1. Chapter 6 Internal Control and Accounting for Cash
In this chapter, we will look at the importance of good internal controls for achieving enterprise objectives and accounting for cash.

2. LO 6-1: Identify the key elements of a strong system of internal control.
Learning Objective 6-1: Identify the key elements of a strong system of internal control.

3. Internal Controls
Internal Control: the process designed to ensure reliable financial reporting, effective and efficient operations, and compliance with applicable laws and regulations.
The framework established by The Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 1992 is the de facto standard by which SOX compliance is judged. COSO’s framework, titled Internal Control—An Integrated Framework, recognizes five interrelated components.
Internal control is the process designed to ensure reliable financial reporting, effective and efficient operations, and compliance with applicable laws and regulations. Safeguarding assets against theft and unauthorized use, acquisition, or disposal is also part of internal control.
The framework established by The Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 1992 is the de facto standard by which SOX compliance is judged. COSO’s framework, titled Internal Control—An Integrated Framework, recognizes five interrelated components.

4. COSO Components The five interrelated COSO components include:
Control Environment
Control Activities
Risk Assessment
Information and Communication
Monitoring
The five interrelated components include:
1. Control Environment. The integrity and ethical values of the company, including its code of conduct, involvement of the board of directors, and other actions that set the tone of the organization.
2. Risk Assessment. Management’s process of identifying potential risks that could result in misstated financial statements and developing actions to address those risks.
3. Control Activities. These are the activities usually thought of as “the internal controls.” They include such things as segregation of duties, account reconciliations, and information processing controls designed to safeguard assets and enable an organization to prepare reliable financial statements in a timely manner.
4. Information and Communication. The internal and external reporting process, including an assessment of the technology environment.
5. Monitoring. Assessing the quality of a company’s internal control over time and taking actions as necessary to ensure it continues to address the risks of the organization.

5. Key Features of Internal Control
Segregation of Duties
Quality of Employees
Bonded Employees
Required Absences
Procedures Manual
Authority and Responsibility
Prenumbered Documents
Physical Control
Performance Evaluations
Here is a list of the nine major internal control features that we will discuss in detail on the following screens.

6. Segregation of Duties
When duties are segregated, the work of one employee can act as a check on the work of another employee.
The likelihood of fraud or theft is greatly reduced.
It is important that a company implement a plan to segregate duties. We do not want one person to be able to order an item, pay for it, and have it under his or her control. When we segregate duties, we are asking one employee to serve as a check on the work of another employee or group of employees. Effective segregation of duties reduces the likelihood of fraud or theft by employees.

7. Quality of Employees
The ability of cross-trained employees to substitute for one another prevents disruptions in the workplace.
Job rotation may help relieve boredom and increase productivity.
It is desirable to cross-train employees. By doing so, one employee can step in and do the work of another in cases of illness, vacation, or extended leave. Cross-training helps minimize disruption in the workplace and often increases the productivity of all workers.

8. Bonded Employees
A fidelity bond provides insurance that protects a company from losses caused by employee dishonesty.
To become bonded, an employee’s background is investigated.
Any employee working with cash, accounts receivable, inventory, and similar assets needs to be placed under a fidelity bond. Bonding provides insurance against theft or dishonesty on the part of a bonded employee. Obviously, to be bonded the employee must go through an extensive background check. The ability to be bonded can be made a precondition of employment.

9. Required Absences
An employee may be able to cover up fraudulent activities if they are always present at work.
All employees should be required to take regular vacations and their duties should be rotated periodically.
All employees should be required to take annual vacations. While they are away from work, a cross-trained employee will fill in and complete the work of the absent employee. If the employee on vacation is involved in any activity that is not in the best interest of the company, the cross-trained employee should be able to discover the problem and bring it to management’s attention.

10. Procedures Manual
Accounting and other important procedures should be written in a procedures manual.
Periodically, management should conduct an investigation to see that required procedures are actually being followed.
Large- and medium-size companies should have a formal set of policies and procedures that all employees are expected to follow. The policies and procedures should be in writing and made available to all employees in the organization. Management should request that the internal audit staff investigate whether the policies and procedures are being followed by members of the organization.

