2. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 1 Internal Control and Managing Cash Chapter 4

3. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 2 Learning Objective 1 Set up an effective system of internal control.

4. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 3 Internal Control It is the organizational plan and all the related measures that an entity adopts. Safeguard assets. Promote operational efficiency. Encourage adherence to company policies. Ensure accurate and reliable accounting records.

5. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 4 Components of an Effective System Competent, reliable, and ethical personnel Assignment of responsibilities Proper authorization Separation of duties

6. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 5 Separation of operations from accounting Separation of the custody of assets from accounting Separation of the authorization of transactions from the custody of related assets Separation of the authorization of transactions from the custody of related assets Separation of Duties

7. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 6 Internal and External Audits An audit is an examination by an outside party of the company’s financial statements, accounting systems, and internal controls. An audit is an examination by an outside party of the company’s financial statements, accounting systems, and internal controls. An internal auditor is an employee of the business. An external auditor is an independent auditor.

8. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 7 Documents and Records Business documents and records include: invoices (bills) paid checks accounting journals accounting ledgers

9. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 8 Electronic and Computer Controls Businesses use electronic devices to safeguard assets.

10. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 9 The Onion Model of E-Commerce System Security Sensitive Hardware, Software, and Data Encryption Firewalls Intrusion detection devices Incident response procedures Audits by external specialists

11. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 10 Encryption It is the transformation of data by a mathematical process 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

12. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 11 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

13. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 12 Other Controls – Fireproof vaults – Burglar alarms – Point of sale terminals – Frequent bank deposits – Bonded cashiers – Mandatory vacations – Job rotation

14. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 13 The Limitations of Internal Control Systems designed to thwart one person’s fraud can be beaten by two or more employees working together – colluding – to defraud the firm. A system of internal control that is too complex can hurt efficiency and control.

15. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 14 Learning Objective 2 Use a bank reconciliation as a control device.

16. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 15 The Bank Account as a Control Device Banks safeguard and help control cash. A check is the document that instructs the bank to pay a specified amount of money. MakerPayeeBank

17. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 16 Electronic Funds Transfer EFT is a system that relies on electronic communications – not paper documents – to transfer cash.

18. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 17 The Bank Reconciliation There are two records of a business’s cash: the company’s cash account on its own books, and… the bank statement, which shows the actual amount of cash in the bank.

19. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 18 The Bank Reconciliation Two common items that cause differences between 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

20. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 19 The Bank Reconciliation 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

21. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 20 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 the books has a balance of $3,294.21. The following reconciling items explain why the two balances differ:

22. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 21 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) 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.

23. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 22 The Bank Reconciliation Illustrated Check No. Date Amount 337Jan. 27$ 286.00 338 28 319.47 339 28 83.00 340 29 203.14 341 30 458.53 Total$1,350.14

24. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 23 The Bank Reconciliation Illustrated 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.

25. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 24 The Bank Reconciliation Illustrated 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.

26. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 25 Balance per bank, January 31$5,931.51 Add deposit in transit 1,591.63 Check erroneously charged 100.00 $7,623.14 Less outstanding checks–1,350.14 Adjusted bank balance$6,273.00 The Bank Reconciliation Illustrated

27. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 26 Balance per books, January 31$3,294.21 Add: ETF receipt of rent revenue 904.03 Collection of note receivable 2,114.00 Interest revenue earned 28.01 Correction of book error 360.00 $6,700.25 Less: Service charge$ 14.25 NSF check 52.00 Payment of insurance expense 361.00 – 427.25 Adjusted book balance$6,273.00 The Bank Reconciliation Illustrated

28. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 27 Learning Objective 3 Apply internal controls to cash receipts and cash payments.

29. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 28 Controlling and Managing Cash Internal control over cash receipts ensures that all cash receipts are deposited in the bank and no collections are lost.

30. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 29 Over the Counter Receipts The point-of-sale terminal (cash register) offers control over the cash received in a store. The point-of-sale terminal (cash register) offers control over the cash received in a store. The cash drawer opens only when the sales clerk enters an amount on the keypad. The cash drawer opens only when the sales clerk enters an amount on the keypad.

31. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 30 Over the Counter Receipts At the end of the day, the cashier deposits the cash in the bank. At the end of the day, the cashier deposits the cash in the bank. The record of cash receipts goes to accounting. The record of cash receipts goes to accounting.

32. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 31 Mail Receipts All incoming mail should be opened by a mailroom employee. All incoming mail should be opened by a mailroom employee. This person should compare the check received with the remittance advice. This person should compare the check received with the remittance advice. The mailroom clerk keeps a running total of cash receipts for the day. The mailroom clerk keeps a running total of cash receipts for the day.

33. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 32 Mail Receipts At the end of the day this control total is given to a responsible official. At the end of the day this control total is given to a responsible official. Cash receipts should be given to the cashier. The mailroom employee forwards the remittance advices to accounting. The mailroom employee forwards the remittance advices to accounting.

34. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 33 Mail Receipts Many companies use a lock-box system. Customers send checks directly to an address that is essentially a bank account. Customers send checks directly to an address that is essentially a bank account.

35. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 34 Element of Internal Control Internal Controls over Cash Receipts Competent, reliable, ethical personnel Carefully screen and train employees. Proper authorization Only designated employees can grant exceptions for customers. Internal Controls Over Cash Receipts

36. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 35 Internal Controls Over Cash Receipts Internal:management policies External:control over cash receipts Internal and external audits Electronic and computer controls Match receipts with remittances and bank deposit ticket daily. Employees who handle cash do not have access to accounting records. Separation of duties

37. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 36 Internal Control: Payments Purchasing Process Purchase order Purchasing department SupplierInvoice (bill)Supplier Accounting department Receiving report Receiving department Accounting department Disbursement packet Accounting department Officer who signs the check Purchase request (requisition) Sales department Purchasing department Business DocumentPrepared bySent to

38. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 37 Internal Control: Payments Disbursement Packet Purchase Request Purchase Order Receiving Report Invoice Disbursement Packet

39. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 38 Element of Internal Control Internal Controls over Cash Payments Competent, reliable, ethical personnel Payments entrusted to high level employees and the treasurer. Proper authorization Large expenditures must be authorized by top management. Internal Controls Over Cash Payments

40. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 39 Internal Controls Over Cash Payments Internal:management policies External:control over cash payments Internal and external audits Electronic and computer controls Computer programmers do not operate the computers. Employees who handle checks have no access to accounting records. Separation of duties

41. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 40 Petty Cash The petty cash fund is a small amount of cash kept on hand to pay for minor expenses. The custodian of the petty cash fund… Cashes a check and places the currency and coin in the fund. Prepares a petty cash ticket for each petty cash payment.

42. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 41 Learning Objective 4 Use a budget to manage cash.

43. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 42 Using a Budget to Manage Cash A budget is a financial plan that helps coordinate business activities. A cash budget helps a company, or an individual, manage cash by planning the receipt and payment of cash during a future period.

44. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 43 Using a Budget to Manage Cash 1. Start with the entity’s cash balance at the beginning of the period. 2. Add the budgeted cash receipts and subtract the budgeted cash payments. Managers proceed as follows to determine how much cash the company will need:

45. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 44 Using a Budget to Manage Cash 3. The beginning balance plus the expected receipts minus the expected payments equals the expected cash balance at the end of the period. 4. Compare the expected cash balance at the end of the period to the desired, or budgeted, cash balance.

46. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 45 Cash Budget 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 $3,072.0 Estimated cash payments: 5. Purchases of inventory$1,906.2 6. Operating expenses 561.0 7. Expansion of existing stores 206.4 8. Opening of new stores 344.6 9. Payment of long-term debt 148.7 10. Payment of dividends 219.0 3,385.9 11. Cash available (needed) before new financing (313.9) 12. Budgeted cash balance, January 1, 20x3 (200.0) 13. Cash available for additional investments$ (513.9) Cash Budget For the Year Ended January 31, 20x3(In millions)

47. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 46 Reporting Cash on the Balance Sheet Companies usually combine all cash amounts into a single total called “Cash and Cash Equivalents” on the balance sheet. Cash equivalents include liquid assets… Time depositsCertificates of deposit

48. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 47 Reporting Cash on the Balance Sheet America Online, Inc. Consolidated Balance Sheet December 31 Excerpts Assets Current assets: Cash and cash equivalents$2,610 Short-term investments 886 Accounts receivable 464 (In Millions)2000

49. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 48 Learning Objective 5 Weigh ethical judgment in business.

50. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 49 Ethics and Accounting Most large companies have a code of ethics designed to encourage ethical and responsible behavior by employees. Accountants have additional incentives to behave ethically. AICPA Code of Professional Conduct Standards of Ethical Conduct for Management Accountants

51. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 50 Ethics and Accounting Conflict of Interest Enron Corporation A. Fastow, CEO Outside Partnership A. Fastow, Principal Business transactions

52. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 4 - 51 End of Chapter 4