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Financial Accounting

Eleventh Edition

Chapter 4

Internal Control and Cash

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Learning Objectives

4.1 Describe fraud and its impact

4.2 Explain the objectives and components of internal control

4.3 Design and use a bank reconciliation

4.4 Evaluate internal controls over cash receipts and cash payments

4.5 Construct and use a cash budget

4.6 Report cash on the balance sheet

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Learning Objective 4.1

Describe fraud and its impact

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Describe Fraud and Its Impact (1 of 2)

Fraud
Intentional misrepresentation of facts
For the purpose of persuading another party to act in a certain way
Causes injury or damage
Growing problem throughout the world with the expansion of e-commerce
Common examples include: insurance fraud, check forgery, Medicare fraud, credit card fraud, and identity theft

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Describe Fraud and Its Impact (2 of 2)

Common Types of Fraud

Misappropriation of assets

Committed by employees
Theft of money or inventory
Bribery and kickback schemes
Overstate expense reimbursements

Fraudulent financial reporting

Committed by managers
False and misleading journal entries
Deceive investors and creditors

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Exhibit 4-1 The Fraud Triangle

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Learning Objective 4.2

Explain the objectives and components of internal control

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Explain the Objectives and Components of Internal Control

Internal Control

Primary way to prevent, detect, and correct fraud
Plan of organization and procedures implemented to accomplish 5 objectives:

Safeguard assets
Encourage employees to follow company policy
Promote operational efficiency
Ensure accurate, reliable accounting records
Comply with legal requirements

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Exhibit 4-2 Excerpt from Public Company Management Report on Internal Controls

Management is responsible for establishing and maintaining adequate internal control over financial reporting …. the company’s internal control over financial reporting includes the maintenance of records that … accurately and fairly reflect the transactions and … assets of the company … provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorization of management and directors of the company …

under the supervision and with the participation of management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting … based on our evaluation

… management concluded that our internal control over financial reporting was effective as of December 31, 2016.

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The Sarbanes-Oxley Act (SOX)

SOX Provisions
Passed by Congress in 2002
Public companies must maintain a system of internal control and issue an internal control report
Auditors must evaluate and report on internal controls
Created Public Company Accounting Oversight Board (PCAOB)
Limits non-audit services of auditing firms
Penalties for violators

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Exhibit 4-3 The Shield of Internal Controls

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Exhibit 4-4 The Components of Internal Control

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The Components of Internal Control (1 of 2)

Control Environment

Tone at the top
Code of ethics

Risk Assessment

Identify business risks
Establish procedures to deal with risks

Information System

Means by which accounting info enters and exits
Accurately track assets, profits, & losses

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The Components of Internal Control (2 of 2)

Control Procedures

Means by which companies gain access to the 5 objectives of internal controls

Monitoring of Controls

Usually programmed into technology
Internal and external auditors

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Internal Control Procedures (1 of 6)

Smart Hiring Practices
Background checks
Training and supervision
Competitive salaries
Clear employee responsibility

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Internal Control Procedures (2 of 6)

Separation of Duties
Asset handling
Record keeping
Transaction approval

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Internal Control Procedures (3 of 6)

Comparison and Compliance Monitoring
Operating and cash budgets
Exception reporting
Audit

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Internal Control Procedures (4 of 6)

Adequate Records
Details of business transactions
Hard copy documents or electronic
Prenumbered documents

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Internal Control Procedures (5 of 6)

Limited Access
Only persons with custodial responsibilities
Lock and key
Lock-box system
Physical access controls
Password and encryption

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Internal Control Procedures (6 of 6)

Proper Approvals
Management’s general or specific approval
Credit approvals
Purchasing department
Human resources department

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Information Technology

Accounting systems continue to rely less on manual procedures and more on information technology (IT).
Improved accuracy and speed
Examples:

Electronic sensors
Bar codes

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Safeguard Controls

Important documents in fireproof vaults
Burglar alarms and security cameras
Loss prevention specialists
Fidelity bonds on cashiers
Mandatory vacations and job rotation

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Internal Controls for E-Commerce

E-commerce creates additional risks, including:
Stolen credit card numbers
Computer viruses and Trojan Horses
Phishing expeditions
Security measures to combat these risks include:
Encryption
Firewalls

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Firewalls

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The Limitations of Internal Control – Cost and Benefits

Ways to circumvent internal controls:
Collusion: two or more people working together
Management override
Human limitations: fatigue and negligence

Benefits of internal controls should always outweigh the costs

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Learning Objective 4.3

Design and use a bank reconciliation

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Design and Use a Bank Reconciliation (1 of 7)

Documents used to control a bank account include:
Signature card
Deposit ticket
Check
Bank Statement
Bank Reconciliation

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Design and Use a Bank Reconciliation (2 of 7)

Signature Card
Banks require each person authorized to sign on an account to provide a signature card
Protects against forgery

