Information System (9th ed.), 2016, p. 213

3. Receiving Goods. The next event in the expenditure cycle is the receipt of the inventory. Goods
arriving from the vendor are reconciled with the blind copy of the PO. The blind copy contains no
quantity or price information about the received products. The purpose of the blind copy is to

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force the receiving clerk to count and inspect inventories prior to completing the receiving report.
Upon completion of the physical count and inspection, the receiving clerk prepares a receiving
report stating the quantity and condition of the inventories (Hall, 2016).
4. Update Inventory Records. Depending on the inventory valuation method in place, the inventory
control procedures may vary somewhat among firms. Organizations that use a standard cost
system carry their inventories at a predetermined standard value regardless of the price paid to
the vendor (Hall, 2016).
5. Set Up Accounts Payable. During this transaction, the set-up AP function has received and
temporarily filed copies of the PO and receiving report. The organization has received inventories
from the vendor and has incurred (realized) an obligation to pay for the goods (Hall, 2016).
6. Post to General Ledger. The general ledger function receives a journal voucher from the AP
department and an account summary from inventory control. The general ledger function posts
from the journal voucher to the inventory and AP control accounts and reconciles the inventory
control account and subsidiary summary. The approved journal vouchers are then posted to the
journal voucher file. With this step, the purchases phase of the expenditure cycle is completed.
B. The Cash Disbursements Systems
The cash disbursement system processes the payment of obligations created in the purchases system.
The principal objective of this system is to ensure that only valid creditors receive payment and that
the amounts paid are timely and correct. The tasks involved in this system are as follows (Hall, 2016):
✓ Identify Liabilities Due. The cash disbursement process begins in the AP department by identifying
items that have come due. Each day, the AP function reviews the open AP file (or vouchers payable
file) for such items. It sends payment approval through a voucher packet (the voucher and/or
supporting documents) to the cash disbursements department (Hall, 2016).
✓ Prepare Cash Disbursement. The cash disbursements clerk receives the voucher packet and
reviews the documents for completeness and clerical accuracy. For each disbursement, the clerk
prepares a check and records the check number, dollar amount, voucher number, and other
pertinent data in the check register, also called the cash disbursements journal (Hall, 2016).
✓ Update AP Record. Upon receipt of the voucher packet, the AP clerk removes the liability by
debiting the AP subsidiary account or recording the check number and payment date in the
voucher register. The voucher packet is filed in the closed voucher file, and an account summary
is prepared and sent to the general ledger function (Hall, 2016).
✓ Post to General Ledger. The general ledger function receives the journal voucher from cash
disbursements and the account summary from AP. The voucher shows the total reductions in the
firm’s obligations and cash account due to supplier payments. These numbers are reconciled with
the AP summary, and the AP control and cash accounts in the general ledger are updated
accordingly. The approved journal voucher is then filed. This concludes the cash disbursement
procedures (Hall, 2016).
2. Physical Systems - These systems combine computer technology and human activity. The mix of possible
technology/human options creates a continuum. At one end are minimal technology systems that rely
heavily on human involvement in manual procedures. At the other end of the continuum are advanced
technology systems, which replace human activity with automated processes (Hall, 2016).

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Systems at different points on the continuum operate differently and present different internal control
issues. The examples of systems at different points on the continuum are (1) basic technology expenditure
cycle systems; and (2) advanced technology expenditure cycle systems (Hall, 2016).

A. Basic Technology Expenditure Cycle Systems. Under these systems, information flows between
departments via hard-copy documents. The computers used are independent or non-networked. In
addition, maintaining physical files of source documents is critical to the audit trail in such systems. By
walking through the flowchart as illustrated in Figure 4, notice that in many departments, after an
individual completes his or her assigned task, documents are filed as evidence that the tasks were
performed (Hall, 2016).

