Chapter 8. Internal Control. Chapter 8-1

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1 8 Internal Control and Cash 8-1

2 Internal Control and Cash Internal Control Cash Controls Use of a Bank Reporting Cash The Sarbanes- Oxley Act Principles Limitations Control over cash receipts Control over cash disbursements Making deposits Writing checks Bank statements Reconciling the bank account Cash equivalents Restricted cash Compensating balances 8-2

3 Internal Control Internal control consists of all the related methods and measures adopted within an organization to: 1. Safeguard its assets. 2. Enhance the accuracy and reliability of its accounting records. Reduce risk of: a. Errors (unintentional) b. Irregularities (intentional) Under the Sarbanes-Oxley Act, all publicly traded U.S. corporations are required to maintain an adequate system of internal control. 8-3

4 Internal Control The Sarbanes-Oxley Act Companies must develop sound principles of control over financial reporting. continually verify that controls are working. Independent outside auditors must attest to the level of internal control. SOX created the Public Company Accounting Oversight Board (PCAOB), which now establishes auditing standards and regulates auditor activity. 8-4

5 Internal Control Principles of Internal Control Illustration 8-1 Measures vary with size and nature of the business. management s control philosophy. h There are six principles p apply to most enterprises: 8-5

6 8-6 Internal Control Principles of Internal Control ESTABLISHMENT OF RESPONSIBILITY Control is most effective when only one person is responsible for a given task. SEGREGATION OF DUTIES - Related duties should be assigned to different individuals. - Record keeping separate from physical custody. DOCUMENTATION PROCEDURES Companies should use prenumbered documents and all documents should be accounted for.

7 Internal Control Principles of Internal Control Illustration 8-3 PHYSICAL, MECHANICAL, AND ELECTRONIC CONTROLS Physical Mechanical cal and Electronic 8-7

8 8-8 Internal Control Principles of Internal Control INDEPENDENT INTERNAL VERIFICATION 1. Records periodically or on a surprise basis verified by an employee who is independent. 2. Discrepancies and exceptions should be reported to a management level that can take corrective actions. OTHER CONTROLS 1. Bond employees who handle cash. 2. Rotate employees duties and require employees to take vacations. 3. Conduct thorough h background checks.

9 Internal Control Limitations of Internal Control Costs should not exceed benefit so that internal control generally provides reasonable assurance. Human element should be considered to prevent the impairments of collusion. Size of the business. 8-9

10 Cash Controls Illustration 8-5 Internal Control over Cash Receipts Establishment of Responsibility Only designated d personnel are authorized to handle cash receipts (cashiers) Documentation Procedures Use remittance advice (mail receipts), cash register tapes, and deposit slips Independent Internal Verification Supervisors count cash receipts daily; treasurer compares total receipts to bank deposits daily 8-10 Segregation of Duties Different individuals receive cash, record cash receipts, and hold the cash Physical, Mechanical, and Electronic Controls Store cash in safes and bank vaults; limit access to storage areas; use cash registers Other Controls Bond personnel who handle cash; require employees to take vacations; deposit all cash in bank daily

11 Cash Controls Discussion Question Q At the corner grocery store, all sales clerks make change out of one cash register drawer. Is this a violation of internal control? Why? 8-11

12 Cash Controls Cash consists of coins, currency, checks, money orders, and money on hand or on deposit in a bank. Cash receipts come from: cash sales collections on account from customers receipt of interest, rent, and dividends investments by owners bank loans proceeds from the sale of noncurrent assets 8-12

13 Over-the the-counter Receipts Cashier s Department Sales Department Illustration 8-7 Prepare daily cash summary Prepare deposit slip 8-13 Cashier ring up sales on registers Supervisor 1. reads register totals 2. makes cash counts 3. prepares cash count sheets Bank Treasurer Accounting (deposit) (verification) (record)

14 8-14 Mail Receipts Control Procedures: Mail receipts should be opened by two people, a list prepared, and each check endorsed. Copy of the list, along with the checks and remittance advices, sent to cashier s s department. Cashier adds the checks to the over-the-counter receipts and prepares a daily cash summary and makes the daily bank deposit. Copy of list sent to treasurer s s office for comparison with total shown on daily cash summary.

