1. Internal Control and Accounting for Cash Chapter Six McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

2. What Is Internal Control? The policies and procedures by which management protects the assets and assures the accuracy and reliability of the accounting records.

3. Internal Controls Internal Controls (policies/procedures to provide assurance that enterprise objectives are accomplished) (1) Accounting controls designed to safeguard company assets and ensure reliable accounting records (2) Administrative controls for evaluating performance and assessing compliance with company policies and public laws 6-2

4. Goals of an internal control system: Resources of the business are safeguarded Policies of management are followed Designed to prevent errors and fraud

5. Key Features of Internal Control 1.Separation of Duties 2.Quality of Employees 3.Bonded Employees 4.Required Absences 5.Procedures Manual 6.Authority and Responsibility 7.Prenumbered Documents 8.Physical Control 9.Performance Evaluations

6. Separation of duties Whenever possible, the functions of authorization, recording and custody should be exercised by separate individuals. This minimizes the likelihood of errors and embezzlement.

7. Quality of employees Hire and keep employees that are: Competent Honest Trained to do a variety of tasks.

8. Parents: Surgeon Operated on Wrong Eye of Washington Boy Quality of employees A Washington couple was considering Tuesday whether to sue a surgeon they accuse of mistakenly operating on their son's left eye during a procedure to stop his right eye from wandering, KATU-TV reported. Dale Matlock and Tasha Gaul, the parents of 4-year-old Jesse Matlock, said the surgeon admitted the error following the operation last Wednesday in Portland, Ore.

9. Bonded Employees A fidelity bond provides insurance that protects a company from loss caused by employee dishonesty. To become bonded, an employee’s background is investigated.

10. Required Absences An employee may be able to cover up fraudulent activities if they are always present at work. All employees should be required to take regular vacations and their duties should be rotated periodically.

11. Procedures Manual Accounting and other important procedures should be written in a procedures manual. Periodically, management should conduct an investigation to see that required procedures are actually being followed.

12. Authority and Responsibility General authority applies to all member of the organization. For example, all employees are required to fly coach and purchase airline tickets from a specific vendor. Specific authority applies only to a specific position within the organization. For example, all checks must be cosigned by the Controller and Treasurer. 6-11

13. Prenumbered Documents. Prenumbered forms are used for all important documents such as checks, purchase orders, receiving reports, and invoices. The use of prenumbered forms helps keep track of all forms issued during a particular period.

14. Physical Control All companies should maintain adequate physical control over valuable assets that may be misappropriated. For example, inventory should be properly stored in a secure location. Serial numbers should be placed on all valuable assets to assist in a physical count of these assets.

15. Performance Evaluation Internal controls should include independent verification of employee performance.Internal controls should include independent verification of employee performance. A physical inventory should be taken at least annually. An independent reconciliation between the general ledger balance and inventory should be compared to the inventory count.A physical inventory should be taken at least annually. An independent reconciliation between the general ledger balance and inventory should be compared to the inventory count. Auditors should evaluate the effectiveness of the control system.Auditors should evaluate the effectiveness of the control system.

16. Limitations Internal controls can be circumvented by collusion among employees. Two or more employees working together can hide embezzlement by covering for each other. No system can prevent fraud.

17. Internal Control in Computer Systems Basic internal controls apply to both manual and computerized systems. Some controls are specific to computerized systems. –Tests of reasonableness – Audit around the computer Proper documentation and system (both program and data) backup are essential. Significant technical expertise may be needed.

18. Accounting for Cash Internal Controls for Cash Internal Controls for Cash Cash receipts should be recorded immediately upon receipt and deposited intact daily. Cash disbursements should be made by prenumbered check. Up to date signature card should be maintained. A deposit ticket should be used for all deposits. A monthly bank reconciliation should be prepared by an independent party.

19. Reconciling the Bank Statement The bank reconciliation reports on the differences between the balance on the bank statement and the balance in the general ledger cash account. The reconciliation results in the true cash balance that will appear on the balance sheet.

20. Reconciling the Bank Statement If an error is found on the bank statement, an adjustment for it is made to the unadjusted bank balance to determine the true cash balance. An error made on our books requires an adjusting journal entry to correct.

