1. Needles Powers Crosson Principles of Accounting 12e Cash and Internal Control 8 C H A P T E R © human/iStockphoto

2. LEARNING OBJECTIVES ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  LO1: Describe the components of internal control, control activities, and limitations on internal control.  LO2: Apply internal control activities to common merchandising transactions.  LO3: Define cash equivalents, and explain methods of controlling cash, including bank reconciliations.  LO4: Demonstrate the use of a simple imprest (petty cash) system.  LO5: Identify the internal control roles of management and the auditor.

3. SECTION 1: CONCEPTS ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Faithful representation: the qualitative characteristic of information that financial information must be complete, neutral, and free from material error

4. Concepts Underlying Internal Control  It is important that a company’s financial statements faithfully represent the company’s operations. –This means, for instance, that the financial statements are free from material error.  Internal control is the process that achieves this goal by establishing the reliability of the accounting records and financial statements and ensures that the company’s assets are protected. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5. The Need for Internal Controls  If a merchandising company does not take steps to protect its assets, it can suffer high losses of both cash and inventory.  Taking a physical inventory facilitates control over merchandise inventory. –This process involves an actual count of all merchandise on hand. –A physical inventory must be taken under both the periodic and perpetual inventory systems. –Merchandisers usually take a physical inventory after the close of business on the last day of their fiscal year. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. The Need for Internal Controls  Most companies experience losses of merchandise inventory from spoilage, shoplifting, and theft. Inventory shortages can also result from honest mistakes, such as incorrectly tagging inventory. –The periodic inventory system provides no means of identifying these losses because the costs are automatically included in the cost of goods sold. –The perpetual inventory system makes it easier to identify such losses.  Because the Merchandise Inventory account is continuously updated, the loss shows up as the difference between the inventory records and the physical inventory. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. Components of Internal Control (slide 1 of 2)  An effective system of internal control has five interrelated components. –Control environment—created by management’s overall attitude, awareness, and actions. It encompasses:  a company’s ethics, philosophy, and operating style  organizational structure  method of assigning authority and responsibility  personnel policies and practices –Risk assessment—involves identifying areas in which risks of loss of assets or inaccuracies in accounting records are high. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

8. Components of Internal Control (slide 2 of 2) –Control activities—the policies and procedures management puts in place to see that its directives are carried out –Information and communication—pertains to the way the accounting system gathers and treats information about the company’s transactions and how it communicates individual responsibilities within the system. –Monitoring—management’s regular assessment of the quality of internal control, including periodic review of compliance with all policies and procedure ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. Control Activities (slide 1 of 3)  The goal of control activities is to safeguard a company’s assets and ensure the reliability of the accounting records. Some standard controls include: –Authorization—the approval of certain transactions and activities –Recording Transactions—To establish accountability for assets, all transactions should be recorded. –Documents and records—Well-designed documents help ensure that transactions are properly recorded. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10. Control Activities (slide 2 of 3) –Physical controls—limit access to assets, including cash registers, warehouses, and storerooms, as well as accounting records. –Periodic independent verification—means that someone other than the people responsible for the accounting records and assets should periodically check the records against the assets. –Separation of duties—means that no one person should authorize transactions, handle assets, and keep records of assets. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. Control Activities (slide 3 of 3) –Sound personnel practices—Personnel practices that promote internal control include:  adequate supervision  rotation of key people among different jobs  insistence that employees take vacations  bonding of personnel who handle cash or inventory –Bonding is the process of carefully checking an employee’s background and insuring the company against theft by that person. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. Internal Control and Achieving Control Objectives  A system of internal control for merchandising activities can achieve important objectives: –Prevent losses of cash and inventory. –Ensure that records of transactions and account balances are accurate. –Keep enough inventory on hand to sell to customers without overstocking merchandise. –Keep sufficient cash on hand to pay for purchases in time to receive discounts. –Keep credit losses as low as possible by making credit sales only to customers who are likely to pay on time. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. Limitations on Internal Control  No system of internal control is without weaknesses.  As long as people perform control procedures, an internal control system will be vulnerable to human errors due to misunderstandings, mistakes in judgment, carelessness, distraction, or fatigue, as well as dishonesty.  Separation of duties can be defeated through collusion by employees.  Controls may become ineffective over time. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15. SECTION 2: ACCOUNTING APPLICATIONS  Account for merchandising transactions  Implement control of cash  Prepare a bank reconciliation  Use petty cash ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

16. Internal Control over Merchandising Transactions (slide 1 of 2)  Maintaining control is especially difficult for a merchandiser because management must not only establish controls for cash sales, receipts, purchases, and cash payments, but also protect its inventory.  Most firms use the following procedures: –Separate the functions of authorization, recordkeeping, and custodianship of cash. –Limit the number of people who have access to cash, and designate who those people are. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17. Internal Control over Merchandising Transactions (slide 2 of 2) –Bond all employees who have access to cash. –Keep the amount of cash on hand to a minimum by using banking facilities as much as possible. –Physically protect cash on hand by using cash registers, cashiers’ cages, and safes. –Record and deposit all cash receipts promptly, and make payments by check rather than by currency. –Have a person who does not handle or record cash make unannounced audits of the cash on hand. –Have a person who does not authorize, handle, or record cash transactions reconcile the Cash account each month. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18. Control of Cash Receipts  Cash payments for sales of goods and services can be received by mail or over the counter in the form of checks, credit or debit cards, or currency.  Whatever the source of the cash, it should be recorded immediately in a cash receipts journal.  When cash is received in the mail, the employee who opens the mail should make a list in triplicate of the money received—one copy to keep, one to go with the cash to the cashier, and the third to go to the accounting department for recording. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. Control of Cash Received Over the Counter  Cash registers and prenumbered sales tickets are common tools for controlling cash received over the counter. –The amount of each cash sale is rung up on the cash register, which should have a locked-in tape on which it prints the day’s transactions. –At the end of the day, the cashier counts the cash in the register and turns it in to the cashier’s office. –The amount of cash turned in and the amount recorded on the tape should agree; if not, any differences must be explained. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20. Control of Purchases and Cash Disbursements  To avoid theft, cash payments should be made only after they have been specifically authorized and supported by documents that establish the validity and amount of the claims.  A company should also separate the duties involved in purchasing goods and services and the duties involved in paying for them.  The graphics on the next four slides show how a large company can maximize the separation of duties and documentation. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

