Internal Control and Cash Chapter 8 Copyright © 2014 Pearson Canada Inc.

Cash Items included in cash are: Cash on hand Petty cash Cash on deposit in bank and trust companies Cash equivalent (Treasury Bills) Cash is the most liquid asset of an organization Cash’s liquidity can be considered a disadvantage because it is the most easily stolen asset Copyright © 2014 Pearson Canada Inc.

Learning Objective 1 Define internal control What is internal control? Copyright © 2014 Pearson Canada Inc.

Internal Control Internal control defined: consists of the process designed and put in place by management to provide reasonable assurance that the organization will achieve its objectives of reliable financial reporting, effective and efficient operations, and compliance with applicable laws and regulations Internal control objectives are: Encouraging operational efficiency Preventing and detecting error and fraud Safeguarding assets and records. Providing accurate, reliable information Copyright © 2014 Pearson Canada Inc.

The Sarbanes-Oxley Act (SOX) Established in the wake of the Enron and WorldCom accounting scandals Provisions of SOX Public companies must issue an internal control report The Public Company Accounting Oversight Board oversees auditors of public companies Accounting firms cannot both audit and provide consulting services for the same client Stiff penalties for violators Copyright © 2014 Pearson Canada Inc.

The Sarbanes-Oxley Act (SOX) The impact of SOX on Canadian companies: Canadian companies listed on U.S. stock exchanges must abide by SOX Canadian regulators are implementing some of the SOX requirements SOX ensures that managers give careful attention to internal controls in their companies Copyright © 2014 Pearson Canada Inc.

What should we think about when designing an internal control system? Learning Objective 2 List and describe the components of internal control and control procedures What should we think about when designing an internal control system? Copyright © 2014 Pearson Canada Inc.

The Components of Internal Control A business can achieve its internal control objectives by applying the following components: Control environment Risk assessment Control procedures Monitoring of controls Information system Copyright © 2014 Pearson Canada Inc.

Components of Internal Control Control environment – this is the “tone at the top” of the business. Owners and its managers must behave honourably to set good examples for employees Risk assessment – a company must identify its risks Control procedures – these are the rules and procedures designed to ensure that the business’s goals are achieved Monitoring of controls – companies hire both internal and external auditors to monitor company controls Information system – companies need accurate information to keep track of assets, and measure profits and losses Copyright © 2014 Pearson Canada Inc.

Internal Control Procedures An effective system of internal controls has these characteristics: Competent, reliable, and ethical personnel Assignment of responsibilities Proper authorization Separation of duties Separate operations from accounting Separate the custody of assets from accounting Separation of the authorization of transactions from the custody of related assets Copyright © 2014 Pearson Canada Inc.

Internal Controls Procedures, Continued Characteristics also include: Internal and external audits Use of documents and records Use of electronic devices and computer controls Other controls Copyright © 2014 Pearson Canada Inc.

Internal Controls for E-Commerce E-commerce pitfalls include: Stolen credit-card numbers Computer viruses and Trojans Phishing expeditions and identity theft Copyright © 2014 Pearson Canada Inc.

Security Measures for E-Commerce Encryption – it is the primary method of achieving confidentiality in e-commerce Encryption rearranges messages by a mathematical process and the encrypted messages cannot be read by anyone who does not know the process Firewalls – limits access to a local network to network members who have access through PINs and passwords Usually several firewalls are built into the system Copyright © 2014 Pearson Canada Inc.

The Limitations of Internal Control – Costs and Benefits Most internal controls can be circumvented or overcome Collusion, where two or more people work as a team to defraud the company Copyright © 2014 Pearson Canada Inc.

The Bank Account as a Control Device Cash is the most liquid asset, and can be concealed, it is easy to move, and it is relatively easy to steal Documents used to control a bank account include: Signature card Deposit ticket Cheque Bank statement Bank reconciliation Copyright © 2014 Pearson Canada Inc.

Prepare a bank reconciliation and the related journal entries Learning Objective 3 Prepare a bank reconciliation and the related journal entries What do we do when the bank statement balance and the cash account balance are not the same? Copyright © 2014 Pearson Canada Inc.

The Bank Reconciliation There are two records of the business’s cash: The Cash account in the company’s general ledger The bank statement, which tells the actual amount of cash the business has in the bank What causes the timing differences between the company’s ledger balance and the bank’s balance? Copyright © 2014 Pearson Canada Inc.