15 Cash Controls Review Question Permitting only designated personnel to handle cash receipts is an application of the principle of: a. segregation of duties. b. establishment of responsibility. c. independent check. d. other controls. 8-15

16 Cash Controls Internal Control over Cash Disbursements Generally, internal control over cash disbursements is more effective when companies pay by check, rather than by cash. Applications: Voucher system Electronic funds transfers (EFT) system Petty cash fund 8-16

17 Cash Controls Illustration 8-8 Internal Control over Cash Disbursements Establishment of Responsibility Only designated personnel are authorized to sign checks (treasurer) Segregation g of Duties Different individuals approve and make payments; check signers do not record disbursements Documentation Procedures Use prenumbered checks and account for them in sequence; each check must have an approved invoice Other Controls Stamp invoices PAID Independent Internal Verification Compare checks to invoices; reconcile bank statement monthly Physical, Mechanical, and Electronic Controls Store blank checks in safes, with limited access; print check amounts by machine in indelible ink 8-17

18 Cash Controls Review Question The use of prenumbered checks in disbursing cash is an application of the principle of: a. establishment of responsibility. b. segregation of duties. c. physical, mechanical, and electronic controls. d. documentation procedures. 8-18

19 Cash Controls Internal Control over Cash Disbursements Voucher System A network of approvals by authorized individuals, acting independently, to ensure all disbursements by check are proper. A voucher is an authorization ti form prepared for each expenditure. 8-19

20 Cash Controls Internal Control over Cash Disbursements Electronic Funds Transfers (EFT) Disbursement systems that use wire, telephone, or computers to transfer cash balances between locations. Procedures that t companies and banks have developed to transfer funds among parties without the use of paper (deposit slips, checks, etc.) 8-20

21 Cash Controls Internal Control over Cash Disbursements Petty Cash Fund -Used to pay relatively small amounts. The operation of a petty cash fund, often called an imprest system, involves three steps: 1. establishing the fund, 2. making payments from the fund, and 3. replenishing the fund. 8-21

22 Petty Cash Fund Establishing The Fund: A petty cash custodian should be appointed to be responsible for the fund. To establish the fund, a company issues a check payable to the petty cash custodian for the stipulated amount. For example, if Laird Company decides to establish a $100 fund on March 1, the journal entry is: March 1 Petty cash 100 Cash

23 Petty Cash Fund Making Payments from The Fund: The petty cash fund custodian has the authority to make payments from the fund that conform to prescribed management policies. Each payment must be documented on a prenumbered petty cash receipt (or petty cash voucher) attached with other supporting documents such as freight bills or invoices. The fund custodian keeps the receipts in the petty cash box until the fund is replenished. When each payment is made from petty cash, no accounting entry is recorded. d Instead, the accounting effects of each payment are recognized when the petty fund is replenished. 8-23

24 Petty Cash Fund Replenishing the Fund The timing for replenishing the petty fund: 1. When the money in the petty cash fund reaches a minimum level, 2. At the end of the accounting gperiod. Note that the replenishment entry does not affect the Petty Cash account. Occasionally, in replenishing a petty cash fund, the Cash Over and Short account is debited or credited to recognize a cash shortage or overage. 8-24

25 Petty Cash Fund Replenishing the Fund Assume that on March 15 Laird s petty cash custodian requests a check for $88. The fund contains $12 cash and petty cash receipts for postage $44, freight-out $38, and miscellaneous expenses $5. The journal entry to record the check is: March 15 Postage expense 44 Freight-out 38 Miscellaneous expense 5 Cash over and short 1 Cash

