College of San Mateo

Accounting 121

Rosemary Nurre


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Chapter 7

Internal Control and Cash

Study Objectives

  • Identify the principles of internal control.
  • Explain the applications of internal control to cash receipts.
  • Explain the applications of internal control to cash disbursements.
  • Prepare a bank reconciliation.
  • Explain the reporting of cash.
  • Discuss the basic principles of cash management.
  • Identify the primary elements of a cash budget.
  • (Appendix) Explain the operation of a petty cash fund.

Chapter Outline

Study Objective 1 - Identify the Principles of Internal Control

Internal control consists of all of the related methods and measures adopted within a business to:

  • Safeguard assets from employee theft, robbery, and unauthorized use.
  • Enhance the accuracy and reliability of its accounting records by reducing the risk of errors (unintentional mistakes) and irregularities (intentional mistakes and misrepresentations) in the accounting process.

Sarbanes-Oxley Act of 2002 (SOX) requires all publicly traded U.S. corporations to maintain an adequate system of internal controls. SOX imposes more responsibilities on corporate executives and boards of directors to ensure that companies’ internal controls are reliable and effective

  • Companies must develop sound principles of control over financial reporting and continually assess that the controls are working.
  • Independent outside auditors must attest to the level of internal controls.

To safeguard assets and enhance the accuracy and reliability of its accounting records, companies follow internal control principles. The following six internal control principles apply to most enterprises :

1. Establishment of Responsibility

  • An essential characteristic of internal control is the assignment of responsibility to specific individuals.
  • Control is most effective when only one person is responsible for a given task.
  • Establishing responsibility includes the authorization and approval of transactions.

2.Segregation of Duties

  • Segregation of duties is indispensable in a system of internal control.
  • The rationale for segregation of duties is that the work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of another employee.
  • There are two common applications of this principle:
    • The responsibility for related activities should be assigned to different individuals.
    • The responsibility for record keeping for an asset should be separate from the physical custody of the asset.
    • Related Activities:
      • When one individual is responsible for all of the related activities, the potential for errors and irregularities is increased.
      • Related purchasing activities should be assigned to different individuals. Related purchasing activities include ordering merchandise, receiving goods, and paying (or authorizing payment) for merchandise.
      • Related sales activities also should be assigned to different individuals. Related sales activities include making a sale, shipping (or delivering) the goods to the customer, and billing the customer.
    • Record Keeping Separate from Physical Custody
      • The custodian of the asset is not likely to convert the assets to personal use if one employee maintains the record of the assets that should be on hand and a different employee has physical custody of the assets.

    Try to recall a trip to the bank. Does the teller receiving the money for deposit take the money to bookkeeping and record the deposit? Why not?

When a cashier at the grocery store ends a shift, does the cashier walk out and let someone else work out of the same cash drawer? What is the usual procedure?

  • Documentation Procedures–
    • Documents provide evidence that transactions and events have occurred.
    • Documents should be prenumbered and all documents should be accounted for.
    • Source documents for accounting entries should be promptly forwarded to the accounting department to help ensure timely recording of the transaction and event.

Why are checks and invoices sequentially numbered? What happens to voided checks?

3. Physical, Mechanical, and Electronic Controls – Physical controls relate primarily to the safeguarding of assets. Mechanical and electronic controls safeguard assets and enhance the accuracy and reliability of the accounting records. Use of physical, mechanical, and electronic controls is essential. Examples of these controls include:

  • Safes, vaults, and safety deposit boxes for cash and business papers.
  • Locked warehouses and storage cabinets for inventory and records.
  • Computer facilities with pass key access or fingerprint or eyeball scans.
  • Alarms to prevent break-ins.
  • Television monitors and garment sensors to deter theft.
  • Time clocks for recording time worked.
Why do you receive a cash register receipt at a fast food restaurant, a grocery store, or a department store? Why do some stores post signs that say “If you do not receive a receipt, we will pay you $5”? What should a movie theater do with its Saturday night receipts?

 4. Independent Internal Verification

  • Independent internal verification involves the review, comparison, and reconciliation of data prepared by employees.
  • Verification should be made periodically or on a surprise basis.
  • Verification should be done by an employee independent of the personnel responsible for the information.
  • Discrepancies and exceptions should be reported to a management level that can take appropriate corrective action.
  • In large companies, independent internal verification is often assigned to internal auditors.
    • Internal auditors are employees of the company who evaluate on a continuous basis the effectiveness of the company’s system of internal control.
    • They periodically review the activities of departments and individuals to determine whether prescribed internal controls are being followed.