21. Internal Controls in a Large Company: Separation of Duties and Documentation ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

22. Internal Control Plan for Purchases and Cash Disbursements (slide 1 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

23. Internal Control Plan for Purchases and Cash Disbursements (slide 2 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

24. Internal Control Plan for Purchases and Cash Disbursements (slide 3 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

26. Cash Equivalents  Management may decide to invest excess cash in short-term interest-bearing accounts or certificates of deposit (CDs) at banks and other financial institutions, in government securities (such as U.S. Treasury notes), or in other securities.  If these investments have a term of 90 days or less when they are purchased, they are called cash equivalents because the funds revert to cash so quickly they are treated as cash on the balance sheet. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

27. Cash Control Methods (slide 1 of 2)  In addition to internal control of cash transactions, other ways of controlling cash include: –Imprest systems—systems, such as petty cash funds, used by a company for small expenditures and cash advances and restored to a fixed amount periodically –Banking services—which include:  Safe depositories for cash  Negotiable instruments and other valuable business documents, such as stocks and bonds  Checking accounts  Collection and payment of certain types of debt ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

28. Cash Control Methods (slide 2 of 2)  Exchange of foreign currencies  Electronic funds transfer—a method of conducting business transactions in which a company electronically transfers cash from its bank to another company’s bank  Automated teller machine (ATM) and debit card transactions— When purchases are made using a debit card, the amount of the purchase is deducted directly from the buyer’s bank account. –Bank reconciliations—the process of accounting for the difference between the balance on a company’s bank statement and the balance in its Cash account. This process is described on the next five slides. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

29. Bank Reconciliations (slide 1 of 5)  The following transactions commonly appear in a company’s records but not on its bank statement: - Outstanding checks—checks that a company has issued and recorded but that do not yet appear on its bank statement - Deposits in transit—deposits a company has sent to its bank but that the bank did not receive in time to enter on the bank statement  Transactions that may appear on the bank statement but not in the company’s records include: - Service charges—fees for the use of a checking account - NSF (nonsufficient funds) checks—An NSF check is a check that a company has deposited but that is not paid when the bank presents it to the issuer’s bank. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

30. Bank Reconciliations (slide 2 of 5) - Miscellaneous debits and credits—including fees charged for other services, such as stopping payment on checks, printing checks, and collections on promissory notes - Interest income—interest paid on a company’s average balance. Accounts that pay interest are sometimes called NOW or money market accounts.  The next slide shows Kalita Service’s bank reconciliation for August. The bank statement shows a balance of $1,735.53 on August 31, and the company’s records show a cash balance of $1,207.95 on the same date. The bank reconciliation adjusts both the bank and book amounts to $1,277.94. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

31. Bank Reconciliations (slide 3 of 5) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

32. Bank Reconciliations (slide 4 of 5) –The circled numbers on the previous slide refer to the following: ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

33. Bank Reconciliations (slide 5 of 5) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

35. Petty Cash Funds  It is sometimes necessary to make small payments of cash for postage stamps, shipping charges due, or minor purchases of office supplies. –For situations in which it is inconvenient to pay by check, most companies set up a petty cash fund using an imprest system, in which the fund is established for a fixed amount.  A voucher documents each cash payment made from the fund.  The fund is periodically reimbursed, based on the vouchers, by the exact amount necessary to restore its original cash balance. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

36. Establishing the Petty Cash Fund (slide 1 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

37. Establishing the Petty Cash Fund (slide 2 of 2) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

38. Making Disbursements from the Petty Cash Fund  The custodian of the petty cash fund should prepare a petty cash voucher, or written authorization, for each expenditure, as shown below. The person who receives the payment signs the voucher. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

39. Reimbursing the Petty Cash Fund (slide 1 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

40. Reimbursing the Petty Cash Fund (slide 2 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

41. Reimbursing the Petty Cash Fund (slide 3 of 3) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

42. Internal Control and the Financial Statements  Internal control applies to all transactions and ensures the fair presentation of the financial statements as shown below. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

44. SECTION 3: BUSINESS APPLICATIONS  Management’s responsibility  Independent auditor’s audit ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

45. Management’s Responsibility for Internal Control  Management is responsible for establishing a satisfactory system of internal controls. –This means that management must:  safeguard the firm’s assets.  ensure reliability of its accounting records.  see that its employees comply with all legal requirements and operate the firm to the best advantage of its owners. –The Sarbanes-Oxley Act requires that the chief executive officer, the chief financial officer, and the auditors of a public company fully document and certify the company’s system of internal controls. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

46. Independent Accountant’s Audit of Internal Control  Although privately owned companies usually are not required to have an independent certified public accountant audit their financial statements, many companies choose to do so. These companies are also not required to have their internal control systems audited.  Public companies, on the other hand, are required to not only have an independent audit of their financial statements, but also to have an audit of their internal control. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.