We all know that Purchase Order is a document, released by an organization, to a vendor, to make supplies of a specified item or material, at a given price, of specified quantity, quality and description. If the mandate to a vendor is for specified services, we call it a Service Order.
At least in 3 areas, I find the Purchase Order serving significant purposes from Internal Financial Control perspective. They are:
a. Vendor Payment related Controls
b. Making suitable provisions in Stock Accounting where Vendor Invoice is yet to be received, and
c. In large Projects under construction, providing the base for Project Accounting.
Vendor Payment related Controls:
Imagine for a moment that your organization does not use any document as a Purchase Order. Instead your Purchase Manager calls up a vendor and asks him to make a supply, giving details over the phone. In such a case, your organization’s commitment to a vendor is not in writing. If the vendor makes a wrong supply, your Stores Manager may not be able to make out and accept the wrong supply. If the vendor charges a price which is higher than what is agreed, your Accounts Manager may not be able to make out and release payment.
It does not stop here. Where the material is received, but the vendor invoice is yet to be received, you may not be able to make suitable provision for stock accounting and any issues made for consumption would not get properly accounted.
While I do not expect organizations to conduct transactions on these lines, I noticed many instances of urgent requirements, where vendors are asked to make supplies before a Purchase Order is released on them. If the Purchase Order is not promptly put in place, it can lead to all the control gaps described above.
3-Way Matching:
The 3 documents I am referring to are Purchase Order, Good Received Note (GRN), and Vendor Invoice. When a vendor is making supplies, he refers to the Purchase Order received by him. Stores Manager prepares a GRN, for the receipts, referring to the description and other details from the Purchase Order. Accounts Manager, who receives the Vendor Invoice, verifies with the Purchase Order and the GRN, matches the quantity in the PO and GRN, and Price as shown in the Purchase Order and creates a payable for the exact amount. This is what we call a 3-Way Matching, and it is an important Internal Financial Control.
While a manual comparison for 3-Way Matching would not eliminate scope for human errors, using ERP applications where Purchase, Stores and Accounts Payable modules are integrated, it is possible to achieve 3-Way Matching through the system and it is error proof. What it means is that the system will not permit a GRN to be prepared for a quantity, in excess of what is specified in the Purchase Order, and system keeps track of quantities supplied in the case of multiple deliveries. Similarly Vendor Payable cannot be created, against an Invoice for any quantity in excess of what is recorded in the GRN, or at any rate which is higher than the rate specified in the Purchase Order.
While in the past, integration of modules like Purchase, Stores and Accounts Payable was available only in large ERP packages, now such features are available even in smaller Packages, making it relevant for small and medium organizations.
Making suitable provisions in Stock Accounting where Vendor Invoice is yet to be received:
Where a Vendor Invoice is yet to be received, usually at the month end, suitable provision for goods received and corresponding increase in the stock on hand needs to be given effect to. It may also happen that issues are made from such stocks, which requires consumption recording. In such instances, Open GRNs (GRNs for which Accounts Payable process is yet to be completed) are valued for the quantity, at the rate specified in the Purchase Order. Thus a purchase Order helps in Stock Accounting.
Once again, if an ERP package is in use with integrated Purchase and Stores modules, it is possible to value open GRNs on an online (up to date) basis.
In large Projects under construction, providing the base for Project Accounting.
We know that Accounting is nothing but classification of transactions, to eventually prepare a Profit & Loss Account and Balance Sheet for Financial Reporting.
But what happens if your organization is in its Project (Construction) phase, or undertakes major in house projects like “Capacity Expansion”? Entire expenditure incurred on the project will eventually get capitalized and a Fixed Asset Record is created. Expenses like Salaries, travel, and Interest on borrowed funds for project purpose, up to the date of Project Commissioning will be loaded on the project cost for Capitalization.
In Project Accounting, for large projects, normal accounting classification does not serve the purpose of creating a Fixed Asset Record. During the course of project execution, entire expenditure goes and sits in Capital Work in Progress. Unless we are able to analyze the costs incurred, in terms of the Fixed Assets created, we will not be able to complete Capitalization. It is here that we find Purchase Order, as the most important document, for providing the Project Accounting base. Every Purchase Order, be it for Equipment supply, Consulting Charges, or for Cement, Steel supplies, has a boundary, around which costs can be accumulated, and we can also know to what extent and in what proportion, it has contributed to the creation of a Fixed Asset. Let us briefly run through the sequence of steps involved:
1. Classify all payments made and costs incurred for the project into “PO Based” and “Non-PO Based” categories.
2. Classify “PO Based” into “Equipment Based” and “Stock Based” where the latter refers to items like Cement and Steel, which are used for many assets.
3. Similarly categorize all Non-PO Expenses like Interest, Salaries, Travel and other costs based on the nature of such expenses.
4. At this stage create a Dummy Fixed Asset Record, with all details that would be available in a Fixed Asset Record, except values.
5. Based on the relationship between a PO / Group of POs which could have become an Asset or a Group of Assets, Entire expenditure pooled under the PO classification is transferred to corresponding assets. Based on actual details on consumption, costs pooled under stock POs get transferred to appropriate assets.
6. Finally, Non-PO costs like Interest and Pre-Operative Expenses get distributed on the Fixed Assets in a suitable proportion, mostly in terms of value of each asset. Thus we generate a Fixed Asset register.
I have briefly gone through the Capitalization process, primarily to drive home the importance of Purchase Order in Project Accounting.
Concluding Remarks:
Following questions may help you assess controls in your organization, in relation to Purchase Orders:
a. Are POs released in a controlled environment where proper track is maintained?
b. Are Open Purchase Orders beyond due dates with no supplies, properly reviewed for closure?
c. Can you employ 3_Way Matching for ensuring accurate Payments to vendors?
d. Have you explored Integrated ERP packages to make this process robust?
For more articles from me, and to know about my book “Translating Operations into Money”, please visit www.operationstomoney.com .
Thank you for your attention.
Tulasi S Sastri.
FCA., CISA.
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