Chapter 6 Cash and Internal Controls. INTERNAL CONTROL SELF– STUDY MATERIALS C1: Define internal...

Chapter 6

Cash and Internal Controls

INTERNAL CONTROL SELF– STUDY MATERIALS

C1: Define internal control and identify its purpose and principles.

C2: Define cash and cash equivalents and explain how to report them.

C3: Identify control features of banking activities.

P1: Apply internal control to cash receipts and disbursements.

-VOUCHER System of control6-2

Analytical Learning Objectives

SELF-STUDY

A1: Compute the days’ sales uncollected ratio and use it to assess liquidity.

6-3

Procedural Learning Objectives

IN-CLASS:

P2: Explain and record petty cash fund transactions.

P3: Prepare a bank reconciliation.

NOT COVERED:P4: Appendix 6A: Describe the use of

documentation and verification to control cash disbursements.

P5: Appendix 6B: Apply the net method to control purchase discounts

6-4

Voucher System of Control

A voucher system establishes procedures for: Verifying, approving and recording

obligations for eventual cash disbursements.

Issuing checks for payment of verified, approved and recorded obligations.

A voucher system establishes procedures for: Verifying, approving and recording

obligations for eventual cash disbursements.

Issuing checks for payment of verified, approved and recorded obligations.

P4

6-5

Voucher System of Control

Cashier

Accounting

Receiving

Supplier (Vendor)

Purchasing

SALES Requesting

CashierAccounting, Requesting& Purchasing

Accounting

Supplier (Vendor)

Purchasing andAccounting

Supplier, Requesting, Receiving & Accounting

Check

Invoice Approval

Receiving Report

Invoice

Purchase Order

Purchase Requisition

VoucherVoucher

P4

SenderSender ReceiverReceiver

6-6

Purpose of Internal Control

Policies and procedures managers use to: Policies and procedures managers use to:

1.1. Protect assets.Protect assets.

2.2. Ensure reliable accounting.Ensure reliable accounting.

3.3. Promote efficient operations.Promote efficient operations.

4.4. Urge adherence to company policies. Urge adherence to company policies.

Policies and procedures managers use to: Policies and procedures managers use to:

1.1. Protect assets.Protect assets.

2.2. Ensure reliable accounting.Ensure reliable accounting.

3.3. Promote efficient operations.Promote efficient operations.

4.4. Urge adherence to company policies. Urge adherence to company policies.

C 1

6-7

The Sarbanes-Oxley Act

The Sarbanes-Oxley Act, also known as SOX, requires management and auditors of publicly held companies to adhere to or perform specific requirements, such as::

1.1. Evaluation of internal controls.Evaluation of internal controls.

2.2. Auditor’s work is overseen by the Public Company Auditor’s work is overseen by the Public Company Accounting Oversight Board (PCAOB).Accounting Oversight Board (PCAOB).

3.3. Restriction on consulting services performed by auditors.Restriction on consulting services performed by auditors.

4.4. Term limits on person leading the audit.Term limits on person leading the audit.

5.5. Harsh penalties for violators, including prison time with severe Harsh penalties for violators, including prison time with severe fines. fines.

The Sarbanes-Oxley Act, also known as SOX, requires management and auditors of publicly held companies to adhere to or perform specific requirements, such as::

1.1. Evaluation of internal controls.Evaluation of internal controls.

2.2. Auditor’s work is overseen by the Public Company Auditor’s work is overseen by the Public Company Accounting Oversight Board (PCAOB).Accounting Oversight Board (PCAOB).

3.3. Restriction on consulting services performed by auditors.Restriction on consulting services performed by auditors.

4.4. Term limits on person leading the audit.Term limits on person leading the audit.

5.5. Harsh penalties for violators, including prison time with severe Harsh penalties for violators, including prison time with severe fines. fines.