11. Authority and Responsibility
General authority applies to all members of the organization. For example, all employees are required to fly coach and purchase airline tickets from a specific vendor.
Specific authority applies only to a specific position within the organization. For example, all checks must be cosigned by the controller and treasurer.
Policies and procedures can be general or specific. General policies apply to all employees. For example, it may be company policy that all air travel be booked at “coach” fare and that tickets be purchased from an authorized vendor.
Specific policies apply to a single individual or a small group of employees. For example, it may be company policy that all checks require two signatures. One of the signers should be in the accounting function to attest to accounting policies being followed, and the other should be from the treasury department. The treasurer has ultimate authority and responsibility for the management of cash.

12. Prenumbered Documents
Prenumbered forms are used for all important documents such as checks, purchase orders, receiving reports, and invoices.
The use of prenumbered forms helps keep track of all forms issued during a particular period.
You probably use prenumbered checks. You may become concerned when you are missing a check number. For example, you wrote and recorded checks 101 and 103, but cannot locate check 102.
Almost all documents used in business are prenumbered. Prenumbered documents include invoices, purchase orders, sales orders, receipts, and many others. Next time someone gives you a receipt, notice that it has a number printed on it. The use of prenumbered documents helps us control and track all forms issued during the accounting period.

13. Physical Control
All companies should maintain adequate physical control over valuable assets that may be misappropriated.
For example, inventory should be properly stored in a secure location.
Serial numbers should be placed on all valuable assets to assist in a physical count of these assets.
Every company should have established policies to physically control and protect its valuable assets. Assets such as cash, inventory, and certain types of equipment can be misappropriated by employees for personal gain. Inventory should be stored in a secure location and be under the control of a warehouse manager. Identifying numbers should be placed on all valuable physical assets that may be subject to misappropriation. Not only is this a good idea for a company, it is an excellent idea for your personal life. If you have recorded serial numbers from your television, DVD player, computer, and other assets, you will be able to assist police in case of a robbery.

14. Performance Evaluation
Internal controls should include independent verification of employee performance.
For example, someone other than the person who has control over inventory should take a physical count of inventory.
Internal and external audits serve as independent verification of performance.
Each employee should be subject to a performance evaluation at least annually. More frequent evaluations increase the effectiveness of the internal controls related to the employee’s job.
Internal and external audits serve as independent verification of performance.

15. Limitations
Internal controls can be circumvented by collusion among employees.
Two or more employees working together can hide embezzlement by covering for each other.
No system can completely prevent fraud.
Regardless of how good a company’s internal control system may be, it can always be circumvented by collusion among two or more employees. When employees collude, they are able to cover for each other and make the embezzlement difficult to find.

16. LO 6-2: Identify special internal controls for cash.
Learning Objective 6-2: Identify special internal controls for cash.

17. Accounting for Cash Controlling cash involves several duties:
Cash receipts should be recorded immediately upon receipt and deposited intact daily.
A deposit ticket should be used for all deposits.
Cash payments should be made by prenumbered check.
A monthly bank reconciliation should be prepared by an independent party.
An up-to-date signature card should be maintained.
Part I Cash is the asset most susceptible to misappropriation, so we need special controls over cash. To begin, all cash receipts should be recorded immediately and deposited intact daily. The only exception is for cash needed for cash registers or petty cash funds.
Part II Prenumbered deposit tickets should be used for all deposits. The deposit tickets should be maintained for as long as necessary.
Part III All cash disbursements, with the exception of petty cash, should be made by prenumbered checks. It is a very good policy to have two check signers.
Part IV All bank accounts should be reconciled each month by an independent party. That party is the internal auditor in large organizations. As a result of the reconciliation, adjusting entries are usually required to have the general ledger account show the true cash balance.
Part V
We must make certain that all current employees who are authorized to sign checks have signed the bank authorized signature card.

