ch05 fundamental of financial accounting by edmonds (4th edition)

Fundamental Fundamental Financial Accounting Financial Accounting

ConceptsConceptsFourth EditionFourth Edition

bybyEdmonds, McNair, Milam, OldsEdmonds, McNair, Milam, Olds

PowerPoint® presentation by

J. Lawrence Bergin

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

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Chapter 6Chapter 6

Internal Controland

Accounting for Cash


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What Is Internal Control?The policies and procedures by which management protects the assets and assures the accuracy and reliability of the accounting records.


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Goals of an internal control system: Resources of the

business are safeguarded

Policies of management are followed

Designed to prevent errors and fraud


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Elements of Internal Control Separation of duties Quality of employees Bonded employees Periods of absence Procedures manual Clear lines of authority &

responsibility Prenumbered documents Physical control over assets Performance evaluations


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Separation of duties

Whenever possible, the functions of authorization, recording and custody should be exercised by separate individuals.

This minimizes the likelihood of errors and embezzlement.


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Quality of employees

Hire and keep employees Hire and keep employees that are:that are:

Competent Honest Trained to do a variety of

tasks.


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Bonded Employees

A Fidelity BondFidelity Bond is insurance coverage to protect the employer if an employee is dishonest (embezzles).


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Periods of AbsenceRequire vacationsvacations and

rotaterotate employees.– Illegal activities are often

uncovered when someone else performs the offender’s duties for a few days.


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Procedures Manual

Provide Procedures Procedures ManualsManuals detailing the correct procedures for processing transactions.– These procedures should

be designed to promote accuracy and internal control.


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Clear lines of authority & responsibility

Make sure employees understand the extent of their authority and responsibilities.

Define and communicate the appropriate chain of command.

Organization Chart


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Prenumbered documents

Reduces the likelihood of unauthorized transactions.

Reduces the likelihood of embezzlements.

Be sure to account for the sequence of documents periodically


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Physical control over assets

Safeguard all assets--cash, equipment, inventory, etc.

Be sure to keep all records and supporting documents in a fireproof safe.


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Performance Evaluations

Independent verification of performance.

Includes such things as an external audit by an independent CPA (Certified Public Accountant), the internal audit function, count of inventory, etc.

Good job!


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Internal Control in Computer Systems Basic internal controls apply to

both manual and computerized systems.

Some controls are specific to computerized systems.– Tests of reasonableness– Audit around the computer

Proper documentation and system (both program and data) backup are essential.

Significant technical expertise may be needed.


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Controlling CASH

Cash has universal appeal and ownership is difficult to prove.

Both cash receipts and cash payments should be recorded immediately when received and made. (Deposit daily, intact.)

Checks should be prenumbered and kept secure.


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Accounting for Cash:Reconciling the Bank Statement

An important part of internal control Need for calculating a true cash balance Two “sections” to be reconciled

– balance per bank– balance per books

If there are any mistakes or transactions that have not been recorded in the company’s books, adjusting journal entries will be needed.


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An example of a reconciliation:A review of the bank statement dated April 30 and the cash ledgeraccount balance on that date revealed:a. April 30 balance according to the bank statement = $8,750.b. April 30 balance according to our cash T-account = $6,900.

Our comparison of the “books” and bank statement revealed the following inconsistencies:

c. Checks #150 for $800 and #156 for $580 have not “cleared” yet.d. The bank statement showed a $30 service charge for the month.e. A $400 deposit made at 8PM, April 30 is not on the bank statement.f. The bank returned a customer’s NSF check for $100 that was part of our April 29th deposit.g. With the bank statement was a credit memo telling us that the bank was successful in collecting a $900 note and $100 interest for us (total collected $1,000).


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Balance per bank section of reconciliation:

Balance per bank $Plus: Less:

“True” Cash Balance $


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Balance per books section of reconciliation:

Balance per books (ledger) $Plus: Less:



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An example of a reconciliation:A review of the bank statement dated April 30 and the cash ledgeraccount balance on that date revealed:

a. April 30 balance according to the bank statement = $8,750.


