© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-1 CHAPTER 4 Internal Control and Managing Cash

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-2 INTERNAL CONTROL Internal control is the organizational plan and all the related measures that an entity adopts to –Safeguard assets –Encourage adherence to company policies –Promote operational efficiency –Ensure accurate and reliable accounting records

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-3 INTERNAL CONTROL Competent, reliable, and ethical personnel Assignment of responsibilities to each employee Proper authorization for deviation from standard policy An effective system of internal control has the following characteristics:

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-4 INTERNAL CONTROL Separation of duties –Separation of operations from the accounting function –Separation of the custody of assets from accounting for them –Separation of the authorization of transactions from the custody of related assets –Separation of duties within the accounting function

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-5 INTERNAL CONTROL Internal and external audits –An audit is the examination of the company’s financial statements and the accounting systems, internal controls, and records that produced them –An internal auditor is an employee of the business who reports directly to the audit committee –An external auditor is an independent auditor hired by a company to audit the financial statements and the factors affecting them

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-6AuditCommittee Board of Directors Vice President, Finance and Accounting Treasurer Vice President, Marketing Vice President, Production Senior Vice President President Collections and Credits Systems Cash Management Investor Relations Banking Relations Other Vice PresidentsExternalAuditing Controller General Accounting TaxesInternalAuditing Budgeting Organizational Chart of a Corporation

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-7 INTERNAL CONTROL Documents and records –Business documents and records include Source documents –Invoices, purchase orders, receipts, etc. Accounting journals Accounting ledgers Electronic and computer controls –Electronic sensors on merchandise –Control totals

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-8 INTERNAL CONTROL Other controls –Fireproof vaults –Burglar alarms –Point of sale terminals –Frequent bank deposits –Bonded cashiers A bond is an insurance policy that reimburses the company for losses due to employee theft –Mandatory vacations –Job rotation

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-9 INTERNAL CONTROL The limitations of internal control –A system designed to thwart an individual employee’s fraud can be beaten by collusion between two or more employees to defraud the system –A system of internal control that is too complex can hurt efficiency and control

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-10 USING THE BANK ACCOUNT AS A CONTROL DEVICE The business should deposit all cash receipts in a bank account and make all cash payments through it. The documents used to control a bank account include the… Signature card Deposit ticket Check Bank statement Bank reconciliation

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-11 USING THE BANK ACCOUNT AS A CONTROL DEVICE Signature Card –A card signed by each person authorized to transact business through an account in a bank It protects both the bank and the depositor against forgery

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-12 Deposit ticket –A form supplied by the bank which serves as proof of a transaction Check –A document instructing the bank to pay the designated person or business a specified amount of money The three parties to a check are –The maker –The payee –The bank USING THE BANK ACCOUNT AS A CONTROL DEVICE

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-13 USING THE BANK ACCOUNT AS A CONTROL DEVICE California Products Bay Area National Bank Three hundred nineteen and 47/ Dollars Check Serial Number BankPayee Maker

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-14 The bank statement shows the account’s beginning and ending balance and lists the month’s transactions processed by the bank as well as the maker’s canceled checks –An electronic funds transfer (EFT) transfers cash by electronic communications EFTs are listed among the deposits and payments on the bank statement USING THE BANK ACCOUNT AS A CONTROL DEVICE

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-15

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-16 The bank reconciliation –Explains the difference between the firm’s cash balance and the bank statement balance on a certain date –Ensures that all cash transactions have been accounted for and that the bank and book records of cash are correct USING THE BANK ACCOUNT AS A CONTROL DEVICE

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-17 Items that cause differences between the bank balance and the book balance are –Items recorded by the company but not yet recorded by the bank Deposits in transit - recorded by the company but not by the bank Outstanding checks - issued and recorded by the company, but not yet paid by the bank USING THE BANK ACCOUNT AS A CONTROL DEVICE

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-18 –Items recorded by the bank but not yet recorded by the company Bank collections received on behalf of the business Electronic funds transfers paid or received on behalf of the business Service charge assessed by the bank for processing the business’s transactions Interest revenue on checking account USING THE BANK ACCOUNT AS A CONTROL DEVICE

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-19 NSF (nonsufficient funds) checks received from customers which are worthless and returned to the payee Checks collected, deposited, and returned to the payee by the bank for reasons other than NSF The cost of printed checks –Errors by either the company or the bank USING THE BANK ACCOUNT AS A CONTROL DEVICE