C 1

6-8

Principles of Internal Control

1.1. Establish responsibilities.Establish responsibilities.

2.2. Maintain adequate records.Maintain adequate records.

3.3. Insure assets and Insure assets and bond key employeesbond key employees..

4.4. Separate recordkeeping from custodySeparate recordkeeping from custodyof assets.of assets.

5.5. Divide responsibility for related transactions.Divide responsibility for related transactions.

6.6. Apply technological controls.Apply technological controls.

7.7. Perform regular and independent reviews.Perform regular and independent reviews.

1.1. Establish responsibilities.Establish responsibilities.

2.2. Maintain adequate records.Maintain adequate records.

3.3. Insure assets and Insure assets and bond key employeesbond key employees..

4.4. Separate recordkeeping from custodySeparate recordkeeping from custodyof assets.of assets.

5.5. Divide responsibility for related transactions.Divide responsibility for related transactions.

6.6. Apply technological controls.Apply technological controls.

7.7. Perform regular and independent reviews.Perform regular and independent reviews.

C1

6-9

Technology and Internal Control

ReducedProcessing

Errors

ReducedProcessing

Errors

MoreExtensive Testing

of Records

MoreExtensive Testing

of Records

LimitedEvidence ofProcessing

LimitedEvidence ofProcessing

CrucialSeparation of

Duties

CrucialSeparation of

Duties

C 1

Increased e-commerce

Increased e-commerce

6-10

Limitations of Internal Control

Human Error

NegligenceFatigue

MisjudgmentConfusion

Human Fraud

Intent todefeat internal

controls forpersonal gain

C 1

6-11

Limitations of Internal Control

The costs of internal controls must not exceed their benefits.The costs of internal controls must not exceed their benefits.

CostsBenefits

C 1

6-12

Cash and Cash EquivalentsCash

Currency, coins and amounts on deposit in bank accounts: checking accounts, and many savings accounts. Also includes items such as customer checks, cashier checks, certified checks, and money orders.

Cash Currency, coins and amounts on deposit in bank

accounts: checking accounts, and many savings accounts. Also includes items such as customer checks, cashier checks, certified checks, and money orders.

Cash Equivalents

Short-term, highly liquid investments that are:

1. Readily convertible to a known cash amount.

2. Close to maturity date and not sensitive to interest rate changes

3. US Treasury Bills & Notes: 3-month maturity.

4. 3-month CDs and Money Market Funds

Cash Equivalents

Short-term, highly liquid investments that are:

1. Readily convertible to a known cash amount.

2. Close to maturity date and not sensitive to interest rate changes

3. US Treasury Bills & Notes: 3-month maturity.

4. 3-month CDs and Money Market Funds6-13

Cash & Cash Equivalents

On Dec. 31, 2010, ABC Co's total CASH COUNT =$1,000,000

The following items are included in the CASH COUNT: Petty cash funds=$12,000, Customers Checks =$3,000, Coins =$1,000 and Stamps =$100.

The following items are not included in cash count: -Three-month CD: $10,000 -Two-month Treasury Note (Bill): $7,000

Required:Prepare the Current Assets Section of the Balance Sheet

Cash, Cash Equivalents, and Liquidity

Liquidity

How easily an asset can be converted into cash to be used to pay for services or obligations.

Liquidity

How easily an asset can be converted into cash to be used to pay for services or obligations.

InventoryInventory CashCash

C 2

6-15

Cash Management Principles

When companies fail, one of the most common causes is their inability to manage cash.

The goals of cash management are twofold:

Plan cash receipts to meet cash payments when due.

Keep the minimum level of cash necessary to operate.

C2

6-16

Control of Cash

An effective system of internal control that protects cash and cash equivalents should meet three basic guidelines:

An effective system of internal control that protects cash and cash equivalents should meet three basic guidelines:

Handling cash is separate from

recordkeeping of cash.

Handling cash is separate from

recordkeeping of cash.

Cash receipts are promptly

deposited in a bank.

Cash receipts are promptly

deposited in a bank.

Cash disbursements are

made by check.

Cash disbursements are

made by check.

C1

6-17

Control of Cash Receipts

Over-the-Counter Cash Receipts

Cash register with locked-in record of transactions.

Compare cash register record with cash reported.

Over-the-Counter Cash Receipts

Cash register with locked-in record of transactions.

Compare cash register record with cash reported.

Cash Receipts By Mail Two people open the

mail. Money to cashier’s

office => Bank List to accounting

dept => Record Copy of list filed.

Cash Receipts by mail

Require four (4) people

Cash Receipts By Mail Two people open the

mail. Money to cashier’s

office => Bank List to accounting

dept => Record Copy of list filed.

Cash Receipts by mail

Require four (4) people

P1

6-18

Control of Cash Disbursements

All expenditures should be made by check. The only exception is for small payments from petty cash.

Separate authorization for check signing and recordkeeping duties.

Use a voucher system.

All expenditures should be made by check. The only exception is for small payments from petty cash.

Separate authorization for check signing and recordkeeping duties.

Use a voucher system.

P1

6-19

Control of Cash Disbursements

To safeguard against theft:

-require all expenditures be made by check (except for small payments made from petty cash fund); and

-deny access to the accounting records to anyone, other than the owner, who has authority to sign checks.

Petty Cash System of Control

Small payments required in most companies for items such as postage, courier fees, repairs and supplies.

Small payments required in most companies for items such as postage, courier fees, repairs and supplies.

