Financial Accounting: Tools for Business Decision Making Kimmel, Weygandt, Kieso ELS 1 1

Chapter 7 2

Chapter 7 Internal Control and Cash PowerPoint Slides After studying Chapter 7, you should be able to: Identify the principles of internal control. Explain the application of internal control to cash receipts. Explain the application of internal control to cash disbursements. Prepare a bank reconciliation. 3 1 3

Chapter 7 Internal Control and Cash After studying Chapter 7, you should be able to: Explain the reporting of cash. Discuss the basic principles of cash management. Identify the primary elements of a cash budget. Identify and interpret measures that evaluate the adequacy of cash. 4 4

Internal Control consists of... all the related methods and measures adopted within a business to: safeguard its assets; enhance accuracy and reliability of accounting of its accounting records. 5 5

Page 289in book 6 6

Establishment of Responsibility Control is most effective when only one person is responsible for a given task. 7 7

Segregation of Duties Responsibility of related activities should be assigned to different individuals. Responsibility of keeping the records of an asset should be separate from physical custody. 8 8

Segregation of Duties Responsibility for related activities should be assigned to different individuals Responsibility for keeping records for an asset should be separate from the physical custody of the asset Page 290 in the book 9 9

Documentation Provide evidence that transactions and events occurred: Shipping documents Sales invoices 10 10

Documentation Procedures Documents should be pre-numbered All documents should be accounted for Sources documents should be promptly forwarded to accounting department 11 11

Physical, Mechanical and Electronic Controls 12 12

Independent Internal Verification Involves review, comparison, and reconciliation of data prepared by employees Verification should be made periodically or on surprise basis Verification should be done by employee who is independent of the personnel responsible for the information Discrepancies and exceptions should be reported to management 13 13

Independent Internal Verification Involves review, comparison, and reconciliation of data prepared by employees. Verification should be made periodically or on surprise basis. Verification should be done by employee who is independent of the personnel responsible for the information. Discrepancies and exceptions should be reported to management. 14 14

Independent Internal Verification 15 15

Other Controls Bonding of employees who handle cash Rotating employee’s duties and requiring employees to take vacations 16 16

Cash consists of... coins currency checks money orders money on hand deposits in bank 17

Cash consists of... coins currency checks money orders money on hand deposits in bank 18 18

Cash is the most desirable asset... because it is readily convertible into any other asset. 19 19

Limitations of Internal Controls Cost/Benefit - cost of establishing procedure should not exceed expected benefit Human element - fatigue, carelessness, indifference Collusion - two or more individuals who work together to get around controls Size of business 20 20

Page 296 in book 21 21

Over Cash Disbursements Internal Control Over Cash Disbursements Page 297 in book 22 22

Electronic Funds Transfer (EFT) An approach to transfer funds among parties without paper (deposit tickets, checks, etc.) EFT uses wire, telephone,telegraph or computer to transfer from one location to another 23 23

Petty Cash Fund is a cash fund used to pay relatively small amounts 24

Petty Cash Fund A cash fund used to pay relatively small amounts. 25

Use of a Bank... is good internal control. PowerPoint Slides Use of a Bank... is good internal control. minimizes the amount of cash that must be kept on hand. provides a double record of all bank transactions one by the business one by the bank a company can safeguard its cash by using a bank as a depository and clearinghouse for checks received and written. 26 24 26

a copy of the bank’s records sent to the customer for periodic review. Bank Statement - a copy of the bank’s records sent to the customer for periodic review. Bank Statement shows check & other debits deposits & other credits daily cash balance 27 27

Company Balance and Bank Balance of Cash Usually Differ Because... PowerPoint Slides Time lags that prevent one of the parties from recording the transaction in the same period. Days pass between the time a check is written and dated and 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. 28 27 28

Reconciliation Procedure PowerPoint Slides Reconciliation Procedure reconcile balance per books and balance per bank to their adjusted or correct balances the reconciliation should be prepared by an employee who has no other responsibilities pertaining to cash 29 28 29

PowerPoint Slides Terms Deposits in transit - deposits recorded by the depositor that have not been recorded by the bank. Outstanding Checks - checks issued and recorded by the company that have not been paid by the bank. NSF Check - a check that is not paid by the bank because of insufficient funds in the customer’s bank account. Adjusted balance - same as true cash balance, correct cash balance 30 29 30

-check printing or other service charge +notes collected by bank Bank Reconciliation Procedures $ Per Bank Statement -outstanding checks +deposits +/- bank errors correct cash amount $ Per Books -NSF Checks -check printing or other service charge +notes collected by bank 31

W.A. Laird Company Bank Reconciliation April 30, 1998 PowerPoint Slides W.A. Laird Company Bank Reconciliation April 30, 1998 Page 302 in book Cash balance per bank statement 15,907.45 Add: Deposits in transit 2,201.40 18,108.85 Less: Outstanding checks No. 453 3,000.00 No. 457 1,401.30 No. 460 1,502.70 5,904.00 Adjusted cash balance per bank 12,204.85 Cash balance per books 11,589.45 Add: Collection of N/R for $ 1000 plus interest earned $50, less collection fee $ 15 1,035.00 Error on recording check No. 443 36.00 1,071.00 12,660.45 Less: NSF check 425.60 Bank service charge 30.00 455.60 31 32

