Chapter 7 Internal Control

and Cash

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Learning Objectives

1. Define internal control and describe the components of internal control and control procedures

2. Apply internal controls to cash receipts

3. Apply internal controls to cash payments

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Learning Objectives

4. Explain and journalize petty cash transactions

5. Demonstrate the use of a bank account as a control device and prepare a bank reconciliation and related journal entries

6. Use the cash ratio to evaluate business performance

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Learning Objective 1

Define internal control and describe the components of internal control and control procedures

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What Is Internal Control, and How Can It Be Used to Protect a Company’s

Assets?

• A key responsibility of a business manager is to control operations.

• Internal control is the organizational plan and all the related measures adopted by an entity to safeguard assets, encourage employees to follow company policies, promote operational efficiency, and ensure accurate and reliable accounting records.

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What Is Internal Control, and How Can It Be Used to Protect a Company’s

Assets?

• Internal control:– Safeguards companies assets– Encourages employees to follow

company policies– Promotes operational efficiency– Ensures accurate, reliable accounting

records

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Internal Control and the Sarbanes-Oxley Act

• U.S. Congress passed a law requiring a public company to maintain a system of internal controls.

• The Sarbanes-Oxley Act (SOX) requires companies to review internal controls.

• Public companies must issue an internal control report.

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The Components of Internal Control

• Control procedures• Risk assessment• Information

system• Monitoring of

controls• Environment

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Internal controls are monitored by internal auditors

and external auditors.

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Internal Control Procedures

• Competent, reliable, and ethical personnel

• Assignment of responsibilities

• Separation of duties

• Audits• Documents

• Electronic devices • e-commerce– Encryption– Firewalls– Passwords and

digital signatures

• Other controls– Fireproof vaults– Alarms– Job rotation

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The Limitations of Internal Control—Costs and Benefits

• Internal controls cannot completely prevent fraud.

• Collusion is when two or more people work together to beat internal controls.

• The stricter the internal controls, the higher the costs. – Internal controls are judged based upon their

cost versus benefit.

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Learning Objective 2

Apply internal controls to cash receipts

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What Are the Internal Control Procedures with Respect to Cash

Receipts?

• Cash receipts occur primarily when a business sells merchandise or services.

• Each source of cash has unique security measures. – A receipt of cash over the counter in a

store involves a point-of-sale terminal (cash register).

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Cash Receipts by Mail

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• Companies receive checks by mail as payments for service or merchandise.

• The control cycle starts in the mail room.– Employees record the checks received and

forward them to the treasurer for deposit in the bank.

– A remittance advice provides information about the payment.

• A lock-box system is a post office box that belongs to a bank, and the bank deposits the funds on behalf of the company.

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Cash Receipts by Mail

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Learning Objective 3

Apply internal controls to cash payments

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What Are the Internal Control Procedures with Respect to Cash

Payments?• Companies make many payments by

check. • Payments by check provide internal

controls:– A check provides a record of the payment.– A check requires a signature by an authorized

official.– Supporting evidence is reviewed prior to

signing the check.

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Controls Over Payment by Check

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Technology streamlines payment procedures: • Evaluated Receipts

Settlement (ERS) is a single-step payment approval process.

• Electronic Data Interchange (EDI) is a streamlined system that communicates inventory levels between vendors and retailers.

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Controls Over Payment by Check

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Learning Objective 4

Explain and journalize petty cash transactions

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How Can a Petty Cash Fund Be Used for Internal Control Purposes?

• Petty cash is used as an in-office source of cash for small immediate purchases.

• It is often the responsibility of a designated employee.

• A petty cash ticket serves as authorization for payment.

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Uses for Petty Cash

• Office donuts• Cleaning supplies• Sympathy flowers• Entertaining clients• Public transportation• Tips for service providers

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Setting Up the Petty Cash Fund

On August 1, Smart Touch Learning creates a petty cash fund of $200. The custodian cashes the $200 check and places the currency in the fund box.

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Setting Up the Petty Cash Fund

• Maintaining the Petty Cash account at its designated balance is the nature of an imprest system.

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Replenishing the Petty Cash Fund

On August 31, the petty cash fund holds $118 in cash and $80 in petty cash tickets. You can see that $2 is missing.

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Replenishing the Petty Cash Fund

• When cash is missing, the Cash Short & Over account is used to record the unaccounted for amount.

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Learning Objective 5

Demonstrate the use of a bank account as a control device and prepare a bank reconciliation and related journal entries

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How Can the Bank Account Be Used as a Control Device?

• Cash is the most liquid asset reported on the balance sheet.

• Common bank account controls: – Signature card– Deposit ticket– Check

• Maker versus payee• Routing number • Account number

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How Can the Bank Account Be Used as a Control Device?

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Bank Statement

• A bank statement reports the activity in a customer’s account. – It shows the account’s beginning and ending

balances.

• Items used to reconcile the bank account: – Canceled checks– Electronic funds transfers (EFTs)

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Bank Statement

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Bank Reconciliation

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• The bank reconciliation compares and explains the differences between cash on the company’s books and the bank’s records.

• Differences arise because of a time lag in recording transactions, called timing differences.

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Preparing the Bank Side of the Bank Reconciliation

• The bank side of the reconciliation includes:– Deposits in transit– Outstanding checks– Adjustments for bank errors

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Preparing the Book Side of the Bank Reconciliation

• The book side of the reconciliation includes:– Credit memorandum (bank collections)– Debit memorandum (bank payments) – Service charges– Interest revenue – Nonsufficient funds checks– Book errors

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Completing the Bank Reconciliation

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Journalizing Transactions from the Bank Reconciliation

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Learning Objective 6

Use the cash ratio to evaluate business performance

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How Can the Cash Ratio Be Used to Evaluate Business Performance?

• Cash is an important part of every business.

• The cash ratio helps determine a company’s ability to meet its short-term obligations.

• Cash equivalents are highly liquid investments that can converted into cash in three months or less.

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How Can the Cash Ratio Be Used to Evaluate Business Performance?

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