Would the cashier count the money in the cash drawer at the end of the workday? Would the person writing the checks prepare the bank reconciliation? Why or why not?

5. Other Controls

  • Bonding of employees who handle cash.
  • Rotating employees' duties and requiring employees to take vacations.

Insurance companies bond employees of other companies who handle cash. Bonding employees is much like having an insurance policy that will reimburse the company if an employee steals money.

Limitations of Internal Control

  • Internal control is designed to provide reasonable assurance that assets are properly safeguarded and that the accounting records are reliable.
  • The concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not exceed their expected benefit.
  • The human element is a factor in every system of internal control.
  • A good system can become ineffective as a result of employee fatigue, carelessness, or indifference. Occasionally two or more employees may work together in order to get around prescribed controls (collusion).
    • Collusion can significantly impair the effectiveness of a system of internal control because it eliminates the protection anticipated from segregation of duties.
  • The size of the business may impose limitations on internal control. A small company may find it difficult to apply the principles of segregation of duties and independent internal verification.
  • An important and inexpensive measure any business can take to reduce employee theft and fraud is to conduct thorough background checks. Two tips include:
  • Check to see whether job applicants actually graduated from the schools they list.
  • Never use the telephone numbers for previous employers given on the reference sheet; always look them up yourself.

Would you expect a very small company to have as sophisticated a system of internal control as that of a much larger company? Why not? What are ways in which a small company can have effective internal control procedures?

Study Objective 2 - Explain the Applications of Internal Control to Cash Receipts

  • Cash Controls
    • Just as cash is the beginning of a company’s operating cycle, it is usually the starting point for a company’s system of internal control.
    • Cash is the asset most susceptible to improper diversion and use.
    • Because of the large volume of cash transactions, numerous errors may occur in executing and recording cash transactions.
    • To safeguard cash and ensure the accuracy of the accounting records for cash, effective internal control over cash is imperative.
    • Cash consists of coins, currency (paper money), checks, money orders, and money on hand or on deposit in a bank or similar depository.
  • Cash receipts result from cash sales; collections on account from customers; the receipt of interest, rents, and dividends; investments by owners; bank loans; and proceeds from the sale of noncurrent assets.
  • The following internal control principles explained earlier apply to cash receipts transactions as shown:
    • Establishment of responsibility - Only designated personnel (cashiers) are authorized to handle cash receipts.
    • Segregation of duties - Different individuals receive cash, record cash receipts, and hold the cash.
    • Documentation procedures - Use remittance advice (mail receipts), cash register tapes, and deposit slips.
    • Physical, mechanical, and electronic controls - Store cash in safes and bank vaults; limit access to storage areas; use cash registers.
    • Independent internal verification - Supervisors count cash receipts daily; treasurer compares total receipts to bank deposits daily.
    • Other controls - Bond personnel who handle cash; require vacations; deposit all cash in bank daily.

Study Objective 3 - Explain the Applications of Internal Control to Cash Disbursements

  • Cash is disbursed to pay expenses and liabilities or to purchase assets.
  • Internal control over cash disbursements is more effective when payments are made by check, rather than by cash, except for incidental amounts that are paid out of petty cash.

Why would internal control over cash disbursements be more effective when payments are made by check rather than by cash?

  • Cash payments are generally made only after specific control procedures have been followed.
  • The paid check provides proof of payment.
  • The principles of internal control apply to cash disbursements as follows:
    • Establishment of responsibility - Only designated personnel (treasurer) are authorized to sign checks.
    • Segregation of duties - Different individuals approve and make payments; check signers do not record disbursements.
    • Documentation procedures - Use prenumbered checks and account for them in sequence; each check must have approved invoice.
    • Physical, mechanical, and electronic controls - Store blank checks in safes with limited access; print check amounts by machine with indelible ink.
    • Independent internal verification - Compare checks to invoices; reconcile bank statement monthly.
    • Other controls - Stamp invoices “PAID”.
  • Electronic Funds Transfer (EFT) System
    • A new approach developed to transfer funds among parties without the use of paper (deposit tickets, checks, etc.). The approach, called electronic funds transfers (EFT), uses wire, telephone, telegraph, or computer to transfer cash from one location to another.
  • Petty Cash Fund - A cash fund used to pay relatively small amounts. Information on the operation of a petty cash fund is provided in the appendix to this chapter.