18. Exhibit 6.1: Balance Sheet Classifications that Include the Word Cash
This pie chart is based on data drawn from the recent annual reports published by the 30 companies that comprise the Dow Jones Industrial Average. It shows that:
Cash and cash equivalents comprise 83%
Cash and equivalents comprise 7%
Cash comprises 7%
Cash and marketable securities comprise 3%
As illustrated in Exhibit 6.1, most companies combine currency and other receivable-on-demand items in a single balance sheet account with varying titles.

19. Exhibit 6.2: Bank Statement
First State Bank of Frisco County
2121 Westbury Drive; Harrison, Nevada
To: Green Shades Resorts, Inc.
1429 Lazy Lane
Harrison, Nevada
Account No
Checking Account Summary
On this date
8/31/Year 1
Your balance was
4,779.86
Deposits Added
3,571.72
No. Deposits 5
Checks Paid
4,537.22
No. Checks 22
Other Debits
297.91
Resulting in a balance of
3,516.45
9/30/Year 1
Enclosures 29
Checks and Debits
Deposits and Credits
Date
Balance
15.82
24.85
600.25
9/3
5,339.44
249.08
497.00
9/5
4,593.36
42.53
124.61
9/7
4,426.22
79.87
859.38
9/8
3,486.97
685.00
742.59
711.43
9/9
2,770.81
25.75
38.98
9/ 12
2,706.08
36.45
59.91
9/14
2,609.72
8.40 DM CM
9/15
3,541.32
61.40
689.47
9/18
4,169.39 NS
9/19
3,879.88
71.59
82.00
9/21
3,726.29
312.87
9/24
3,413.42
25.00
630.57
9/27
4,018.99
227.00
9/28
3,791.99
95.06
180.48
9/30
Legend – NS Nonsufficient funds * DM Debit Memo *CM Credit Memo
Bank statements normally report (a) the balance of the account at the beginning of the period; (b) additions for customer deposits made during the period; (c) other additions described in credit memos (e.g., for interest earned); (d) subtractions for the payment of checks drawn on the account during the period; (e) other subtractions described in debit memos (e.g., for service charges); (f) a running balance of the account; and (g) the balance of the account at the end of the period.
The sample bank statement in Exhibit 6.2 illustrates these items with references to the preceding letters in parentheses.

20. Bank Statement
Bank statement debit memos describe transactions that reduce the customer’s account balance (the bank’s liability).
Bank statement credit memos describe activities that increase the customer’s account balance (the bank’s liability).
Because a checking account is an asset (cash) to the depositor, a bank statement debit memo requires a credit entry to the Cash account on the depositor’s books.
The bank statement is presented from the bank’s point of view.
Therefore, in the bank’s accounting records a customer’s checking account has a credit balance. As a result, bank statement debit memos describe transactions that reduce the customer’s account balance (the bank’s liability). Bank statement credit memos describe activities that increase the customer’s account balance (the bank’s liability).
Because a checking account is an asset (cash) to the depositor, a bank statement debit memo requires a credit entry to the Cash account on the depositor’s books.

21. LO 6-3: Prepare a bank reconciliation.
Learning Objective 6-3: Prepare a bank reconciliation.

22. Reconciling the Bank Statement
The bank reconciliation reports on the differences between the balance on the bank statement and the balance in the general ledger cash account. The result of the reconciliation is the true cash balance that will appear on the balance sheet.
Part I As you know from your personal finances, the bank reconciliation explains the difference between the cash balance shown on your bank statement and the cash balance in the general ledger cash account. In your case, the general ledger is your checkbook. We should be able to reconcile the bank statement to the true cash balance and the cash account to the same true cash balance.
Part II Common adjustments to the cash balance shown on the bank statement are deposits in transit and checks that are outstanding at the end of the period. We always add the deposits in transit to the bank balance and deduct any checks outstanding.
Part III Some common adjustments to the general ledger cash account include amounts collected for use by the bank and interest earned on our checking account. Both of these amounts will be added to the general ledger cash balance. Any bank service charge and non-sufficient-funds checks are subtracted. A non-sufficient-funds check is one that we deposited in our checking account but the maker of the check did not have sufficient cash to cover it. Sometimes we refer to these as “bounced” checks.
6-21

