1. of Financial Accounting, 3e CORNERSTONES

2. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CHAPTER 4: INTERNAL CONTROL AND CASH Cornerstones of Financial Accounting, 3e

3. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Role of Internal Control  To control employees’ activities, management puts in place procedures that collectively are called the internal control system. LO-1

4. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Role of Internal Control  Internal control systems include all the policies and procedures to provide reasonable assurance that the company’s objectives are being met in the three areas:  effectiveness and efficiency of operations  reliability of financial reporting  compliance with applicable laws and regulations LO-1

5. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Components of Internal Control  The Committee of Sponsoring Organizations of the Treadway Commission (COSO) established five components of internal control: 1. The control environment 2. Risk assessment 3. Control activities 4. Information and communication 5. Monitoring activities LO-2

6. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Components of Internal Control (Cont.)  The foundation of the internal control system is the control environment—the collection of environmental factors that influence the effectiveness of control procedures. LO-2

7. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Components of Internal Control (Cont.)  The control environment includes the following:  philosophy and operating style of management  personnel policies and practices of the business  overall integrity, attitude, awareness, and actions of everyone in the business concerning the importance of control (commonly called the tone at the top) LO-2

8. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Components of Internal Control (Cont.)  Risk Assessment  Risk assessment procedures (also called Enterprise Risk Management or ERM) are designed to identify, analyze, and manage strategic risks and business process risks. LO-2

9. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Components of Internal Control (Cont.)  Strategic risks are threats to the organization’s success in accomplishing its objectives and are external.  Forces such as competitors, and customers, substitute products or services, suppliers, and threat of new competitors (Porter’s Five Forces) or factors such as political, economic, social, and technological (PEST factors). LO-2

10. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Components of Internal Control (Cont.)  Business Process Risks  Business processes are the internal processes of the company—how the company allocates its resources to meet its objectives.  Some of the more common ones are materials acquisition, production, logistics and distribution, branding and marketing, and human resources. LO-2

11. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Components of Internal Control (Cont.)  Control Activities  Control activities are the policies and procedures top management establishes to help insure that its objectives are met.  Control activities can be identified with one of five categories. LO-2

12. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Components of Internal Control (Cont.) 1. Clearly Defined Authority and Responsibility 2. Segregation of Duties 3. Adequate Documents and Records 4. Safeguards over Assets and Records  Safeguarding requires physical protection of the assets. 5. Checks on Recorded Amounts LO-2

13. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Relationship Between Control Activities and the Accounting System  The accounting system consists of the methods and records used to identify, measure, record, and communicate financial information about a business.  The accounting system and the internal control system are really one integrated system designed to meet the needs of a particular business. LO-2

14. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accounting and Reporting Cash  Cash is not only currency and coins, but also includes savings and checking accounts and negotiable instruments like checks and money orders.  When cash is received, a cash account is increased by a debit; and when cash is paid out, a cash account is decreased by a credit. LO-3

15. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accounting and Reporting Cash (cont.)  Cash is reported on both the balance sheet and the statement of cash flows.  The balance sheet typically reports the amount of cash and cash equivalents available at the balance sheet date. LO-3

16. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Controls  Internal controls are designed to protect all assets.  But the more liquid an asset (the more ‘‘liquid’’ an asset, the more easily it is converted into cash), the more likely it is to be stolen.  The following internal controls help businesses effectively control cash: LO-4

17. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Controls (cont.)  The authority to collect, hold, and pay cash must be clearly assigned to specific individuals. Cash-handling and record-keeping activities should be assigned to different individuals.  Cash records should be examined by an objective party for evaluating the performance of cash-handling activities.  Controls should be supported by a record- keeping system.  Cash must be safeguarded (vaults and banks). LO-4

18. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reconciliation of Accounting Records to Bank Statement  Bank’s and company’s accounting records often disagree due to timing differences.  Records must be ‘‘reconciled’’ to ensure that the accounting records are consistent with the bank’s accounting records.  This process is called the bank reconciliation. LO-4

19. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reconciliation of Accounting Records to Bank Statement (cont.)  Reconciliation of these separately maintained records serves two purposes:  As a control function by identifying errors and providing an inspection of detailed records that deters theft.  As a transaction detection function by identifying transactions performed by the bank, so the business can make the necessary entries in its records. LO-4

20. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reconciliation of Accounting Records to Bank Statement (cont.)  Differences between the cash account balance and the bank balance develop from three sources: 1. transactions recorded by the business, but not recorded by the bank in time to appear on the current bank statement 2. transactions recorded by the bank, but not yet recorded by the business 3. errors in transactions on either set of records LO-4

21. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transactions Recorded by the Business, But Not Yet Recorded by the Bank  There are generally two types of transactions recorded by the business, but not recorded by the bank in time to appear on the current statement:  An outstanding check is a check issued and recorded by the business that has not been ‘‘cashed’’ by the recipient of the check.  Outstanding checks cause the bank balance to be higher than the business’s cash account balance. LO-4

22. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transactions Recorded by the Business, But Not Yet Recorded by the Bank (cont.)  A deposit in transit is an amount received and recorded by the business, but which has not been recorded by the bank in time to appear on the current bank statement.  Deposits in transit cause the bank balance to be smaller than the business’s cash account balance. LO-4

23. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transactions Recorded by the Bank, but Not Yet Recorded by the Business  Several types of transactions are recorded by the bank, but not yet recorded by the business:  Service charges are fees charged by the bank for checking account services.  The amount of the fee is not known to the business (and therefore cannot be recorded) until the bank statement is received. LO-4

24. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transactions Recorded by the Bank, but Not Yet Recorded by the Business (cont.)  A non-sufficient funds (NSF) check is a check that has been returned to the depositor because funds in the issuer’s account are not sufficient to pay the check (bounced check).  A debit memo might result if the bank makes a prearranged deduction from the business’s account to pay a bill.  A credit memo could result if the bank collected a note receivable for the business. LO-4

25. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Errors  Errors in recording transactions represent yet another source of difference between a business’s cash account balance and the bank balance. LO-4

26. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Errors (cont.)  Errors are inevitable in any accounting system and should be corrected as soon as discovered.  In addition, an effort should be made to determine the cause of any error as a basis for corrective action. LO-4

27. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Making Adjusting Entries as a Result of the Bank Reconciliation  Once the bank reconciliation is completed, some adjustments to the accounting records may be necessary.  No adjustments are necessary for outstanding checks or deposits in transit because the accounting records have correctly recorded these amounts.  Adjustments are necessary for any company errors or items such as bank charges or interest that the company does not find out about until receiving the bank statement. LO-4

28. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Short and Over  Another important control activity requires that cash receipts be deposited in a bank daily.  The amount deposited should equal the total of cash register tapes.  If it does not the discrepancy is recorded in an account called cash over and short. LO-4

29. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Short and Over (cont.)  One common source of cash over and short is errors in making change for cash sales. LO-4

30. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Petty Cash  Issuing checks to pay small amounts is usually more costly than paying cash.  For this reason, a company may establish a petty cash fund to pay for trivial items such as stamps.  The petty cash fund is overseen by a petty cash custodian. LO-4

31. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Operating Cycle LO-5

32. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Management  The activities of the operating cycle transform cash into goods and services and then back, through sales, into cash.  Cash management principles entail the following:  delaying paying suppliers (so a company can earn as much interest on their cash as possible)  speeding up collection from customers (in order to invest the cash sooner)  earning the greatest return on any excess cash LO-5

33. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Buying Inventory  The first stage of the operating cycle is buying inventory.  Money that is tied up in inventory sitting on the shelves is not earning any return.  As such, an important aspect of cash management is to keep inventory levels low.  This decreases the need for cash. LO-5

34. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Paying for Inventory  The second stage of the operating cycle is paying for the inventory.  As with all payments, a good cash management principle is to delay payments as long as possible while maintaining a good relationship with the payee.  The longer a company keeps cash, the more interest it can collect. LO-5

35. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Selling Inventory  The third stage is selling the inventory, which often produces receivables.  Good cash management suggests increasing the speed of receivable collections.  In fact, many companies sell their receivables rather than wait for their customers to pay. LO-5

36. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Short-Term Investments  Businesses try to keep their bank cash balances to a minimum because most bank accounts earn relatively small amounts of interest.  Accordingly, short-term investments are purchased with temporary cash surpluses.  The value and composition of short-term investment portfolios change continually in response to seasonal factors and other shifts in the business environment. LO-5