Internal Control Procedures and Bank Reconciliation Preparation

Fraud and Its Impact Fraud:  an intentional misrepresentation of facts, made for the purpose of persuading another party to act in a way that causes injury or damage to the party

Two Most Common Types of Fraud that Impact Financial Statements Misappropriation of assets: committed by employees of an entity who steal money from the company and cover it up through erroneous entries in the books Other examples of employee theft of inventory, bribery or kickback schemes in the purchasing function, or employee overstatement of expense reimbursement requests Fraudulent financial reporting: committed by company managers who make false and misleading entries in the books, making financial results of the company appear to be better than they actually are Purpose is to deceive investors and creditors into investing or loaning money to the company that they might not otherwise have invested or loaned

Most Common Form of Fraudulent Financial Reporting: Earnings Management Reasons: To meet profit targets set by market analysts so that the company’s share price will increase E.g. company’s earnings are actually $1.12 a share but analysts predicted $1.18 a share –the fraud: management reverses bad debt write-downs, reducing expenses to increase earnings To meet loan covenants (agreement) so the lender won’t demand payment of a loan E.g. loan agreement requires company to maintain a working capital ratio of 2:1 and its actual ratio is 1.8:1—the fraud: management reverses an inventory write-down to increase the value of inventory so the new ratio is 2.1:1

Most Common Form of Fraudulent Financial Reporting: Earnings Management Reasons: To meet an earnings target that will result in a management bonus The fraud: management overstates revenue by recording subsequent year sales in the current year, resulting in a misstated net income number so that the desired bonus is achieved To convert a loss to a profit E.g. the company suffers a net loss—the fraud: management overstates revenue to turn the loss into a profit

The Fraud Triangle Motive Opportunity Rationalization

Elements of Fraud Motive: usually results from either critical need or greed on the part of the person who commits the fraud Opportunity: usually arises through weak internal controls Rationalization: the person who commits the fraud engages in distorted thinking such as “I deserve this”; “Nobody treats me fairly,” “Everyone else is doing it.”

Internal Control A plan of organization and system of procedures implemented, and maintained by company management and the board of directors to deal with risks to the business that have been identified and that relate to: The reliability of the company’s financial records and financial reporting The company’s ability to operate effectively and efficiently The company’s compliance with legal requirements

What are the 5 Procedures of Internal Control? Proper authorization: people responsible for certain activities have the authority to enforce the policies associated with the activities e.g. Apple might assign the authority for determining which customers can pay on account to one person and that person is accountable Separation of duties: business transactions should be divided into 4 phases Approval Execution Custody Recording—entering transactions into accounting system

Separation of Duties (cont’d) Employee receiving cheques in mail should be different from employee recording receipt of cheques Require employees to take vacations—other employees will review the work of the one on vacation Routinely check on the employee’s work Send questionnaires to customers and ask them to confirm their account balances

What are the 5 Procedures of Internal Control? Maintaining adequate documentation: allows managers to trace transactions e.g. pre- numbering documents and limiting access to authorized employees Physically controlling assets and documents: limit access by unauthorized personnel e.g. use cash registers that produce a written receipt and record of transactions, locking storerooms, using fireproof safes; fences around company buildings and storage lots, passwords for electronic data

What are the 5 Procedures of Internal Control? Providing independent checks on performance: have another employee who was not involved in the original activity check the work e.g. an independent person compares the amount recorded as cash receipts in the accounting records with the records of the bank Independent checks guard against intentional theft and fraud and also reveal cases where employees perform certain procedures incorrectly

What are the Internal Controls for Cash? Cash receipts physically safeguard cash by using a cash register For each sales transaction one copy of a sales slip is given to the customer who provides an independent check An independent person compares the amount of money in the register at the end of a shift with the recorded sales

What are the Internal Controls for Cash? Cash disbursements Proper authorization —only make payments for items the business has approved Separate duties of cheque writing, signing, mailing, keeping accounting records and checking that payments have been authorized