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Balance per bank $ 8,750Plus: Less:



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b. April 30 balance according to our cash T-account = $6,900.


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Balance per books (ledger) $ 6,900Plus: Less:



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c. Checks #150 for $800 and #156 for $580 have not “cleared” yet.


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Balance per bank $ 8,750Plus: Less: Outstanding Checks

#150 (800)#156 (580)



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d. The bank statement showed a $30 service charge for the month.


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Balance per books (ledger) $ 6,900Plus: Less: Bank Service Charge Exp. (30)



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e. A $400 deposit made at 8PM, April 30 is not on the bank statement.


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Balance per bank $ 8,750Plus: Deposit in Transit 400 Less: Outstanding Checks

#150 (800)#156 (580)



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f. The bank returned a customer’s NSF check for $100 that was part

of our April 29th deposit.


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Balance per books (ledger) $ 6,900Plus: Less: Bank Service Charge Exp. (30) Customer’s NSF check (100)“True” Cash Balance $


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f. The bank returned a customer’s NSF check for $100 that was part

of our April 29th deposit.

g. With the bank statement was a credit memo telling us that the

bank was successful in collecting a $900 note and $100 interest

for us (total collected $1,000).


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Balance per books (ledger) $ 6,900Plus: Note Receivable Collected 900 Interest Revenue Collected 100 Less: Bank Service Charge Exp. (30) Customer’s NSF check (100)“True” Cash Balance $


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There is one true cash balance...

Bank balance per statement is reconciled to the TRUE cash balance

Book balance (general ledger balance) is reconciled to the TRUE cash balance


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Balance per bank $ 8,750Plus: Deposit in Transit 400 Less: Outstanding Checks

#150 (800)#156 (580)

“True” Cash Balance $ 7,770


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Balance per books (ledger) $ 6,900Plus: Note Receivable Collected 900 Interest Revenue Collected 100 Less: Bank Service Charge Exp. (30) Customer’s NSF check (100)“True” Cash Balance $ 7,770


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Our accounting records… Our goal is to have the correct

CASH balance in the General Ledger. So, all adjustments noted on the “books” part of the reconciliation require an adjusting journal entry (and posting) in our journal and ledger.


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Journal entries….

Only those journal entries (and postings) needed to correct our book balance are recorded.

Every item on the book side of the reconciliation will require a journal entry.


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Date Account Title Debit Credit

Apr 30 Cash 1,000 Notes Receivable 900

Interest Revenue 100 Note and inter. collected by bank

30 Bank Service Charge Expense 30 Cash 30

Record Bank Service Charge

30 Accounts Receivable 100Cash 100

Customer’s NSF check put back


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Cash account after posting

Cash

Bal. 6900

1000 30

100

True 7770

April 30 balance before reconciliation

Cash


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What about the “bank” side?

If the bank has made an error, we can’t fix their books... but we will call them to let them know!

There is a difference between a “timing” difference and an “error.” Only “errors” should be called to the bank’s attention.

.


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Accounting for Cash:Petty Cash

Needed for small payments that need to be paid in cash--postage, taxi fares, etc.

Usually maintained on an imprest basis--that means that fund is replenished periodically.

To start the fund, DEBIT Petty Cash and CREDIT Cash.

As the fund is used, receipts are kept (and employees usually sign voucher).


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Petty Cash continued... When the fund is

replenished, two entries are needed:– DEBIT Each Expense

incurred or Asset purchased, CREDIT Petty Cash.

– DEBIT Petty Cash, CREDIT Cash.


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Cash Short and Over Sometimes the actual petty cash

balance is not what the vouchers indicate it should be.

A special account called CASH SHORT AND OVER is used to absorb the difference.

It can be a Debit or Credit--i.e., a little expense (debit) or revenue (credit). At year end it will be closed out to retained earnings.


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Petty cash example: ABC Company decided to establish a petty

cash fund of $150. What is the journal entry to establish the

fund?


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Petty cash example: ABC Company decided to establish a petty

cash fund of $150. What is the journal entry to establish the

fund?

Petty Cash $150

Cash $150


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Petty cash continued... When the fund gets low, let’s say $30,

the fund custodian counts the receipts in the box.