    Why would a business use a petty cash fund? In what instances would the petty cash fund be used?
  • Use of a Bank
  • Contributes significantly to good internal control over cash.
  • Minimizes the amount of currency that must be kept on hand.
  • Facilitates the control of cash because a double record is maintained of all bank transactions - one by the business and one by the bank.The asset account Cash maintained by the company is the “flip-side” of the bank’s liability account for that company. It should be possible to reconcile these accounts—make them agree—at any time.
  • Bank statements - Each month the company receives a bank statement showing its bank transactions and balances. Some transactions and balances shown include:
    • Checks paid and other debits that reduce the balance in the depositor's account.
    • Deposits and other credits that increase the balance in the epositor's account.
    • The account balance after each day's transactions.
  • Bank statements are prepared from the bank’s perspective.
    • Every deposit the bank receives is an increase in the bank’s liabilities (an accounts payable) to the depositor.
    • Every check the bank funds or pays for a depositor decreases the bank’s liability (an accounts payable) to the depositor.

Study Objective 4 - Prepare a Bank Reconciliation

The bank and the company maintain independent records of the checking account. The two balances are seldom the same because of:

  • Time lags that prevent one of the parties from recording the transaction in the same period.
    • Days elapse between the time a check is written and dated and the date it is paid by the bank.
    • A day may pass between the time receipts are recorded by the company and the time they are recorded by the bank.
    • A time lag may occur when the bank mails a debit or credit memo to the company.
  • Errors by either party in recording transactions. The incidence of errors depends on the effectiveness of internal controls maintained by the company and the bank. Bank errors are infrequent.
  •  Reconciliation procedure - In reconciling the bank account, it is customary to reconcile the balance per books and balance per bank to their ad justed (correct or true) cash balances. To obtain maximum benefit from a bank reconciliation, the reconciliation should be prepared by an employee who has no other responsibilities related to cash.
  • The reconciliation schedule is divided into two sections - balance per bank and balance per books. The following steps should reveal all the reconciling items causing the difference between the two balances:
    • Compare the individual deposits on the bank statement with the deposits in transit from the preceding bank reconciliation and with the deposits per company records or copies of duplicate deposit slips. Deposits recorded by the depositor that have not been recorded by the bank represent deposits in transit and are added to the balance per bank.
    • Compare the paid checks shown on the bank statement or the paid checks returned with the bank statement with (a) checks outstanding from the preceding bank reconciliation and (b) checks issued by the company as recorded in the cash payments journal. Issued checks recorded by the company that have not been paid by the bank represent outstanding checks that are deducted from the balance per bank.
    • Note any errors discovered in the foregoing steps and list them in the appropriate section of the reconciliation schedule. All errors made by the depositor are reconciling items in determining the ad justed cash balance per books. In contrast, all errors made by the bank are reconciling items in determining the ad justed cash balance per bank.
    • Trace bank memoranda to the depositor's records. Any unrecorded memoranda should be listed in the appropriate section of the reconciliation schedule.

An example of preparing a bank reconciliation follows:

 The April bank statement for Laird Company indicates a balance on April 30 of $15,907.45. On that date the balance of cash per books is $11,589.45. From the foregoing steps, the following reconciling items are determined:

 1. Deposits in transit: April 30 deposit (received by bank on May 1) $2,201.40
2. Outstanding checks:
No. 453, $3,000.00; No. 457, $1,401.30; No. 460, $1,502.70 3. Errors: Check No. 443 was correctly written by Laird for $1,226.00 and was correctly paid by the bank, but recorded for $1,262.00 by Laird.
4. Bank memoranda:

a. Debit—NSF check from J. R. Baron for $425.60.
b. Debit—Printing company checks charge, $30.
c. Credit—Collection of note receivable for $1,000 plus interest earned, $50, less bank collection fee $15

 The bank reconciliation is shown below:

 Cash balance per bank statement..............$15,907.45

Add: Deposits in transit ..................................2,201.40

Less: Outstanding checks

No. 453 ........$3,000.00

No. 457 ............,401.30

No. 460......... 1,502.70 ..................5,904.00

Ad justed cash balance per bank ..............$12,204.85


 Cash balance per books ...........................$11,589.45

Add: Collection of note receivable for
$1,000 plus interest earned $50,
less collection fee $15 ...........
Error in recording
check No. 443 ...............................36.00......1,071.00

Less: Bank service charge .........30.00
NSF Check ................................425.60........... 425.60
Adjusted cash balance per books .............$12,204.85

  • Entries from Bank Reconciliation - Each reconciling item used in determining ad justed cash balance per books should be recorded by the depositor. If these items are not journalized and posted, the Cash account will not show the correct balance.

