TRANSACTION CYCLES

Transaction cycles are the means through which an accounting system process transactions of
related activities such as sale of goods to customers; acquisition of merchandise and payment to
vendors; production of finished products for sale; and payment to employees for services they had
rendered.

Categories
To understand these transaction cycles, we explore the nature of these cycles using the following five
categories of interrelated major cycles:

Category Inclusion
•  receives order from the customer
•  examines the order for credit worthiness
Revenue and receipt •  ships goods or provides services to customer
•  issues an invoice
•  collects payment
•  issues a purchase order to a supplier
•  receives the goods or services
Expenditure and disbursement
•  records the related liability
•  pays the supplier
•  acquires services from employees
•  monitors and records the time of its employees
Human resources and payroll •  verifies hours and overtime worked
•  calculates gross pay, deductions, and net pay
•  pays the employees
Production or conversion  monitors and records the production of entity’s product for sale
•  generates capital funds from outside investors
Financing and investing
•  invests capital funds to other profitable activities

Entity’s responsibility
A key role of the entity, through its management and those charged with governance, is to design and
implement appropriate set of policies, procedures, forms, and integrated controls for each of these
transaction cycles to minimize the opportunities for fraudulent activities and ensure that
transactions are processed in as reliable and consistent manner as possible.

Auditor’s objective
The auditor should consider and obtain an understanding of these transaction cycles sufficient to
plan the audit and develop an effective and efficient audit approach. Moreover, the auditor will give
emphasis to the following objectives.

 To determine the reliability of financial reporting of the different functions affected by each
transaction cycle.
 To determine the fairness of presentation in accordance with applicable financial reporting
framework of the account balances affected by each transaction cycle.

UNDERSTANDING THE TRANSACTION CYCLES

For a better understanding of these transaction cycles, reader should be aware of the following basic
concepts of each cycle.
General objectives
The following are general objectives of transaction cycles:

 To promote adequate segregation of incompatible duties

 To provide safeguards to entity’s resources

Basic concepts

1. Departments involved, including its functions, objective, and possible control that may be
implemented
2. Forms or documents initiated and processed
The following are the important concepts related to forms or documents initiated and
processed. ü The department that initiated the processing approves the form.
✓The department that initiated the processing is accountable for unused forms. Also, access
to those forms shall be limited to the said department.
✓The notification of forms does not necessarily mean a hard copy shall be forwarded.
Notification can be done thru electronic mail.
✓The department that initiated, received or processed a form shall retain a copy for filing
(not necessarily a hard copy).

Major assumptions
On the following transaction cycles discussed, the following assumptions are used:

1. Entities are operating under normal operating cycle condition. With this, we will only be
accounting for sales and purchases on account.
2. Entities are using imprest and voucher systems.

REVENUE AND RECEIPT CYLCE

The revenue and receipt cycle is comprised of various classes of transactions. It covers two main
transactions, the sale transaction and the collection transaction. This cycle starts when an entity
accepts an order from the customer and ends when the related receivable arising from the sale has
been collected.

Two major business functions are

Business functions •Resources are distributed to customers in exchange for promises of future payments
•Customers pay cash for resources distributed to them
Accounts affected include the following:
• Sales and related sales returns, allowances and discount
Accounts affected
• Receivable, allowance for bad debts and Bad debts expense
• Cash
Departments involved Significant departments affecting the cycle are:
Revenue
•  Sales or Customer order
•  Credit
•  Inventory control or Warehouse
•  Shipping
•  Billing
•  Accounting (inventory, receivable and general)
Receipt
•  Mail room or receptionist
 •  Treasury
•  Accounting (receivable and general)

Forms or documents received, initiated and processed

Form Description Initiated by: Distributed to:

•   Customers
Contains the details of goods
Sales order (order slip; •   Credit
ordered (quantity, prices and Sales department
customer order) •   Shipping
payment terms)
•   Billing
Shipping document (bill Describes the goods to be •   Carrier
of lading or delivery shipped and serves as contract Shipping department •   Customers
receipt) between the entity and carrier •   Billing
Sales invoice (billing Describes the goods sold,
•   Customers
statement or statement of amount due and the terms of Billing department
•   Accounting 
account) payment
Intended to facilitate the
Remittance advice Billing department •  Customers  
accounting for cash collection
Receivable and Treasury •   General
Summarizes transactions
(for sales and collection, accounting
Daily summaries recorded during the day by the
respectively) Mail room •   Treasury       and
different department
(for mail received) Receivable

EXPENDITURE AND DISBURSEMENT CYCLE

The expenditure and disbursement cycle is comprised of various classes of transactions. It covers two
main transactions, the acquisition transaction and the disbursement transaction. This cycle starts
when an entity placed an order to a supplier and ends when the related payable arising from the
acquisition has been paid.

Two major business functions are

Business functions • Resources are acquired from vendors in exchange for obligations to pay
• Entity pays cash to vendors and employees
Accounts affected include the following:
•  Purchases (e.g. Inventory and Supplies)
Accounts affected •  Purchase returns, allowances and discount
•  Payables
•  Cash
Significant departments affecting the cycle are:
Expenditure
•  User (any department within the entity)
•  Purchasing
•  Receiving
Departments involved
•  Accounts payable
•  Accounting (inventory and general)
Disbursement
•  Treasury
•  Accounting (receivable and general)

Forms or documents received, initiated and processed

Form Description Initiated by: Distributed to:
Requisition              Contains the details of the user
User department • Purchasing
slip (purchase requisition) department’s request
•   Vendor
Describes the goods to be •   User
Purchase order acquired (quantity and Purchasing department •   Receiving
description) •   Accounts
payable
Describes the goods received •   Purchasing
Receiving report (quantity, description and Receiving department •   Accounts
condition) payable 
Describes the goods to be
Vendor     (thru      the • Receiving
Shipping document shipped and serves as contract
carrier) report  
between the entity and carrier
Describes the goods sold,
• Accounts
Vendors invoice amount due and the terms of Vendor
payable
payment
Summarizes transactions Accounts payable (for
• General
Daily summaries recorded during the day by the purchases) Treasury
accounting
different department (for payment)

HUMAN RESOURCES AND PAYROLL CYCLE

Human resources and payroll cycle is a continuation of the expenditure and disbursement cycle. 
This cycle covers the entity’s acquisition of services from its employees or personnel.  The following
are main reasons why the auditor is concern with this cycle.

1. Payroll include different categories of employee benefits (short-term; post-employment,

other long-term and retirement) that could significantly affect major elements of financial
statements; and
2. For most entities, significant amount of resources is incurred

Two major business functions are

Business functions • Services are received from employees in exchange for obligations to pay 
• Entity pays cash to employees
Accounts affected include, but not limited to the following:
• Salaries and wages expense and payable
• Premiums expense and payable
Accounts affected
• Withholding taxes payable
• Inventories (for inventoriable salaries and wages)
•Cash
Significant departments affecting the cycle are:
Expenditure
•  User (any department within the entity)
•  Human resources (HR) or Personnel
Departments involved •  Payroll
•  Accounting (inventory and general)
Disbursement and distribution
•  Treasury
•  Accounting (general)
Forms or documents received, initiated and processed

Form Description Initiated by: Distributed to:

It contains all information
related to entity’s employees
from time they are hired up to
their eventual termination.    It
• Payroll (limited
HR                 records (Personnel documents all actions taken by
HR department to payroll related
records or 201 file) the employees or management
information only)
on behalf of an employee.  
Commonly, it also documents
salary rates, deductions, and
other payroll-related information
Describes the number of hours
Daily    time             worked by an employee during a
User department • Payroll
record (DTR) particular day covered by a pay
period
Shows all related payroll
•   Treasury
information  (gross pay, all
Payroll register Payroll •   General
deductions, and net pay) for each
accounting
pay period
Shows payroll information
which is capitalizable or can be • Inventory
Labor                  cost summary Payroll
attributed to a particular job or accounting  
customer order
Shows the cumulative, year-to-
• Accounts
Employee earnings record date summary of earnings and Payroll
payable
deductions of every employee
Payroll (for liability
recognition)
Summarizes transactions
Inventory (for • General
Daily summaries recorded during the day by the
capitalizable labor accounting
different department
costs) Treasury
(for payment)