P2

6-21

Operating a Petty Cash Fund

Petty Cash

CompanyCompanyCashierCashier

Petty Petty CashierCashier

May 1 Petty cash 400 Cash 400

AccountantAccountant

P2

6-22

Petty Cash

Operating a Petty Cash Fund

Petty Petty CashierCashier

P2

6-23

39¢

Stamps$45

Courier$80

Operating a Petty Cash Fund

Petty Petty CashierCashier

A petty cash fund is used only

for business expenses.

A petty cash fund is used only

for business expenses.

P2

6-24

Operating a Petty Cash Fund

Receipts

Petty cash receipts with

either no signature or a

forged signature usually indicate misuse of petty

cash.

Petty cash receipts with

either no signature or a

forged signature usually indicate misuse of petty

cash.

Petty Petty CashierCashier

39¢

Stamps$45

Courier$80

P2

6-25

Receipts

Company Company CashierCashier

$125To reimburse

petty cash fund

Use a CashOver and Short

account if needed.

Use a CashOver and Short

account if needed.

Operating a Petty Cash Fund

Petty Petty CashierCashier

May 31 Postage expense 45 Delivery expense 80

Cash 125

AccountantAccountant

P2

6-26

Operating a Petty Cash Fund

Sometimes, the petty cash receipts plus the cash remaining will not total to the fund balance.

i. A shortage is recorded as an expense in the reimbursing entry with a debit to the Cash Over and Short account.

ii. An overage is recorded with a credit to the Cash Over and Short account in the reimbursing entry.

Petty Cash Example

Tension Co. maintains a petty cash fund of $400. The following summary information was taken from petty cash vouchers for July:

Travel Expenses $79.30

Customer Business Lunches 93.42

Express Mail Postage 55.00

Miscellaneous Office Supplies 32.48 $260.20

Let’s look at replenishing the fund if the

Cash Balance on July 31 was $137.80.

Tension Co. maintains a petty cash fund of $400. The following summary information was taken from petty cash vouchers for July:

Travel Expenses $79.30

Customer Business Lunches 93.42

Express Mail Postage 55.00

Miscellaneous Office Supplies 32.48 $260.20

Let’s look at replenishing the fund if the

Cash Balance on July 31 was $137.80.

P2

6-28

Petty Cash Example

What amount of cash will be required to replenish the petty cash fund?

a. $260.20

b. $262.20

c. $139.80

d. $137.80

What amount of cash will be required to replenish the petty cash fund?

a. $260.20

b. $262.20

c. $139.80

d. $137.80

P2

6-29

Petty Cash Example

What amount of cash will be required to replenish the petty cash fund?

a. $260.20

b. $262.20

c. $139.80

d. $137.80

What amount of cash will be required to replenish the petty cash fund?

a. $260.20

b. $262.20

c. $139.80

d. $137.80

Let’s prepare the journal entry to replenish the petty cash fund.

P2

6-30

Petty Cash Example

Dr. Cr.

Travel Expense 79.30

Entertainment Expense 93.42

Postage Expense 55.00

Office Supplies Expense 32.48

Cash Over and Short 2.00

Cash 262.20

July 31

Journal entry to replenish petty cash fund

P2

6-31

Quick Study 4

Exercise 5

Exercise 6

Banking Activities as Controls

Bank AccountsBank Accounts Signature CardsSignature Cards Deposit TicketsDeposit Tickets

ChecksChecksElectronic

Funds Transfer

Electronic Funds

Transfer

Bank Statements

Bank Statements

C 3

6-33

Bank Activities

A bank account is a record set up by a bank for a customer.

All persons authorized to write checks, sign a signature card.

Each bank deposit is supported by a deposit ticket.

Electronic Funds Transfer (EFT) is the electronic communication transfer of cash from one party to another.

To withdraw money, depositors use a check.

A check involves three parties:

Maker: Who signs the check;

Payee: The recipient;Bank (Payer): On which the check is drawn

Bank Statement

Once a month, the bank sends each depositor a bank statement showing activities of a bank account.

A bank statement includes, at least, the following:1.Beginning cash balance per bank;

2.Check & other debits decreasing the balance;

3.Deposits & other credits increasing the balance;

4.Ending cash balance per bank.

First National BankNashville, TN 37459 May 31, 2009

Clothes MartNashville, TN

Acct No 278609

Previous Balance Total Checks

Total Deposits

Current Balance

1488.79 1,367.09 2,604.22 2,725.92

5/1 107 55.00

5/2 1,251.88

5/4 108 279.50

5/7 109 44.75

5/9 110 21.81

5/12 111 37.55

5/15 825.04

5/18 112 175.98

5/21 113 288.31

5/27 114 12.54

5/30 527.30

5/31 115 451.65

Bank Statement

Bank Reconciliation A bank reconciliation is prepared periodically to

explain the difference between cash reported on the bank statement and the cash balance on company’s books.

