Chapt# 5: ACCOUNTING TRANSACTION CYCLES

Introduction:-
 Transaction Cycle:- A set of accounting transaction occurring in normal sequence and used to record
economic events. For example, a sales transaction is normally followed by a shipping transaction, a
billing transaction, a cash receipt transaction, thus, constitutes a cycle.
 The chapter explain four transaction cycles, that is, financial cycle, expenditure cycle, revenue cycle,
conversion cycle. Detail description is explained in later chapter.
Economic Events
An economic event is an action taken by an organization affecting its assets, liabilities and owner
equity.
Transaction:- Economic events produces transaction that must be process by an accounting system. In
other words, economic event is recorded in the form of transaction in an accounting system by using
specific rules of accounting.
Difference b/w event & transaction
Every incident that may change the status of a person, a community or an organization is called event.
But when an incident occur in monetary term, that is, when money is involved it is called transaction.
So we can say “ All transactions are events but all events are not transactions.
 The Cycle of Business Activities
 Even though businesses are differ in their
operations, however all of them engage in a cycle
of basic activities, common to most of them. Since
these basic activities are repeated in the form of a
cycle therefore it is called cycle of business
activities (as shown in the illustration).
 The cycle composed of four basic activities;
 1. Capital Investment
 2.Input Acquisition
 3. Conversion
 4.Sales
1. Capital Investment
 The cycle of business activities begins when capital is invested in a
business. The capital may comes from;
 I) Owners:- If source is from the owners, then the investment is called
owner equity.
 II) Creditors:- if the source is from the borrowing, then investment is
either long-term debt or current liabilities.
 In many businesses, most of the capital is used to purchase long term
productive assets such as property, plant & equipments etc. The
productive assets is used to increase its capital.
 Periodically, the business reports the results of its operation in the form
of financial reports to the sources of capitals, that is, investors/owners &
creditors.
 Economic Events:- The capital investment component of the business activities
has two significant economic events. These are 1) Raising Capital 2) Using capital to
acquire productive assets.
 Non Economic Event: Another event during this activity is not economics in the sense of the
other two is that the business periodically reports to its sources of capital.
2. Input Acquisition
 The second component of the cycle is the acquisition of
material & overhead items. These inputs are used to increase
the capital of the business.
 Since most businesses operate on credit. Hence when a
business purchase inputs, it receives inputs in return for a
promise to pay for them. The business record an obligation to
pay, and pay for them at a later date. So the activity of input
acquisition has four economic events.
 Economic events: I) Ordering of inputs II) Receiving the inputs
III) Recording an obligation to pay for them. IV) Paying for the
inputs
3. Conversion
 The third step in the cycle of business activities is the conversion of inputs into
goods or services.
 The conversion process is different for different businesses. For instance,
 Manufacturing companies buy raw materials, apply labor & overhead to them,
and produce finish goods different form the materials purchased.
 Service companies convert input that are predominantly labor into out put in
the form of service.
 In contrast of service companies, the conversion process of merchandising
businesses ( retailers & wholesalers) uses relatively little labors. They purchases
ready to sales finished goods, repackage them and then market them/ sell them.
 Economic Events: A single economic event taking place during the conversion is
the consumption of labor, material & overhead to produce salable product or
service.
4. Sales
 The final component in the cycle of business activities is the sales
of goods or services that were out put of conversion process.
 Capital investment of the business is increases when the goods or
services sold at a profit. The profit so generated is reinvested in
the business or paid to the sources of capital in the form of
dividends and interest.
 The sales component by providing a source of additional capital
complete the cycle of business activities.
 Economic Events:- The sales of goods or services consist of 04
economic events; 1) Receiving costumers order. 2) Deliver goods
to the costumers 3) Request payment for the goods 4) Receiving
payments.
 Economic Events and Accounting Transactions
 Accounting system records economic events in the form of transaction, summarizes
those transactions and reports them in the form of financial statements to the sources
of capital ( investors & creditors)
 The study of transaction cycles is the convenient way to understand how accounting
system work.
 Transaction Cycles
 Transaction cycles record the economic events of a component in the cycle of business
activities.
 From the cycle of business activities illustration that shows the four basic business
activities, the following four accounting transaction cycles can be identified.
I. The Financial Cycle
II. The Expenditure Cycle
III. The Revenue Cycle
IV. The Conversion Cycle
Financial Cycle
Financial cycle consist of those accounting transactions that record the acquisition of
capital from owners & creditors, the use of that capital to acquire productive assets such
as property, plant, equipments and reporting to the owners & creditors on how it is used.
Economic events in financial Cycle
 Two significant economic events in the financial cycle are; I) Raising Capital II) The use of
that capital to acquire property, plant & equipments.
Non-economic event
• A third event, not really economic one, is periodic reporting to the source of capital.
• The basic financial statements that provide periodic reporting include, balance sheet,
income statement, and the statement of cash flow. The summaries in these reports
comes from the general ledger.
• Periodic reporting to the source of capital enables a business to raise additional capital.
For this reason the series of transaction is viewed as a cycle.
Application Systems in the Financial Cycle
• The three accounting application systems that record the events in the financial cycle
are: 1) Property System. 2) Journal entry System. 3) Financial reporting system.
Illustration of Financial Cycle
Expenditure Cycle
 The expenditure cycle consists of those transactions incurred to acquire material and
overhead items for the conversion process of the business.
 Economic events in the expenditure cycle
• This cycle processes transactions representing the following economic events;
I) Requesting the items. II) Receive the items.
III) Recording the obligation to pay for the item
IV) And paying for them
 Application system in the expenditure cycle
• The application systems in the expenditure cycle that execute these transactions
include; purchasing, receiving, voucher, and the cash disbursement systems.
 Most businesses use a purchasing department to acquire materials and supplies. A
purchasing agent orders material from a vendor ,who ships the material and mails an
invoice. The business uses the invoice to record the payable and later pays the vendor.
When the vendor is paid according to the terms of the sale, the vendor again sells
items to the business. This causes the sequence of transactions to form a cycle.
Illustration of Expenditure Cycle
Revenue Cycle
 The revenue cycle includes the accounting transactions that record the generation of
revenue from the outputs of the conversion process.
 Economic Events
 The four economic events that generate revenue are, as already mentioned, are
I)receiving an order from a customer, II) delivering goods or services to the costumer, III)
requesting payment from the costumer, and IV) receiving the payment.
 Whenever companies sell goods or services on credit, each of these events produces a
transaction. Each transaction may occur at separate times. If the sale is a cash sale, then
ordering, delivery, request and payment occur at the same time. In this case, accounting
systems ordinarily record these four events with one transaction. When a customer pays
and the accounting system records the cash receipt, the business is willing to sell again to
the customer. This causes the cycle of transactions to repeat.
 Application systems
 Companies that sell on credit use four application systems I the revenue cycle. They are
the order entry, shipping, billing, and the cash receipts systems.
 Companies that sell on cash basis frequently use a point-of-sale system that combines the
four economic events in one transaction
Illustration of the revenue cycle

