ACCT 2301 CH 7 Internal Control and Cash

For good internal control, the purchasing agent (the employee who prepares the purchase order) should

should neither receive the goods nor approve the payment. If these duties are not separated, a purchasing agent could buy goods and have them shipped to his or her home. Or a purchasing agent could overpay for purchases, approve the payment, and split the excess with the supplier.

This check has two parts, the check itself and the remittance advice. In addition

the check includes the routing number and account number. The routing number is a 9-digit number that identifies the bank upon which the payment is drawn. The account number identifies the account upon which the payment is drawn.

Controller

the chief accounting officer in an organization accounts for the cash

As part of the internal control system,

the company's business risk, as well as the risk concerning individual accounts, must be assessed. The higher the risk, the more controls a company must put in place to safeguard its assets and accounting records.

The stricter the internal control

the more it costs. A complex system of internal controls can strangle the business with red tape. Internal controls must always be judged in light of their costs versus their benefits.

Errors are always recorded on

the side of the reconciliation of the party that made the error. If the bank made the error, it is recorded on the bank side. If the business made the error, it is recorded on the book side.

Auditor

trained accounting professional

increasing petty cash fund

(not replenish) debit petty cash and credit cash for the amount of increase Journal Entry: Accounts: Petty Cash Cash Notation: To increase the petty cash fund

Other controls

- fireproof vaults to store important documents - burglar alarms, fire alarms, and security cameras - loss-prevention specialists who train company employees to spot suspicious activity - fidelity bonds to reimburse the company for any losses do to employee theft - mandatory vacations and job rotation - deposit cash soon enough for adequate security

Exhibit 7.1 - How companies control cash received by mail

1. All incoming mail is opened by a mailroom employee. The mailroom sends all customer checks to the treasurer and all remittance advices to the accounting department. 2. The treasurer has the cashier deposit the checks in the bank. The cashier receives a deposit receipt. 3. The accounting department (or bookkeeper) uses the remittance advices to record the journal entries to Cash and customer accounts. 4. As a final control, the controller compares the following records for the day: • bank deposit amount from the treasurer • Debit to cash from the accounting department

Internal Control Procedures - all companies need the following

1. Competent, reliable, and ethical personnel 2. Assignment of responsibilities 3. Separate of duties 4. Audits 5. Documents 6. Electronic Devices 7. E-commerce 8. Other controls - fireproof vaults - burglar alarms - loss prevention specialists - fidelity bonds - mandatory vacation and job rotation

The processor agreement specifies how fees are paid to the processor. The following are two common methods of handling the proceeds and processing fees:

1. Net—The total sale less the processing fee assessed equals the net amount of cash deposited by the processor, usually within a few days of the sale date. 2. Gross—The total sale is deposited daily within a few days of the actual sale date. The processing fees for all transactions processed for the month are deducted from the company's bank account by the processor, often on the last day of the month.

3 Types of Timing Differences

1. When a business writes a check, it immediately deducts the amount in its checkbook and Cash account. The bank, however, does not subtract the check from the company's account until the bank pays the check a few days later. 2. When a company deposits cash in its account, it immediately adds the cash receipt to the checkbook and Cash account. The bank, however, may take a day or two to add deposits to the company's balance. 3. EFT cash payments and EFT cash receipts are often recorded by the bank before a company learns of them.

Having a cash ratio below

1.0 is a good thing. A cash ratio above 1.0 might signify that the company has an unnecessarily large amount of cash supply. This cash could be used to generate higher profits or be paid out for dividends. However, a very low ratio doesn't send a strong message to investors and creditors that the company has the ability to repay its short-term debt.

Deposit Ticket

A bank form that is completed by the customer and shows the amount of each deposit. As proof of the transaction, the customer receives a deposit receipt from the bank.

signature card

A card that shows each authorized person's signature for a bank account. This helps protect against forgery because the signature card should be checked frequently by bank personnel to authenticate written checks or deposits made by the business.

Committee of Sponsoring Organizations (COSO)

A committee that provides thought leadership related to enterprise risk management, internal control, and fraud deterrence. COSO's mission is to develop frameworks and guidance to help companies improve their internal controls and reduce fraud in organizations.

Risk Assessment

A company must identify its risks. All companies face the risk of bankruptcy. Companies facing difficulties might be tempted to falsify their financial statements to make themselves look better than they really are.

Safeguard Assets

A company must protect its assets; otherwise it is throwing away resources. If you fail to safeguard cash, the most liquid of assets, it will quickly slip away.