The Bank Reconciliation, Continued Items recorded by a company in the general ledger, but not yet recorded by the bank include: Deposits in transit (outstanding deposits) Outstanding cheques Bank errors Copyright © 2014 Pearson Canada Inc.

The Bank Reconciliation, Continued Items recorded by the bank but not yet recorded by the business include: Bank collections Electronic funds transfers (EFT) receipts and payments Service charges Interest revenue on chequing account Nonsufficient funds (NSF) cheques Cost of printed cheques Book errors Copyright © 2014 Pearson Canada Inc.

Bank Reconciliation, Continued Balance per bank + Deposits in transit – Outstanding cheques = Adjusted bank balance Balance per books + Bank collections +/– EFT cash receipts + Interest revenue – Service charges = Adjusted book balance Adjusted bank balance must equal Adjusted book balance Copyright © 2014 Pearson Canada Inc.

Bank Reconciliation, Example Business Research Inc.’s books indicate a balance of $3,294.21 The bank statement showed a balance of $5,902.48 Reconciling items include the following: Deposit in transit, $1,591.63 Bank error. The bank deducted $100.00 for a cheque written by another company. Add $100.00 to bank balance Copyright © 2014 Pearson Canada Inc.

Bank Reconciliation, Example Continued Outstanding cheques: no. 337, $286.00; no. 338, $319.47; no. 339, $83.00; no. 340, $203.14; no. 341, $458.53 EFT receipt of rent revenue, $900.00 Bank collection of note receivable, $2,114.00, including interest revenue of $114.00 Interest earned on bank balance, $28.01 Bank error: cheque no. 333 for $150.00 paid to Brown Corp. on account was recorded as $510.00 Bank service charges, $39.25 ($25.00 + $14.25) Copyright © 2014 Pearson Canada Inc.

Bank Reconciliation, Example Continued NSF cheque from L. Ross, $52.00 EFT payment to insurance expense, $361.00 Copyright © 2014 Pearson Canada Inc.

Bank Reconciliation, Example Continued BUSINESS RESEARCH INC. Bank Reconciliation January, 31, 2014 Bank Books Bank balance, January 31, 2014 $5,902.48 Book balance, January 31, 2014 $3,294.21 Add: 1. Deposit, Jan. 31, in transit 1,591.63 4. EFT receipt of rent revenue 900.00 2. Correction of bank error – Business Research cheque erroneously charged against company account 100.00 5. Bank collection of note receivable including interest revenue of $114 2,114.00 Less outstanding cheques 6. Interest revenue earned on bank balance 28.01 No. 337 338 339 340 341 286.00 319.47 83.00 203.14 458.53 (1,350.14) 7. Correction of book error – overstated amount of cheque no. 333 360.00 Less: 8. Service charges 39.25 NSF Cheque 52.00 10. EFT payment of insurance expense 361.00 (452.25) Adjusted Bank Balance $6,243.97 Adjusted Book Balance Copyright © 2014 Pearson Canada Inc.

Journalizing Transactions from the Reconciliation The journal entries resulting from the bank reconciliation are as follows: Date Accounts Post Ref Debit Credit (4) Jan. 31 Cash Rent Revenue Receipt of monthly rent. 900.00 (5) Jan. 31 Notes Receivable Interest Revenue Notes receivable collected by bank. 2,144.00 2,000.00 114.00 (6) Jan. 31 Interest earned on bank balance. 28.01 Copyright © 2014 Pearson Canada Inc.

Journalizing Transactions from the Reconciliation, Continued Date Accounts Post Ref Debit Credit (7) Jan. 31 Cash Accounts Payable – Brown. Corp. Correction of cheque no. 333. 360.00 (8) Jan. 31 Bank Charges Expense Bank service charges, $25 NSF + 14.25. 39.25 (9) Jan. 31 Accounts Receivable – L. Ross NSF cheque returned by bank. 52.00 (10) Jan. 31 Insurance Expense Payment of monthly insurance. 361.00 Copyright © 2014 Pearson Canada Inc.

Learning Objective 4 Apply internal controls to cash receipts How do we implement internal controls for cash receipts? Copyright © 2014 Pearson Canada Inc.

Internal Control over Cash Receipts Internal control over cash receipts ensures that cash receipts are deposited quickly for safekeeping Cash receipts over the counter: The cash register should be positioned so that customers can see the amount the cashier enters into the terminal A receipt is issued for each sale recorded The cash drawer should open only when the clerk enters a transaction Cash needs to be deposited in the bank, and the machine tape goes to accounting to record daily sales Copyright © 2014 Pearson Canada Inc.