23. Reconciling the Bank Statement (Continued)
If an error is found on the bank statement, an adjustment is made to the unadjusted bank balance to determine the true cash balance.
An error made on our books requires an adjusting journal entry to correct.
Both the bank and our accounting department can make errors that go undetected until we prepare the bank reconciliation. These errors always need to be analyzed and corrected. All reconciling items that appear on the general ledger cash side of our reconciliation require an adjustment to our books. The adjustments change the general ledger balance to the true cash balance.

24. Bank Reconciliation Information
Green Shades Resorts, Inc. is preparing the bank reconciliation for the month of September.
The September 30th balance on the bank statement is $3,516.45, and the Cash general ledger balance on this date is $3,
There was a deposit in transit in the amount of $
The bank erroneously deducted a $25 check drawn on the books of Grand Valley Resorts from our account.
At September 30th three checks are outstanding: Check 639 dated 9/18 for $13.75; Check 646 dated 9/20 for $29.00; and Check 672 dated 9/27 for $ (continued).
On the next two screens we present information relating to the bank reconciliation for Green Shades Resorts for the month of September. You may choose to either print these screens or jot down the information.

25. Bank Reconciliation Information (Continued)
During the month of September the bank collected an account receivable for us in the amount of $
A check actually written for $36.45 for utilities expense was erroneously recorded in our records by the bookkeeper as $63.45.
The bank assessed a service charge of $8.40 for September.
We deposited an NSF check in the amount of $
Now, let’s prepare the bank reconciliation.
Here is the remainder of the information for Green Shades Resorts.

26. Starting with the Unadjusted Bank Balance
Deposits in transit are added to the unadjusted bank balance since these were not included by the bank.

27. Starting with the Unadjusted Bank Balance (Continued)
The check drawn on Grand Valley Resorts should not have been deducted from GSRI’s bank balance and is added back here.

28. Starting with the Unadjusted Bank Balance (Concluded)
The outstanding checks have not yet reached the bank and should be deducted from the unadjusted bank balance.

29. Starting with the Unadjusted Book Balance
After making these adjustments to the bank statement balance, we arrive at the true cash balance on September 30th. Next, let’s adjust the book balance. Our books do not reflect the receivable collected by the bank and it is added back here.

30. Starting with the Unadjusted Book Balance (Continued)
Our books show an amount of $63.45 deducted for check number 633 while the true amount was $ Therefore, the difference of $27.00 must be added back.

31. Starting with the Unadjusted Book Balance (Concluded)
We deduct the bank service charge of $8.40. The NSF check did not clear the bank. We recorded it as a deposit in our books but the bank was unable to obtain the funds from the maker so the check was returned. We deduct all NSF checks from the unadjusted book balance.
Notice that the true cash balance on the bank side of the reconciliation and on the book side are the same. We have been able to explain all of the differences between the bank account balance and the balance on our books.
We must prepare adjusting entries for all items on the book portion of the reconciliation. After we prepare the adjustments, the general ledger balance will be equal to $4, Let’s make the adjusting entries now.

32. Adjustment 1
Record a $940 receivable collection. This Asset Exchange Transaction: (1) increases assets (Cash) and (2) decreases assets (Accounts Receivable).
Date
Account Title
Debit
Credit
Adj. 1
Cash
940
Accounts Receivable
Assets =
Liab. +
Stockholders' Equity
Cash
Acct. Rec.
Common Stock
Retained Earnings
Revenue -
Expenses
Net Income
Cash Flow
940
(940)
n/a OA
Part I
Adjustment 1: Recording the $940 receivable collection increases Cash and reduces Accounts Receivable.
Part II
This is considered to be an asset exchange transaction.
Part III
Here is the journal entry and the effect of this transaction on the financial statements model. Cash, an asset, increases by $940 and Accounts Receivable, an asset, decreases by $940.