Public Company

A company that sells its stock to the general public. Are required by the U.S. Congress to maintain a system of internal controls.

Firewall

A device that enables members of a local network to access the network, while keeping nonmembers out of the network. Usually several firewalls are built into the system. At the point of entry, additional security measures, such as passwords, PINs, and signatures are used. For additional security, more sophisticated firewalls are used deeper in the network to protect more sensitive data.

Bank Reconciliation

A document explaining the reasons for the difference between a depositor's cash records and the depositor's cash balance in its bank account. on a specific date Bank Side - Always: Add deposits in transit Subtract outstanding checks Add OR subtract corrections of bank errors Book Side - Always: Add - * Bank Collections * Interest Revenue * EFT Receipts Subtract - * service charges * NSF checks * EFT Payments Add OR Subtract corrections of book errors

bank statement

A document from the bank that reports the activity in the customer's account. It shows the bank account's beginning and ending balances and lists the month's cash transactions conducted through the bank account.

Check

A document that instructs a bank to pay the designated person or business a specified amount of money. prenumbered

petty cash

A fund containing a small amount of cash that is used to pay for minor expenditures. We have already established that cash is the most liquid of assets. Petty cash is more liquid than cash in the bank because none of the bank controls are in place.

Streamlined Procedures : Evaluated Receipt Settlement (ERS)

A procedure that compresses the payment approval process into a single step by comparing the receiving report to the purchase order. If those documents match, then Smart Touch Learning got the tablets it ordered and payment is made to the vendor.

Internal control report

A report by management describing its responsibility for and the adequacy of internal controls over financial reporting.

Lock-Box System

A system in which customers send their checks to a post office box that belongs to a bank. A bank employee empties the box daily and records the deposits into the company's bank account. Internal control is tight because company personnel never touch incoming cash. The lock-box system puts a businesses' cash into the company's bank account quickly.

Electronic Funds Transfers (EFT)

A system that transfers cash by electronic communication rather than by paper documents. Many bills and other payments, such as salaries, rent, utilities, and insurance, are now paid by EFT. It is much cheaper to pay these items by EFT without having to mail a check. Debit card transactions and direct deposits are also considered EFTs.

Imprest System

A way to account for petty cash by maintaining a constant balance in the petty cash account. At any time, cash plus petty cash tickets must total the amount allocated to the petty cash fund.

Separating the custody of assets from accounting for assets is a part of which element of internal control?

Accountants must not handle cash, and cashiers must not have access to the accounting records. If one employee has both duties, that employee could steal cash and conceal the theft in the accounting records. Applies to all assets, not just cash.

Separating operations from accounting

Accounting should be completely separate from the operating departments, such as production and sales. Sales figures could be inflated, and then top managers would not know how much the company actually sold.

Journal - Petty Cash

Accounts: Petty Cash Cash Notation: To open the petty cash fund

Ensure accurate, reliable accounting records

Accurate, reliable accounting records are essential. Without reliable records, managers cannot tell which part of the business is profitable and which part needs improvement. A business could be losing money on every product sold and not realize it - unless it keeps accurate and reliable records.

Internal Auditor

An employee of the business who ensures the company's employees are following company policies, that the company meets all legal requirements, and that operations are running efficiently.

Remittance Advice

An optional attachment to a check that tells the business the reason for the payment.

External Auditor

An outside accountant, completely independent of the business, who evaluates the controls to ensure that the financial statements are presented fairly in accordance with GAAP.

Outstanding Checks

Bank Side A check issued by a company and recorded on its books but not yet paid by its bank.

Deposits in Transit (Outstanding Deposits)

Bank Side A deposit recorded by the company but not yet by its bank. These are shown as "Add: Deposits in transit" on the bank side because when the bank does record these deposits, it will increase the bank balance.

Bank Errors

Bank Side posting errors made by the bank that either incorrectly increase or decrease the bank balance

Exhibit 7-3 shows Smart Touch Learning's payment packet of documents, which may be in either electronic or paper format.

Before signing the check for payment of goods, the controller or the treasurer should examine the packet to prove that all the documents agree. Only then does the company know the following: 1. It received the goods ordered. 2. It is paying only for the goods received and authorized. 3. It is paying the correct amount. After payment, the payment packet is marked as paid to prevent the bill from being paid twice. Electronically paid invoices are automatically marked "paid" by most accounting systems.

Interest Revenue on a Checking Account

Book Side A business will sometimes earn interest if it keeps enough cash in its account. The bank statement tells the company of this cash receipt. This will show as "Add: Interest revenue" on the book side of the reconciliation because it represents cash receipts not yet added in the company's cash balance.