26 Petty Cash Fund E8-7 Lincolnville Company uses an imprest petty cash system. The fund was established on March 1 with a balance of $100. During March the following petty cash receipts were found in the petty cash box. Receipt Date No. For Amount 3/5 1 Postage Expense $ Freight-out Miscellaneous expense Travel expense Miscellaneous expense 5 The fund was replenished on March 15 when the fund contained $3 in cash. On March 20, the amount in the fund was increased to $150. Instructions: Journalize the entries in March that pertain to the operation of the petty cash fund. 8-26

27 Petty Cash Fund E8-7 The fund was established on March 1 with a balance of $100 March 1 Petty cash 100 Cash

28 Petty Cash Fund E8-7 The fund was replenished on March 15 when the fund contained $3 in cash. March 15 Postage expense 39 Freight-out 21 Miscellaneous expense 11 Travel expense 24 Cash over and short 2 Cash

29 Petty Cash Fund E8-7 On March 20, the amount in the fund was increased to $150. March 20 Petty cash 50 Cash

30 Use of a Bank Contributes significantly to good internal control over cash. Minimizes the amount of currency on hand. Creates a double record of bank transactions. Bank reconciliation. 8-30

31 Use of a Bank Making Bank Deposits Authorized employee should make deposit. Illustration 8-10 Bank Code Numbers 8-31 Front Side Reverse Side

32 Use of a Bank Writing Checks Illustration 8-11 Written order signed by depositor directing bank to pay a specified sum of money to a designated recipient. Maker Payee Payer 8-32

33 WRITING CHECKS Three parties to a check are: 1 Maker/drawer issues the check 2 Bank/payer py on which check is drawn 3 Payee to whom check is payable 8-33

34 Use of a Bank Bank Statements Illustration 8-12 Debit Memorandum Bank service charge NSF (not sufficient funds) Credit Memorandum Collect notes receivable. Interest earned. 8-34

35 BANK STATEMENTS A bank statement shows: 1 checks paid and other debits charged against the account 2 deposits and other credits made to the account 3 account balance after each day s transactions Debit memorandum indicate charges against the depositor s account. (ATM service charges). Credit memorandum idi indicate amounts that increase the depositor s account. (Interest revenue). 8-35

36 8-36 Use of a Bank Review Question The control features of a bank account do not include: a. having bank auditors verify the correctness of the bank balance per books. b. minimizing the amount of cash that must be kept on hand. c. providing a double record of all bank transactions. ti d. safeguarding cash by using a bank as a depository.

37 RECONCILING THE BANK ACCOUNT Reconciliation is necessary because the balance per bank and balance per books are seldom in agreement due to time lags and errors. Reconciliation should be prepared by an employee who has no other responsibilities pertaining i to cash. 8-37

38 RECONCILING THE BANK ACCOUNT The lack of agreement between the two balances has two causes: 1. Time lags that prevent one of the parties from recording the transaction in the same period as the other party. 2. Errors by either party in recording transactions. 8-38

39 RECONCILING THE BANK ACCOUNT Reconcile balance per books and balance per bank to their adjusted (corrected) cash balances. Reconciling Items: 1. Deposits in transit. 2. Outstanding checks. 3. Errors. 4. Bank memoranda. 8-39

40 RECONCILING THE BANK ACCOUNT Steps in preparing a bank reconciliation: 1. Determine deposits in transit 2D 2. Determine outstanding checks 3. Note any errors discovered 4. Trace bank memoranda to the records Each reconciling item used in determining the adjusted cash balance per books should be recorded by the depositor. 8-40

41 RECONCILING THE BANK ACCOUNT Reconciliation Procedures Illustration Deposit in Transit - Outstanding t Checks +/- Bank Errors CORRECT BALANCE + Notes collected by bank - NSF (bounced) checks - Check printing or other service charges +/- Company Errors CORRECT BALANCE 8-41

