Internal Control and Managing Cash Chapter 4

system of internal control. Set up an effective system of internal control.

Internal Control Safeguard assets. Promote operational efficiency. It is the organizational plan and all the related measures that an entity adopts. Encourage Adherence to company policies. Safeguard assets. Ensure Accurate and reliable accounting records. Promote operational efficiency.

Components of an Effective System Competent, reliable, and ethical personnel Assignment of responsibilities Authorization Recording Custody Separation of duties

Separation of Duties Separation of the Authorization of transactions from the Recording of transactions from the Custody of assets

Internal and External Audits An audit is an examination by an outside party of the company’s financial statements, accounting systems, and internal controls. An internal auditor is an employee of the business. An external auditor is an independent auditor.

Business documents and records include: invoices (bills) paid checks accounting journals accounting ledgers

Electronic and Computer Controls Businesses use electronic devices to safeguard assets.

The Onion Model of E-Commerce System Security Sensitive Hardware, Software, and Data Encryption Firewalls Intrusion detection devices Incident response procedures Audits by external specialists

Encryption It is the transformation of data by a mathematical process into a form that is unreadable by anyone who does not have the secret decryption key. Same key Clear message Encryption Encoded Decryption

Firewall Internet Passwords Other codes It is a technique that limits access to hardware, software, or data to persons within a network. Inquirers Customers Hackers Firewall 1 Firewall 2 Firewall 3 Internet Passwords Other codes

Other Controls – Fireproof vaults – Burglar alarms – Point of sale terminals – Frequent bank deposits – Mandatory vacations – Job rotation

The Limitations of Internal Control Systems designed to thwart one person’s fraud can be beaten by two or more employees working together – colluding – to defraud the firm. A system of internal control that is too complex can be inefficient.

Use a bank reconciliation as a control device.

The Bank Reconciliation There are two records of a business’s cash: the company’s cash account on its own books, and… 1 the bank statement, which shows the actual amount of cash in the bank. 2

The Bank Reconciliation Two common items that cause differences between the bank balance and the book balance. 1. Items recorded by the company but not yet recorded by the bank: – Deposits in transit – Outstanding checks

The Bank Reconciliation 2. Items on a bank statement and not recorded by the business: – Bank collections – Electronic funds transfers – Service charge – Interest revenue earned on account – NSF checks – Errors

Bank Reconciliation Illustrated The bank statement of Business Research, Inc., shows a balance of $5,931.51 on January 31. The company Cash account on the books has a balance of $3,294.21. The following reconciling items explain why the two balances differ:

The Bank Reconciliation Illustrated 1. The January 30 deposit of $1,591.63 does not appear on the bank statement. 2. The bank erroneously charged to the account a $100 check (No. 656) not written by Business Research Associates. 3. Five company checks issued late in January and recorded in the journal have not been paid by the bank.

The Bank Reconciliation Illustrated Check No. Date Amount 337 Jan. 27 $ 286.00 338 28 319.47 339 28 83.00 340 29 203.14 341 30 458.53 Total $1,350.14

The Bank Reconciliation Illustrated 4. The bank received $904.03 by EFT on behalf of Business Research, Inc. 5. The bank collected on behalf of the company a note receivable, $2,114 (including interest revenue of $214). 6. The bank statement shows interest revenue of $28.01.

The Bank Reconciliation Illustrated 7. Check number 333 for $150 paid to Brown Company on account was recorded as a cash payment of $510. 8. The bank service charge for the month was $14.25. 9. The bank statement shows an NSF check for $52. 10. Business Research pays insurance expense by EFT and has not recorded this $361 payment.

The Bank Reconciliation Illustrated Balance per bank, January 31 $5,931.51 Add deposit in transit 1,591.63 Check erroneously charged 100.00 $7,623.14 Less outstanding checks –1,350.14 Adjusted bank balance $6,273.00

The Bank Reconciliation Illustrated Balance per books, January 31 $3,294.21 Add: ETF receipt of rent revenue 904.03 Collection of note receivable 2,114.00 Interest revenue earned 28.01 Correction of book error 360.00 $6,700.25 Less: Service charge $ 14.25 NSF check 52.00 Payment of insurance expense 361.00 – 427.25 Adjusted book balance $6,273.00

Apply internal controls to cash receipts and cash payments.

