Principles of Financial Accounting, 11e 8 Internal Control and Cash Principles of Financial Accounting, 11e Reeve • Warren • Duchac

1 2 3 Internal Control and Cash After studying this chapter, you should be able to: 1 Describe the impact on internal controls and financial reporting. 2 Describe and illustrate the objectives and elements of internal control. 3 Describe and illustrate the application of internal controls to cash. 8-2

Internal Control and Cash (continued) 4 Describe the nature of a bank account and its use in controlling cash. 5 Describe and illustrate the use of a bank reconciliation in controlling cash. 6 Describe the accounting for special-purpose cash funds. 7 Describe and illustrate the reporting of cash and cash equivalents in the financial statements. 8-3

1 Describe the impact of internal controls and financial reporting. 9-4 8-4

Process information accurately. 1 Internal control is broadly defined as the procedures and processes used by a company to: Safeguard its assets. Process information accurately. Ensure compliance with laws and regulations.

2 Describe and illustrate the objectives and elements of internal control. 8-10

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2 Employee fraud is the intentional act of deceiving an employer for personal gain.

Five Elements of Internal Control 2 Five Elements of Internal Control Management is responsible for designing and applying five elements of internal control to meet the three internal control objectives. These elements are as follows: Control environment Risk assessment Control procedures Monitoring Information and communication

Limitations of Internal Control 2 Limitations of Internal Control The human element of control Cost-benefit considerations

Describe and illustrate the application of internal controls to cash. 3 Describe and illustrate the application of internal controls to cash. 8-26

3 Cash includes coins, currency (paper money), checks, and money orders. Cash is the asset most likely to be stolen or used improperly in a business.

3 Sources of Cash Businesses normally receive cash from two main sources: Customers purchasing products or services. Customers making payments on account.

Control of Cash Receipts 3 Control of Cash Receipts One of the most important controls to protect cash received in over-the-counter sales is a cash register.

Control of Cash Receipts 3 Control of Cash Receipts A predetermined amount of money that is given to each cash register clerk in a cash drawer is called a change fund.

3 Cash Short and Over Cash sales for March 19 totaled $35,690 per the cash register tape. After removing the change fund, only $35,668 was on hand. If there had been cash over, Cash Short and Over would have been credited for the overage.

3 Cash Received in Mail Cash is received in the mail when customers pay their bills. Most companies design their invoices so that customers return a portion of the invoice, called a remittance advice, with their payment.

3 Cash may be received from customers through electronic funds transfers (EFT). Customers may authorize automatic electronic transfers from their checking accounts to pay monthly bills.

Control of Cash Payments 3 Control of Cash Payments The control of cash payments should provide reasonable assurance that: Payments are made for only authorized transactions. Cash is used effectively and efficiently.

3 A voucher system is a set of procedures for authorizing and recording liabilities and cash payments. It may be either manual or computerized.

3 A voucher is any document that serves as proof of authority to pay cash or issue an electronic funds transfer.

Describe the nature of a bank account and its use in controlling cash. 4 Describe the nature of a bank account and its use in controlling cash. 8-38

4 Bank Accounts A major reason that businesses use bank accounts is for internal control. Some of the control advantages of using bank accounts are as follows: Bank accounts reduce the amount of cash on hand. Bank accounts provide an independent recording of cash transactions. Use of bank accounts facilitates the transfer of funds using EFT systems.

4 A summary received from the bank of all checking account transactions is called a bank statement.

4 Exhibit 5 Bank Statement (continued)

4 Exhibit 5 Bank Statement (continued)

4 Typical credit or debit memorandum entries found on the bank statement: EC — Error correction to correct bank error. NSF — Not sufficient funds check. SC — Service charge. ACH — Automated Clearing House entry for electronic funds transfer. MS — Miscellaneous items.