Nonsufficient Funds (NSF) Checks

Book Side A check for which the maker's bank account has insufficient money to pay the check. represent checks received from customers for payment of services rendered or merchandise sold that have turned out to be worthless. NSF checks (sometimes called hot checks or bad checks) are treated as subtractions on a company's bank reconciliation. NSF checks will show as "Less: NSF checks" on the book side of the reconciliation, as the company previously recorded this receipt as an increase in cash, which now has to be deducted as the funds were not actually received.

debit memorandum

Book Side A decrease in a bank account.

credit memorandum

Book Side An increase in a bank account A bank collection (which increases the bank balance) that appears on the bank statement will show as "Add: Bank collections" on the book side of the reconciliation because it represents cash receipts not yet recorded by the company.

Electronic Funds Transfers

Book Side The bank may receive or pay cash on a company's behalf. An EFT may be a cash receipt or a cash payment. These will either show up on the book side of the reconciliation as "Add: EFT" for receipts not yet added to the company's books or "Less: EFT" for payments not yet deducted on the company's books.

Journalizing Transactions from the Bank Reconciliation

Book Side Only The bank reconciliation in Exhibit 7-7 requires Smart Touch Learning to make journal entries to bring the Cash account up to date. Numbers in the journal entries correspond to the reconciling items listed in Exhibit 7-7, Panel A, and to the book side of the reconciliation in Panel B. Note that we chose to list each item in a separate journal entry here, but one compound entry could be made instead of the five separate entries illustrated.

Promote operational efficiency

Businesses cannot afford to waste resources. Businesses work hard to make sales and do not want to waste any of the benefits. Promoting operational efficiency reduces expense and increases profits.

In addition to receiving cash receipts from customers over the counter, most companies also accept credit cards and debit cards.

By accepting credit cards and debit cards, such as Visa, MasterCard, and American Express, businesses are able to attract more customers. Credit cards offer the customer the convenience of buying something without having to pay cash immediately.

Petty Cash Fund Example - short

Cash Short & Over - $2 Debit

Petty Cash Fund Example - over

Cash Short & Over - $8 Credit

Monitoring of Controls

Companies hire auditors to monitor their controls.

Components of Internal Control

Control procedures Risk assessment Information system Monitoring of controls Environment

Proceeds from credit and debit card transactions are usually deposited within a few business days after the sale. Therefore, credit and debit card sales are journalized similar to cash sales.

Credit Card Net Method The customer pays with a third-party credit card. Smart Touch Learning would record the entry, assuming the card processor assesses a 4% fee and deposits the net amount, as follows: Journal Accounts: Cash (D) - note will be less than sale Credit Card Expense (CR) sale * % Sales Revenue (CR) - full amount of sale Notation: Recorded credit card sales, net of fee.

Petty cash needs controls such as the following

Designate a custodian of the petty cash fund. The custodian is the individual assigned responsibility for the petty cash fund. Designate a specific amount of cash to be kept in the petty cash fund. Support all petty cash fund payments with a petty cash ticket. These tickets are sequentially numbered. The petty cash ticket serves as an authorization voucher and explanation.

Control Procedures

Designed to ensure business's goals are achieved

timing differences

Difference that arises between the balance on the bank statement and the balance on the company's books because of a time lag in recording transactions.

Separation of Duties

Dividing responsibilities between two or more people to limit fraud and promote accuracy of accounting records. 1. Separating operations from accounting 2. Separate the custody of assets from accounting

E-commerce

E-commerce creates in own unique types of risks. Hackers may gain access to confidential information, such as account numbers and passwords, or introduce computer viruses, Trojans, or phishing expeditions.

Companies receive cash either over the counter, through the mail, or by electronic funds transfer.

Each source of cash has its own security measures.

competent, reliable, and ethical personnel

Employees should be competent, reliable, and ethical. Paying good salaries will attract high-quality employees. Employees should be also be trained to do the job and their work should be adequately supervised.

Streamlined Procedures: Electronic Data Interchange (EDI)

Even more streamlined A streamlined process that bypasses paper documents altogether. Computers of customers communicate directly with the computers of suppliers to automate routine business transactions. When the retailer's inventory reaches a low level, the computer creates and sends an electronic purchase order to the supplier. The supplier then ships the inventory and electronically sends an invoice to the retailer. A manager approves the invoice, and then an electronic fund transfer (EFT) sends the retailer's payment to the supplier. These streamlined EDI procedures are used for both cash payments and cash receipts in many companies.