The following section outlines the key activities in basic technology expenditure cycle systems (Hall,
2016):

• Inventory Control. When inventories drop to a predetermined reorder point, the clerk prepares a
purchase requisition. A copy of the requisition is sent to the purchasing department, and one (1)
copy is placed in the open purchase requisition file.
Note that the inventory control department is separated from the purchasing department, which
executes the transaction to provide proper authorization control.
• Purchasing Department. The purchasing department receives the purchase requisitions, sorts
them by the vendor, and prepares a multipart purchase order (PO) for each vendor. Two (2) copies
of the PO are sent to the vendor. A copy of the PO is sent to inventory control, where the clerk
files it with the open purchase requisition. A copy of the PO is sent to AP for filing in the AP pending
file. One (1) copy (the blind copy) is sent to the receiving department, which is filed until the
inventories arrive. The clerk files the last copy and purchase requisition in the open PO file.
• Receiving. Goods arriving from the vendor are reconciled with the blind copy of the PO. Upon
completion of the physical count and inspection, the receiving clerk prepares a multipart receiving
report stating the quantity and condition of the inventories.
One (1) copy of the receiving report accompanies the physical inventories to the storeroom.
Another copy is sent to the purchasing department, where the purchasing clerk reconciles it with
the open PO. The clerk closes the open PO by filing the purchase requisition, the PO, and the
receiving report in the closed PO file. A third copy of the receiving report is sent to inventory
control, where (assuming a standard cost system) the inventory subsidiary ledger is updated. A
fourth copy of the receiving report is sent to the AP department, where it is filed in the AP pending
file. The final copy of the receiving report is filed in the receiving department.
• AP Department. When the invoice arrives, the AP clerk reconciles the financial information with
the documents in the pending file, records the transaction in the purchases journal, and posts it
to the supplier’s account in the AP subsidiary ledger (voucher register). After recording the liability,
the AP clerk transfers the source documents (PO, receiving report, and invoice) to the open
vouchers payable (AP) file.
• General Ledger Department. The general ledger department receives a journal voucher from the
AP department and an account summary from inventory control. The general ledger clerk
reconciles these and posts them to the inventory and AP control accounts. With this step, the
purchases phase of the expenditure cycle is completed.

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B. Advanced Technology Expenditure Cycle Systems - The purpose of advanced technologies in

accounting information systems is to integrate accounting and other business functions through a
common information system. Integration improves operational performance and reduces costs by
eliminating non-value added tasks. These systems will not be discussed further because their key
activities and processes are the same as the topic of computerized accounting systems.

Source: Accounting Information System (7th ed.), 2011, p. 231

Figure 4. Manual Purchase System

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3. Computerized Accounting Systems. Automation involves using technology to improve the efficiency and
effectiveness of a task. Reengineering involves replacing traditional procedures with innovative
procedures that are often very different from those that previously existed (Hall, 2016).
The following are the departments involved in the automated purchasing system and their corresponding
tasks:
A. Computer Operations Department - The computer application under this department performs the
following tasks automatically:
1. The system reads the purchase requisition file for items that need replenishment. The
requisitions are then sorted by the vendor and matched against the valid vendor file for
vendor address and contact information.
2. Hard-copy purchase orders (PO) are prepared and sent to the vendor.
3. A record is added to the open PO file.
4. A digital transaction listing of POs is created, downloaded by the purchasing agent,
reviewed, and filed in the department.
B. Receiving Department - When the goods arrive, the receiving clerk accesses a blind copy of the open
PO file in real-time by entering the PO number taken from the packing slip. The receiving screen then
prompts the clerk to enter quantities received for each item on the PO. The following tasks are
performed automatically by the systems:
1. A record is added to the receiving report file.
2. Quantities of items received are matched against the open PO record, and the PO is closed
by placing the receiving report number in the PO closed flag.
3. The inventory subsidiary accounting records are updated to reflect the receipt of the
inventory items.
4. The general ledger inventory control account is updated.
C. Accounts Payable Department - When the accounts payable (AP) clerk receives the supplier’s invoice,
the clerk accesses the system and adds a record to the vendor invoice file. The clerk then files the
hard-copy invoice in the department. The following tasks are performed automatically by the system:
1. Using the PO number as a common attribute, the system links the vendor invoice to the
associated purchase order and receiving report records.
2. The system reconciles the supporting documents and creates a virtual AP packet to
authorize payment.
3. The system displays the virtual AP packet on the AP clerk’s computer screen for review. The
virtual AP packet allows the AP clerk to browse the supporting documents and modify
documents if necessary to reconcile quantity or price discrepancies that may exist.
4. Assuming that no discrepancies demand the AP clerk’s intervention, the system
automatically approves the payment and sets a payment due date.

