CHAPTER 2 THEORETICAL FOUNDATIONS. organization which responsible to record and employs physical resources and other

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1 CHAPTER 2 THEORETICAL FOUNDATIONS 2.1 Accounting Information System (AIS) Accounting information system can be defined as an integrated system within an organization which responsible to record and employs physical resources and other components to transform economic data into accounting information (Wilkinson, Cerullo, Raval, & Wong-On-Wing, 2000). Therefore, the sole purpose of AIS is to provide important information that will directly assist the process decision making in the organization s daily operations. To help serve its purpose, AIS is composed of three major subsystems: the transaction processing system, the financial reporting system, and the management reporting system (Hall, 2008). The transaction processing system supports daily business operations with numerous reports, documents, and messages for users throughout the organization; while the financial reporting system produces traditional financial statement and reports that is required by law, such as balance sheet, income statement, and tax returns. Lastly, the management reporting system is the one that help internal management with their decision making, by providing internal management important reports and information that is necessary; such as budgets and variance reports (Hall, 2008). 6

2 7 2.2 Revenue Cycle Nature of Revenue Cycle First of all, revenue is company s generated incomes from its business activities. It can be achieved from goods or services that company offer to the market. Revenue is usually referred as sales or net sales. There are common misconception between revenue and profit. The difference lies on that profit is equal to revenues minus expenses. Therefore, positive revenue does not guarantee positive profit, if the expenses are greater than the revenue; which creates negative profits. Furthermore, revenue cycle is considered to be the modern perspective of sales cycle, where companies follow through the transactions with customers and maintaining long term relationship between them; through revenue cycle management. Revenue cycle is a recurring set of business activities and related information processing operations associated with providing goods and services to customers and collecting payment for those sale (Romney, Marshall B., Steinbart, Paul John., 2006) Business accounting activities which its purpose is to control the exchange of goods and services companies offer with customers cash. Hence, it is a system installed for the purpose of ensuring the flow of the revenue to be on time and as smooth as possible. Revenue cycle management is critical in a firm's decision-making processes. Without an appropriate revenue cycle management strategy, the firm may experience liquidity problems in the short term. Revenue cycle management consists of two major subsystems (Halls, 2008):

3 8 1. Sales Order Processing, which includes tasks such as: Preparing sales orders Granting credit Shipping products to the customers Billing and recording the transaction 2. Cash Receipts, which includes tasks such as: Collecting cash Depositing cash in the bank Recording the events in the accounts General structure of good revenue cycle management system Business environment nowadays is unpredictable and firm should be ready for anything that could happen, and an enhancements in revenue cycle management can help providers tackle new market realities (Buysman, 2010). However, the task of deciding what and which changes are to make can be a dilemma for a firm. To address this issue, Loren Buysman had listed and explained five attributes that describe a good revenue cycle management system, which are: 1. The ability to provide real-time information

4 9 Real-time information access enables providers to make necessary interventions within the revenue cycle in time for their actions to make a difference. Moreover, this type of access can improve relationship with customers. 2. Expectation-based workflow Exception-based workflow is an automated process that can help staff to be more focus on specific objectives that drives the highest value to the company. The system will prioritize tasks and direct staffs to work on the highest monetary value first, thus allowing staff to collect money owed to the company; while on the other hand, making it possible to effectively utilize revenue cycle staff without constantly running reports. 3. Features that support financially aware System to help minimize credit risk and also to let customers know what would their financial obligations will be. Revenue cycle management system will help indicates the customer s ability to pay. With this information, staff can create alternate for that particular customer, such as decreasing the orders allowed for the particular customers to half or to the level where it is certain that the customers could handle.