Encourage employees to follow company policies

Everyone in an organization needs to work toward the same goals. These policies are also important for the company to ensure that all customers are treated similarly and that results can be measured effectively.

Preparing the Bank Side of the Bank Reconciliation

Here are the items that appear on the bank side of the bank reconciliation. They all cause differences between the bank balance and the book balance. The bank side contains items not yet recorded by the bank but recorded by the company, or errors made by the bank. These items include the following: Deposits in Transit Outstanding Checks Bank Errors

The debit to Cash should equal the amount deposited in the bank.

If it does, all cash receipts are safe in the bank, and the company's books are up to date.

Infomation System

Is critical. Controls must be in place within the IS to ensure that only authorized users have access to various parts of the accounting information system. Additionally, controls must be in place to ensure adequate approvals for recorded transactions are required. The decision makers need accurate information to keep track of assets and measure profits and losses.

The bank reconciliation is an accountant's tool separate from the journals and ledgers.

It does not account for transactions in the journal. To get the transactions into the accounts, we must make journal entries and post to the ledger. All items on the book side of the bank reconciliation require journal entries. We make no journal entries from the items on the bank side because we have already recorded these items in the business's Cash account.

cash receipts by mail

Many companies receive check by mail for payments of services or merchandise. Checks sent via mail are considered to be cash receipts.

Assignment of Responsibilities

No duty is overlooked Each employee has certain, carefully defined responsibilities. The assignment of responsibilities creates job accountability, thus ensuring all important tasks get done

routing number

On a check, the 9-digit number that identifies the bank upon which the payment is drawn.

account number

On a check, the number that identifies the account upon which the payment is drawn.

Canceled Checks

Physical or scanned copies of the maker's cashed (paid) checks.

Documents

Provide the details of business transactions and include invoices and orders, which may be paper or electronic. Documents should be prenumbered to prevent theft and inefficiency. A gap in the numbered sequence draws attention.

Encryption

Rearranging plain-text messages by a mathematical process - the primary method of achieving security in e-commerce. Cannot be read by those who do not know the code

Sarbanes-Oxley Act (SOX)

Requires companies to review internal control and take responsibility for the accuracy and completeness of their financial reports. 1. Public companies must issue an internal control report. 2. Formed the Public Company Accounting Oversight Board (PCAOB) 3. Accounting firms cannot audit a public company and also provide certain consulting services for the same client. 4. Stiff penalties for violators - 25 years in prison for securities fraud and 20 years for an executive making false sworn statements.

Bank Controls

Signature Card Deposit Ticket Check

For each petty cash payment, the custodian prepares a petty cash ticket like the one in Exhibit 7-4.

Signatures (or initials) identify the recipient of the cash and the fund custodian. The custodian keeps the petty cash tickets in the fund box. The sum of the cash plus the total of the petty cash tickets should equal the fund balance, $200, at all times.

Controls Over Purchases and Payments To illustrate the internal control over cash payments by check, suppose Smart Touch Learning buys its tablets from an electronics manufacturer.

Step 1: Smart Touch Learning sends a purchase order to the electronics manufacturer that contains the quantity and type of goods needed. Step 2: The electronics manufacturer ships the inventory and sends an invoice back to Smart Touch Learning. Step 3: Smart Touch Learning receives the inventory and prepares a receiving report. Step 4: After approving all documents, Smart Touch Learning sends a check to the electronics manufacturer.

Preparing the Book Side of the Bank Reconciliation

The book side contains items not yet recorded by the company on its books but that have been recorded by the bank, or errors made by the company. Items to show on the book side include the following: -Bank Collections -Electronic Fund Transfers -Service Charge -Interest Revenue on a Checking Account -Nonsufficient Funds Checks (NSF) -Book Errors

Payment by check is an important internal control for the following reasons:

The check provides a record of the payment. The check must be signed by an authorized official. Before signing the check, the official reviews the invoice or other evidence supporting the payment.

Companies hire a third-party processor to process credit and debit card transactions. Transactions are usually entered into an electronic terminal (card scanner) that the company either purchases or rents from the processor.

The fees the card processor charges the company for its processing services vary depending on the type of card and the specific agreement the company has with the card processor.

Payee

The individual or business to whom the check is paid.

Internal Controls

The organizational plan and all the related measures adopted by an entity to 1. safeguard assets, 2. encourage employees to follow company policies 3. promote operational efficiency, and 4. ensure accurate and reliable accounting records.