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Payroll and Fixed Asset Cycle: Conceptual, Physical, and Computerized Systems
In a business, payroll processing is a purchasing system wherein the business purchases labor rather than raw
materials or finished goods for resale. Hall (2016) stated that the nature of payroll processing creates the need
for specialized procedures for the following reasons:
• A firm can design general purchasing and disbursement procedures for all vendors and inventory items.
Payroll procedures, however, differ greatly among classes of employees. For example, different
procedures are needed for hourly, salaried, piece, and commissioned employees. Also, payroll
processing requires special accounting procedures for employee deductions and withholdings for taxes
that do not apply to trade accounts.
• General expenditure activities constitute a relatively steady stream of purchasing and disbursing
transactions. Business organizations thus design purchasing systems to deal with their normal activity
level. On the other hand, payroll activities are discrete events in which employee disbursements occur
weekly, semi-monthly, or monthly. The task of periodically preparing large numbers of payroll checks in
addition to the normal trade account checks can overload the general purchasing and cash disbursement
system.
• Writing checks to employees requires special controls. Combining payroll and trade transactions can
encourage payroll fraud.
Although specific payroll procedures vary among firms, an illustration will present the data flow diagram
depicting the general tasks of the payroll system in a manufacturing firm.

Figure 5. The Conceptual Payroll System

Source: Accounting Information System (9th ed.), 2016, p. 253

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The following are the key points of the process (Hall, 2016):
• Personnel Department. This department prepares and submits personnel action forms to the prepare
payroll function. These documents (personnel action forms) identify employees authorized to receive
a paycheck and are used to reflect changes in hourly pay rates, payroll deductions, and job
classification.
• Production Department. Production department employees prepare two (2) types of time records:
job tickets and time cards. Job tickets capture the time that individual workers spend on each
production job. Cost accounting uses these documents to allocate direct labor charges to work-in-
process (WIP) accounts. Time cards capture the time the employee is at work. These are sent to the
prepare payroll function to calculate the employee’s paycheck amount.
• Update Work-in-Process (WIP) Account. After cost accounting allocates labor costs to the WIP
accounts, the charges are summarized in a labor distribution summary and forwarded to the general
ledger function.
• Prepare Payroll. The payroll department receives pay rate and withholding data from the personnel
department and hours worked data from the production department.

A clerk in payroll performs the following tasks:

o Prepares the payroll register showing gross pay, deductions, overtime pay, and net pay
o Enters this information into the employee payroll records
o Prepares employee paychecks
o Sends the paychecks to the distribute paycheck function
o Files the time cards, personnel action forms, and copy of the payroll register

• Distribute Paycheck. Submitting time cards for nonexistent employees is a form of payroll fraud. Many
companies use a paymaster to distribute the paychecks to employees to prevent this. This individual
is independent of the payroll process, meaning he/she is not involved in payroll authorization or
preparation tasks. The paymaster returns the check to payroll if a valid employee does not claim a
paycheck. The reason the check went unclaimed can then be investigated (Hall, 2016).

• Prepare Accounts Payable. The accounts payable (AP) clerk reviews the payroll register for
correctness and prepares copies of a cash disbursement voucher for the amount of the payroll. The
clerk records the voucher in the voucher register and submits the voucher packet (voucher and payroll
register) to cash disbursements. A copy of the disbursement voucher is sent to the general ledger
function (Hall, 2016).

• Prepare Cash Disbursement. Upon receipt of the voucher packet, the cash disbursements function
prepares a single check for the entire amount of the payroll and deposits it in the payroll imprest fund.
The employee paychecks are drawn on this account, which is used only for payroll.

Funds must be transferred from the general cash account to this imprest account before the paychecks
can be cashed. The clerk sends a copy of the check, the disbursement voucher, and the payroll register
to the AP department, where they are filed. Finally, a journal voucher is prepared and sent to the
general ledger function (Hall, 2016).

