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Internal Control and Internal Control and Managing CashManaging Cash

Chapter 4Chapter 4

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Learning Objective 1Learning Objective 1

Set up an effective system of internal control.Set up an effective system of internal control.

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Internal ControlInternal Control

Organizational plan and all related measures that an Organizational plan and all related measures that an entity adoptsentity adopts– Safeguard assets from theft or lossSafeguard assets from theft or loss– Encourage adherence to company policiesEncourage adherence to company policies– Promote operational efficiencyPromote operational efficiency– Ensure accurate and reliable accounting recordsEnsure accurate and reliable accounting records

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Components of anComponents of anEffective System Effective System

Competent, reliable, and ethical personnelCompetent, reliable, and ethical personnel Assignment of responsibilitiesAssignment of responsibilities Proper authorization of transactionsProper authorization of transactions Separation of dutiesSeparation of duties

– Operations or authorization of transactionsOperations or authorization of transactions– Custody of assetsCustody of assets– Data entry function for those transactionsData entry function for those transactions

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AuditAudit

Examination of company’s financial Examination of company’s financial statements, accounting systems, and statements, accounting systems, and internal controls, by an objective partyinternal controls, by an objective party– Internal auditorsInternal auditors

employees of the companyemployees of the company An aspect of the company’s internal controlsAn aspect of the company’s internal controls

– External auditorsExternal auditors Independent of the companyIndependent of the company Issue audit reports on the company’s financial Issue audit reports on the company’s financial

statements for benefit of investors and creditorsstatements for benefit of investors and creditors

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Limitations of Internal ControlLimitations of Internal Control Collusion - two or more employees, whose duties should Collusion - two or more employees, whose duties should

be segregated, working together to defraud the firmbe segregated, working together to defraud the firm All systems of internal control have “inherent limitations:” All systems of internal control have “inherent limitations:”

– Management can always override controls, as management Management can always override controls, as management establishes and is above many system controlsestablishes and is above many system controls

– Breakdowns can occur due to mistakes, carelessness, fatigueBreakdowns can occur due to mistakes, carelessness, fatigue– No system of controls can be perfect in an imperfect world!No system of controls can be perfect in an imperfect world!

A system of internal control that is too complex can hurt A system of internal control that is too complex can hurt efficiency and controlefficiency and control

Frequently small businesses have control deficiencies. Frequently small businesses have control deficiencies. Why?Why?

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Learning Objective 2Learning Objective 2

The bank reconciliation as a control device.The bank reconciliation as a control device.

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The Bank ReconciliationThe Bank Reconciliation

Items that cause differences between bank balance Items that cause differences between bank balance and book balanceand book balance

1.1. Items recorded by the company but not yet Items recorded by the company but not yet recorded by the bank:recorded by the bank:

• Deposits in transitDeposits in transit• Outstanding checksOutstanding checks

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The Bank ReconciliationThe Bank ReconciliationItems that cause differences between bank balance and book balanceItems that cause differences between bank balance and book balance2.2. Items on a bank statement, but not yet recorded by the business:Items on a bank statement, but not yet recorded by the business:

• Bank collections on behalf of the company, e.g. a note receivableBank collections on behalf of the company, e.g. a note receivable• Electronic funds transfers (EFT’s) for Electronic funds transfers (EFT’s) for

• payments of cash by the companypayments of cash by the company• collections of cash on behalf of the companycollections of cash on behalf of the company

• Service chargesService charges• Interest revenue earned on accountInterest revenue earned on account• NSF checksNSF checks• Errors made by the company or the bank. Examples:Errors made by the company or the bank. Examples:

• The bank charges someone else’s check to the company’s accountThe bank charges someone else’s check to the company’s account• The company writes a check for $420, but makes a journal entry for $240The company writes a check for $420, but makes a journal entry for $240

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There Is a Reciprocal Relationship There Is a Reciprocal Relationship between the Bank’s Records and the between the Bank’s Records and the