21. Bank Reconciliation Matrix, Inc. is preparing the bank reconciliation for the month of June. 1.The June 30 th balance on the bank statement is $4,892.56, and the Cash general ledger balance on this date is $4,240.54. 2.There was a deposit in transit in the amount of $475.

22. Bank Reconciliation

23. Matrix, Inc. is preparing the bank reconciliation for the month of June. 1.The June 30 th balance on the bank statement is $4,892.56, and the Cash general ledger balance on this date is $4,240.54. 2.There was a deposit in transit in the amount of $475. 3.The bank erroneously deducted a $200 check drawn on the books of Matters, Inc. from our account.

24. Bank Reconciliation

25. Matrix, Inc. is preparing the bank reconciliation for the month of June. 1.The June 30 th balance on the bank statement is $4,892.56, and the Cash general ledger balance on this date is $4,240.54. 2.There was a deposit in transit in the amount of $475. 3.The bank erroneously deducted a $200 check drawn on the books of Matters, Inc. from our account. 4.At June 30 th there were three checks outstanding. Check 1078 dated 6/28, for $372.33; Check 1080 dated 6/29, for $402.41; and Check 1081 dated 6/30, for $66.89.

26. Bank Reconciliation

27. 5.During the month of June the bank collected an account receivable for us in the amount of $875.

28. Bank Reconciliation

29. 5.During the month of June the bank collected an account receivable for us in the amount of $875. 6.A check actually written for $146.88 for supplies was erroneously recorded in our records by the bookkeeper as $173.88. 7.Matrix earned interest of $9.25 on its checking account.

30. Bank Reconciliation

31. 5.During the month of June the bank collected an account receivable for us in the amount of $875. 6.A check actually written for $146.88 for supplies was erroneously recorded in our records by the bookkeeper as $173.88. 7.Matrix earned interest of $9.25 on its checking account. 8.The bank sent a debit memo for a service charge of $12.75 for June and a check we deposited was deemed NSF in the amount of $413.11.

32. Bank Reconciliation

33. Adjusting the Books Every reconciling item that appears on the unadjusted book balance section requires a journal entry to adjust the general ledger cash balance to the true cash balance.

34. Cash Short and Over When using a cash register, employees sometimes make mistakes in collecting cash or making change for customers. If the cash register does not reconcile by a small amount at the end of the day, we use an account called cash short and over to force a balance. Assume a cash register was to have a balance of $500 (based on receipts), but contained only $499 at the end of the day. Assume a cash register was to have a balance of $500 (based on receipts), but contained only $499 at the end of the day.

35. Using Petty Cash Funds A petty cash fund is used to make small expenditures that cannot wait for the formal check- writing process. The fund is operated on an imprest basis. This means that when the fund gets low on cash it is replenished. The petty cashier is always responsible for the cash in the fund. This is an excellent internal control.

36. Using Petty Cash Funds Establishing a $500 petty cash fund. Treasurer prepares a $500 check payable to the petty cashier. Petty cashier takes the check to the bank and gets $500 cash for the fund.

37. Using Petty Cash Funds During the month the petty cashier paid out $217 for FedEx deliveries, $34.50 for late-working employee meals, $27 for cab fare to the airport for a salesperson, and $187.60 for office postage stamps. The petty cashier asked for and received a receipt for each disbursement made this month. The fund is getting low on cash so the petty cashier requests that the fund be replenished.

38. Using Petty Cash Funds Here is an analysis of the impact of the replenishment. The journal entry to record the reimbursement would be:

39. Using Petty Cash Funds Treasurer prepares a $466.10 check payable to the petty cashier. Petty cashier takes the check to the bank and gets $466.10 cash for the fund. The fund is now returned to its $500 balance.