Internal Control over Cash Receipts, Continued Cash receipts by mail: All incoming mail is opened by the a mailroom employee Payments are sent to the treasurer, who has the cashier deposit the funds in the bank Remittance advices and records of payment go to the accounting department Some companies use a lock-box system and receipts are sent directly to a box belonging to the bank, which directly deposits it to the customer’s bank account; company personnel never touch incoming cash Copyright © 2014 Pearson Canada Inc.

Internal Control over Cash Receipts, Continued Cash Short and Over: An account that accumulates the difference between actual cash receipts and the day’s record of cash received A net debit/credit balance is shown as Cash Short and Over, an expense account on the income statement A net credit balance is shown as Cash Over on the income statement A large balance in Cash Short and Over signals there are potential internal control issues Copyright © 2014 Pearson Canada Inc.

Cash Short and Over, Example Suppose the tapes from the cash register indicated sales revenue of $15,000, but the cash received was $14,980 The journal entry to record the cash short and over is: Cash 14,980 Cash Short and Over 20 Sales Revenue 15,000 To record daily cash sales. Copyright © 2014 Pearson Canada Inc.

Learning Objective 5 Apply internal controls to cash payments How do we implement internal controls for cash payments? Copyright © 2014 Pearson Canada Inc.

Internal Control over Cash Payments Payment by cheque is an important internal control because: The cheque provides a record of payment The cheque must be signed by an authorized official or preferably two signatures The signing official studies the evidence supporting the cheque Copyright © 2014 Pearson Canada Inc.

Controls over Purchase and Payment The purchasing and payment process follows these steps: Prepare a purchase order to the supplier The supplier ships the merchandise and mails the invoice The receiving department checks the goods and completes a receiving report The accounting department checks and confirms all the foregoing documents, then a cheque is issued to the supplier Copyright © 2014 Pearson Canada Inc.

Controlling Petty Cash Payments Petty cash defined: Companies keep cash on hand to pay small amounts Internal controls over petty cash include: Designating a custodian of the petty cash fund Keeping a specific amount of cash on hand in a secure location Supporting all fund payments for expenses with a petty cash ticket or voucher Copyright © 2014 Pearson Canada Inc.

Creating the Petty Cash Fund Assume on Feb. 28 the business creates a petty cash fund of $400 The journal entry to start the fund is: For each petty cash payment, the custodian prepares a petty cash ticket or cash voucher No journal entries are made for petty cash payments until the fund is replenished Feb. 28 Petty Cash 400 Cash To open petty cash fund. Copyright © 2014 Pearson Canada Inc.

Replenishing the Petty Cash On March 31, the petty cash fund holds $230 in petty cash and $164 in vouchers; note that there is $6 missing To replenish the petty cash fund on March 31 and bring the balance back to $400, the journal entry is: Mar. 31 Office Supplies 46 Delivery Expense 34 Cash Short and Over 6 Selling Expense 84 Cash 170 To replenish the petty cash fund. Copyright © 2014 Pearson Canada Inc.

Reporting Cash on the Balance Sheet Cash is the first asset listed on the balance sheet because it is the most liquid Businesses usually have several bank accounts and petty cash funds – combined, it is called “Cash and Cash Equivalents” Cash equivalents include term deposits and certificates of deposit Copyright © 2014 Pearson Canada Inc.

Learning Objective 6 Make ethical business judgments Are there steps we can follow when making ethical business judgments? Copyright © 2014 Pearson Canada Inc.

Corporate and Professional Codes of Ethics Most companies have a code of ethics to encourage employees to behave ethically Owners and mangers must set a high ethical tone Accountants are expected to adhere to rules of professional conduct of their organization Copyright © 2014 Pearson Canada Inc.

How does IFRS impact cash? Learning Objective 7 Assess the impact on cash of international financial reporting standards (IFRS) How does IFRS impact cash? Copyright © 2014 Pearson Canada Inc.

The Effects of IFRS on Cash Because of its liquidity, there is little that is different in the way cash is valued under ASPE and under IFRS A goal of IFRS is to present balance sheet information as close to fair value as possible The presentation of cash can be different under IFRS – some organizations may list cash at the end of the asset side of the balance sheet Copyright © 2014 Pearson Canada Inc.