1. Copyright © by Houghton Mifflin Company. All rights reserved.1 Principles of Financial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson - - - - - - - - - - - Multimedia Slides by: Harry Hooper Santa Fe Community College

2. Chapter 8 Internal Control

3. Copyright © by Houghton Mifflin Company. All rights reserved.3 1.Define internal control, identify the five components of internal control, and explain seven examples of control activities. 2.Describe the inherent limitations of internal control. 3.Apply internal control activities to common merchandising transactions. 4.Demonstrate the control of cash by preparing a bank reconciliation. LEARNING OBJECTIVES

4. Copyright © by Houghton Mifflin Company. All rights reserved.4 5.Demonstrate the use of a simple imprest system. 6.Define voucher system and describe the components of a voucher system. 7.Describe and carry out the five steps in operating a voucher system. SUPPLEMENTAL OBJECTIVES

5. Copyright © by Houghton Mifflin Company. All rights reserved.5 Internal Control: Basic Components and Control Activities OBJECTIVE 1 Define internal control, identify the five components of internal control, and explain seven examples of control activities.

6. Copyright © by Houghton Mifflin Company. All rights reserved.6 Management’s Responsibility for Internal Control u Internal control is all the policies and procedures management uses to safeguard the firm’s assets and have reliable accounting records. It involves: 4 Ensuring the reliability of financial reporting. 4 Ensuring operating effectiveness and efficiency. 4 Ensuring compliance with legal requirements.

7. Copyright © by Houghton Mifflin Company. All rights reserved.7 Components of Internal Control 1. Control Environment – Created by the attitude, awareness and actions of management. 2. Risk Assessment – The identification of areas where the risks of losses or inaccuracies are high.

8. Copyright © by Houghton Mifflin Company. All rights reserved.8 3.Information and Communication –Systems established to identify, assemble, analyze, classify, record, and report a company’s transactions. 4.Control Activities –The policies and procedures implemented to see that management’s directives are carried out. 5.Monitoring –The regular assessment of the quality of internal control. Components of Internal Control (continued…)

9. Copyright © by Houghton Mifflin Company. All rights reserved.9 Control Activities 1.Authorization. 2.Recording transactions. 3.Documents and records. 4.Physical Controls. 5.Periodic independent verification. 6.Separation of duties. 7.Sound personnel procedures, including Bonding.

10. Copyright © by Houghton Mifflin Company. All rights reserved.10 Discussion Q.A good system of internal controls accomplishes what broad objectives? A.It safeguards the company’s assets, produces reliable accounting records, promotes operating efficiency, and encourages adherence to management’s policies.

11. Copyright © by Houghton Mifflin Company. All rights reserved.11 Limitations of Internal Control OBJECTIVE 2 Describe the inherent limitations of internal control.

12. Copyright © by Houghton Mifflin Company. All rights reserved.12 Limitations of Internal Control u Human error. u Misunderstandings. u Mistakes in judgment. u Carelessness. u Distraction. u Fatigue. u Collusion. u Dishonesty. u Changes in conditions.

13. Copyright © by Houghton Mifflin Company. All rights reserved.13 Limitations of Internal Control Costs of establishing and maintaining systems may exceed benefits. In a small business, active involvement by the owner can substitute for the separation of some duties.

14. Copyright © by Houghton Mifflin Company. All rights reserved.14 Discussion Q.Why is the separation of duties necessary to ensure sound internal control? What does this principle assume about the relationships of employees in a company and the possibility of two or more of them stealing from the company?

15. Copyright © by Houghton Mifflin Company. All rights reserved.15 A. The separation of duties is important to sound internal control because a person who combines the responsibilities of keeping records, operating a department, and managing assets would be able to misappropriate assets without detection. The separation of duties assumes that two or more employees will not work together to overcome the controls.

16. Copyright © by Houghton Mifflin Company. All rights reserved.16 Internal Control over Merchandising Transactions OBJECTIVE 3 Apply internal control activities to common merchandising transactions.

