1. © 2012 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 & Managerial Accounting, 2e

2. © 2012 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. Learning Objectives 1.Discuss the role of internal controls in managing a business. 2.Discuss the five elements of internal control. 3.Describe how businesses account for and report cash. 4.Describe how businesses control cash. 5.Describe the operating cycle and explain the principles of cash management.

3. © 2012 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. ► Internal control systems include all the policies and procedures established by top management and the board of directors to provide reasonable assurance that the company’s objectives are being met in the following three areas: ► effectiveness and efficiency of operations ► reliability of financial reporting ► compliance with applicable laws and regulations 1

4. © 2012 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. Sarbanes-Oxley Act Requirements ► Under the Sarbanes-Oxley Act of 2002, top management of publicly-traded corporations have an increased responsibility for a system of internal controls that ensures the reliability of the financial statements. ► Section 404 of the Act requires management to produce an internal control report acknowledging that management is responsible for establishing and maintaining an adequate internal control system and procedures for financial reporting and also assessing the effectiveness of these controls. ► Section 302 of the Act requires the principal executive and financial officers to certify that they are responsible for establishing and maintaining the system of internal control over financial reporting. 1

5. © 2012 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. Elements of Internal Control 2

6. © 2012 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. Control Environment and Ethical Behavior ► The foundation of the internal control system is the control environment—the collection of environmental factors that influence the effectiveness of control procedures. ► The control environment includes the following: ► the philosophy and operating style of management ► the personnel policies and practices of the business ► the overall integrity, attitude, awareness, and actions of everyone in the business concerning the importance of control (commonly called the tone at the top). ► An important feature of the control environment is recognizing that an individual employee’s goals may differ from the goals of other individuals and the goals of the business. ► Resolving these conflicting incentives in an ethical manner that promotes organizational objectives is highly dependent on the tone at the top. 2

7. © 2012 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. Risk Assessment ► Risk assessment procedures are designed to identify, analyze, and manage strategic risks and business process risks. ► Strategic risks are possible threats to the organization’s success in accomplishing its objectives and are external to the organization. ► These risks are often classified around industry forces such as competitors, customers, substitute products or services, suppliers, and threat of new competitors (known as Porter’s five forces) or macro factors such as political, economic, social, and technological (also known as PEST factors). ► Business process risks arise out of the internal processes of the company—specifically, how the company allocates its resources to meet its objectives. 2

8. © 2012 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. Control Activities ► Control activities are the policies and procedures top management establishes to help insure that its objectives are met. ► The control activities most directly related to the accounting system and financial statements vary widely from one business to another, but generally can be identified with one of the following five categories: ► Clearly Defined Authority and Responsibility ► Segregation of Duties ► Adequate Documents and Records ► Safeguards over Assets and Records ► Checks on Recorded Amounts 2

9. © 2012 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. Clearly Defined Authority and Responsibility ► The authority to perform important duties is delegated to specific individuals, and those individuals should be held responsible for the performance of those duties in the evaluation of their performance. ► The clear delegation of authority and responsibility motivates individuals to perform well because they know they are accountable for their actions. 2

10. © 2012 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. Segregation of Duties ► Accounting and administrative duties should be performed by different individuals, so that no one person prepares all the documents and records for an activity. ► This segregation of duties (also called separation of duties) reduces the likelihood that records could be used to conceal irregularities (intentional misstatements, theft, or fraud) and increases the likelihood that irregularities will be discovered. ► Segregation of duties also reduces the likelihood that unintentional record-keeping errors will remain undiscovered. 2

11. © 2012 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. Adequate Documents and Records ► Accounting records are the basis for the financial statements and other reports prepared for managers, owners, and others both inside and outside the business. ► Summary records and their underlying documentation must provide information about specific activities and help in the evaluation of individual performance. 2

12. © 2012 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. Safeguards over Assets and Records ► Both assets and records must be secured against theft and destruction. ► Safeguarding requires physical protection of the assets through, for example, fireproof vaults, locked storage facilities, keycard access, and antitheft tags on merchandise. ► An increasingly important part of safeguarding assets and records is access controls for computers. ► Safeguards must be provided for computer programs and data files, which are more fragile and susceptible to unauthorized access than manual record-keeping systems. 2

13. © 2012 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. Checks on Recorded Amounts ► Recorded amounts should be checked by an independent person to determine that amounts are correct and that they correspond to properly authorized activities. ► These procedures include clerical checks, reconciliations, comparisons of asset inspection reports with recorded amounts, computer-programmed controls, and management review of reports. 2

14. © 2012 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. Information and Communication ► An internal control system will be unable to help a company achieve its objective unless adequate information is identified and gathered on a timely basis. ► Further, this information must be communicated to the appropriate employees in the organization. ► If information is not gathered and communicated, then management may not become aware of problems until it is too late and returns and complaints are made by dissatisfied customers. 2

15. © 2012 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. Monitoring ► Monitoring is the process of tracking potential and actual problems in the internal control system. ► Monitoring is accomplished through normal supervising activities such as when a manager asks a subordinate how things are going. ► However, best practices for larger organizations suggest that an internal audit group help monitor the effectiveness of the internal control system. ► Monitoring the system of internal controls allows the organization to identify potential and actual weaknesses that could, if uncorrected, produce problems. ► Sarbanes-Oxley Act requires all publicly-traded corporations to have an internal audit function that reports to the audit committee of the board of directors. 2

16. © 2012 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. ► It is difficult to generalize the relationship between internal control activities and accounting systems because it directly depends on the objectives of a particular business. 2

