MODULE 1:

TRANSACTION CYCLES AND BUSINESS PROCESSES

TRANSACTION PROCESS SYSTEM

An economic event that affects the assets and equities of the firm, is reflected in its accounts, and is measured in
monetary terms. Transaction Processing System (TPS) Is an activity consisting of three major subsystems called cycles:
the revenue cycle, the expenditure cycle, and the conversion cycle.

Even though each cycle performs different specific tasks and supports different objectives, they share common
characteristics:
 all three TPS cycles capture financial transactions
 record the effects of transactions in accounting records; and
 provide information about transactions to users in support of their day-to-day activities.

Transaction cycles produce much of the raw data from which management reports and financial statements are derived.
Because of their financial impact on the firm, transaction cycles command much of the accountant’s professional
attention.

FIG. 1: Relationship between Transaction Cycles

A. The Expenditure Cycle

Business activities begin with the acquisition of materials, property, and labor in exchange for cash—the expenditure
cycle. From a systems perspective, this transaction has two parts: a physical component (the acquisition of the
goods) and a financial component (the cash disbursement to the supplier). A separate subsystem of the cycle
processes each component.
 Purchases/accounts payable system
 Cash disbursements system
 Payroll system
 Fixed asset system

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B. The Conversion Cycle
The conversion cycle is composed of two major subsystems:
 Production System
 Cost Accounting System

Manufacturing firms convert raw materials into finished products through formal conversion cycle operations. The
conversion cycle is not usually formal and observable in service and retailing establishments. Nevertheless, these
firms still engage in conversion cycle activities that culminate in the development of a salable product or service.

C. The Revenue Cycle

Firms sell their finished goods to customers through the revenue cycle, which involves processing cash sales, credit
sales, and the receipt of cash following a credit sale. Revenue cycle transactions also have a physical and a financial
component, which are processed separately. The primary subsystems of the revenue cycle are:
 Sales order processing
 Cash receipts

ACCOUNTING RECORDS
A. Manual Records
This section describes the purpose of each type of accounting record used in transaction cycles. We begin with
traditional records used in manual systems (documents, journals, and ledgers) and then examine their magnetic
counterparts in computer-based systems.
a. Documents
A document provides evidence of an economic event and may be used to initiate transaction processing. Some
documents are a result of transaction processing.
i. Source Documents
Economic events result in some documents being created at the beginning (the source) of the transaction.
These are called source documents. Source documents are used to capture and formalize transaction data
that the transaction cycle needs for processing.
Fig. 1: Source Document

ii. Product Documents

Product documents are the result of transaction processing rather than the triggering mechanism for the
process.

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 Fig. 2: Product Document

iii. Turnaround Documents

Turnaround documents are product documents of one system that become source documents for another
system. A turnaround document contains important information about a customer’s account to help the
cash receipts system process the payment.
Fig. 3: Turnaround Document

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b. Journals
A journal is a record of a chronological entry. At some point in the transaction process, when all relevant facts
about the transaction are known, the event is recorded in a journal in chronological order. Documents are the
primary source of data for journals.
Fig. 4: Sales Order recorded in a Sales Journal

i. Special Journals
Special journals are used to record specific classes of transactions that occur in high volume. Such
transactions can be grouped together in a special journal and processed more efficiently than a general
journal permits. The term register is often used to denote certain types of special journals. For example, the
payroll journal is often called the payroll register. We also use the term register, however, to denote a log.

ii. General Journals

Firms use the general journal to record nonrecurring, infrequent, and dissimilar transactions. For example,
we usually record periodic depreciation and closing entries in the general journal.

As a practical matter, most organizations have replaced their general journal with a journal voucher system.
A journal voucher is actually a special source document that contains a single journal entry specifying the
general ledger accounts that are affected. Journal vouchers are used to record summaries of routine
transactions, nonroutine transactions, adjusting entries, and closing entries. The total of journal vouchers
processed is equivalent to the general journal.

c. Ledgers
A ledger is a book of accounts that reflects the financial effects of the firm’s transactions after they are posted
from the various journals. Whereas journals show the chronological effect of business activity, ledgers show
activity by account type. A ledger indicates the increases, decreases, and current balance of each account.
Fig. 5: Flow of Information from the Economic Event to the General Ledger

i. General Ledgers
The general ledger (GL) summarizes the activity for each of the organization’s accounts. The general ledger
department updates these records from journal vouchers prepared from special journals and other sources
located throughout the organization.

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 ii. Subsidiary Ledgers
Subsidiary ledgers are kept in various accounting departments of the firm, including inventory, accounts
payable, payroll, and accounts receivable. This separation provides better control and support of operations.
Any event incorrectly recorded in a journal or subsidiary ledger will cause an out-of-balance condition that
should
be detected during the general ledger update.

d. Audit Trails
The accounting records described previously provide an audit trail for tracing transactions from source
documents to the financial statements. Of the many purposes of the audit trail, most important to accountants
is the year-end audit.

The audit of AR often includes a procedure called confirmation. This involves contacting selected customers
to determine if the transactions recorded in the accounts actually took place and that customers agree with the
recorded balance. Information contained in source documents and subsidiary accounts enables the auditor to
identify and locate customers chosen for confirmation.

The auditor performs similar tests on all of the client firm’s major accounts and transactions to arrive at an
overall opinion about the fair presentation of the financial statement. The audit trail plays an important role in
this process.

B. Computer-Based Systems
Audit trails in computer-based systems are less observable than in traditional manual systems, but they still exist.
Accounting records in computer-based systems are represented by four different types of magnetic files: master
files, transaction files, reference files, and archive files.
a. Master File
A master file generally contains account data. The general ledger and subsidiary ledgers are examples of master
files. Data values in master files are updated from transactions.

b. Transaction File
A transaction file is a temporary file of transaction records used to change or update data in a master file. Sales
orders, inventory receipts, and cash receipts are examples of transaction files.

c. Reference File
A reference file stores data that are used as standards for processing transactions. Other reference files include
price lists used for preparing customer invoices, lists of authorized suppliers, employee rosters, and customer
credit files for approving credit sales.
d. Archive File
An archive file contains records of past transactions that are retained for future reference. These transactions
form an important part of the audit trail. Archive files include journals, prior-period payroll information, lists of
former employees, records of accounts written off, and prior-period ledgers.

e. Digital Audit Trails

Like the paper trail, this digital audit trail allows transaction tracing. Again, an auditor attempting to evaluate
the accuracy of the AR figure published in the balance sheet could do so via the following steps provided in
Fig. 6

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Fig. 6: Accounting Records in a Computer-Based System

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