Company’s RecordsCompany’s Records

When the company receives cash:When the company receives cash:– The company The company debitsdebits cash on their bookscash on their books– However, the bank However, the bank creditscredits the company’s the company’s

account on the bank’s booksaccount on the bank’s books– This is because the bank has a liability to the This is because the bank has a liability to the

company in the amount of the cash balance company in the amount of the cash balance held at the bankheld at the bank

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There Is a Reciprocal Relationship There Is a Reciprocal Relationship between the Bank’s Records and the between the Bank’s Records and the

Company’s Records (con.)Company’s Records (con.) When the company issues a check:When the company issues a check:

– The company The company creditscredits cash on their books cash on their books– However, the bank However, the bank debitsdebits (charges) the (charges) the

company’s account on the bank’s bookscompany’s account on the bank’s books– This is because the bank’s liability to the This is because the bank’s liability to the

company is reduced by disbursing the check company is reduced by disbursing the check amount to the payeeamount to the payee

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Bank Reconciliation IllustrationBank Reconciliation IllustrationBusiness Research, Inc., shows a balance on its bank statement of Business Research, Inc., shows a balance on its bank statement of

$5,931.51 on January 31. The company Cash account has a $5,931.51 on January 31. The company Cash account has a balance of $3,294.21.balance of $3,294.21.

1.1. The January 30 deposit of $1,591.63 does not appear on the bank The January 30 deposit of $1,591.63 does not appear on the bank statement.statement.

2.2. The bank erroneously charged (debited) to the account a $100 The bank erroneously charged (debited) to the account a $100 check (No. 656) written by a similarly named company, Business check (No. 656) written by a similarly named company, Business Research Associates.Research Associates.

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The Bank Reconciliation The Bank Reconciliation IllustratedIllustrated

3.3. Five company checks, totaling $1,350.14, issued late in January Five company checks, totaling $1,350.14, issued late in January and recorded in the journal have not been paid by the bank.and recorded in the journal have not been paid by the bank.

4.4. The bank received $904.03 by EFT on behalf of Business The bank received $904.03 by EFT on behalf of Business Research, Inc.Research, Inc.

5.5. The bank collected on behalf of the company a note receivable, The bank collected on behalf of the company a note receivable, $2,114 (including interest revenue of $214).$2,114 (including interest revenue of $214).

6.6. The bank statement shows interest revenue of $28.01.The bank statement shows interest revenue of $28.01.

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The Bank Reconciliation The Bank Reconciliation IllustratedIllustrated

7.7. Check number 333 for $150 paid to Brown Company on account Check number 333 for $150 paid to Brown Company on account was recorded as a cash payment of $510, a transposition error.was recorded as a cash payment of $510, a transposition error.

8.8. The bank service charge for the month was $14.25.The bank service charge for the month was $14.25.9.9. The bank statement shows an NSF check for $52.The bank statement shows an NSF check for $52.10.10. Business Research pays insurance expense by EFT and has not Business Research pays insurance expense by EFT and has not

recorded this $361 payment.recorded this $361 payment.

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

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

The Bank Reconciliation The Bank Reconciliation IllustratedIllustrated

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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 error: check no. 333 360.00

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

The Bank Reconciliation The Bank Reconciliation IllustratedIllustrated

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Note That the Adjusted Bank Note That the Adjusted Bank Balance and Book Balance Must Be Balance and Book Balance Must Be

Equal in Amount in a Proper Equal in Amount in a Proper ReconciliationReconciliation

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Learning Objective 3Learning Objective 3

Apply internal controls to cash receipts and Apply internal controls to cash receipts and cash payments.cash payments.