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• Update General Ledger. The general ledger function receives the labor distribution summary from
cost accounting, the disbursement voucher from AP, and the journal voucher from cash
disbursements.

With this information, the general ledger clerk makes the following accounting entries (Hall, 2016):

From the Labor Distribution Summary

Work-in-Process (Direct labor) xxx

Factory Overhead (Indirect labor) xxx
Wages Payable xxx

From Disbursement Voucher

Wages Payable xxx

Cash xxx
Withholding Tax Payable xxx
PhilHealth Contribution Payable xxx
SSS Contribution Payable xxx
HDMF Contribution Payable xxx

The debits and credits from these entries must be equal. If they do not, there is an error in calculating
either labor distribution charges or payroll. The clerk files the voucher and labor distribution summary
when the equality has been verified.

The Physical Payroll System

The following are the key tasks performed in a manual payroll system (Hall, 2016):
• Payroll authorization and hours worked enter the payroll department from two (2) different
sources: personnel and production.
• The payroll department reconciles this information, calculates the payroll and distributes
paychecks to the employees.
• Cost accounting receives information regarding the time spent on each job from production.
This is used for posting to a WIP account.
• AP receives payroll summary information from the payroll department and authorizes the cash
disbursements department to deposit a single check, in the amount of the total payroll, in a
bank imprest account on which the payroll is drawn.
• The general ledger department reconciles summary information from cost accounting and AP.
Control accounts are updated to reflect these transactions.

The Computerized Payroll System

The following are the two (2) ways to integrate a payroll system in a computerized environment:

1. Automating the payroll system using batch processing. Because payroll systems run periodically,
weekly or monthly, automated payroll systems are well suited to batch processing. Presented
in Figure 6 is the flowchart for an automated payroll system.

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Figure 6. Automated Payroll System

Source: Accounting Information System (7th ed.), 2011, p. 278

The data processing department receives a hard copy of the personnel action forms, job tickets, and time
cards, which it converts to digital files. Batch computer programs perform the check writing, detailed
record keeping, and general ledger functions. This system promotes accounting accuracy and reduces
check-writing errors. Beyond this, it does not significantly enhance operational efficiency; however, for
many types of organizations, this level of technology is adequate (Hall, 2016).
2. Reengineering the payroll system. For moderate-sized and large organizations, payroll processing is
often integrated into the human resource management (HRM) system. The HRM system captures
and processes a wide range of personnel-related data, including employee benefits, labor resource
planning, employee relations, employee skills, personnel actions like pay rates, deductions, and so
on, and payroll. HRM systems must provide real-time access to personnel files forirect inquiries and
recording changes in employee status as they occur (Hall, 2016).
This system differs from the simple automated system in three (3) ways (Hall, 2016):
a) the various departments transmit transactions to data processing via terminals;
b) direct access files are used for data storage; and
c) many processes are now performed in real time.

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• Personnel. The personnel department makes changes to the employee file in real time via terminals. These
changes include additions of new employees, deletions of terminated employees, changes in dependents,
changes in withholding, and changes in job status or pay rate.
• Cost accounting. The cost accounting department enters job cost data—real time or daily—to create the
labor usage file.
• Time-Keeping. Upon receipt of the approved time cards from the supervisor at the end of the week, the
time-keeping department creates the current attendance file.
• Data processing. At the end of the work period, the following tasks are performed in a batch process
(Hall, 2016):
o Labor costs are distributed to various WIP, overhead, and expense accounts.
o An online labor distribution summary file is created. Copies of the file are sent to the cost
accounting and general ledger departments.
o An online payroll register is created from the attendance and employee files. Copies of the files
are sent to the AP and cash disbursements departments.
o The employee records file is updated.
o Payroll checks are prepared and signed. They are sent to the treasurer for review and
reconciliation with the payroll register. The paychecks are then distributed to the employees.
o The disbursement voucher file is updated, and a check is prepared for the fund transfer to the
payroll imprest account. The check and a hard copy of the disbursement voucher are sent to cash
disbursements. One (1) copy of the voucher is sent to the general ledger department, and the final
copy is sent to AP.
o At the end of the processing, the system retrieves the labor distribution summary file and the
disbursements voucher file and updates the general ledger file.