42 BANK RECONCILIATION LAIRD COMPANY Bank Reconciliation April 30, 2008 Cash balance per bank statement $ 15, Add: Deposits in transit 2, The bank statement for 18, the Laird Company Less: Outstanding checks shows a balance per No. 453 $ 3, No. 457 bank of $15, on 1, No. 460 April 30, , , Adjusted cash balance per bank $12, Cash balance per books $ 11, Add: Collection of $1,000 note receivable plus interest earned $50, less collection fee $15 $ 1, Error in recording check , , Less: NSF check On this date the Bank service charge balance of cash per Adjusted cash balance per books books is $11, $12,

43 ENTRIES FROM THE BANK RECONCILIATION GENERAL JOURNAL Date Account Titles and Explanation Debit Credit Apr. 30 Cash Miscellaneous Expense 1, Notes Receivable 1, Interest Revenue (To record collection of notes receivable by bank) Collection of Note Receivable. This entry involves four accounts. Interest of $50 has not been accrued and the collection fee is charged to Miscellaneous Expense. 8-43

44 ENTRIES FROM THE BANK RECONCILIATION GENERAL JOURNAL Date Account Titles and Explanation Debit Credit Apr. 30 Cash Accounts Payable Andrea Company (To correct error in recording check No. 443) Book Error. An examination of the cash disbursements journal shows that check No. 443 was a payment on account to Andrea Company, a supplier. The check, with a correct amount of $1,226.00, was recorded at $1,

45 ENTRIES FROM THE BANK RECONCILIATION GENERAL JOURNAL Date Account Titles and Explanation Debit Credit Apr. 30 Accounts Receivable J. R. Baron Cash (To record NSF check) NSF Check An NSF check becomes an accounts receivable to the depositor. 8-45

46 ENTRIES FROM THE BANK RECONCILIATION GENERAL JOURNAL Date Account Titles and Explanation Debit Credit Apr. 30 Miscellaneous Expense Cash (To record charge for printing company checks) Bank Service Charges Check printing charges (DM) and other bank service charges (SC) are debited to Miscellaneous Expense because they are usually nominal in amount. 8-46

47 8-47 RECONCILING THE BANK ACCOUNT E8-9 The following information pertains to Vince s Video Company. 1. Cash balance per bank, July 31, $2, Cash balance per books, July 31, $2, July bank service charge not recorded by the depositor $ Deposits in transit, July 31, $ Bank collected $300 note for Family in July, plus interest $36, less fee $15.The collection has not been recorded by Vince s, and no interest t has been accrued. 6. Outstanding checks, July 31, $207. Instructions a) Prepare a bank reconciliation at July 31. b) Journalize the adjusting entries at July 31 on the books of Vince s Video Company.

48 RECONCILING THE BANK ACCOUNT E8-9 a) Prepare a bank reconciliation at July 31. Cash balance per bank statement $2,542 Add: Deposit in transit 525 Less: Outstanding checks (207) Adjusted cash balance per bank $2,860 Cash balance per books $2,549 Add: Collection of notes receivable 300 Collection of interest 36 Less: Bank service charge (10) Note collection fee (15) Adjusted cash balance per books $2,

49 RECONCILING THE BANK ACCOUNT E8-9 b) Journalize the adjusting entries at July 31 on the books of Vince s Video Company. Dr. Cr. July 31 Cash 311 Bank charge expense 10 Miscellaneous expense 15 Notes receivable 300 Interest revenue 36 Note: Adjusting journal entry includes only the adjustments to the cash balance per books. 8-49

50 RECONCILING THE BANK ACCOUNT Review Question The reconciling item in a bank reconciliation that will result in an adjusting entry by the depositor is: a. outstanding checks. b. deposit in transit. c. a bank error. d. bank service charges. 8-50

51 Reporting Cash Most liquid asset, listed first in current assets section of balance sheet. Illustration 8-16 Cash equivalents Restricted cash Compensating balances 8-51

52 8-52 Use of a Bank Review Question Which of the following statements correctly describes the reporting of cash? a. Cash cannot be combined with cash equivalents. b. Restricted cash funds may be combined with Cash. c. Cash is listed first in the current assets section. d. Restricted cash funds cannot be reported as a current asset.

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