PRODUCTION OR CONVERSION CYCLE

Production or conversion cycle covers the production of entity’s product for sale. It is where
materials, labor and overhead are converted into finished goods. The primary objective of this cycle
is the proper valuation of inventories and cost of goods sold. Such objective encompasses the proper
allocation of costs to each run made by the production department. In order to attain this, the
production department uses inputs from the expenditure and disbursement cycle and provides
resources and information to revenue and receipt cycle.

Summary of control-related duties and responsibilities

Duties and
Person/s assigned to perform the function Procedures performed by auditor
responsibilities
Custody Physical custody of materials and labor Auditor observes physical count and
documents is normally held by reconciles the result of such count to
 entity’s records.   If held by other
the production department.   Since most parties, auditor may send
of the assets here are highly susceptible to confirmation requests to the
theft and misappropriation, adequate custodian (e.g. third-party
physical controls must be implemented.  warehouses, consignees, agents, or
branches)
The production department is authorized
Auditor reviews production orders
to make normal production runs.   However,
and related documents supporting
in case of special runs (to meet a special
Authorization production runs made by the
order), authorization must come from the
department to determine whether it
board of directors or its authorized
bears the necessary authorization.  
representative.
Transactions are recorded by the cost Auditor normally reviews the
accounting. Daily summaries are then
✓ competency of the individuals
Recording prepared and forwarded to general
making journal entries.
accounting for recording and posting in the
general journal and ledger, respectively. ✓ reconciliation of the general ledger 

FINANCE AND INVESTMENT CYCLE

Finance and investment cycle generally involves three major categories of transactions: investments,
long-term debts, and shareholders’ equity. It covers complicated processes such as accounting for
investments, mergers, long-term liabilities, and equity transactions. Summary of control-related
duties and responsibilities Finance cycle

Duties and Procedures performed by

Person/s assigned to perform the function
responsibilities auditor
Auditor inquires directly to
Unissued equity and debt certificates must be
assigned custodians.   If held
kept by appropriate internal official (e.g.
Custody internally, auditor observes the 
Corporate Secretary) or independent external
accounting of unissued
custodian. 
certificates.
As mentioned, transactions covered in this cycle
involve large amounts of cash or other Auditor reviews minutes of the
Authorization
resources. With this, transactions shall be board of directors meetings.  
approved by the board of directors.
Auditor normally reviews the
✓ competency of the individuals
Transactions are recorded in the general journal
Recording making journal entries.
by personnel in the general accounting.
✓ reconciliation of the subsidiary
and general ledgers

Investment cycle

Duties and Procedures performed by

Person/s assigned to perform the function
responsibilities auditor
Custody Generally, investment certificates are kept as Auditor inquires directly to
follows: assigned custodians thru sending
•   Negotiable certificates – brokerage account of confirmation requests.   If held
•   Titles to real estate – may be kept in a safe internally, the auditor observes
 the accounting for certificates
with the entity or bank safe deposit box    
held.
As mentioned, transactions covered in this
cycle involve large amounts of cash or other
Auditor reviews minutes of the
Authorization resources. With this, transactions shall be
board of directors meetings.  
approved by the board of directors or by
an investment committee.
Transactions are recorded in the general journal Auditor normally reviews the
by personnel in the general accounting.  
✓ competency of the individuals
Moreover, most companies monitor
Recording making journal entries.
transactions in the investment cycle through a
subsidiary ledger/s maintained by the treasury ✓ periodic reconciliation of
department. subsidiary and general ledgers