The process of making ad justing entries from the bank reconciliation using the entries to ad just Laird Company’s cash account follows:

Apr. 30 .....Cash ................................1,035
Miscellaneous Expense...... 15
............................ Notes Receivable ..................1,000
............................ Interest Revenue....................... 50
(To record collection of note receivable by bank)

 Apr. 30 .....Cash ....................................36
.............................Accounts Payable....................... 36
(To correct error in recording check No. 443)

Apr. 30..... Accounts Receivable
..................– J. R. Baron ...................425.60
Cash.................................... 425.60
(To record NSF check)

 Apr. 30 .....Miscellaneous Expense .........30
(To record charge for printing company checks)

Study Objective 5 - Explain the Reporting of Cash

  • Cash is recorded in both the balance sheet and the statement of cash flows. The balance sheet shows the amount of cash available at a given point in time. The statement of cash flows shows the sources and uses of cash during a period of time.
  • Cash on hand, cash in banks, and petty cash are often combined and reported simply as cash.
  • Cash is the most liquid asset and listed first in the current assets section of the balance sheet.
  • Many companies use the designation "Cash and cash equivalents" in reporting cash. Cash equivalents are short-term, highly liquid investments that are both:
    • Readily convertible to known amounts of cash, and
    • So near their maturity that their market value is relatively insensitive to changes in interest rates.
  • A negative balance in the cash account should be rare. It should be reported among current liabilities.
  • A company may have cash that is not available for general use but rather is restricted for a special purpose. Cash restricted in use should be reported separately on the balance sheet as restricted cash. If the restricted cash is expected to be used within the next year, the amount should be reported as a current asset. When this is not the case the restricted funds should be reported as a noncurrent asset.

Study Objective 6 - Discuss the Basic Principles of Cash Management

Many companies struggle, not because they fail to generate sales, but because they cannot manage their cash. Managing the often-precarious balance created by the ebb and flow of cash during the operating cycle is one of a company’s greatest challenges.

  • Management of cash is the responsibility of the company treasurer.
  • A company can improve its chances of having adequate cash by following five basic principles of cash management:
  1.  Increase the speed of collection on receivables
    • The more quickly customers pay the more quickly a company can use those funds.
    • Any attempt to force customers to pay earlier must be carefully weighted against the possibility of angering or alienating customers.
    • One common way to encourage customers to pay more quickly is to offer cash discounts for early payment.
  2. Keep inventory levels low

    Maintaining large inventories ties up large amounts of cash, as well as warehouse space.
    Increasingly, firms are using techniques to reduce the inventory on hand, thus conserving their cash.
  3. Delay payment of liabilities
    • A company should use the full payment period, but not “stretch” payment past the point that could damage its credit rating.
    4. Plan the timing of major expenditures
    • In order to increase the likelihood of obtaining outside financing, a company should carefully consider the timing of ma jor expenditures in light of its operating cycle. If at all possible, the expenditure should be made when the company normally has excess cash—usually during the off-season.

 5. Invest idle cash

  • Cash on hand earns nothing.
  • An important part of the treasurer’s job is to ensure that any excess cash is invested, even if it is only overnight.
  • A liquid investment is one with a market in which someone is always willing to buy or sell the investment.
  • A risk-free investment means there is no concern that the party will default on its promise to pay its principal and interest.

 How would you go about increasing the speed of collection on receivables?

Study Objective 7 - Identify the Primary Elements of a Cash Budget

Cash is vital and planning the company's cash needs is a key business activity. The cash budget shows the anticipated cash flows, over a one- to two-year period. The cash budget contains the following three sections:

  • Cash receipts section—includes expected receipts from the company's principal source(s) of revenue, such as cash sales and collections from customers on credit sales. This section also shows anticipated receipts of interest and dividends, and proceeds from planned sales of investments, plant assets, and the company's capital stock.
  • Cash disbursements section—shows expected payments for direct materials, direct labor, manufacturing overhead, and selling and administrative expenses. This section also includes pro jected payments for income taxes, dividends, investments, and plant assets.
  • Financingsection—shows expected borrowings and the repayment of the borrowed funds and interest.

Data in the cash budget must be prepared in sequence because the ending cash balance of one period becomes the beginning cash balance for the next period.

Data for preparing the cash budget are obtained from other budgets and from information provided by management.

A cash budget contributes to more effective cash management.

Do you budget your cash? You may not have a written record of your budget. However, most of you have thought about when you will receive money and when you will make cash payments. This is, although very informal, a form of budgeting. Do you think you would save more money if you budgeted? Why or why not?

Where would you go for financing if your cash disbursements exceed cash receipts.