The real-time features of the payroll system provide many of the operational benefits discussed earlier,
including reductions in paper, clerical labor, and the lag time between event occurrences and recording
them. Computerized systems must produce adequate records for independent verification and audit
purposes. Controls must be implemented to protect against unauthorized access to data files and
computer programs.
The Conceptual Fixed Asset System
Hall (2016) discussed that fixed assets are the property, plant, and equipment used in the operation of a
business. These are relatively permanent items that often collectively represent the largest financial
investment by the organization. Examples of fixed assets include land, buildings, furniture, machinery, and
motor vehicles. A firm’s fixed asset system processes transactions on acquiring, maintaining, and disposing of
its fixed assets. The specific objectives of the fixed asset system are to:
o process the acquisition of fixed assets as needed and per formal management approval and
procedures;
o maintain adequate accounting records of asset acquisition, cost, description, and physical location
in the organization;
o maintain accurate depreciation records for depreciable assets under acceptable methods;

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o provide management with information to help plan for future fixed asset investments; and
o properly record the retirement and disposal of fixed assets.
The process of a fixed asset system involves three (3) categories of tasks: asset acquisition, asset maintenance,
and asset disposal (Hall, 2016).
• Asset Acquisition. It usually begins with the
departmental manager (user) recognizing
the need to obtain a new asset or replace an
existing one. Authorization and approval
procedures over the transaction will depend
on the asset’s value. Department managers
are typically able to approve purchases
below a certain materiality limit. Capital
expenditures above the limit will require
approval from the higher management
levels. This may involve a formal cost-benefit
analysis and soliciting bids from suppliers.
Once the request is approved and a supplier
is selected, the fixed asset acquisition task is
similar to the expenditure cycle procedures
with two (2) noteworthy differences. First,
the receiving department delivers the asset
into the custody of the user/manager rather
than a central store or warehouse. Second,
the fixed asset department performs the
record-keeping function.

• Asset Maintenance. This involves

adjusting the fixed asset subsidiary
account balances as the assets, excluding
land, depreciate over time or with usage.

• Asset Disposal. As Hall (2016) discussed,

when an asset has reached the end of its
Figure 7. Computerized Fixed Asset System useful life or when management decides
Source: Accounting Information System (9th ed.), 2016, p. 273
to dispose of it, the asset must be
removed from the fixed asset subsidiary
ledger.

Computerized Fixed Asset System

Figure 7 presents a computerized fixed asset system that demonstrates a real-time processing. The top portion
of the flowchart presents the fixed asset acquisition procedures, the center portion presents fixed asset
maintenance procedures, and the bottom portion presents the asset disposal procedures.

• Acquisition Procedures. The process begins when the fixed asset accounting clerk receives a receiving
report and a cash disbursement voucher. These documents provide evidence that the firm has physically

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received the asset and show its cost. From the computer terminal, a clerk creates a record of the asset in
the fixed asset subsidiary ledger (Hall, 2016).
• Asset Maintenance. The fixed asset system uses the depreciation schedules to record end-of-period
depreciation transactions automatically. The specific tasks include (Hall, 2016):
o calculating the current period’s depreciation;
o updating the accumulated depreciation and book value fields in the subsidiary records;
o posting the total amount of depreciation to the affected general ledger accounts (depreciation
expense and accumulated depreciation); and
o recording the depreciation transaction by adding a record to the journal voucher file.
Finally, a fixed asset depreciation report is sent to the fixed asset department for review.

• Disposal Procedures. The disposal report formally authorizes the fixed asset department to remove
from the ledger an asset disposed of by the user department. When the clerk deletes the record from
the fixed asset subsidiary ledger, the system automatically (Hall, 2016):
o posts an adjusting entry to the fixed asset control account in the general ledger;
o records any loss and gain associated with the disposal; and
o prepares a journal voucher.

A fixed asset status report containing details of the deletion is sent to the fixed asset department for
review.

References

Hall, J. A. (2016). Accounting information system (9th ed.). Taguig City: Cengage Learning Asia Pte Ltd.

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