17. Copyright © by Houghton Mifflin Company. All rights reserved.17 Internal Control and Management Goals u Goals for the success of a merchandising business. 4 Prevent losses of cash or inventory owing to theft or fraud. 4 Provide accurate records of merchandising transactions and account balances.

18. Copyright © by Houghton Mifflin Company. All rights reserved.18 Goals for Management u Keep enough inventory on hand to sell to customers without overstocking. u Keep enough cash on hand to pay for purchases in time to receive discounts. u Keep credit losses as low as possible by making credit sales only to customers who are likely to pay on time.

19. Copyright © by Houghton Mifflin Company. All rights reserved.19 Controls for Meeting Management’s Goals u Cash budget. u Separation of duties.

20. Copyright © by Houghton Mifflin Company. All rights reserved.20 Activities for Effective Internal Control over Cash 1.Separate authorization, recordkeeping, and custodianship functions. 2.Limit the number of people with access to cash. 3.Designate who is responsible for handling cash. 4.Use banking facilities when possible; keep cash on hand to a minimum. 5.Bond employees who have access to cash.

21. Copyright © by Houghton Mifflin Company. All rights reserved.21 More Activities for Internal Controls over Cash (continued…) 6.Physically protect cash on hand. 7.Make unannounced audits of cash on hand. 8.Record all cash receipts promptly. 9.Deposit all cash receipts promptly. 10.Make payments by check rather than currency. 11.Reconcile the Cash account independently.

22. Copyright © by Houghton Mifflin Company. All rights reserved.22 Control of Cash Sales Receipts u Cash is received either by mail or over the counter. In either case it should be recorded immediately in the cash receipts journal in order to establish a written record of cash receipts.

23. Copyright © by Houghton Mifflin Company. All rights reserved.23 Control of Cash Sales Receipts (continued…) u Control of cash received through the mail. 4 Encourage customers to pay by check. 4 Have two or more employees handle the cash. 4 Make a list of receipts in triplicate. u Control of cash received over the counter. 4 Cash registers. 4 Prenumbered sales tickets.

24. Copyright © by Houghton Mifflin Company. All rights reserved.24 Control of Purchases and Cash Disbursements u Make payments only after specific authorization. u Support authorization by documents validating the amount. u Maximize separation of duties.

25. Copyright © by Houghton Mifflin Company. All rights reserved.25 Internal Control for Purchasing and Paying for Goods and Services

26. Copyright © by Houghton Mifflin Company. All rights reserved.26Discussion Q.Name the documents needed for an internal control plan for purchases and cash disbursements. A.Purchase requisition, purchase order, invoice, receiving report, check authorization, check with a remittance advice.

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33. Preparing a Bank Reconciliation OBJECTIVE 4 Demonstrate the control of cash by preparing a bank reconciliation.

34. Copyright © by Houghton Mifflin Company. All rights reserved.34 Bank Reconciliation u The Cash account balance on the books rarely agrees with that on the bank statement. u Transactions may appear on one but not the other. u Bank reconciliations account for the differences between the company’s records and the bank statement.

35. Copyright © by Houghton Mifflin Company. All rights reserved.35 Bank Reconciliation u Transactions shown on the company’s record but not the bank’s include: 4 Outstanding checks. n Checks that have been issued by the company but have yet to appear on the bank statement. 4 Deposits in transit. n Deposits that were mailed or taken to the bank but not received in time to be on the bank statement.

36. Copyright © by Houghton Mifflin Company. All rights reserved.36 Bank Reconciliation u Transactions shown on the bank statement but not recorded on the company’s books include: 4 Service charges. 4 NSF (nonsufficient funds) checks. n Checks deposited by company that were not paid by maker’s bank. 4 Interest income. 4 Miscellaneous charges and credits. u Errors by the bank or company require immediate correction.

37. Copyright © by Houghton Mifflin Company. All rights reserved.37 Illustration of a Bank Reconciliation Balance per bankXX Add deposit in transitXX Less outstanding checks (XX) Adjusted bank balanceXX Balance per books Add: Collected notesXX Interest incomeXX Less: NSF checks (XX) Service fee (XX) Adjusted book balanceXX u The adjusted balances should be equal after completing the bank reconciliation.