A bank reconciliation is prepared periodically to explain the difference between cash reported on the bank statement and the cash balance on company’s books.

First National BankNashville, TN 37459 May 31, 2009

Clothes MartNashville, TN

Acct No 278609

Previous Balance Total Checks

Total Deposits

Current Balance

1488.79 1,367.09 2,604.22 2,725.92

5/1 107 55.00

5/2 1,251.88

5/4 108 279.50

5/7 109 44.75

5/9 110 21.81

5/12 111 37.55

5/15 825.04

5/18 112 175.98

5/21 113 288.31

5/27 114 12.54

5/30 527.30

5/31 115 451.65

Bank Statement

Why are thebalances different?

Why are thebalances different?*

P3

6-37

Reconciling Items

Bank Statement Balance Add:

Deposits in transit. Deduct: Outstanding

Checks Add or Deduct: Bank

errors.

Adjusted Bank Balance

Bank Statement Balance Add:

Deposits in transit. Deduct: Outstanding

Checks Add or Deduct: Bank

errors.

Adjusted Bank Balance

Book Balance

• Add: Collections made by the bank.

• Add: Interest earned on checking account. =>CM

• Deduct: Nonsufficient funds check (NSF).

• Deduct: Bank service charge =>DM

• Add or Deduct: Book errors

Adjusted Book Balance.

Book Balance

• Add: Collections made by the bank.

• Add: Interest earned on checking account. =>CM

• Deduct: Nonsufficient funds check (NSF).

• Deduct: Bank service charge =>DM

• Add or Deduct: Book errors

Adjusted Book Balance.

6-38

Reconciling ItemsIdentify and list any unrecorded Debit Memoranda (DM) from the bank for NSF Checks, service charges, and errors over stating the book balance. => Deduct them from the book balance. Identify and list any unrecorded Credit Memoranda (CM) from the bank for interest, collections, and errors under stating the book balance. => Add them to the book balance.

Bank Reconciliation

Two sections:1. Reconcile bank statement balance to the

adjusted bank balance.2. Reconcile book balance to the

adjusted book balance.

The adjusted balances should be equal.

Two sections:1. Reconcile bank statement balance to the

adjusted bank balance.2. Reconcile book balance to the

adjusted book balance.

The adjusted balances should be equal.

P3

6-40

Bank Reconciliation Example

Let’s prepare a July 31 bank reconciliation statement for the Simmons Company.

The July 31 bank statement indicated a balance of $9,610.

The cash general ledger account on that date shows a balance of $7,430.

Additional information necessary for the reconciliation is shown on the next screen.

Let’s prepare a July 31 bank reconciliation statement for the Simmons Company.

The July 31 bank statement indicated a balance of $9,610.

The cash general ledger account on that date shows a balance of $7,430.

Additional information necessary for the reconciliation is shown on the next screen.

P3

6-41

Bank Reconciliation Example

1. Outstanding checks totaled $2,417.

2. A $500 check mailed to the bank for deposit had not reached the bank at the statement date.

3. The bank returned a customer’s NSF check for $225 received as payment on account receivable.

4. The bank statement showed $30 interest earned during July.

5. Check No. 781 for supplies expense cleared the bank for $268 but was erroneously recorded in our books as $240.

6. A $486 deposit by Acme Company was erroneously credited to our account by the bank.

6-42

Bank Reconciliation ExampleP3

6-43

Dr. Cr.July 31 Cash 30

Interest revenue 30

July 31 Supplies expense 28 Accounts receivable 225

Cash 253

Recording Adjusting Entries from a Bank Reconciliation

Only amounts shown on the book portion of the reconciliation require an adjusting entry.

Only amounts shown on the book portion of the reconciliation require an adjusting entry.

P3

6-44

Recording Adjusting Entries from a Bank Reconciliation

After posting the reconciling entries the cash account looks like this:

After posting the reconciling entries the cash account looks like this:

Adjusted balance on July 31.Adjusted balance on July 31.

P3

6-45

Quick Study 6

Exercise 7

Exercise 9 & 10

Days’ Sales Uncollected

Days’Sales

Uncollected

Accounts Receivable Net Sales

× 365=

How much time is likely to pass beforewe receive cash receipts from credit sales.How much time is likely to pass beforewe receive cash receipts from credit sales.

A1

6-47