How much should the receipts total?$120 ($150 - $30 in box)

The cash and the receipts should total $150 (the petty cash fund balance) at all times.


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Petty cash example: The receipts were for:

– Taxi fare to go to supplier to pick up items that our customer has requested at our store, $10.

– C.O.D charge on merchandise delivered, $60.– Paid $45 to run an advertisement in today’s newspaper.

What is the journal entry to replenish the fund? There are two parts:

– A journal entry to record (Debit) the expenses and costs and (Credit) reduce the petty cash fund.

– A journal entry to record the cash reimbursement to the fund.


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Petty cash example: REMEMBER:

– Always check for a Cash Short or Over when you replenish the Petty Cash fund!

The three receipts total $115.

How much SHOULD still be in the petty cash box?

$150 fund - $115 receipts = $35

But, there is only $30 in the box!


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Petty cash example... (Assume use of Periodic Inventory system.)

Transportation In $ 10

Purchases 60

Advertising Expense 45

Cash shortshort and over 5Petty Cash $120

and

Petty Cash $120

Cash $120

150

- 30

120


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Using Accounting Information Current versus non-current

– What is a current asset?» one which will be converted into cash or

consumed in one year or less (from the balance sheet date) or an operating cycle, whichever is longer.

– What is a current liability?» one which will be paid, using current assets, in

one year or less (from the balance sheet date) or an operating cycle, whichever is longer.


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Current vs. noncurrent...

Classified balance sheet – separation of current and

noncurrent items

– enhances the usefulness of the information

Here’s an example………..Here’s an example………..


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Winona Co. Balance Sheet at Dec. 31 AssetsAssets Liabilities and Owners’ EquityLiabilities and Owners’ EquityCurrent Assets:Current Assets: Current Liabilities:Current Liabilities: Cash $ 100 Accounts Payable $ 800 Marketable Securities 300 Notes Payable 700 Accounts Receivable 600 Unearned Revenue 300 Office Supplies 40 Total Cur. Liab. Total Cur. Liab. $ 1,800$ 1,800 Inventory 2,900 Long-Term Liabilities:Long-Term Liabilities: Prepaid Insurance 60 Mortgage Payable $ 2,800 Total Current AssetsTotal Current Assets $ 4,000$ 4,000 Notes Payable 2,000

Tot.. Lg-Term Liab. $ 4,800Property, Plant and Equip:Property, Plant and Equip: Total Liabilities $ 6,000 Land $ 200 Equity Equity Building, net 3,000 Contributed Capital $ 1,000 Equipment, net 2,800 Retained Earnings 3,000 Total Prop.,Plant, Equip. $ 6,000 Total Owners’ Equity $ 4,000Total Assets $10,000 Tot. Liab. and Own. Eq. $10,000


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Operating cycle the average time it takes a

business to convert cash into inventory, inventory into AR, and AR back into cash.

Cash

Inventory


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Cash

AR

Inventory


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Cash

AR

Inventory


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The Current Ratio Used to evaluate a

company’s liquidity (a company’s ability to generate short term cash flows)

Current Assets

Current Liabilities

Calculate the Current Ratio using the Balance Sheet data on the following slide.


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Winona Co. Balance Sheet at Dec. 31 AssetsAssets Liabilities and Owners’ EquityLiabilities and Owners’ EquityCurrent Assets:Current Assets: Current Liabilities:Current Liabilities: Cash $ 100 Accounts Payable $ 800 Marketable Securities 300 Notes Payable 700 Accounts Receivable 600 Unearned Revenue 300 Office Supplies 40 Total Cur. Liab. Total Cur. Liab. $ 1,800$ 1,800 Inventory 2,900 Long-Term Liabilities: Prepaid Insurance 60 Mortgage Payable $ 2,800 Total Current AssetsTotal Current Assets $ 4,000$ 4,000 Notes Payable 2,000

Tot.. Lg-Term Liab. $ 4,800Property, Plant and Equip: Total Liabilities $ 6,000 Land $ 200 Equity Building, net 3,000 Contributed Capital $ 1,000 Equipment, net 2,800 Retained Earnings 3,000 Total Prop.,Plant, Equip. $ 6,000 Total Owners’ Equity $ 4,000Total Assets $10,000 Tot. Liab. and Own. Eq. $10,000