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Basic Cash Controls ConceptsBasic Cash Controls Concepts Essential to segregate cash recording and custody Essential to segregate cash recording and custody

functions!functions!– Persons having data entry functions for disbursement or receipt of Persons having data entry functions for disbursement or receipt of

cash should not have access to physical cash (e.g. write checks or cash should not have access to physical cash (e.g. write checks or handle checks received in mail)handle checks received in mail)

– Persons having custody of physical cash should not make entries Persons having custody of physical cash should not make entries to the books for cashto the books for cash

– The Merrill Lynch employee described in the chapter had both cash The Merrill Lynch employee described in the chapter had both cash custody and data entry functions, causing the embezzlementcustody and data entry functions, causing the embezzlement

The bank account should always be reconciled by persons The bank account should always be reconciled by persons with no cash recording or custody functions, e.g. the with no cash recording or custody functions, e.g. the business owner or other competent employeebusiness owner or other competent employee

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Basic Cash Controls Concepts (con.)Basic Cash Controls Concepts (con.)

Smart small business owners will want to:Smart small business owners will want to:– Insist on signing checks after preparation by an Insist on signing checks after preparation by an

employee, or Quick Books, etc. [This controls employee, or Quick Books, etc. [This controls cash disbursements effectively.]cash disbursements effectively.]

– Compare total of daily cash collected (as Compare total of daily cash collected (as prepared by the mail opener) to validated prepared by the mail opener) to validated deposit slip from the bank [This is a good deposit slip from the bank [This is a good control over cash collections.]control over cash collections.]

– Prepare, or at least carefully review, the bank Prepare, or at least carefully review, the bank reconciliationreconciliation

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Imprest Petty Cash FundImprest Petty Cash Fund

A small amount of cash kept on hand to pay A small amount of cash kept on hand to pay for minor expenses.for minor expenses.

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Learning Objective 4Learning Objective 4

Use a budget to manage cash.Use a budget to manage cash.

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Using a Budget to Manage CashUsing a Budget to Manage Cash

A financial plan that helps coordinate A financial plan that helps coordinate business activitiesbusiness activities

Cash budget - helps an entity manage cash Cash budget - helps an entity manage cash by planning receipt and payment of cash by planning receipt and payment of cash during a future periodduring a future period

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Using a Budget to Manage CashUsing a Budget to Manage Cash

Cash balance, beginning Cash balance, beginning + Budgeted (expected) cash receipts+ Budgeted (expected) cash receipts- - Budgeted (expected) cash paymentsBudgeted (expected) cash paymentsExpected cash balance, endingExpected cash balance, ending

If the expected cash balance is < budgeted If the expected cash balance is < budgeted (necessary) cash balance, the company will (necessary) cash balance, the company will need to seek additional financingneed to seek additional financing

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Reporting Cash onReporting Cash onthe Balance Sheet the Balance Sheet

Companies usually combine all cash amount into single Companies usually combine all cash amount into single total called total called ““Cash and Cash EquivalentsCash and Cash Equivalents”” on the balance on the balance sheet.sheet.

Cash equivalents include liquid assetsCash equivalents include liquid assets– Time depositsTime deposits– Certificates of depositCertificates of deposit

Restricted cash pledged as collateral should be reported Restricted cash pledged as collateral should be reported separately from cash, as shown on the Merrill Lynch separately from cash, as shown on the Merrill Lynch excerpted balance sheet (pg. 192 in your text)excerpted balance sheet (pg. 192 in your text)

It’s not really available to the company for daily useIt’s not really available to the company for daily use

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Learning Objective 5Learning Objective 5

Weigh ethical judgment in business.Weigh ethical judgment in business.

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Ethics and AccountingEthics and Accounting Larger companies often have written codes of Larger companies often have written codes of

ethical and responsible behavior by employeesethical and responsible behavior by employees Smaller companies will have less formal Smaller companies will have less formal

means of conveying ethical valuesmeans of conveying ethical values In either case, management must establish the In either case, management must establish the

proper “tone at the top” proper “tone at the top” AICPA Code of Professional ConductAICPA Code of Professional Conduct Standards of Ethical Conduct for Management Standards of Ethical Conduct for Management

Accountants and Institute of Internal auditorsAccountants and Institute of Internal auditors