Cash and Internal Control Chapter 6 Cash and Internal Control

Learning Objectives LO1 Identify and describe the various forms of cash reported on a balance sheet. LO2 Describe the various techniques that companies use to control cash. LO3 Explain the importance of internal control to a business and the significance of the Sarbanes-Oxley Act of 2002. LO4 Describe the basic internal control procedures. LO5 Describe the various documents used in recording purchases and their role in controlling cash disbursements.

Module 1 Accounting and Controlling for Cash There are various forms of cash and cash equivalents reported on the balance sheet Companies use various techniques to control cash Module 1

Cash Coin and currency on hand Cash on deposit in the form of checking and savings accounts Undeposited, cashier, and certified checks Module 1: LO 1

Cash Equivalents Investment readily convertible to cash Example: Maturity—three months or less Example: Commercial paper Treasury bills issued by the federal government Money market funds Six-month bank certificate of deposit would not be a cash equivalent Module 1: LO 1

Exhibit 6-1—Cash and Cash Equivalents on the Balance Sheet and the Statement of Cash Flows Module 1: LO 1

Cash Management Tools of cash management Cash flows statement Cash budgets Bank reconciliations Petty cash funds Module 1: LO 2

Bank Statements Two principles of internal control for cash: Cash receipts should be deposited intact daily Cash payments should be made by check Bank statement: a detailed list, provided by the bank, of all activity for a particular account during the month Module 1: LO 2

Reading a Bank Statement Outstanding check: a check written by a company but not yet presented to the bank for payment Deposit in transit: a deposit recorded on the books but not yet reflected on the bank statement Module 1: LO 2

Exhibit 6-2—Bank Statement Module 1: LO 2

The Bank Reconciliation Reconcile or resolve any differences between balance on the bank statement with balance shown in the accounting records Steps used in preparing a bank reconciliation: Prepare a list of the deposits in transit Prepare a list of the outstanding checks Prepare a list of credit memoranda Prepare a list of debit memoranda Identify any errors Module 1: LO 2

Step 1: Prepare a List of the Deposits in Transit Trace deposits listed on the bank statement to the books Identify the deposits in transit Any deposits recorded on the books but not yet shown on the bank statement Add to the bank balance Module 1: LO 2

Step 2: Prepare a List of the Outstanding Checks Arrange the canceled checks in numerical order Trace each of them to the books Any checks recorded on the books but not yet listed on the bank statement are outstanding Subtract from the bank balance Module 1: LO 2

Step 3: Prepare a List of Credit Memoranda Credit memoranda: additions on a bank statement for such items as interest paid and notes collected List all items, other than deposits, shown as additions on the bank statement Interest paid by the bank Amounts collected by the bank for the customer For these items, bank increases, or credits, its liability to the company on its own books Module 1: LO 2

Step 3: Prepare a List of Credit Memoranda (continued) List all items, other than deposits, shown as additions on the bank statement Interest paid by the bank Amounts collected by the bank for the customer For these items, bank increases, or credits, its liability to the company on its own books Module 1: LO 2

Step 3: Prepare a List of Credit Memoranda (continued) List all items, other than deposits, shown as additions on the bank statement Interest paid by the bank Amounts collected by the bank for the customer For these items, bank increases, or credits, its liability to the company on its own books Module 1: LO 2

Step 4: Prepare a List of Debit Memoranda Debit memoranda: deductions on a bank statement for items such as NSF checks and various service charges Module 1: LO 2

Step 4: Prepare a List of Debit Memoranda (continued) List all amounts, other than canceled checks, shown as subtractions on the bank statement NSF checks Service charges A liability is created on the books of the bank when a company deposits money in a bank Bank reduces the amount of its liability for these various items and debits the liability on its own books Module 1: LO 2

Step 5: Identify Any Errors Identify any errors made by the bank or by the company in recording cash transactions Module 1: LO 2

Example 6-3—Recording Journal Entries from a Bank Reconciliation Recognition of bank’s collection of a customer’s note, with interest Module 1: LO 2

Example 6-3—Recording Journal Entries from a Bank Reconciliation (continued) Record interest earned on checking account Module 1: LO 2

Example 6-3—Recording Journal Entries from a Bank Reconciliation (continued) Correction of error in recording purchase of supplies Module 1: LO 2

Example 6-3—Recording Journal Entries from a Bank Reconciliation (continued) Record customer’s NSF check Module 1: LO 2

Example 6-3—Recording Journal Entries from a Bank Reconciliation (continued) Recognize collection fee on note—charged by bank Module 1: LO 2

Example 6-3—Recording Journal Entries from a Bank Reconciliation (continued) Record rental charge on lockbox Module 1: LO 2

Petty Cash Fund Money kept on hand for making minor disbursements rather than by writing checks Periodically, the fund is replenished Module 1: LO 2

Example 6-4—Recording Journal Entries for a Petty Cash Fund Establishment of petty cash fund Module 1: LO 2

Example 6-4—Recording Journal Entries for a Petty Cash Fund (continued) Replenishment of petty cash fund Module 1: LO 2

Exhibit 6-3—Use of a Petty Cash Fund Module 1: LO 2

Module 2 Internal Control Companies must maintain an effective internal control system and use basic procedures to help make a system effective The use of business documents can add to the effectiveness of an internal control system Module 2

Internal Control System Policies and procedures necessary to ensure: Safeguarding of an entity’s assets Reliability of accounting records Accomplishment of overall company objectives Module 2: LO 3