40. Cash Short and Over For Petty Cash: 1.Add up all receipts (total $85) 2.Subtract total from opening balance of cash ($200 – 85) = $115 3.Count cash in box: If it is a.Less than $115, then you are short b.More than $115, then you are over

41. Current Versus Noncurrent Current assets are expected to be converted to cash or consumed within one year or an operating cycle, whichever is longer. Current assets include: CashCash Marketable SecuritiesMarketable Securities Accounts ReceivableAccounts Receivable Short-Term Notes ReceivableShort-Term Notes Receivable Interest ReceivableInterest Receivable InventoryInventory SuppliesSupplies PrepaidsPrepaids CashCash Marketable SecuritiesMarketable Securities Accounts ReceivableAccounts Receivable Short-Term Notes ReceivableShort-Term Notes Receivable Interest ReceivableInterest Receivable InventoryInventory SuppliesSupplies PrepaidsPrepaids

42. Current Versus Noncurrent Current liabilities are due within one year or an operating cycle, whichever is longer. Current liabilities include: Accounts PayableAccounts Payable Short-Term Notes PayableShort-Term Notes Payable Wages PayableWages Payable Taxes PayableTaxes Payable Interest PayableInterest Payable Accounts PayableAccounts Payable Short-Term Notes PayableShort-Term Notes Payable Wages PayableWages Payable Taxes PayableTaxes Payable Interest PayableInterest Payable

43. Winona Co. Balance Sheet at Dec. 31 AssetsLiabilities and Owners’ Equity Assets Liabilities and Owners’ Equity Current Assets:Current Liabilities: Current Assets: Current Liabilities: Cash$ 100 Accounts Payable $ 800 Marketable Securities 300 Notes Payable700 Accounts Receivable 600 Unearned Revenue 300 Total Cur. Liab. $ 1,800 Office Supplies 40 Total Cur. Liab. $ 1,800 Long-Term Liabilities: Inventory 2,900 Long-Term Liabilities: Prepaid Insurance 60 Mortgage Payable $ 2,800 Total Current Assets$ 4,000 Total Current Assets$ 4,000 Notes Payable 2,000 Tot.. Lg-Term Liab. $ 4,800 Property, Plant and Equip: Property, Plant and Equip: Total Liabilities $ 6,000 Equity Land$ 200 Equity Building, net 3,000 Contributed Capital $ 1,000 Equipment, net 2,800 Retained Earnings 3,000 Total Prop.,Plant, Equip.$ 6,000 Total Owners’ Equity $ 4,000 Total Assets$10,000 Tot. Liab. and Own. Eq. $10,000

44. Operating cycle the average time it takes a business to convert cash into inventory, inventory into AR, and AR back into cash. Cash Inventory

45. Operating cycle the average time it takes a business to convert cash into inventory, inventory into AR, and AR back into cash. Cash AR Inventory

46. Operating cycle the average time it takes a business to convert cash into inventory, inventory into AR, and AR back into cash. Cash AR Inventory

47. The Current Ratio Used to evaluate a company’s liquidity (a company’s ability to generate short term cash flows) Current Assets Current Liabilities Calculate the Current Ratio using the Balance Sheet data on the following slide.

48. Winona Co. Balance Sheet at Dec. 31 AssetsLiabilities and Owners’ Equity Assets Liabilities and Owners’ Equity Current Assets:Current Liabilities: Current Assets: Current Liabilities: Cash$ 100 Accounts Payable $ 800 Marketable Securities 300 Notes Payable700 Accounts Receivable 600 Unearned Revenue 300 Total Cur. Liab. $ 1,800 Office Supplies 40 Total Cur. Liab. $ 1,800 Inventory 2,900 Long-Term Liabilities: Prepaid Insurance 60 Mortgage Payable $ 2,800 Total Current Assets$ 4,000 Total Current Assets$ 4,000 Notes Payable 2,000 Tot.. Lg-Term Liab. $ 4,800 Property, Plant and Equip: Total Liabilities $ 6,000 Land$ 200 Equity Building, net 3,000 Contributed Capital $ 1,000 Equipment, net 2,800 Retained Earnings 3,000 Total Prop.,Plant, Equip.$ 6,000 Total Owners’ Equity $ 4,000 Total Assets$10,000 Tot. Liab. and Own. Eq. $10,000

49. Winona Co. Balance Sheet at Dec. 31 AssetsLiabilities and Owners’ Equity Assets Liabilities and Owners’ Equity Current Assets:Current Liabilities: Current Assets: Current Liabilities: Cash$ 100 Accounts Payable $ 800 Marketable Securities 300 Notes Payable700 Accounts Receivable 600 Unearned Revenue 300 Total Cur. Liab. $ 1,800 Office Supplies 40 Total Cur. Liab. $ 1,800 Inventory 2,900 Prepaid Insurance 60 Total Current Assets$ 4,000 Current Ratio = Current Assets Current Liabilities = $4,000 $1,800 =2.22 to 1 You have $2.22 of current assets for each $1 of current liabilities. Is that enough?

