1 Chapter 7

2 Internal controls –Safeguards assets from theft, robbery & unauthorized use –Enhance accuracy & reliability of accounting records

3 Internal controls are both: –Preventive, keep thefts from occurring –Detective detect thefts once they happen Key internal control principles include:

4 Establishment of Responsibility –Have one person responsible for a task –Know who to blame

5 Segregation of Duties –Don’t let one person do everything –If someone does everything easy to do something wrong without detection. –If more people involved Easier to spot irregularities

6 Example: –One person should order goods –Another should sign for the receipt of goods –A third should pay for the goods If one person did everything –he or she could have company pay for inventory never received.

7 Example –One person should make a sale –Another should ship the goods –Third should bill the customer If one person did everything –he or she could fail to fully bill customers for shipped goods kickbacks or sales to friends

8 Example –One opens mail and endorses checks –Another person does books accounting for checks. If one person receives and records payments from customers –he or she could pocket the receipts while telling customers that their bills are paid and telling company that payment isn’t received yet.

9 Example –One person makes sales –Another authorizes credit If one person does both jobs –he or she might extend credit to inappropriate persons in order to increase sales commissions.

10 Documentation Procedures –Procedures should require use of documents –All documents should be prenumbered and accounted for Prevents undocumented transactions from failing to be recorded Prevents documents from being lost

11 Physical, Mechanical and Electronic Controls –Help to safeguard assets Examples –Safes and locked cash boxes – help safeguard cash and documents –Locked warehouses, burglar alarms, security cameras - helps safeguard inventory –Use of passwords on computers – helps safeguard company assets and records –Use of time clocks - helps to prevent employees from coming late and leaving early

12  Independent Internal Verification  Company checks for discrepancies in records.  Done regularly or on surprise basis  Done by an employee independent of the person being checked.  Discrepancies reported to management

13 Rotating Employees Duties & Requiring Vacations –Every employee should take a vacation. –When someone else does a job it is easier to spot discrepancies. –Dishonest employees never take vacations for fear of discovery. –For the same reason, a company should not let the same person stay in one job for long periods.

14  Bonding of Employees Who Handle Cash  Bonding companies insure against losses from employee theft  They screens employees before insuring them  If any loss occurs, and insurance company will  Prosecute all offenders and  Track them down  This deters others

15 A voucher system should be used –For payments on liabilities –No check is made without voucher Approved by an official of the company Electronic funds transfer (EFT) systems are used to keep the cost of issuing checks down.

16 D.Petty Cash$100 Cr.Cash$100 Sometimes company has to pay cash. Company sets up a petty cash fund. The journal entry is:

17 D.Office Supplies$50 Store Supplies40 Miscellaneous Expense10 Cr.Cash$100 When petty cash taken - note how funds spent When petty cash fund is replenished, treat expenditure as payment for prior uses of petty cash:

18 Bank Accounts –A check register lists every check written on the account. –Once a month, bank sends bank statement. –A bank statement's end-of-month balance rarely agrees with the balance in the company's books for that date. –Must prepare a bank reconciliation account for this difference and locate any errors

19 The bank reconciliation begins with –balance per books figure and –balance per bank statement figure Each figure is adjusted resulting in two adjusted cash balance figures –which should agree.

20 The balance per books figure –adjusted by information that the bank knew but company did not. The balance per bank statement figure –adjusted by information that the company knew but the bank did not.

21 Examples of adjustments are as follows: –Outstanding checks - deduction from balance per bank statement –Deposits in transit - addition to balance per bank statement. –Service charges - deduction from balance per books. –A customer's non-sufficient funds (NSF) check - deducted from balance per books. –Interest earned on a checking account - added to balance per books. –Miscellaneous charges - deducted from balance per books miscellaneous credits - added to balance per books. –If the bank is collecting promissory notes Collection added to balance per books.

22 D.Cash$100 Cr.Note Receivable$100 After bank reconciliation - adjusting entries must be made –To reflect new information supplied by the bank statement. Promissory Note collected by bank:

23 D.Accounts Receivable$100 Cr.Cash$100 Check returned from bank "Not Sufficient Funds":

24 D.Bank Service Charge Expense$100 Cr.Cash$100 Service Charge for month:

25 D.Cash$100 Cr.Interest Income$100 Interest accrued on bank account:

26 D.Cash$100 Cr.Accounts Payable$100 Recorded amount of check received lower than actual amount (Book Error – Need to reduce Cash and Account Payable by more):

27 Cash and cash equivalents include –coin, currency, checks, money orders, and money on deposit with banks and similar financial institutions. –Money on deposit Unrestricted withdrawal Deposits restricted for under 90 days considered cash.

28 Companies with excess cash –Invested in cash equivalents. short-term, highly liquid investments Cash Equivalents are both: –Readily convertible to cash; and –So near to maturity that market value insensitive to interest rate changes

29 Examples of cash equivalents –Treasury bills, –Commercial paper (short-term corporate notes), and –Money market funds. Cash and cash equivalents do not include restricted cash –E.g. landfill companies are required to maintain a fund of restricted cash to ensure that they will have adequate resources to cover closing and clean-up costs at the end of a landfill site’s useful life. –Restricted cash is reported on a balance sheet as “Restricted Cash” not part of “Cash and Cash Equivalents”.

30 Managing and Monitoring Cash –A business needs to make sure that it has enough cash to meet its needs –Treasurers or chief financial officers need to manage their cash receipts and payments effectively. –The following are basic principles of cash management:

31 Increase the speed of collection on receivables –(e.g., offer sales discounts). Inventory ties up resources. Keep inventory levels low –(e.g., just in time inventory practices). Delay payment of liabilities, –but don’t pass up purchase discounts. Plan timing of major expenditures so –still have adequate cash to meet current needs. Invest idle cash to earn interest.

32 Cash Budgeting –Need to forecast future cash receipts and needs to manage its cash effectively. –Use a cash budget. Usually covers a one-year or two-year period. Shows cash inflows, cash outflows, and cash from financing

33 Cash Budget Beginning Balance of Cash$38,000 Add: Cash Receipts (itemized) Collections from customers$168,000 Sale of Securities2,000 Total Cash Receipts170,000 Total Available Cash$208,000

34 Cash Budget (continued) Total Available Cash$208,000 Less: Cash Disbursements Materials$23,200 Salaries62,000 Cash Selling & Adm. Expenses94,300 Truck Purchase30,000 Income Tax Expense3,000 Total Cash Disbursements-212,500 Cash Deficiency-$4,500 Add: Financing Borrowings10,000 Ending Cash Balance$5,500

35 Financial analysts study how effectively a company manages its cash flow using two ratios: –Ratio of Cash to Daily Cash Expense –Free Cash Flow

36 Ratio of Cash to Daily Cash Expense –Gives number of days that company can operate without additional infusion of cash: Cash and Cash Equivalents Average Daily Cash Expenses

37 Cash Provided by Operations –Capital Expenditures –Cash Dividends Free Cash Flow –Provides an assessment of a company’s liquidity and financial flexibility – its cash cushion –It is a raw number