17. © 2012 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 the Accounting System and Control Procedures 2

18. © 2012 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. ► 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. 3

19. © 2012 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: ► The authority to collect, hold, and pay cash must be clearly assigned to specific individuals. Whenever feasible, cash-handling activities and cash record-keeping activities should be assigned to different individuals. ► Cash records should be examined often by an objective party as a basis for evaluating the performance of cash-handling activities. ► Controls should be supported by an appropriately designed record- keeping system. ► Cash should be safeguarded in vaults and banks. 4

20. © 2012 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 (continued) ► The three most important areas where the accounting system interacts with the internal control system to strengthen cash controls include: ► bank reconciliations ► cash over and short ► petty cash 4

21. © 2012 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 ► The use of a bank is one of the most important controls over cash. ► Since the bank’s accounting records and company’s accounting records often disagree due to timing differences, these must be ‘‘reconciled’’ to ensure that the accounting records are consistent with the bank’s accounting records. ► This process is called the bank reconciliation. ► Reconciliation of these separately maintained records serves two purposes: ► It serves a control function by identifying errors and providing an inspection of detailed records that deters theft. ► It serves a transaction detection function by identifying transactions performed by the bank, so the business can make the necessary entries in its records. 4

22. © 2012 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 (continued) ► In general, differences between the cash account balance and the bank statement balance develop from three sources: ► transactions recorded by the business, but not recorded by the bank in time to appear on the current bank statement ► transactions recorded by the bank, but not yet recorded by the business ► errors in recording transactions on either set of records 4

23. © 2012 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. ► 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. 4

24. © 2012 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. ► 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. 4

25. © 2012 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 ► The previous differences between the accounting records and bank account balances are the result of time lags between the recording of a transaction by the business and its recording by the bank. ► Errors in recording transactions represent yet another source of difference between a business’s cash account balance and the bank balance. ► 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. 4

26. © 2012 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. Performing a Bank Reconciliation ► To begin the reconciliation, start with the ‘‘cash balance from the bank statement’’ and the ‘‘cash balance from company records.’’ ► These two balances are then adjusted as necessary to produce identical ‘‘adjusted cash balances’’ by following four steps. ► These steps are explained in the following slides with the help of an example. 4

27. © 2012 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. Bank Statement 4

28. © 2012 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. T-Account for Cash, Prior to Reconciliation: Ohio Enterprises Inc. 4

29. Concept: Bank reconciliation is the process of comparing the accounting records and the bank statement, determining where discrepancies occur, and accounting for them. Information: Refer to the bank statement and the cash account shown in previous slides. Recognize that the beginning balance was reconciled at the end of last month (July). Assume that this was performed correctly and all outstanding checks (numbers 1883, 1884, and 1885) and deposits in transit from July cleared during August. Required: 1. Determine the adjustments needed by comparing the bank statement to the cash account. 2. Complete the bank reconciliation. © 2012 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. 4 Cornerstone 4-1 Performing a Bank Reconciliation

30. © 2012 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. 4 Cornerstone 4-1 Performing a Bank Reconciliation (continued)

31. © 2012 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. 4

32. Concept: Adjusting journal entries are required for all transactions correctly recorded by the bank that have not yet been included in the accounting records. Information: Refer to the bank reconciliation performed in Cornerstone 4-1. Assume that all checks from this account were written to satisfy accounts payable. Required: Prepare the necessary adjusting journal entries. © 2012 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. 4 Cornerstone 4-2 Making Adjusting Entries as a Result of the Bank Reconciliation

33. © 2012 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. 4 Cornerstone 4-2 Making Adjusting Entries as a Result of the Bank Reconciliation (continued)

34. © 2012 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. ► At the end of each day, the amount of cash received during the day is debited to the cash accounts to which it has been deposited. ► The amount deposited should equal the total of cash register tapes. ► If it does not (and differences will occasionally occur even when cash-handling procedures are carefully designed and executed), the discrepancy is recorded in an account called cash over and short. ► One common source of cash over and short is errors in making change for cash sales. 4

35. © 2012 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. 4 Cornerstone 4-3 Recording Cash Short and Over

36. © 2012 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 with Checks ► Cash controls are more effective when companies pay with a check for the following reasons: ► Only certain people have the authority to sign the check. ► Those authorized to sign do not keep the accounting records and only sign the check with the proper documentation supporting the payment (e.g., evidence that the goods being paid for were properly ordered and received). ► Supporting documents are marked paid to avoid duplicate payment. ► Checks are prenumbered, which makes it easy to identify any missing checks. 4

37. © 2012 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 ► Unfortunately, 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 items such as stamps or a cake for an employee birthday party. ► The petty cash fund is overseen by a petty cash custodian, who both pays for small dollar amounts directly from the fund and reimburses employees who have receipts for items they’ve bought with their own money. 4

38. © 2012 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. 4 Cornerstone 4-4 Accounting for Petty Cash

39. © 2012 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. 4 Cornerstone 4-4 Accounting for Petty Cash (continued)

40. © 2012 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 5

41. © 2012 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. ► This sequence of activities includes a continual process of paying and receiving 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 5

42. © 2012 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. 5

43. © 2012 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. 5

44. © 2012 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. ► Of course, they sell the receivables for less than they will receive (which represents interest and return for the buyer), but it also allows the company to receive the cash sooner and avoid hiring employees to service the receivables. 5

45. © 2012 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 ► Beyond delaying payments and speeding up collections, 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. 5