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Design and Use a Bank Reconciliation (3 of 7)

Deposit Ticket
Banks supply standard deposit tickets
Customer fills out deposit ticket and receives a receipt as proof of the transaction

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Design and Use a Bank Reconciliation (4 of 7)

Check

Three parties to a check

Maker → signs check
Payee → whom the check is paid
Bank → check drawn from

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Design and Use a Bank Reconciliation (5 of 7)

Bank Statement
Sent to customer monthly
Reports customer’s cash activity

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Exhibit 4-6 Bank Statement

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Design and Use a Bank Reconciliation (6 of 7)

Bank Reconciliation
Explanation for the differences between the book (company’s cash records) and bank balance
Differences due to time lag in recording transactions

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Design and Use a Bank Reconciliation (7 of 7)

Preparing the Bank Reconciliation

Bank Side
Deposits in transit
Outstanding checks
Bank errors

Book Side
Bank collections
Electronic funds transfers
Service charge
Interest revenue
NSF checks
Cost of printed checks
Book errors

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Exhibit 4-8 Bank Reconciliation (1 of 3)

Bank side:

Deposit in transit, $ 1,600.
Bank error: the bank deducted $ 100 for a check written by another company. Add $ 100 to the bank balance.
outstanding check-total of $ 1,340

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Exhibit 4-8 Bank Reconciliation (2 of 3)

Book side:

EFT receipt of your dividend revenue earned on an investment, $900
Bank collection of your account receivable, $2,100.
interest revenue earned on your bank balance, $30.
Book error: you recorded check no. 333 for $510. the amount you actually paid on account was $150. add $360 to your book balance.
Bank service charge, $20.
NSF check from a customer, $50. subtract $50 from your book balance.
EFT payment of insurance expense, $400.

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Exhibit 4-8 Bank Reconciliation (3 of 3)

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Journalizing Transactions from the Bank Reconciliation

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Summary of Various Reconciling Items

Bank Balance—Always
Add deposits in transit.
Subtract outstanding checks.
Add or subtract corrections of bank errors.
Book Balance—Always
Add bank collection, interest revenue, and EFT receipts.
Subtract service charges, NSF checks, and EFT payments.
Add or subtract corrections of book errors.

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Exhibit 4-9 Online Banking—Account History

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Learning Objective 4.4

Evaluate internal controls over cash receipts and cash payments

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Evaluate Internal Controls Over Cash Receipts and Cash Payments

Cash requires specific internal controls because it is easy to steal and convert to other forms of wealth.

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Cash Receipts Over the Counter

Point-of-sale terminals

Provide control over cash receipts
Record sale, cost of item sold, and reduction to inventory
Effective inventory control

Customer issued a receipt as proof of purchase
Sales associate turns in cash drawer at end of shift

Combined with other cash and deposited

Accounting department reconciles sales per terminal to cash in drawer

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Exhibit 4-11 Cash Receipts by Mail

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Controls Over Payment by Check (1 of 3)

Companies make most payments by check or EFT. This in an important internal control because:
Provides record of payment
Must be signed by authorized official
Payment supported by evidence

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Controls Over Payment by Check (2 of 3)

Controls over Purchase and Payment

Split the following duties

Purchasing goods
Receiving goods
Preparing check or EFT for payment
Approval of payment

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Exhibit 4-12 Cash Payments by Check or EFT

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Exhibit 4-13 Payment Packet

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Controls Over Payment by Check (3 of 3)

Petty Cash

Used to pay for minor expenses
Opened with a particular amount of cash
Custodian prepares a petty cash voucher list
Imprest system – sum of fund plus vouchers paid should equal specified balance
Debit cards may be used

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Learning Objective 4.5

Construct and use a cash budget

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Construct and Use a Cash Budget

Budget – financial plan that helps coordinate business activities
Cash budget – helps a company manage cash by planning receipts and payments

Start with beginning cash balance
Add budgeted receipts and subtract budgeted payments
Equals cash available before new financing
Compare cash available before new financing to budgeted cash at end of period

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Exhibit 4-14 Cash Budget

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Learning Objective 4.6

Report cash on the balance sheet

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Report Cash on the Balance Sheet (1 of 3)

Cash and Cash Equivalents
Time deposits
Certificates of deposit
High-grade U.S. or foreign government securities (close to maturity)

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Report Cash on the Balance Sheet (2 of 3)

Most public companies will include a footnote to their financial statements such as the following:

Cash equivalents…

All highly liquid investment with maturities of three months or less at the date of purchase are classified as cash equivalents.

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Report Cash on the Balance Sheet (3 of 3)

Compensating Balance Agreements

Cash – liquid assets available for day-to-day use

Balance should not be restricted in any way, restricted amounts separately disclosed

Compensating Balance Agreements

Borrowing company agrees to maintain minimum balance in checking account at all times
Long-term asset, not cash

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