38. Copyright © by Houghton Mifflin Company. All rights reserved.38 Recording Transactions After Reconciliation u Entries must be made for the transactions necessary to update the book balance. u All items reported by the bank but not yet recorded by the company must be recorded in the general journal.

39. Copyright © by Houghton Mifflin Company. All rights reserved.39 Recording Transactions After Reconciliation (continued…) Example: Interest income. Cash100 Interest Income100 To record interest credited to bank account Example: NSF check. Account Receivable150 Cash150 To record return of customer’s check

40. Copyright © by Houghton Mifflin Company. All rights reserved.40Discussion Q.What are the two major reasons the balance per books does not usually agree with the balance per the bank statement? A.(1) Items recorded by one but not the other and (2) errors by either or both.

41. Petty Cash Procedures SUPPLEMENTAL OBJECTIVE 5 Demonstrate the use of a simple imprest system.

42. Copyright © by Houghton Mifflin Company. All rights reserved.42 Petty Cash u Petty cash funds are set up to make small payments when it is inconvenient to pay by check. u Often an imprest system is used to monitor petty cash. 4 Petty cash is established for a fixed amount. 4 Each disbursement is documented by a voucher. 4 Periodically the fund is reimbursed, based upon the vouchers, to its original fixed amount.

43. Copyright © by Houghton Mifflin Company. All rights reserved.43 Establishing the Petty Cash Fund u To establish a petty cash fund in the amount of $100, the following entry would be made: Petty Cash100 Cash100 u As disbursements are made vouchers are prepared to support the payment.

44. Copyright © by Houghton Mifflin Company. All rights reserved.44 Moving Disbursements from the Petty Cash Fund u Custodian and Payee must sign a Petty Cash voucher. u Make occasional unannounced audits of fund. u At specified intervals, and at the end of the accounting period, replenish fund.

45. Copyright © by Houghton Mifflin Company. All rights reserved.45 Reimbursing the Petty Cash Fund u If the sum of the vouchers and currency do not equal the fixed amount, then the journal entry would require either a debit or credit to Cash Short or Over. u Assume the fund has $20 in currency and two vouchers (1) $45 for supplies and (2) $30 for postage. Entry to replenish the fund: Supplies45 Postage Expense30 Cash Short or Over 5 Cash80

46. Copyright © by Houghton Mifflin Company. All rights reserved.46 Reimbursing the Petty Cash Fund (continued…) u The Cash Short or Over account would appear on the income statement as an expense if it had a debit balance and a revenue if it had a credit balance at the end of the accounting period. u Unless fund is increased, no entry to Petty Cash account is made except when the account is established.

47. Copyright © by Houghton Mifflin Company. All rights reserved.47 Petty Cash Voucher

48. Copyright © by Houghton Mifflin Company. All rights reserved.48Discussion Q.What does it mean if the Cash Short or Over account has a debit balance at the end of the period? A.If the account has a debit balance then it means the account was short for the period and would be reported as an expense on the income statement.

49. Voucher Systems SUPPLEMENTAL OBJECTIVE 6 Define voucher system and describe the components of a voucher system.

50. Copyright © by Houghton Mifflin Company. All rights reserved.50 Voucher Systems u A voucher system is any system that gives documentary proof of and written authorization for business transactions. u A voucher system provides strong internal control by separating duties and responsibilities for: 4 Authorization of expenditures. 4 Receipt of goods and services. 4 Validation of liability. 4 Payment of expenditures by check.

51. Copyright © by Houghton Mifflin Company. All rights reserved.51 Voucher System u There are many ways to set up a voucher system, but most systems use: n Vouchers. n Voucher checks. n Voucher register. n Check register.

52. Copyright © by Houghton Mifflin Company. All rights reserved.52Vouchers u Vouchers control expenditures. They serve as the basis of an accounting entry. u Characteristics of vouchers include: 4 Sequentially numbered. 4 Authorizing signature and explanation. 4 Accounts and amounts to be debited/credited. 4 Vouchers are recorded in both the voucher register and check registers.