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren Maker writes check to payee 2 Payee deposits check in bank, which increases payee’s balance 3 Payee’s bank sends check to Maker’s bank 4 Maker’s bank decreases Maker’s balance and sends cancelled check to Maker 1 Maker writes check to payee 2 Payee deposits check in bank, which increases Payee’s balance 4 Maker’s bank account not sufficient to pay the check 3 Payee’s bank sends check to Maker’s bank 5 Maker’s bank returns worthless check to Payee’s bank 6 Payee’s bank decreases payees balance and returns worthless check to payee 7 Payee holds worthless check The Paths That Two Checks Take

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-21 BANK RECONCILIATION ILLUSTRATED The bank statement for Business Research, Inc., on the next slide indicates that the January 31 bank balance is $5,931.51

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-22

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-23 BANK RECONCILIATION ILLUSTRATED The detail of Business Research, Inc.’s, cash records is presented on the following slide The company’s Cash account has a balance of $3, Cash

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren X1 Jan 1Balance 6, Cash receipt 1, , Cash receipt , Cash payments6, Cash payments 6, , Cash receipt 1, , Ledger: ACCOUNT Cash Date Item DebitCredit Balance 332$3, $ , Cash Payments Check No. AmountCheck No. Amount

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-25 BANK RECONCILIATION ILLUSTRATED  The following reconciling items explain why the two balances differ: ÀThe January 31 deposit of $1, does not appear on the bank statement ÁThe bank erroneously charged to the account a $100 check (No. 656) written by Business Research Associates

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-26 ÂFive company checks issued late in January and recorded in the journal have not been paid by the bank BANK RECONCILIATION ILLUSTRATED Check No. DateAmount 337Jan. 27$ Check No. DateAmount 337Jan. 27$

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-27 ÃThe bank received $ by EFT on behalf of Business Research, Inc. ÄThe bank collected on behalf of the company a note receivable, $2,114 (including interest of $214) ÅThe bank statement shows interest revenue of $28.01 BANK RECONCILIATION ILLUSTRATED

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-28 ÆCheck number 333 for $150 paid to Brown Company on account was recorded as a cash payment of $510 ÇThe bank service charge for the month was $14.25 ÈThe bank statement shows an NSF check for $52 ÉBusiness Research pays insurance expense by EFT and has not recorded this $361 payment BANK RECONCILIATION ILLUSTRATED

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-29 BANK RECONCILIATION ILLUSTRATED

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-30 To the bank balance always –Add deposits –Subtract outstanding checks –Add or subtract corrections of bank errors, as appropriate BANK RECONCILIATION ILLUSTRATED Reconciling items are treated as follows:

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-31 To the book balance always –Add bank collection items, interest revenue, and EFT receipts –Subtract service charges, NSF checks, and EFT payments –Add or subtract correction of book errors, as appropriate BANK RECONCILIATION ILLUSTRATED Reconciling items are treated as follows:

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-32 BANK RECONCILIATION ILLUSTRATED On the basis of the reconciliation, Business Research, Inc., makes the following entries (numbers in parentheses correspond to the reconciling items): Jan. 31 (4)Cash Rent Revenue Receipt of monthly rent Jan. 31 (4)Cash Rent Revenue Receipt of monthly rent

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-33 BANK RECONCILIATION ILLUSTRATED Jan. 31 (5)Cash 2, Notes Receivable1, Interest Receivable Note receivable collected by bank Jan. 31 (5)Cash 2, Notes Receivable1, Interest Receivable Note receivable collected by bank Jan. 31 (6)Cash Interest Revenue Interest earned on bank balance Jan. 31 (6)Cash Interest Revenue Interest earned on bank balance

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-34 BANK RECONCILIATION ILLUSTRATED Jan. 31 (7)Cash Accounts Payable - Brown Co Correction of check no. 333 Jan. 31 (7)Cash Accounts Payable - Brown Co Correction of check no. 333 Jan. 31 (8)Misc. Expense Cash Bank service charge Jan. 31 (8)Misc. Expense Cash Bank service charge