4 Example Exercise 8-2 Items on Company’s Bank Statement The following items may appear on a bank statement: (1) NSF check (2) EFT Deposit Service Charge Bank correction of an error from recording a $400 check as $40. Indicate whether the item would appear as a debit or credit memorandum on the bank statement and whether the item would increase or decrease the balance of the company’s account. 8-45

Example Exercise 8-2 (continued) 4 Follow My Example 8-2 Increases or Decreases the Balance of the Company’s Bank Account Appears on the Bank Statement as a Debit or Credit Memo Item No. (1) debit memo decreases (2) credit memo increases (3) debit memo decreases (4) debit memo decreases For Practice: PE 8-2A, PE 8-2B 8-46

4 Power Networking’s Records and Bank Statement Exhibit 6

5 Describe and illustrate the use of a bank reconciliation in controlling cash. 8-48

5 A bank reconciliation is an analysis of the items and amounts that cause the cash balance reported in the bank statement to differ from the balance of the cash account in the ledger in order to determine the adjusted cash balance.

5 The Adjusted Balance Must be equal

Steps in a Bank Reconciliation 5 Steps in a Bank Reconciliation (continued)

Steps in a Bank Reconciliation 5 Steps in a Bank Reconciliation

Power Networking’s Records 5 Bank’s Records Power Networking’s Records Beginning balance $3,359.78 Beginning balance $2,549.99 Step 1 Power Networking prepares to reconcile the monthly bank statement as of July 31. The bank statement shows an ending cash balance of $3,359.78. The company’s Cash account has a July 31 balance of $2,549.99.

Power Networking’s Records 5 Bank’s Records Power Networking’s Records Beginning balance $3,359.78 Beginning balance $2,549.99 Add deposit not recorded by bank 816.20 $4,175.98 Step 2 A deposit of $816.20 did not appear on the bank statement.

Power Networking’s Records 5 Bank’s Records Power Networking’s Records Beginning balance $3,359.78 Beginning balance $2,549.99 Add deposit not recorded by bank 816.20 $4,175.98 Deduct outstanding checks: No. 812 $1,061.00 No. 878 435.39 No. 883 48.60 1,544.99 Step 3 Three checks that were written during the period did not appear on the bank statement: No. 812, $1,061; No. 878, $435.39, No. 883, $48.60.

Power Networking’s Records 5 Bank’s Records Power Networking’s Records Beginning balance $3,359.78 Beginning balance $2,549.99 Add deposit not recorded by bank 816.20 Add note and interest collected by bank 408.00 $4,175.98 Deduct outstanding checks: No. 812 $1,061.00 No. 878 435.39 No. 883 48.60 1,544.99 $2,957.99 Step 4 The bank collected a note in the amount of $400 and the related interest of $8 for Power Networking

Power Networking’s Records 5 Bank’s Records Power Networking’s Records Beginning balance $3,359.78 Beginning balance $2,549.99 Add deposit not recorded by bank 816.20 Add note and interest collected by bank 408.00 $4,175.98 Deduct outstanding checks: No. 812 $1,061.00 No. 878 435.39 No. 883 48.60 1,544.99 $2,957.99 Deduct check NSF $300.00 Step 5 The bank returned a check for $300 from customer (Thomas Ivey) because of insufficient funds (NSF).

Power Networking’s Records Bank service charges for the month, $18. 5 Bank’s Records Power Networking’s Records Beginning balance $3,359.78 Beginning balance $2,549.99 Add deposit not recorded by bank 816.20 Add note and interest collected by bank 408.00 $4,175.98 Deduct outstanding checks: No. 812 $1,061.00 No. 878 435.39 No. 883 48.60 1,544.99 $2,957.99 Deduct check NSF $300.00 Bank service charges 18.00 Step 6 Bank service charges for the month, $18.

Power Networking’s Records 5 Bank’s Records Power Networking’s Records Beginning balance $3,359.78 Beginning balance $2,549.99 Add deposit not recorded by bank 816.20 Add note and interest collected by bank 408.00 $4,175.98 Deduct outstanding checks: No. 812 $1,061.00 No. 878 435.39 No. 883 48.60 1,544.99 $2,957.99 Deduct check NSF $300.00 Bank service charges 18.00 Error recording Chk. No. 879 9.00 Step 7 Check No. 879 for $732.26 to Taylor Co. on account, erroneously recorded in journal as $723.26.