Bank Reconciliation There are two records of a business’s cash: The Cash account in the company’s general ledger The bank statement, which shows the cash receipts and payments transacted through the bank The books and the bank statement usually show different cash balances Differences arise because of a time lag in recording transactions. For example: When the business writes a cheque the amount is immediately subtracted from the cash account balance but the bank doesn’t deduct the amount from the bank account until the cheque is cashed When the business receives cash from customers they add the amount to the cash account balance but the bank doesn’t add the amount until the deposit is made

Preparing the Bank Reconciliation the items that appear on a bank reconciliation all cause differences between the bank balance and the book balance (the company cash record is referred to as the “book” balance) Bank Side of the Reconciliation Items to show on the Bank side of the bank reconciliation include the following: Deposits in transit (outstanding deposits). You have recorded these deposits but the bank has not. Add deposits in transit on the bank reconciliation Outstanding cheques. You have recorded these cheques, but the bank has not yet paid them. Subtract outstanding cheques. Bank errors. Correct all bank errors on the Bank side of the reconciliation. For example, the bank may erroneously subtract from your account a cheque written by someone else

Preparing the Bank Reconciliation the items that appear on a bank reconciliation all cause differences between the bank balance and the book balance (the company cash record is referred to as the “book” balance) Book Side of the Reconciliation Items to show on the Book side of the bank reconciliation include the following: Bank Collections. These are cash receipts that the bank has recorded for your account. Many businesses have their customers pay directly to their bank—this is called a lockbox system and reduces theft. Add bank collections on the bank reconciliation. Electronic funds transfers. The bank may receive or pay cash on your behalf. Add EFT receipts and Subtract EFT payments Service Charge. This cash payment is the bank’s fee for processing your transactions. Subtract service charges. Interest revenue on your account. Add interest revenue Nonsufficient funds (NSF) cheques. This represents cash receipts from customers who do not have sufficient funds in their bank account to cover the amount. Subtract NSF cheques Book errors. Any errors made in recording transactions in the books are corrected on this side. Depending on the error, the amount may be added or subtracted

What are the Adjustments to the Bank Balance? Outstanding cheques Cheques written by the company that have not been processed (yet) by the bank Subtract from the bank balance Deposits in transit Deposits made by the company that have not been processed (yet) by the bank Add to the bank balance Errors made by the bank

What are the Adjustments to the Book (Bank/Cash account) Balance? Interest earned Interest-bearing checking accounts earn interest Add to the book balance Service charges Fees charged by the bank for services rendered Subtract from the book balance NSF cheques Cheques accepted by the company that “bounced” due to insufficient funds Subtract from book balance Errors made by the company

Common Discrepancy Items Bank’s Record Deduct: Outstanding cheques (cheques which have been written and recorded by the company but not cashed by the bank) Add: Late deposits (deposits made and entered in the company’s book on the last day of the period covered by the bank statement which doesn’t appear due to the (processing delay) Company’s Records Deduct: Debit memos on the bank statement for interest charges, service charges, etc. Errors made in recording payments Add: Credit memos on the bank statement for interest earned

Bank Reconciliation Example

Journalizing Transactions from the Bank Reconciliation The bank reconciliation is an accountant’s tool separate from the journals and ledgers It does not account for transactions in the journal To get the transactions into the accounts, we must make journal entries and post to the ledger All items on the Book side of the bank reconciliation require journal entries Note that Cash will be debited for any items added to the Book side of the reconciliation and Cash will be credited for any items subtracted on the Book side of the reconciliation E.g. journal entry for NSF cheque journal entry for interest revenue A/R Debit Cash Debit Cash Credit Interest Revenue Credit

Lecture Examples A company just received its bank statement. According to the bank, the balance in the cash account should be $4,678.65. But according to the accounting records (books), the balance in the cash account is $4,378.21. After carefully comparing the cheque register to the bank statement, the following items were discovered: Deposit in transit $ 560.33 Interest earned 5.47 NSF cheque 218.49 Outstanding cheques 1,242.79 Service charge on NSF cheque 25.00 In addition, it was discovered that cheque #5567 which was written for $160.50 was incorrectly recorded in the accounting records for $16.50. What is the correct balance in the cash account?