For Cash To Show the Correct Balance Each reconciling item in determining the adjusted balance per books must be journalized and posted. 33 33

W.A. Laird Company Bank Reconciliation April 30, 1998 PowerPoint Slides W.A. Laird Company Bank Reconciliation April 30, 1998 Page 302 in book Cash balance per bank statement 15,907.45 Add: Deposits in transit 2,201.40 18,108.85 Less: Outstanding checks No. 453 3,000.00 No. 457 1,401.30 No. 460 1,502.70 5,904.00 Adjusted cash balance per bank 12,204.85 Cash balance per books 11,589.45 Add: Collection of N/R for $ 1000 plus interest earned $50, less collection fee $ 15 1,035.00 Error on recording check No. 443 36.00 1,071.00 12,660.45 Less: NSF check 425.60 Bank service charge 30.00 455.60 31 34

JOURNAL Apr 30 Cash 1,035.00 Miscellaneous Expense 15.00 Notes Receivable 1,000.00 Interest Revenue 50.00 Apr 30 Cash 36.00 Accounts Payable 36.00 Apr 30 Accounts Receivable-Baron 425.60 Cash 425.60 Apr 30 Miscellaneous Expense 30.00 Cash 30.00 35

PowerPoint Slides Reporting 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. 36 38 36

Cash Equivalents Readily convertible to known amount of cash So near maturity that market value is relatively insensitive to changes in interest rates Examples: Treasury bills Commercial paper Money Market Funds 37 37

Restricted Cash... Is cash that is not available for general use. Is set aside for special purpose. If not to be used within next year, report as noncurrent asset. 38 38

PowerPoint Slides Operating Cycle of a Merchandising Company…is the average time it takes to go from cash to cash in producing revenues. Page 306 in book 39 33

Five Principles of Cash Management PowerPoint Slides Five Principles of Cash Management Page 308 in book 40 33

PowerPoint Slides Reporting Cash Cash on hand, cash in banks, and petty cash are often combined and reported as cash. Cash is the most liquid asset and listed first in the current asset section of the balance sheet. 41 39 41

Cash Budget Cash is vital. PowerPoint Slides Cash Budget Cash is vital. Planning the company's cash needs is a key business activity. Cash budget shows the anticipated cash flows, over a 1 to 21-year period. 42 42 42

Cash Budget The cash budget contains : Cash receipts section; PowerPoint Slides Cash Budget The cash budget contains : Cash receipts section; Cash disbursements section; Financing section. 43 43 43

PowerPoint Slides 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 also shows anticipated receipts of interest and dividends, and proceeds from planned sales of investments, plant assets, and the company's capital stock 44 44 44

Cash Disbursements Section PowerPoint Slides Cash Disbursements Section shows expected payments for direct materials, direct labor, manufacturing overhead, and selling and administrative expenses. includes projected payments for income taxes, dividends, investments, and plant assets. 45 45 45

PowerPoint Slides Financing Section Shows expected borrowings and the repayment of the borrowed funds and interest 46 46 46

PowerPoint Slides Adequacy Of Cash Net cash provided by operating activities is used to compute two ratios which measure liquidity and solvency. 47 47 47

Net Cash Provided by Operating Activities Current Liabilities Liquidity - the ability of a company to pay obligations that are expected to come due within the next year. PowerPoint Slides Current Cash Debt Coverage Ratio -indicates whether a company can pay off its current liabilities from current operations. Net Cash Provided by Operating Activities Current Liabilities 48 48 48

Net Cash Provided by Operating Activities Total Liabilities Solvency - the ability of a company to pay interest as it comes due and to repay the face value of debt at maturity PowerPoint Slides Cash Debt Coverage Ratio -indicates whether a company can pay off its total liabilities from current operations Net Cash Provided by Operating Activities Total Liabilities 49 48 49

Additional Tools Used to Measure the Adequacy of Cash PowerPoint Slides Two additional tools used to measure the adequacy of cash are: ratio of cash to daily cash expenses; free cash flow. 50 50 50

Ratio of Cash to Daily Cash Expenses PowerPoint Slides Ratio of Cash to Daily Cash Expenses Computes the number of days of cash expenses the cash on hand can cover Average daily cash expenses can be approximated by subtracting depreciation (a noncash expense) from total expenses and dividing by 365 days 51 51 51

Ratio of Cash to Daily Cash Expenses PowerPoint Slides Ratio of Cash to Daily Cash Expenses balance in cash and cash equivalent average daily cash expenses 52 51 52

PowerPoint Slides Free Cash Flow Free cash flow is the amount of discretionary cash flow a company has for: purchasing additional investments paying its debt adding to its liquidity Net cash provided by operating activities $250,000 Less: Capital expenditures $80,000 Dividends paid 50,000 130,000 Free Cash Flow $120,000 53 52 53

54