1 Internal Control and Managing Cash Chapter 4

2 Learning Objective 1 Set up an effective system of internal control.

3 Internal Control Organizational plan and all related measures that an entity adopts –Safeguard assets from theft or loss –Encourage adherence to company policies –Promote operational efficiency –Ensure accurate and reliable accounting records

4 Components of an Effective System  Competent, reliable, and ethical personnel  Assignment of responsibilities  Proper authorization of transactions  Separation of duties –Operations or authorization of transactions –Custody of assets –Data entry function for those transactions

5 Audit  Examination of company’s financial statements, accounting systems, and internal controls, by an objective party –Internal auditors  employees of the company  An aspect of the company’s internal controls –External auditors  Independent of the company  Issue audit reports on the company’s financial statements for benefit of investors and creditors

6 Limitations of Internal Control  Collusion - two or more employees, whose duties should be segregated, working together to defraud the firm  All systems of internal control have “inherent limitations:” –Management can always override controls, as management establishes and is above many system controls –Breakdowns can occur due to mistakes, carelessness, fatigue –No system of controls can be perfect in an imperfect world!  A system of internal control that is too complex can hurt efficiency and control  Frequently small businesses have control deficiencies. Why?

7 Learning Objective 2 The bank reconciliation as a control device.

8 The Bank Reconciliation Items that cause differences between bank balance and book balance 1.Items recorded by the company but not yet recorded by the bank: Deposits in transitDeposits in transit Outstanding checksOutstanding checks

9 The Bank Reconciliation Items that cause differences between bank balance and book balance 2.Items on a bank statement, but not yet recorded by the business: Bank collections on behalf of the company, e.g. a note receivableBank collections on behalf of the company, e.g. a note receivable Electronic funds transfers (EFT’s) forElectronic funds transfers (EFT’s) for payments of cash by the companypayments of cash by the company collections of cash on behalf of the companycollections of cash on behalf of the company Service chargesService charges Interest revenue earned on accountInterest revenue earned on account NSF checksNSF checks Errors made by the company or the bank. Examples:Errors made by the company or the bank. Examples: The bank charges someone else’s check to the company’s accountThe bank charges someone else’s check to the company’s account The company writes a check for $420, but makes a journal entry for $240The company writes a check for $420, but makes a journal entry for $240

10 There Is a Reciprocal Relationship between the Bank’s Records and the Company’s Records  When the company receives cash: –The company debits cash on their books –However, the bank credits the company’s account on the bank’s books –This is because the bank has a liability to the company in the amount of the cash balance held at the bank

11 There Is a Reciprocal Relationship between the Bank’s Records and the Company’s Records (con.)  When the company issues a check: –The company credits cash on their books –However, the bank debits (charges) the company’s account on the bank’s books –This is because the bank’s liability to the company is reduced by disbursing the check amount to the payee

12 Bank Reconciliation Illustration Business Research, Inc., shows a balance on its bank statement of $5, on January 31. The company Cash account has a balance of $3, The January 30 deposit of $1, does not appear on the bank statement. 2.The bank erroneously charged (debited) to the account a $100 check (No. 656) written by a similarly named company, Business Research Associates.

13 The Bank Reconciliation Illustrated 3.Five company checks, totaling $1,350.14, issued late in January and recorded in the journal have not been paid by the bank. 4.The bank received $ by EFT on behalf of Business Research, Inc. 5.The bank collected on behalf of the company a note receivable, $2,114 (including interest revenue of $214). 6.The bank statement shows interest revenue of $28.01.

14 The Bank Reconciliation Illustrated 7.Check number 333 for $150 paid to Brown Company on account was recorded as a cash payment of $510, a transposition error. 8.The bank service charge for the month was $ The bank statement shows an NSF check for $ Business Research pays insurance expense by EFT and has not recorded this $361 payment.

15 Balance per bank, January 31$5, Add deposit in transit1, Check erroneously charged $7, Less outstanding checks(1,350.14) Adjusted bank balance$6, The Bank Reconciliation Illustrated

16 Balance per books, January 31$3, Add: ETF receipt of rent revenue Collection of note receivable2, Interest revenue earned28.01 Correction of error: check no $6, Less: Service charge$ NSF check52.00 Payment of insurance expense ( ) Adjusted book balance$6, The Bank Reconciliation Illustrated

17 Note That the Adjusted Bank Balance and Book Balance Must Be Equal in Amount in a Proper Reconciliation Note That the Adjusted Bank Balance and Book Balance Must Be Equal in Amount in a Proper Reconciliation

18 Learning Objective 3 Apply internal controls to cash receipts and cash payments.

19 Basic Cash Controls Concepts  Essential to segregate cash recording and custody functions! –Persons having data entry functions for disbursement or receipt of cash should not have access to physical cash (e.g. write checks or handle checks received in mail) –Persons having custody of physical cash should not make entries to the books for cash –The Merrill Lynch employee described in the chapter had both cash custody and data entry functions, causing the embezzlement  The bank account should always be reconciled by persons with no cash recording or custody functions, e.g. the business owner or other competent employee

20 Basic Cash Controls Concepts (con.)  Smart small business owners will want to: –Insist on signing checks after preparation by an employee, or Quick Books, etc. [This controls cash disbursements effectively.] –Compare total of daily cash collected (as prepared by the mail opener) to validated deposit slip from the bank [This is a good control over cash collections.] –Prepare, or at least carefully review, the bank reconciliation

21 Imprest Petty Cash Fund A small amount of cash kept on hand to pay for minor expenses.

22 Learning Objective 4 Use a budget to manage cash.

23 Using a Budget to Manage Cash  A financial plan that helps coordinate business activities  Cash budget - helps an entity manage cash by planning receipt and payment of cash during a future period

24 Using a Budget to Manage Cash Cash balance, beginning + Budgeted (expected) cash receipts - Budgeted (expected) cash payments Expected cash balance, ending If the expected cash balance is < budgeted (necessary) cash balance, the company will need to seek additional financing

25 Reporting Cash on the Balance Sheet  Companies usually combine all cash amount into single total called “Cash and Cash Equivalents” on the balance sheet.  Cash equivalents include liquid assets –Time deposits –Certificates of deposit  Restricted cash pledged as collateral should be reported separately from cash, as shown on the Merrill Lynch excerpted balance sheet (pg. 192 in your text)  It’s not really available to the company for daily use

26 Learning Objective 5 Weigh ethical judgment in business.

27 Ethics and Accounting  Larger companies often have written codes of ethical and responsible behavior by employees  Smaller companies will have less formal means of conveying ethical values  In either case, management must establish the proper “tone at the top”  AICPA Code of Professional Conduct  Standards of Ethical Conduct for Management Accountants and Institute of Internal auditors