53. Copyright © by Houghton Mifflin Company. All rights reserved.53 Voucher Checks u Voucher checks may simply be regular business checks. u Many businesses use a form of voucher check that tells the payee the reason why the check was issued. 4 The information is written either on the check itself or on a detachable stub.

54. Copyright © by Houghton Mifflin Company. All rights reserved.54 Voucher Register u The voucher register is the book of original entry in which vouchers are recorded after they have been approved. u All expenditures are recorded in a voucher register.

55. Copyright © by Houghton Mifflin Company. All rights reserved.55 Check Register u The check register is used in a voucher system as the journal in which checks are listed as they are written. u The incurrence of a liability is recorded in the voucher register and its payment is recorded in the check register.

56. Copyright © by Houghton Mifflin Company. All rights reserved.56 Front and Back of a Typical Voucher Form

57. Copyright © by Houghton Mifflin Company. All rights reserved.57Discussion Q.What are the four components of a typical voucher system? A.(1) Vouchers. (2) Voucher checks. (3) Voucher register. (4) Check register.

58. Operation of a Voucher System SUPPLEMENTAL OBJECTIVE 7 Describe and carry out the five steps in operating a voucher system.

59. Copyright © by Houghton Mifflin Company. All rights reserved.59 Operation of a Voucher System u Steps: 1. Preparing the voucher. 2. Recording the voucher. 3. Paying the voucher. 4. Posting the voucher and check registers. 5. Summarizing unpaid vouchers.

60. Copyright © by Houghton Mifflin Company. All rights reserved.60 Operation of a Voucher System u Step 1: Preparing the voucher. 4 A voucher is prepared for each expenditure. 4 All supporting documents should be attached to the voucher (e.g., purchase orders, invoices, receiving reports).

61. Copyright © by Houghton Mifflin Company. All rights reserved.61 Operation of a Voucher System (continued…) u Step 2: Recording the voucher. 4 All approved vouchers are recorded in the voucher register. 4 There is always a credit entry in the Vouchers Payable column. 4 Vouchers without required supporting documents are investigated immediately.

62. Copyright © by Houghton Mifflin Company. All rights reserved.62 Operation of a Voucher System (continued…) u Step 3: Paying the voucher. 4 After recording the voucher, it is placed in an unpaid voucher file. 4 Shortly before the due date, a check is written to be accompanied by the voucher and supporting documents and is presented to the person authorized to sign the check. 4 After signing, the payment is recorded in the check register.

63. Copyright © by Houghton Mifflin Company. All rights reserved.63 Operation of a Voucher System (continued…) u Step 4: Posting the voucher and the check registers. 4 This step is very similar to posting the purchases journal and cash payments journal. 4 The only difference is that the Vouchers Payable account is substituted for the Accounts Payable account.

64. Copyright © by Houghton Mifflin Company. All rights reserved.64 Operation of a Voucher System (continued…) u Step 5: Summarizing unpaid vouchers. 4 The total of unpaid vouchers should always equal the credit balance in the Vouchers Payable account. 4 At the end of the period, a reconciliation should be performed to be sure that these two amounts agree. 4 On the balance sheets, Vouchers Payable is usually shown as part of Accounts Payable.

65. Copyright © by Houghton Mifflin Company. All rights reserved.65 OK, LET’S REVIEW… 1.Define internal control, identify the five components of internal control, and explain seven examples of control activities. 2.Describe the inherent limitations of internal control.

66. Copyright © by Houghton Mifflin Company. All rights reserved.66 CONTINUING OUR REVIEW… 3.Apply internal control activities to common merchandising transactions. 4.Demonstrate the control of cash by preparing a bank reconciliation.

67. Copyright © by Houghton Mifflin Company. All rights reserved.67 AND FINALLY… 5.Demonstrate the use of a simple imprest system. 6.Define voucher system and describe the components of a voucher system. 7.Describe and carry out the five steps in operating a voucher system.