Accounts Payable Control - Authorization and Verification

An accounts payable control system basically comes down to two fundamental concepts or processes:

1. Authorization
2. Verification

Authorization constitutes the initial phase, when decisions are made as to what commitments the business should take on and what disbursements should be made.

Verification constitutes the entire process of assuring that cash disbursements are made as authorized, and in accordance with the terms and conditions agreed upon.

These concepts are inherent in any business.  A sole proprietorship or a small business may not have a formally documented accounts payable control system.  The number of persons and steps involved may be limited, while in a larger business, the control system may be fully documented and very specific as to who does what, and how they do it.

But in either case, there needs to be an awareness of what accounts payable controls are really about, and that even the best designed internal control procedures will not serve their ultimate purpose, which is to safeguard business assets and resources, and contribute to an effective and efficient operation, unless they are carried out in practice.  And this involves each person taking responsibility for the internal control practices and procedures that apply to his or her daily activities in the business.

Authorization

Authorization is really about responsibility, and internal control comes down to each person taking responsibility for his or her decisions and actions, and their effects and consequences for the business.

The authorization phase of the accounts payable process doesn’t start when a disbursement is made, but rather when a commitment is made, with a vendor, contractor, or any other party.  Commitments should be made based on pre-established criteria, originating from the budget, and before that, from the business plan and strategy. 

In a large company there may be formalized delegations of authority procedures to determine who can approve what level of commitments or disbursements, and there may be powers of attorney granting certain individuals the formal authority to approve purchase orders, enter into contracts, or otherwise commit the company to an obligation with a vendor or contractor.

In a sole proprietorship, the owner probably makes virtually all the decisions regarding commitments and disbursements.  In a small business, this authority may be concentrated in just one person or shared among a small group of people.  The procedure for authorizing commitments may be formalized and documented, or it may be informal and based on mutual understanding and trust.  Nevertheless, whether there is a formal written procedure or not, there needs to be a clear understanding as to who can approve what.  This is necessary not only for properly managing the business, but also for maintaining good relationships, both inside the business and with outside suppliers, vendors, contractors, and others.

In a partnership there needs to be clear agreement about whether one partner can make a decision to commit the partnership, whether the partners need to mutually agree on all or certain commitment decisions, or whether a combination of both is to be used, for example with one partner authorized to make commitments up to a certain value, and amounts over that limit requiring authorization by all partners.  It may be advisable to put this agreement in writing, and possibly include it in the partnership by-laws.  Or powers of attorney could be drawn up, identifying each partner’s level of authority.

The authorization phase may involve more than one step, or approval level.  A certain expenditure may be proposed internally by one person or department, and then evaluated and approved by another person or at another level, before agreeing with the outside vendor or contractor, and making a commitment.

Commitments

An authorization generates a commitment - an obligation to pay for products or services solicited.  Commitments should reflect what has been budgeted, but for control purposes, commitments should be tracked separately.  Without having clear up-to-date information on outstanding commitments, it could be easy to overspend the budget, or disrupt a projected cash flow.  A budgeted expenditure is planned, and a forecasted cash flow is projected, but a committed expenditure is a real obligation that will be realized.

Many companies have a formal system for tracking commitments.  This could be in the form of a commitments log.  This log may consist of different types of registers, or they may all be combined into one single log.  The basic components would include:

• Contract log
  • Contracts for recurring services that are billed on a monthly, quarterly, annual or other basis
  • One-time contracts, for specific projects or jobs
• Purchase order log
• Work request log

Some of the advantages to be gained by establishing and using a commitments log include the following:

• It can be used to report on the status of the budget – total original budget, amount committed to date, budget remaining.
• It can serve as the basis for the disbursement side of cash flow projections:
  • Due dates for contracts with recurring payments
  • Payment schedules for contracts for specific projects or jobs
  • Delivery dates and payment terms on purchase orders
• It can be used for verification of invoices and progress payments on contracts.
• It can be used as a tool in determining and following up on timelines of progress on projects or business operations.

Verification

Verification is the process in which invoices and other bills are compared and reviewed to ensure that they are in accordance with the terms and conditions established in the authorization phase, supported by the documentation of commitments, prior to making payment.

If a small business has a purchasing person or department, many of these control procedures will be carried out by purchasing.  There should be close coordination between purchasing and accounting, with the appropriate segregation of duties, if possible.  In a sole proprietorship or a small business in which most or all of these functions are concentrated in one person or a small group of people, duties may be combined, but the basic control concepts are the same.

Receiving

For purchases of materials, supplies, and equipment or other items, there should be an independent process for:

• Inspecting the goods received to ensure they arrive in good condition.
• Physically counting, measuring, or weighing the goods received to ensure the quantity corresponds to the purchase order.
• Preparing receiving reports, noting any discrepancies in terms of condition, quality, or quantity.

Registers should be maintained for:

• Open purchase orders, for shipments not yet received
• Purchase orders received but pending billing
• Closed purchase orders, for shipments received and billed

Accounting

Whether the accounting and purchasing functions are separate or combined, there should be a procedure in place to maintain control over all incoming invoices and bills, that enables you to know their status at all times, and to perform the necessary follow-up.  It may be necessary to keep a log of all invoices received, and incoming invoices should be stamped with the date they are received.  If an invoice turns out to be incorrect and needs to be returned to the vendor, this can be noted in the log.

Invoices for goods should be checked for the following:

• Is the invoice valid?
  • Is the invoice original?
  • Is the vendor correct?
  • Has the invoice been altered in any way?
  • Has it already been paid?
• Are quantities indicated on the invoice accurate as compared with the purchase order and receiving report?
• Are the prices correct as compared with the purchase order?
• Are the applicable taxes correctly calculated?
• Is the total correct?
• Are the payment terms or due date correct?
• Has the invoice been approved by the designated person responsible for authorization of the disbursement?

Invoices for services should be compared with the work request and confirmed with a completion report.

Invoices for payments on contracts should be compared with progress payment statements, and completion reports.  Contractual terms should be verified, and the due date should be confirmed in accordance with the payment schedule indicated in the contract.

Accounting should be responsible for coding invoices to the appropriate general ledger accounts.  The account may be indicated on the purchase order or work request, but it should be verified before booking the invoice. 

Once it is properly verified, booked and scheduled for payment, the original invoice should be filed together with a copy of the purchase order, receiving report, work request, progress payment statement, or any other supporting documentation.  After payment, the invoice should be stamped or otherwise indicated as paid.

The accounting system should include an accounts payable, or vendor subledger, to keep track of the balance with each individual vendor.  This subledger should always agree with the control account on the general ledger and should be reconciled at least monthly.