internal control and managing cash chapter 4. set up an effective system of internal control

Internal Control and

Managing Cash

Chapter 4

Set up an effective

system of internal control.

Internal Control

It is the organizational plan and all therelated measures that an entity adopts.

Safeguard assets.

Promote operational efficiency.

Encourage Adherence to company policies.

Ensure Accurate and reliable accounting records.

Components of anEffective System

Competent, reliable, and ethical personnelCompetent, reliable, and ethical personnel

Assignment of responsibilitiesAuthorization

RecordingCustody

Assignment of responsibilitiesAuthorization

RecordingCustody

Separation of dutiesSeparation of duties

Separation of the Authorization of transactions

from the Recording of transactions

from the Custody of assets

Separation of the Authorization of transactions

from the Recording of transactions

from the Custody of assets

Separation of Duties

Internal and External Audits

An audit is an examination by an outside partyof the company’s financial statements,

accounting systems, and internal controls.

An audit is an examination by an outside partyof the company’s financial statements,

accounting systems, and internal controls.

An internal auditor is an employee of the business.An internal auditor is an employee of the business.

An external auditor is an independent auditor.An external auditor is an independent auditor.

Documents and Records

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

SensitiveHardware,Software,and Data

Encryption

Firewalls

Intrusion detection devices

Incident response procedures

Audits by external specialists

Encryption

It is the transformation of data by a mathematicalprocess into a form that is unreadable by anyone

who does not have the secret decryption key.

Clear message

Encryption

Encoded message

Clear message

Decryption

Same key

Firewall

It is a technique that limits access to hardware,software, or data to persons within a network.

Inquirers

Customers

Hackers

Firewall 1

Inquirers

Customers

Firewall 2

Customers

Firewall 3

Other Controls

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

The Limitations ofInternal Control

Systems designed to thwart one person’sfraud can be beaten by two or more

employees working together –colluding – to defraud the firm.

A system of internal control that is toocomplex 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 accounton its own books, and…

the bank statement, which shows theactual amount of cash in the bank.


Two common items that cause differencesbetween 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


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 thebooks has a balance of $3,294.21.

The following reconciling itemsexplain 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.


Check No. Date Amount 337 Jan. 27 $ 286.00338 28 319.47339 28 83.00340 29 203.14341 30 458.53

Total $1,350.14


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.


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.

Balance per bank, January 31 $5,931.51Add deposit in transit 1,591.63Check erroneously charged 100.00

$7,623.14Less outstanding checks –1,350.14Adjusted bank balance $6,273.00


Balance per books, January 31 $3,294.21Add: ETF receipt of rent revenue 904.03Collection of note receivable 2,114.00Interest revenue earned 28.01Correction of book error 360.00

$6,700.25Less: Service charge $ 14.25NSF check 52.00Payment of insurance expense 361.00 – 427.25Adjusted book balance $6,273.00


Apply internal controls

to cash receipts and

cash payments.

Controlling and Managing Cash

Internal control over cash receipts ensuresthat all cash receipts are deposited in the

bank and no collections are lost.

Over the Counter Receipts

The point-of-sale terminal (cash register) offerscontrol over the cash received in a store.

The point-of-sale terminal (cash register) offerscontrol over the cash received in a store.

Mail Receipts

All incoming mail should be openedby a mailroom employee.

All incoming mail should be openedby a mailroom employee.

This person should compare the checkreceived with the remittance advice.

This person should compare the checkreceived with the remittance advice.

The mailroom clerk keeps a runningtotal of cash receipts for the day.

The mailroom clerk keeps a runningtotal of cash receipts for the day.

Mail Receipts

Many companies use a lock-box system.Many companies use a lock-box system.

Customers send checks directly to anaddress that is essentially a bank account.

Customers send checks directly to anaddress that is essentially a bank account.

Element ofInternal Control

Internal Controls overCash Receipts

Competent, reliable,ethical personnel

Carefully screen andtrain employees.

Proper authorizationOnly designated employees cangrant exceptions for customers.

Internal ControlsOver Cash Receipts

Internal ControlsOver Cash Receipts

Internal: management policiesExternal: control over cash receipts

Internal andexternal audits

Electronic andcomputer controls

Match receipts with remittancesand bank deposit ticket daily.

Employees who handle cash do nothave access to accounting records.

Separation of duties

Internal Control: Payments Purchasing Process

Purchase order Purchasingdepartment Supplier

Invoice (bill) Supplier Accountingdepartment

Receiving report Receivingdepartment

Accountingdepartment

Disbursementpacket

Accountingdepartment

Officer whosigns the check

Purchase request(requisition)

Salesdepartment

Purchasingdepartment

Business Document Prepared by Sent to

Internal Control: Payments Disbursement Packet

Purchase Request

Purchase Order

Receiving Report

Invoice

Disbursement Packet

Element ofInternal Control

Internal Controls overCash Payments

Competent, reliable,ethical personnel

Payments entrusted to high levelemployees and the treasurer.

Proper authorizationLarge expenditures must be

authorized by top management.

Internal ControlsOver Cash Payments

Internal ControlsOver Cash Payments

Internal: management policiesExternal: control over cash payments

Internal andexternal audits

Electronic andcomputer controls

Computer programmers do notoperate the computers.

Employees who handle checks haveno access to accounting records.

Separation of duties

Use a budget to

manage cash.

Using a Budget to Manage Cash

A budget is a financial plan thathelps coordinate business activities.

A cash budget helps a company,or an individual, manage cash byplanning 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

$3,072.0Estimated 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 148.710. Payment of dividends 219.0 3,385.911. Net cash position at January 31, 20x3 (111.3)12. Budgeted / Desired cash balance, January 31, 20x3 200.013. 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 onthe Balance Sheet

Companies usually combine all cash amountsinto a single total called “Cash and Cash

Equivalents” on the balance sheet.

Cash equivalents include liquid assets…

Time deposits Certificates of deposit

Reporting Cash onthe Balance Sheet

America Online, Inc.Consolidated Balance Sheet

December 31 Excerpts

AssetsCurrent assets:

Cash and cash equivalents $2,610Short-term investments 886Accounts receivable 464

(In Millions) 2000

Weigh ethical judgment in

business.

Ethics and Accounting

Most large companies have a code of ethicsdesigned to encourage ethical and

responsible behavior by employees.

Accountants have additionalincentives to behave ethically.

AICPA Code of Professional Conduct

Standards of Ethical Conductfor Management Accountants

Ethics and Accounting

Conflict of Interest

EnronCorporation

A. Fastow, CEO

OutsidePartnershipA. Fastow,Principal

Business

transactions

End of Chapter 4