Controlling and Managing Cash Internal control over cash receipts ensures that all cash receipts are deposited in the bank and no collections are lost.

Over the Counter Receipts The point-of-sale terminal (cash register) offers control over the cash received in a store.

Mail Receipts All incoming mail should be opened by a mailroom employee. This person should compare the check received with the remittance advice. The mailroom clerk keeps a running total of cash receipts for the day.

Mail Receipts Many companies use a lock-box system. Customers send checks directly to an address that is essentially a bank account.

Internal Controls Over Cash Receipts Element of Internal Control Internal Controls over Cash Receipts Competent, reliable, ethical personnel Carefully screen and train employees. Proper authorization Only designated employees can grant exceptions for customers.

Internal Controls Over Cash Receipts Separation of duties Employees who handle cash do not have access to accounting records. Internal: management policies External: control over cash receipts Internal and external audits Electronic and computer controls Match receipts with remittances and bank deposit ticket daily.

Internal Control: Payments Purchasing Process Purchase request (requisition) Sales department Purchasing Business Document Prepared by Sent to Purchase order Purchasing department Supplier Invoice (bill) Supplier Accounting department Receiving report Receiving department Accounting Disbursement packet Accounting department Officer who signs the check

Internal Control: Payments Disbursement Packet Purchase Request Purchase Order Receiving Report Invoice Disbursement Packet

Internal Controls Over Cash Payments Element of Internal Control Internal Controls over Cash Payments Competent, reliable, ethical personnel Payments entrusted to high level employees and the treasurer. Proper authorization Large expenditures must be authorized by top management.

Internal Controls Over Cash Payments Separation of duties Employees who handle checks have no access to accounting records. Internal: management policies External: control over cash payments Internal and external audits Electronic and computer controls Computer programmers do not operate the computers.

Use a budget to manage cash.

Using a Budget to Manage Cash A budget is a financial plan that helps coordinate business activities. A cash budget helps a company, or an individual, manage cash by planning the receipt and payment of cash during a future period.

Cash Budget Example 1. Cash balance, February1, 20x2 $ 202.6 Estimated cash receipts: 2. Collections from customers 2,858.3 3. Interest and dividends on investments 6.2 4. Sale of store fixtures 4.9 $3,072.0 Estimated cash payments: 5. Purchases of inventory $1,906.2 6. Operating expenses 561.0 7. Expansion of existing stores 206.4 8. Opening of new stores 344.6 9. Payment of long-term debt 148.7 10. Payment of dividends 219.0 3,385.9 11. Net cash position at January 31, 20x3 (111.3) 12. Budgeted / Desired cash balance, January 31, 20x3 200.0 13. Additional cash needed to meet desired 1/31/x3 balance $ 311.3 Cash Budget For the Year Ended January 31, 20x3 (In millions)

Reporting Cash on the Balance Sheet Companies usually combine all cash amounts into a single total called “Cash and Cash Equivalents” on the balance sheet. Cash equivalents include liquid assets… Time deposits Certificates of deposit

Reporting Cash on the Balance Sheet America Online, Inc. Consolidated Balance Sheet December 31 Excerpts (In Millions) 2000 Assets Current assets: Cash and cash equivalents $2,610 Short-term investments 886 Accounts receivable 464

Weigh ethical judgment in business.

Ethics and Accounting Most large companies have a code of ethics designed to encourage ethical and responsible behavior by employees. Accountants have additional incentives to behave ethically. AICPA Code of Professional Conduct Standards of Ethical Conduct for Management Accountants

Ethics and Accounting Conflict of Interest Business transactions Enron Corporation A. Fastow, CEO Outside Partnership A. Fastow, Principal Business transactions

End of Chapter 4