33. Adjustment 2
Assume the $27 recording error occurred because GSRI’s accountant accidentally transposed two numbers when recording check number 633 for utilities expense. This Error Correction: (1) increases assets (Cash) and (2) decreases expenses (Utilities Expense).
Date
Account Title
Debit
Credit
Adj. 2
Cash 27
Utilities Expense
Assets =
Liab. +
Stockholders' Equity
Cash
Acct. Rec.
Common Stock
Retained Earnings
Revenue -
Expenses
Net Income
Cash Flow 27
n/a
(27) OA
Part I
Adjustment 2: Assume the $27 recording error occurred because GSRI’s accountant accidentally transposed two numbers when recording check number 633 for utilities expense.
Part II
This is an error correction that will increase net income.
Part III
Here is the journal entry and the effect of this transaction on the financial statements model. Cash, an asset, increases by $27 and Utilities Expense, a stockholders’ equity (the expense decreases), increases by $27.

34. Adjustment 3
Record an $8.40 service charge. This expense transaction reduces assets, stockholders’ equity, net income, and cash, by (1) increasing expense (Bank Service Charge Expense) and (2) decreasing assets (Cash).
Date
Account Title
Debit
Credit
Adj. 3
Bank Service Charge Expense
8.40
Cash
Assets =
Liab. +
Stockholders' Equity
Cash
Acct. Rec.
Common Stock
Retained Earnings
Revenue -
Expenses
Net Income
Cash Flow
(8.40)
n/a
8.40 OA
Part I
Adjustment 3: The $8.40 service charge is an expense that reduces assets, stockholders’ equity, net income, and cash.
Part II
This adjustment will increase expense, thereby decreasing net income.
Part III
Here is the journal entry and the effect of this transaction on the financial statements model. Cash, an asset, decreases by $8.40 and Bank Service Charge Expense, a stockholders’ equity (the expense increases), decreases by $8.40.

35. Adjustment 4
The $ NSF check reduces GSRI’s cash balance. This Asset Exchange Transaction: (1) increases assets (Accounts Receivable) and (2) decreases assets (Cash).
Date
Account Title
Debit
Credit
Adj. 2
Accounts Receivable
289.51
Cash
289,51
Assets =
Liab. +
Stockholders' Equity
Cash
Acct. Rec.
Common Stock
Retained Earnings
Revenue -
Expenses
Net Income
Cash Flow
(289.51)
289.51
n/a OA
Part I
Adjustment 4: The $ NSF check reduces GSRI’s cash balance.
Part II
This adjustment is an asset exchange transaction.
Part III
Here is the journal entry and the effect of this transaction on the financial statements model. Accounts Receivable, an asset, increases by $ and Cash, an asset, decreases by $

36. LO 6-5: Describe the auditor’s role in financial reporting.
Learning Objective 6-5: Describe the auditor’s role in financial reporting.

37. The Financial Analyst
Companies communicate to analysts and users through annual reports.
There are four sections:
Financial Statements
Notes to the Financial Statements
Management’s Discussion and Analysis
Auditor’s Report
Companies communicate information to analysts and other users through a document called the annual report. These reports are usually printed in color on high-quality paper and contain lots of photographs. However, in an effort to reduce cost, some companies issue their annual reports in black and white on low-grade paper or in electronic form. A company’s annual report contains much more than the financial statements. Annual reports often have 40 or more pages. The financial statements require only four to six pages. What is printed on all those other pages?
In general, the annual report of a large company has four major sections: (1) financial statements, (2) notes to the financial statements, (3) management’s discussion and analysis, and (4) auditors’ report. The notes and management’s discussion and analysis make up the bulk of the report.