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-35 BANK RECONCILIATION ILLUSTRATED Jan. 31 (9)Accounts Receivable - L. Ross Cash NSF check returned by bank Jan. 31 (9)Accounts Receivable - L. Ross Cash NSF check returned by bank Jan 31. (10)Insurance Expense Cash Payment of monthly insurance Jan 31. (10)Insurance Expense Cash Payment of monthly insurance

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-36 Cash Inventory Accounts Receivable Accounts Receivable Purchases Collection of Cash Sales on Account OPERATING CYCLE OF A BUSINESS

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-37 MANAGING CASH Companies –Sell most of their goods on account –Keep a subsidiary accounts receivable ledger with a separate account for each customer –Use the accounts receivable ledger to pursue collection from individual customers  Speeding the collection of cash from sales

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-38 Accounts Receivable Toys “R” Us Target Kmart Bal. 1,800 Bal. 1,000 Bal. 300 Bal. 500 GENERAL LEDGER ACCOUNTS RECEIVABLE SUDSIDIARY LEDGER Cash Bal. XX Total 1,800

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-39 MANAGING CASH Companies offer sales discounts that motivate customers to pay within a specified period Credit terms of “2/10, n/30” means the customer can –Take a 2% discount by paying within ten days of the date of the sale or –Pay the full amount within 30 days

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-40 MANAGING CASH Suppose Fisher-Price makes a $50,000 sale to Toys “R” Us on August 4. If credit terms are 2/10, n/30 and Fisher- Price collects on August 14, Fisher-Price would record the sale and collection with these journal entries: Aug. 4 Accounts Receivable - Toys “R” Us50,000 Sales Revenue50,000 Sale on account Aug. 4 Accounts Receivable - Toys “R” Us50,000 Sales Revenue50,000 Sale on account Aug. 14 Cash ($50,000 x.98)49,000 Sales Discount ($50,000 x.02) 1,000 Accounts Receivable - Toys “R” Us50,000 Collection on account Aug. 14 Cash ($50,000 x.98)49,000 Sales Discount ($50,000 x.02) 1,000 Accounts Receivable - Toys “R” Us50,000 Collection on account

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-41 Internal control over cash receipts ensures that –All cash receipts are deposited in the bank –The company’s cashier combines them with any cash received over the counter and prepares the bank deposit MANAGING CASH

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-42 Competent, reliable,Companies carefully screen employees for ethical personnelundesirable personality traits. They also spend large sums for training programs. Assignment ofSpecific employees are designated as cashiers, responsibilitiessupervisors of cashiers, or accountants for cash receipts. Proper authorizationOnly designated employees, such as department managers, can grant exceptions for customers, approve check receipts above a certain amount, and allow customers to purchase on credit. Separation of dutiesCashiers and mailroom employees who handle cash do not have access to the accounting records. Accountants who record cash receipts have no opportunity to handle cash. Element of Internal Control Internal Controls over Cash Receipts INTERNAL CONTROLS OVER CASH RECEIPTS

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-43 Internal and externalInternal auditors examine company transactions auditsfor agreement with management policies. External auditors examine the internal controls over cash receipts to determine whether the accounting system produces accurate amounts for revenues, receivables, and other items related to cash receipts. Documents and recordsCustomers receive receipts as transaction records. Bank statements list cash receipts for reconciliation with company records (deposit tickets). Customers who pay by mail include a remittance advice showing the amount of cash they sent to the company. Electronic and computerCash registers serve as transaction records. Each controlsday’s receipts are matched with customer remittance advices and with the day’s deposit ticket from the bank. Other controlsCashiers are bonded. Cash is stored in vaults and banks. Employees are rotated among jobs and are required to take vacations.

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-44 INTERNAL CONTROL OVER CASH PAYMENTS Purchase requestSales departmentPurchasing department (requisition) Purchase orderPurchasing Outside company that departmentsells the needed merchandise (supplier or vendor) Invoice (bill)Outside company Accounting department that sells the needed merchandise (supplier or vendor) Receiving reportReceiving departmentAccounting department Disbursement packetAccounting departmentOfficer who signs the check Business Document Prepared bySent to The Purchasing Process

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-45 Purchase Request Purchase Order Invoice Receiving Report INTERNAL CONTROL OVER CASH PAYMENTS Disbursement Packet