The Sarbanes-Oxley Act of 2002 An act of Congress in 2002 Intended to bring reform to corporate accountability and stewardship in the wake of a number of major corporate scandals Module 2: LO 3

The Sarbanes-Oxley Act of 2002 (continued) Internal control report: a report required by Section 404 of the Sarbanes-Oxley Act Maintain an adequate internal control structure Assesses effectiveness of internal control structure Outside auditors must issue report on company’s internal control Module 2: LO 3

The Sarbanes-Oxley Act of 2002 (continued) Public Company Accounting Oversight Board (PCAOB): five-member body created by SOX Set auditing standards in the United States Board of directors: consists of key officers of a corporation and outside members responsible for general oversight of the affairs of the entity Audit committee: a subset of the board of directors Provides direct contact between the stockholders and the independent accounting firm Module 2: LO 3

The Control Environment Factors that influence internal control Management’s competence and operating style Personnel policies and practices Board of directors, particularly audit committee Module 2: LO 3

Exhibit 6-4—Management Report on Internal Control—Regal Entertainment Module 2: LO 3

The Accounting System Methods and records used to accurately report entity’s transactions and maintain accountability for assets and liabilities Use of a journal is an integral part of all accounting systems Can be completely manual, fully computerized, or a mixture of both Module 2: LO 3

Internal Control Procedures Administrative controls Procedures concerned with efficient operation of the business and adherence to managerial policies Accounting controls Procedures concerned with safeguarding the assets or the reliability of the financial statements Module 2: LO 4

Important Internal Control Procedures Proper authorizations Segregation of duties Independent verification Safeguarding of assets and records Independent review and appraisal Design and use of business documents Module 2: LO 4

Limitations on Internal Control Not totally foolproof Does not ensure prevention of collusion Maintenance of controls can be costly Small businesses cannot afford Human errors can weaken the system Misunderstood instructions, carelessness, fatigue, and distraction can lead to errors Module 2: LO 4

Computerized Business Documents and Internal Control All cash receipts should be deposited intact in the bank on a daily basis Intact means that no disbursements should be made from the cash received from customers All cash disbursements should be made by check Module 2: LO 5

Control Over Cash Receipts Most merchandisers receive checks and currency from customers in two ways: Cash received over the counter Cash received in the mail Cash discrepancies Discrepancies occur occasionally due to theft by dishonest employees and to human error Module 2: LO 5

The Role of Computerized Business Documents in Controlling Cash Disbursements Purchase requisition form A form a department uses to initiate a request to order merchandise Purchase order A form sent by the purchasing department to the supplier Invoice A form sent by the seller to the buyer as evidence of a sale Module 2: LO 5

Exhibit 6-6—Document Flow for the Purchasing Function Module 2: LO 5

Exhibit 6-7—Purchase Requisition Module 2: LO 5

Exhibit 6-8—Computer-Generated Purchase Order Module 2: LO 5

Exhibit 6-9—Invoice A form sent by the seller to the buyer as evidence of a sale Module 2: LO 5

Blind Receiving Report A form used by the receiving department to account for the quantity and condition of merchandise received from a supplier Module 2: LO 5

Exhibit 6-10—Computer-Generated Receiving Report Module 2: LO 5

Exhibit 6-11—Invoice Approval Form A form the accounting department uses before making payment to document the accuracy of all information about a purchase Module 2: LO 5

Exhibit 6-12—Check with Remittance Advice A form used by the receiving department to account for the quantity and condition of merchandise received from a supplier Module 2: LO 5

Review LO1 Identify and describe the various forms of cash reported on a balance sheet. Cash can take many forms; however, the key attribute is that the asset is readily available to pay debts. Cash equivalents are investments that are readily convertible to a known amount of cash. Readily means three months or less.

Review LO2 Describe the various techniques that companies use to control cash. The liquidity of cash makes controls over it very important to have in place. Cash management means managing the need to have enough cash on hand to ensure cash flow needs but not so much that excess funds earn little return and may be vulnerable to misappropriation. Bank reconciliations use third-party documents (bank statements) to reconcile differences between the amount in the bank and on the books. Done by an independent party, bank reconciliations are effective control procedures. Petty cash funds are an effective way to minimize access to large cash accounts to pay for relatively small expenditures.

Review LO3 Explain the importance of internal control to a business and the significance of the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 required publicly traded companies to improve the documentation and functioning of their internal controls. Management must now render an opinion on the efficiency of the company’s internal control system. A strong control environment is a must for companies. Auditors also must increase their documentation and understanding of the internal controls of their clients. Significant amounts of resources have been devoted to comply with the provisions of Sarbanes-Oxley.

Review LO4 Describe the basic internal control procedures. Control procedures are actions that company personnel take to make sure that policies set forth by management are followed. Important accounting controls are concerned with safeguarding assets and producing accurate and timely financial statements. They include: Proper authorizations—only certain personnel may authorize transactions. Segregation of duties—physical custody of assets must not be combined with the ability to account for those assets. Independent verification—for example, an inventory count. Safeguarding of assets and records—both must be adequately protected. Independent review and appraisal—done primarily by internal audit. Design and use of business documents—source document control.

Review LO5 Describe the various documents used in recording purchases and their role in controlling cash disbursements. The documents used to record purchase transactions are instrumental in controlling both cash and inventory. The document flow diagram in Exhibit 6-6 provides an excellent summary of documents in the purchasing process. Some of the key documents are as follows: Purchase order Receiving report Vendor invoice Check

End of Chapter 6