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Winona Co. Balance Sheet at Dec. 31 AssetsAssets Liabilities and Owners’ EquityLiabilities and Owners’ EquityCurrent Assets:Current Assets: Current Liabilities:Current Liabilities: Cash $ 100 Accounts Payable $ 800 Marketable Securities 300 Notes Payable 700 Accounts Receivable 600 Unearned Revenue 300 Office Supplies 40 Total Cur. Liab. Total Cur. Liab. $ 1,800$ 1,800 Inventory 2,900 Prepaid Insurance 60 Total Current AssetsTotal Current Assets $ 4,000$ 4,000

Current Ratio = Current Assets

Current Liabilities=

$4,000

$1,800= 2.22 to 1

You have $2.22 of current assets for each $1 of current liabilities.

Is that enough?Is that enough?


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The Current Ratio Rough “Rule of Thumb” is 2 to 1,

but varies by industry. (Many successful companies have a current ratio significantly less than 2.0.)

Question: What if the Winona Company is a toy retailer?

Does the company have adequate liquidity?

Ratios


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Winona Co. Balance Sheet at Dec. 31 AssetsAssets Liabilities and Owners’ EquityLiabilities and Owners’ EquityCurrent Assets:Current Assets: Current Liabilities:Current Liabilities: Cash $ 100 Accounts Payable $ 800 Marketable Securities 300 Notes Payable 700 Accounts Receivable 600 Unearned Revenue 300 Office Supplies 40 Total Cur. Liab. Total Cur. Liab. $ 1,800$ 1,800 Inventory Inventory 2,900 2,900 Prepaid Insurance 60 Total Current AssetsTotal Current Assets $ 4,000$ 4,000 Most of a toy retailer’s sales come in the last few months of the Most of a toy retailer’s sales come in the last few months of the year because of Christmas. If the company has a large amount year because of Christmas. If the company has a large amount of unsold inventory at the end of the year, it will have a hard of unsold inventory at the end of the year, it will have a hard time “converting” this inventory to cash to pay bills. time “converting” this inventory to cash to pay bills. So, ……..


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The Quick (Acid-Test) Ratio A STRICTER test of a

company’s liquidity. The numerator only includes

cash, short term receivables and short-term investments (never includes inventory, supplies or prepaids).

Quick Assets

Current Liabilities


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Dec. 31 Balance Sheet data AssetsAssets Liabilities and Owners’ EquityLiabilities and Owners’ EquityCurrent Assets:Current Assets: Current Liabilities:Current Liabilities: CashCash $ 100$ 100 Accounts Payable $ 800 Marketable SecuritiesMarketable Securities 300 300 Notes Payable 700 Accounts ReceivableAccounts Receivable 600 600 Unearned Revenue 300 Office Supplies 40 Total Cur. Liab. Total Cur. Liab. $ 1,800$ 1,800 Inventory 2,900 Prepaid Insurance 60 Total Current AssetsTotal Current Assets $ 4,000$ 4,000

QuickQuick Ratio = Quick Assets

Current Liabilities=

$1,000$1,000

$1,800= .56 to 1

Winona has $0.56 of “quick” assets for each $1 of current liabilities.

Is that enough? “Rule of Thumb” is 1 to 1 (but varies by industry).Is that enough? “Rule of Thumb” is 1 to 1 (but varies by industry).


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Balance Sheet Analysis

The same techniques used in Ch. 5 to analyze the Income Statement are used for the Balance Sheet.

Common-size Analysis:

Use the TOTAL ASSETS amount as the 100% figure. So, …….. Express each Balance Sheet item as a % of Total Assets.

Trend Analysis:

Same approach as used on the income statement.

1. Calculate the $ change for each bal. sheet item. 2. Express the $ change as a % of the previous year’s (or base year’s) amount.


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Chapter 6:

The End

Financial

Accounting

Documents

ch05 fundamental of financial accounting by edmonds (4th edition)