Illustration provides a graphic representation

of the revenue cycle
Conversion Cycle
 The conversion cycle contains those transaction incurred when inputs are converted
into salable goods or services.
 Economic events
 one economic event exist in the conversion cycle. Materials, labor, and overhead are
consumed in the conversion process.
 Application Systems
 Depending on the type of organization, the conversion cycle contains either two or
three application system. Manufacturing companies uses cost accounting system to
record material, labor and overhead costs. All types of organization uses the payroll
system. It ensure that employees are paid for their labor. Manufacturing &
merchandizing companies use the inventory system to maintain records of inventory on
hand.
 In merchandising and manufacturing companies, the systems of the conversion cycle
provide interfaces b/w the expenditure and revenue cycles. Because it contains only one
event, the conversion cycle cannot be represented as a circle as can the other cycles.
The Conversion Cycle in a Merchandising Company
• A merchandising company maintains
a merchandise inventory for sale.
• The expenditure cycle adds to this
inventory and the revenue cycle takes
from it.
• The inventory system records the
associated transactions.
• The payroll system in merchandising
company compensates sales and
administrative personnel for their
work.
• Illustration shows the interfaces b/w
the expenditure and revenue cycle
and the inventory and payroll systems
in such a company.
 The Conversion Cycle in a Manufacturing Company
• A manufacturing company has raw
materials, work in process, and finished
goods inventories.
• The production process convert raw
materials into finished goods.
• Raw materials are acquired in the
expenditure cycle and finished goods are
sold in the revenue cycle.
• So in this ways these inventory
accounts , that is, raw materials, work in
process, and finished goods, are a part of
the two cycles.
• the cost accounting, payroll, and
inventory systems provide interfaces by
recording transactions during the
production process.