50. The Current Ratio Rough “Rule of Thumb” is 2 to 1, but varies by industry. (Many successful companies have a current ratio significantly less than 2.0.) Question: What if the Winona Company is a toy retailer? Does the company have adequate liquidity? Ratios

51. Winona Co. Balance Sheet at Dec. 31 AssetsLiabilities and Owners’ Equity Assets Liabilities and Owners’ Equity Current Assets:Current Liabilities: Current Assets: Current Liabilities: Cash$ 100 Accounts Payable $ 800 Marketable Securities 300 Notes Payable700 Accounts Receivable 600 Unearned Revenue 300 Total Cur. Liab. $ 1,800 Office Supplies 40 Total Cur. Liab. $ 1,800 Inventory 2,900 Prepaid Insurance 60 Total Current Assets$ 4,000 Most of a toy retailer’s sales come in the last few months of the year because of Christmas. If the company has a large amount of unsold inventory at the end of the year, it will have a hard time “converting” this inventory to cash to pay bills. So, ……..

52. The Quick (Acid-Test) Ratio A STRICTER test of a company’s liquidity. The numerator only includes cash, short term receivables and short-term investments (never includes inventory, supplies or prepaids). Quick Assets Current Liabilities

53. Dec. 31 Balance Sheet data AssetsLiabilities and Owners’ Equity Assets Liabilities and Owners’ Equity Current Assets:Current Liabilities: Current Assets: Current Liabilities: Cash$ 100 Cash$ 100 Accounts Payable $ 800 Marketable Securities 300 Marketable Securities 300 Notes Payable700 Accounts Receivable 600 Accounts Receivable 600 Unearned Revenue 300 Total Cur. Liab. $ 1,800 Office Supplies 40 Total Cur. Liab. $ 1,800 Inventory 2,900 Prepaid Insurance 60 Total Current Assets$ 4,000 Quick Quick Ratio = Quick Assets Current Liabilities = $1,000 $1,800 =.56 to 1 Winona has $0.56 of “quick” assets for each $1 of current liabilities. Is that enough? “Rule of Thumb” is 1 to 1 (but varies by industry).

54. The Financial Analyst How can a financial analyst know that a company really did follow GAAP? Certified Public Accountants

55. Materiality and Financial Audits Auditors do not guarantee that financial statements are absolutely correct—only that they are materially correct. Material Item An error, or other reporting problem, that would influence the decision of an average prudent investor.

56. Types of Audit Opinions UnqualifiedAdverse QualifiedDisclaimer

57. Unqualified Opinion: Best opinion. It means the statements used GAAP (Generally Accepted Accounting Principles) and are a FAIR representation of the company’s actual financial condition. Types of Audit Opinions It is up to the statement reader to decide if the company is in GOOD financial condition. The auditor only states that the statements fairly present the actual financial condition.

58. Adverse Opinion: Worst opinion. It means the statements did not follow GAAP and the statements do NOT fairly represent the company’s actual financial condition. These opinions are rare because the company will normally make the changes requested by the auditor. Types of Audit Opinions

59. Qualified Opinion: It means the statements followed GAAP for the most part, but there is some special situation that needs to be called to the attention of the statement readers. The auditor’s report will explain why the qualified opinion was issued. Types of Audit Opinions

60. Disclaimer of Opinion: It means the auditor could not obtain enough information to determine if the statements followed GAAP. Therefore, the auditor could not express an opinion about the statements. Types of Audit Opinions

61. Confidentiality The confidentiality rules in the code of ethics for CPAs prohibits auditors from voluntarily disclosing information they have acquired as a result of their accountant-client relationships. However, accountants may be required to testify in a court of law. 6-60

62. The Securities and Exchange Commission (SEC) The SEC is a government agency authorized to establish and enforce the accounting rules for public companies. Public companies, have to follow the reporting rules of the SEC as well as GAAP. 6-61

63. Sarbanes-Oxley Act (SOX) of 2002 Prior to 2002, the SEC left much of the regulation and oversight of independent audits to the AICPA. However, SOX established the PCAOB to enforce audit standards for SEC audits. 6-62

64. End of Chapter Six