38. The Financial Analyst (Continued)
How can a financial analyst know that a company really did follow GAAP?
Certified Public Accountants (CPAs)
Audits
Part I
How can a financial analyst know that a company really did follow generally accepted accounting principles?
Part II
Analysts and other users rely on audits conducted by certified public accountants. An audit is a detailed examination of a company’s financial statements and underlying accounting records.
The primary roles of an independent auditor are:
Conducts a financial statement audit.
Assumes both legal and professional responsibilities to the public as well as to the company paying the auditor.
Determines if financial statements are materially correct rather than absolutely correct.
Presents conclusions in an audit report that includes an opinion as to whether the statements are prepared in conformity with generally accepted accounting principles.
Maintains professional confidentiality of client records. However, this does not exempt the auditor from legal obligations such as testifying in court.

39. Materiality and Financial Audits
Auditors do not guarantee that financial statements are absolutely correct—only that they are materially correct.
Material Item: An error, or other reporting problem, that would influence the decision of an average prudent investor.
Part I
As mentioned in the primary roles of auditors on the previous slide, auditors do not guarantee that financial statements are absolutely correct—only that they are materially correct. The question then becomes “How big is material?”
The concept of materiality is very subjective. If Exxon Mobil inadvertently overstated its sales by $1,000,000, would this be material? In 2013, Exxon Mobil had approximately $438,000,000,000 of sales! A $1,000,000 error in sales at Exxon Mobil is like a $1 error in computing the pay of a person who makes $438,000 a year—not material at all!
Part II
An error, or other reporting problem, is material if knowing about it would influence the decision of an average prudent investor.

40. Types of Audit Opinions
The Types of Audit Opinions include:
Unqualified
Qualified
Adverse
Disclaimer
Part I
Once an audit is complete, the auditors present their conclusions in a report that includes an audit opinion. If auditors are satisfied that the financial statements are “fairly presented in accordance with generally accepted accounting principles” they issue an unqualified audit report. An unqualified audit report indicates that the financial statements are useful and that creditors and investors can trust what is reported.
Part II
The most negative report an auditor can issue is an adverse opinion. An adverse opinion means that one or more departures from generally accepted accounting principles are so material the financial statements do not present a fair picture of the company’s status.
Part III
A qualified opinion falls between an unqualified and an adverse opinion. A qualified opinion means that for the most part, the company’s financial statements are in compliance with generally accepted accounting principles, but the auditors have reservations about something in the statements. The auditor’s report explains why the opinion is qualified.
Part IV
If an auditor is unable to perform the audit procedures necessary to determine whether the statements are prepared in accordance with generally accepted accounting principles, the auditor cannot issue an opinion on the financial statements. Instead, the auditor issues a disclaimer of audit opinion. A disclaimer is neither negative nor positive. It simply means that the auditor is unable to obtain enough information to confirm compliance with generally accepted accounting principles.

41. Confidentiality
The confidentiality rules in the code of ethics for CPAs prohibit auditors from voluntarily disclosing information they have acquired as a result of their accountant-client relationships.
However, accountants may be required to testify in a court of law.
The confidentiality rules in the code of ethics for CPAs prohibit auditors from voluntarily disclosing information they have acquired as a result of their accountant-client relationships. However, accountants may be required to testify in a court of law. In general, federal law does not recognize an accountant-client privilege as it does with attorneys and clergy.

42. The Securities and Exchange Commission (SEC)
The SEC is a government agency authorized to establish and enforce the accounting rules for public companies.
Public companies have to follow the reporting rules of the SEC as well as GAAP.
The SEC is a government agency authorized to establish and enforce the accounting rules for public companies. Public companies have to follow the reporting rules of the SEC as well as GAAP. SEC companies must file specific information directly with the SEC annually, quarterly, and in-between, if required.

43. End of Chapter 6
End of Chapter 6. Internal control is one of those subjects that does not seem as important while you are a student as it is in the business world. Once you graduate, the company you work with will have extensive internal controls. It is crucial that you are aware of the controls and how they will impact your job.