5 10 4. Virtual business office functionality Virtual business office functionality can be use to organize customers payment, in case of consumers good company. The revenue cycle management provides continuous payment processing and editing, eliminating the need for subsequent payments scrubbing down the line. The credit payment claim is submitted immediately instead a few days after the transactions, which are the typical time lag in the traditional systems. 5. Functionality that supports and enhanced online consumer experience In consumer s good industry, easy access to integrated information can help customers or distributors to gain information regarding prices and credit terms that will help them to manage their finances beforehand. Examples of information that can be offered are pricing and quality transparency, expense estimation, electronic funds transfer, and online bill pay Improvement of Revenue Cycle Risk and problems in revenue cycle mostly lies on the pre and post transaction with the customer. It could be prices given, credit, delivery, and collection. Some of the most common events are the unauthorized discounts to certain customers, additional credit time for customers which have bad credit risk, miss record of transaction, and more importantly incapable of credit collections from the customers. A good flow of payment can optimize the firm s margins, and to have a good flow, the entire revenue cycle must function at peak performance, otherwise the revenue cycle can leak revenue at various

6 11 stage of the process (Clark, 2008). Therefore, the cycle should have a very strong system to support it. Based on Jonathan Clark s theory, there are four steps method to strengthen the revenue cycle and optimize payment. Those steps are: 1. Establish and track the right key performance indicators for each department. 2. Implement the proper organizational structure for the overall revenue cycle 3. Hire outstanding and high performing leaders 4. Implement efficient processes throughout each department Threats and Controls in the Revenue Cycle (Romney, Marshall B. & Steinbart, Paul John., 2003) Table 2.1 Threat and Control of Revenue Cycle Process Threat Control Procedures Sales Order Entry 1. Incomplete / inaccurate customer orders 2. Credit Sales to poor credit customers 3. Legitimacy of orders 4. Stock outs, carrying costs, and markdowns 1. Data entry checks 2. Credit approval by manager, not by sales function 3. Signature on paper document 4. Inventory control systems

7 12 Shipping 5. Shipping Error: Wrong merchandise Wrong quantities Wrong address 6. Theft of inventory 5. Reconciliation of sales order with packing slip 6. Restrict physical access to inventory Billing & A/R 7. Failure to bill customers 8. Billing errors 9. Posting errors in A/R 7. Separation of shipping and billing functions 8. Data entry edit controls; price list 9. Reconciliation of subsidiary A/R ledger with general ledger Cash Collections 10. Theft of cash 10. Segregation of duties, minimization of cash handling General Control Issues 11. Loss of data 12. Poor performance 11. Back up and access control 12. preparation and review of performance report

8 Internal control Definition of Internal Control According to AICPA (American Institute of CPAs, 2009), internal control is a systematic measure that is put in place to keep the organization on course toward profitability goals and achievement of its mission and to minimize surprises along the way (Ratcliffe, Landes, 2009). Ratcliffe also states that internal control will provide efficiency, reduce risks of asset loss, and helps ensure the reliability of financial statements and compliance with laws and regulations (Hall, 2008), There are four objectives of internal control system, which are: Safeguards organization s assets and resources Internal control system perform a routine checks, which included assets and resources verifying. With regular checks, organization s assets and resources exposures to risk and fraud can be reduce to minimal. Ensure accuracy and reliability of organization s accounting data Internal control system is able to detect any error or misinterpret of data by performing routine verification. Support efficiency (reliability and time) of its operations With the data ensured to be accurate and reliable, errors will be very unlikely; therefore, operations can run efficiently and reliably.

9 14 To encourage fulfillment to organization s policies and plans Routines check and control will direct organization s operations towards the company s goal. These days, internal controls are considered to be very essentially important in business; regardless of the business size. Its main purpose is to help managers work with employees, customers, and creditors to be more efficient and effective (Noordin, 1997) Internal Control Components Based on Committee of Sponsoring Organization (COSO) under SAS 78, there are five main elements of internal controls which will ensure it to achieve its objectives (Geiger, 2004); they are: 1. Control Environment The internal control environment is the first and the base foundation for all internal controls elements. It includes all of the actions, method, and disciplines necessary to achieve good internal control. Based on AICPA, those actions and disciplines are: Integrity and ethical values Nowadays, ethics and integrity are viewed very differently than in the past. Integrity and values today are considered the foundation for sustainable values, code of conducts and performance drivers; which will guide decision making during crucial time, when there are no rules, when rules are unclear, or when existing rules would lead to the wrong