Maker

The party who issues the check

Treasurer

The person in charge of signing checks handles cash

Setting Up the Petty Cash Fund

The petty cash fund is opened when the company writes a check for the designated amount. The company makes the check payable to Petty Cash. The Petty Cash account is used in a journal entry only when the fund is started (see the August 1 entry) or when its amount is increased or decreased.

Service Charge

This cash payment is the bank's fee for processing a company's transactions. Service charges can also include the cost of printed checks and other bank fees such as ATM fees. Service charges could also include the fees charged by the bank for processing credit and debit card transactions if the company used the gross method for recording credit card sales. A service charge is often referred to as a debit memorandum and represents a decrease in the bank account. This will show as "Less: Service charges" on the book side of the reconciliation because it represents a cash payment not yet subtracted from the company's cash balance.

Collusion

Two or more people working together to circumvent internal controls and defraud a company.

Limitations of Internal Control

Unfortunately, most internal controls can be overcome - collusion

Credit Card - Gross Method

Would show an entry for the transaction on the sale date and a separate entry at the end of the month. Journal (normal) for transaction on sale date: Accounts: Cash Sales Revenue Notation: Recorded credit card sales. At end of month Accounts: Credit Card Expense Cash Notation: Paid fees assessed by credit card processor.

Cash Short & Over

a special ledger account that is used to keep track of unexplained shortages or overages of cash Normal credit balance

The books and the bank statement usually show different cash balances. Differences may arise because of

a time lag in recording transactions, called timing differences

Electronic Devices

accounting systems are relying less on paper documents and more on electronic documents and digital storage devices For example, retailers control inventory by attaching an electronic sensor to merchandise, the cashier removes the sensor after a sale is made.

To obtain accurate cash records, a company must update its Cash account

after the company receives its bank statement. A bank reconciliation is used to carry out the updating process. The bank reconciliation explains all differences between the company's cash records and the bank's records of the company's balance. The person who prepares the bank reconciliation should have no other cash duties.

Debit cards, on the other hand, reduce the customer's bank account immediately but

allow the customer to pay electronically instead of with currency or by writing a check.

Audits

assess adequacy and accuracy of their accounting records, most companies perform both internal and external audits internal audits are performed by employees of the company External audits are performed by independent auditors who are not employees of the company

Cash is the most liquid asset reported on the balance sheet because it is the medium of exchange. Because cash is easy to conceal and relatively easy to steal,

businesses keep their cash in a bank account. The bank has established practices for safeguarding the business's money.

Bank Collections

cash receipts the bank has received and recorded for a company's account but that the company has not recorded yet on its books. An example of a bank collection would occur when a business has its customers use a lock-box system. Another example is a bank collecting on a note receivable for a business. A bank collection is often referred to as a credit memorandum.

All cash receipts should be

deposited in the bank for safekeeping shortly after the cash is received.

When replenishing the petty cash fund, the company debits

either the associated expense incurred or the asset purchased with the funds.

Book Errors

errors made on the books of the company that either incorrectly increase or decrease the cash balance in the company's general ledger. All book errors are corrected on the book side of the reconciliation by reversing the effect of the errors.

cash equivalents

highly liquid investments that can be converted into cash in three months or less. Examples of cash equivalents are money-market accounts and investments in U.S. government securities

Cash Receipts Over the Counter

involves a point-of-sale terminal (cash register) that provides control over the cash receipts. For each transaction the retail store: • issues a receipt to ensure that the each sale is recorded • the cash drawer opens after the clerk enters a transaction • the machine records it • at the end of the day a manager proves the cash by comparing the cash in the drawer against the machine's record of cash sales (this step helps prevent theft by the clerk) • at the end of the day (or several times a day if business is brisk) the manager deposits cash in the bank • the machine tape then goes to the accounting department to record the journal entry for cash receipts and sales revenue The measures, coupled with oversight by a manager discourage theft

Environment

is the tone at the top or the culture of the business. It starts with the CFO or CEO and the top managers. They must behave honorably to set a good example for company employees. Each must demonstrate the importance of internal controls if he / she expects the employees to take the controls seriously.

Cash Ratio

measure a company's liquidity helps to determine a company's ability to meet its short-term obligations =(Cash+Cash equivalents)/Total current liabilities This ratio is the most conservative valuation of liquidity because it looks at only cash and cash equivalents, leaving out other current assets such as merchandise inventory and accounts receivable.

Included with the statement sometimes are

physical or scanned copies of the maker's canceled checks