Power Networking’s Records 5 Bank’s Records Power Networking’s Records Beginning balance $3,359.78 Beginning balance $2,549.99 Add deposit not recorded by bank 816.20 Add note and interest collected by bank 408.00 $4,175.98 Deduct outstanding checks: No. 812 $1,061.00 No. 878 435.39 No. 883 48.60 1,544.99 $2,957.99 Deduct check NSF $300.00 Bank service charges 18.00 Error recording Chk. No. 879 9.00 327.00 $2,630.99 Adjusted balance

5 Exhibit 7 Bank Reconciliation for Power Networking

5 The journal entries for Power Networking, based on the bank reconciliation in Slide 61 are as follows:

5 Example Exercise 8-3 Bank Reconciliation The following data were gathered to use in reconciling the bank account of Photo Op. Balance per bank............................................. $14,500 Balance per company records………………. 13,875 Bank service charges………………………… 75 Deposit in transit…………………………….. 3,750 NSF check……………………………………. 800 Outstanding checks………………………….. 5,250 What is the adjusted balance on the bank reconciliation? Journalize any necessary entries for Photo OP based upon the bank reconciliation. 8-63

5 Follow My Example 8-3 $13,000, as shown below. Example Exercise 8-3 (continued) 5 Follow My Example 8-3 $13,000, as shown below. Bank section of reconciliation: $14,500 + $3,750 – $5,250 = $13,000 Company section of reconciliation: $13,875 – $75 – $800 = $13,000 b. Accounts Receivable………………… 800 Miscellaneous Expense……………… 75 Cash………………………………… 875 For Practice: PE 8-3A, PE 8-3B 8-64

Describe the accounting for special-purpose cash funds. 6 Describe the accounting for special-purpose cash funds. 8-65

6 Petty Cash Fund It is usually not practical for a business to write checks to pay small amounts. Thus, it is desirable to control such payments by using a special cash fund, called a petty cash fund.

6 A petty cash fund of $500 is established on August 1. The entry to record the transaction is as follows:

6 IMPORTANT! The only time Petty Cash is debited is when the fund is initially established or when the fund is increased. The only time Petty Cash is credited is when the fund is being decreased.

6 At the end of August, the petty cash receipts indicate expenditures for the following items: Office supplies $380 Postage (debit Office Supplies) 22 Store supplies 35 Misc. administrative expenses 30 Total $467

6 Example Exercise 8-4 Petty Cash Fund Prepare journal entries for each of the following; Issued check to establish a petty cash fund of $500. The amount of cash in the petty cash fund is currently $120. Issued a check to replenish the fund, based on the following summary of petty cash receipts: office supplies, $300 and miscellaneous administrative expense, $75. Record any missing funds in the cash short and over account. 8-70

6 Follow My Example 8-4 Petty Cash………………………........ 500 Example Exercise 8-4 (continued) 6 Follow My Example 8-4 Petty Cash………………………........ 500 Cash…………………………........ 500 Office Supplies………………………. 300 Miscellaneous Admin. Expense….. 75 Cash Short and Over……………….. 5 Cash……………………………….. 380 For Practice: PE 8-4A, PE 8-4B 8-71

7 Describe and illustrate the reporting of cash and cash equivalents in the financial statements. 8-72

7 Cash Equivalents A company’s excess cash is normally invested in highly liquid investments. These investments are called cash equivalents.

7 Companies that have invested excess cash in cash equivalents usually report Cash and cash equivalents as one amount on the balance sheet.

7 Compensating Balance Banks may require depositors to maintain minimum cash balances in their bank accounts. Such a balance is called a compensating balance.

Negative Cash Flows from Operations 7 Monthly Cash Expenses A cash ratio that is especially useful for companies, starting up or in financial distress, is the ratio of cash to monthly cash expenses. First, the monthly cash expenses are determined. Monthly Cash Expenses = Negative Cash Flows from Operations 12

Ratio of Cash to Monthly Cash Expenses 7 Ratio of Cash to Monthly Cash Expenses The ratio of cash to monthly cash expenses can then be computed as follows: Ratio of Cash to Monthly Cash Expenses Cash and Cash Equivalent as of Year-End Monthly Cash Expenses =