10 15 conduct (Verschoor, 2004). Moreover, according to COSO, management integrity and ethical behavior represents the corporate culture which can act as a strong form of control (Accola, 1992). Commitment to competence Commitment to competence refers to the need for employees to have the necessary knowledge and competence to perform their duties properly (Sage, 2006). It is one factor that will help inspire employees to have high motivation and performance by creating a positive atmosphere and harmony. Board of directors or audit committee Both directors and committee should be independent from management. Sufficiency and timeliness with which information is provided to board or committee members, to allow monitoring of management s objectives and strategies, the entity s financial position and operating results, and terms of significant agreements (AICPA, 1994). Management philosophy and operating style Ways of dealing with financial report, which can also be describe as management attitudes. Example: High Risk undertaking or Risk calculating (AICPA, 1994).

11 16 Organizational structure The appropriateness of the entity s organizational structure, and to provide the necessary information flow to manage its activities (AICPA, 1994). Assignment of authority and responsibility Assignment of responsibility and delegation of authority to deal with organizational goals and objectives, and assigning appropriate numbers of people with the necessary skills level for the complexity of the activities and system (AICPA, 1994). Human resources policies and practice Company s standard policies in regards to hire, train, and promote employees. For examples, prior to hiring employee, company should do a background check to consider whether the employee is considered to be acceptable or unacceptable based on the policies. 2. Risk Assessment Risk assessment is the identification, analysis, and management of risks relevant to the preparation of financial statements presented in conformity with generally accepted accounting principles (GAAP).

12 17 3. Control Activities Actions and procedures that can be taken to insure control on firm s objectives; such as: Performance reviews Performance review is used to evaluate employee s work performance, where it will show employee s strength and weaknesses, thus controlling employee s quality. From this review, company can decide whether or not the employee s performance is in line with company s goal. Information processing Processing data gathered into useful information that can be use by management to impose controls and reduce exposure to risk. Physical controls Physical controls are also considered as manual controls that rely only on human activities, without any helps from computer logic (Halls, 2008). Segregation of duties It is a form of control where incompatible duties should be separated to minimize risk and fraud, by limiting the staff access to the available information. For examples, inventory control staff should be different with staff that is in purchasing department (Halls, 2008).

13 18 4. Information and Communication Information system: o Identify and record all valid transaction o Describe transactions in sufficient detail to permit proper classification o Measure value of transactions to ensure proper valuation o Determine proper time period of transaction o Proper presentation and disclosure of financial information Communication o Providing an understanding of individual roles and responsibilities pertaining to internal control over financial reporting 5. Monitoring Monitoring is the part where quality controls of operations and designs are done regularly. It must be done with well-timed schedule to ensure that the controls are operated as intended. In addition, any corrective actions in the controls that are needed for it to better serve its purpose can be done immediately to eliminate potential risk and waste of resources.

14 General Structure of good internal control Based on Conor s (2004) work, he listed six-point of control procedures which an organization should implement in order to have standardized model of a good internal control structure: 1. Segregation of Duties It is the first and the most important control of the structure. Segregating employees duties will reduce incompatible functions, and will eliminate any chances of fraud from employees daily duties. 2. Authorization Procedures An organization should also have authorization process as a preventive back up to the segregation. Its purpose is to make certain that all the transactions are valid, and at the same time it limits employees authority to make a decision. 3. Independent Checks This step can also be called verification procedures. Actions such as comparing internal data with external data, and checking numerical accuracy are taken in this step, to spot any errors and misinterpretations that might took place.

15 20 4. Physical Control Assets Conor divided physical control into two parts: assets and books & records. Physical controls of assets are the same as an access control. It limits direct access to company s assets, which then also act as a preventive action of theft and fraud from unauthorized personnel. 5. Physical Control Books and Records On the other hand, physical controls of books and records serve the same purpose as physical control of assets. However, it limits direct access to records instead of assets, which prevent any scheme of records manipulation. 6. Adequate Documentation Make sure that all the recorded document are controlled and approved to the standard of the organization.