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-46 Competent, reliable,Cash payments are entrusted to high-level ethical personnelemployees, with larger amounts paid by the treasurer or assistant treasurer. Assignment ofSpecific employees approve purchase documents responsibilitiesfor payment. Executives examine approvals, then sign checks. Proper authorizationLarge expenditures must be authorized by the company owner or board of directors to ensure agreement with organizational goals. Separation of dutiesComputer operators and other employees who handle checks have no access to the accounting records. Accountants who record cash payments have no opportunity to handle cash. Element of Internal Control Internal Controls over Cash Payments INTERNAL CONTROLS OVER CASH PAYMENTS

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-47 Internal and externalInternal auditors examine company transactions auditsfor agreement with management policies. External auditors examine the internal controls over cash payments to determine whether the accounting system produces accurate amounts for expenses, assets, and other items related to cash disbursement. Documents and recordsSuppliers issue invoices that document the need to pay cash. Bank statements list cash payments (checks and EFT disbursements) for reconciliation with company records. Checks are prenumbered in sequence to account for payments. Electronic, computer,Blank checks are stored in a vault and controlled and other controls by a responsible official with no accounting duties. Machines stamp the amount on a check in indelible ink. Paid invoices are punched to avoid duplicate payment.

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-48 INTERNAL CONTROL OVER CASH PAYMENTS Controlling Petty Cash The petty cash fund is –A small amount of cash kept on hand to pay for minor expenses –Opened with a particular amount of cash The custodian of the petty cash fund –Cashes a check and places the currency and coin in the fund –Prepares a petty cash ticket for each petty cash payment

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-49 INTERNAL CONTROL OVER CASH PAYMENTS Petty Cash Ticket Date Mar. 25, 20X4No. 47 Amount $23.00 For Box of floppy diskettes Debit Office supplies, Acct. No. 145 Received by Fund Custodian Petty Cash Ticket Date Mar. 25, 20X4No. 47 Amount $23.00 For Box of floppy diskettes Debit Office supplies, Acct. No. 145 Received by Fund Custodian

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-50 In an imprest petty cash system –The sum of the cash in the petty cash fund plus the total of the ticket amounts should equal the opening balance at all times –The petty cash account keeps its prescribed balance at all times INTERNAL CONTROL OVER CASH PAYMENTS

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-51 USING A BUDGET TO MANAGE CASH A budget –Is a quantitative expression of a plan that helps managers coordinate the entity’s activities –Helps a company manage its cash by expressing the plan for the receipt and payment of cash during a future period

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-52 USING A BUDGET TO MANAGE CASH To prepare for future cash needs, managers proceed in four steps: ÀStart with the entity’s cash balance at the beginning of the period ÁAdd the budgeted cash receipts and subtract the budgeted cash payments –Revenue and expense transactions (operating activities from the income statement)

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-53 –Asset acquisition and sale transactions (investing activities from the statement of cash flows) –Liability and stockholders’ equity transactions (financing activities from the statement of cash flows) ÂThe beginning balance plus the expected receipts minus the expected payments equals the expected cash balance at the end of the period USING A BUDGET TO MANAGE CASH

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-54 ÃCompare the expected cash balance to the desired, or budgeted, cash balance at the end of the period –Excess cash can be invested –Cash balances below the budgeted balance may require additional financing to reach the desired cash balance The following slide shows an example of a cash budget for The Gap, Inc. USING A BUDGET TO MANAGE CASH

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-55 (In millions)

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-56 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 such as –Time deposits –Certificates of deposit

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-57 REPORTING CASH ON THE BALANCE SHEET

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-58 ETHICS AND ACCOUNTING

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-59 CORPORATE AND PROFESSIONAL CODES OF ETHICS Most large companies have a code of ethics designed to encourage ethical and responsible behavior by their employees

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-60 Accountants have additional incentives to behave ethically –Independent accountants must abide by the AICPA Code of Professional Conduct –Members of the Institute of Management Accountants are bound by the Standards of Ethical Conduct for Management Accountants CORPORATE AND PROFESSIONAL CODES OF ETHICS

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-61 ETHICAL ISSUES IN ACCOUNTING ÀDetermine the facts ÁIdentify the ethical issues ÂSpecify the alternatives ÃIdentify the people involved ÄAssess the possible outcomes ÅMake the decision To make ethical decisions, people should proceed in six steps:

© 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 4-62 End of Chapter 4