Principles of Accounting
2002e
Belverd E. Needles, Jr.
Marian Powers
Susan Crosson
----------Multimedia Slides by:
Harry Hooper
Santa Fe Community College
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1
Chapter 8
Internal Control
LEARNING OBJECTIVES
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.
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3
SUPPLEMENTAL OBJECTIVES
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.
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4
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.
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5
Management’s Responsibility
for Internal Control

Internal control is all the policies and procedures
management uses to safeguard the firm’s assets
and have reliable accounting records. It involves:

Ensuring the reliability of financial reporting.

Ensuring operating effectiveness and efficiency.

Ensuring compliance with legal requirements.
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Components of Internal Control
1.
Control Environment
–
2.
Created by the attitude, awareness and
actions of management.
Risk Assessment
–
The identification of areas where the
risks of losses or inaccuracies are high.
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Components of Internal Control
(continued…)
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.
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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.
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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.
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Limitations of Internal Control
OBJECTIVE 2
Describe the inherent
limitations of internal control.
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Limitations of Internal Control
 Human
error.
 Misunderstandings.
 Mistakes in judgment.
 Carelessness.
 Distraction.
 Fatigue.
 Collusion.
 Dishonesty.
 Changes in conditions.
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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.
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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?
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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.
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15
Internal Control over
Merchandising Transactions
OBJECTIVE 3
Apply internal control activities to
common merchandising transactions.
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Internal Control and
Management Goals
 Goals
for the success of a merchandising
business.
 Prevent
losses of cash or inventory owing to
theft or fraud.
 Provide
accurate records of merchandising
transactions and account balances.
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Goals for Management
 Keep
enough inventory on hand to sell to
customers without overstocking.
 Keep
enough 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.
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18
Controls for Meeting
Management’s Goals

Cash budget.

Separation of duties.
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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.
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More Activities for Internal
Controls over Cash
(continued…)
6.
7.
Physically protect cash on hand.
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.
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Control of Cash Sales Receipts
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.
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Control of Cash Sales Receipts
(continued…)
 Control
of cash received through the mail.
 Encourage
customers to pay by check.
 Have two or more employees handle the cash.
 Make a list of receipts in triplicate.
 Control
of cash received over the counter.
 Cash
registers.
 Prenumbered sales tickets.
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23
Control of Purchases and Cash
Disbursements
Make
payments only after specific
authorization.
Support authorization by
documents validating the amount.
Maximize separation of duties.
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24
Internal Control for Purchasing and Paying for Goods and Services
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Discussion
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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Preparing a Bank
Reconciliation
OBJECTIVE 4
Demonstrate the control of cash
by preparing a bank reconciliation.
Bank Reconciliation
 The
Cash account balance on the books
rarely agrees with that on the bank
statement.
 Transactions
may appear on one but not
the other.
 Bank
reconciliations account for the
differences between the company’s
records and the bank statement.
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Bank Reconciliation
 Transactions
shown on the company’s record but
not the bank’s include:

Outstanding checks.


Checks that have been issued by the
company but have yet to appear on the
bank statement.
Deposits in transit.

Deposits that were mailed or taken to the
bank but not received in time to be on the
bank statement.
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Bank Reconciliation
 Transactions
shown on the bank statement but
not recorded on the company’s books include:
 Service charges.
 NSF (nonsufficient funds) checks.
Checks deposited by company that were not
paid by maker’s bank.
 Interest income.
 Miscellaneous charges and credits.
 Errors by the bank or company require
immediate correction.

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Illustration of a Bank Reconciliation
Balance per bank
Add deposit in transit
Less outstanding checks
Adjusted bank balance
XX
XX
(XX)
XX
Balance per books
Add: Collected notes
Interest income
Less: NSF checks
Service fee
Adjusted book balance
XX
XX
(XX)
(XX)
XX
 The
adjusted balances should be equal after
completing the bank reconciliation.
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Recording Transactions After
Reconciliation
 Entries
must be made for the
transactions necessary to update the
book balance.
 All
items reported by the bank but not
yet recorded by the company must be
recorded in the general journal.
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Recording Transactions After
Reconciliation
(continued…)
Example: Interest income.
Cash
100
Interest Income
100
To record interest
credited to bank
account
Example: NSF check.
Account Receivable
150
Cash
150
To record return of
customer’s check
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Discussion
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.
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Petty Cash Procedures
SUPPLEMENTAL OBJECTIVE 5
Demonstrate the use of a simple
imprest system.
Petty Cash
 Petty
cash funds are set up to make small
payments when it is inconvenient to pay by
check.
 Often an imprest system is used to monitor
petty cash.
 Petty
cash is established for a fixed amount.
 Each disbursement is documented by a voucher.
 Periodically the fund is reimbursed, based upon
the vouchers, to its original fixed amount.
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Establishing the Petty Cash
Fund
 To
establish a petty cash fund in the amount of
$100, the following entry would be made:
Petty Cash
100
Cash
 As
100
disbursements are made vouchers are
prepared to support the payment.
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Moving Disbursements from
the Petty Cash Fund
Custodian
and Payee must sign a
Petty Cash voucher.
Make occasional unannounced
audits of fund.
At specified intervals, and at the
end of the accounting period,
replenish fund.
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Reimbursing the Petty
Cash Fund
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.
 Assume the fund has $20 in currency and two
vouchers (1) $45 for supplies and (2) $30 for postage.
Entry to replenish the fund:
Supplies
45
Postage Expense
30
Cash Short or Over
5
Cash
80

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Reimbursing the Petty Cash
Fund
(continued…)
 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.
 Unless
fund is increased, no entry to Petty
Cash account is made except when the
account is established.
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46
Petty Cash Voucher
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47
Discussion
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.
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Voucher Systems
SUPPLEMENTAL OBJECTIVE 6
Define voucher system and
describe the components of
a voucher system.
Voucher Systems
 A voucher
system is any system that gives
documentary proof of and written authorization
for business transactions.
 A voucher
system provides strong internal control
by separating duties and responsibilities for:

Authorization of expenditures.

Receipt of goods and services.

Validation of liability.

Payment of expenditures by check.
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Voucher System

There are many ways to set up a
voucher system, but most systems
use:

Vouchers.

Voucher checks.

Voucher register.

Check register.
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Vouchers
 Vouchers
control expenditures. They serve as the
basis of an accounting entry.
 Characteristics
of vouchers include:
 Sequentially
numbered.
 Authorizing
signature and explanation.
 Accounts
and amounts to be debited/credited.
 Vouchers
are recorded in both the voucher
register and check registers.
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Voucher Checks

Voucher checks may simply be regular
business checks.

Many businesses use a form of voucher
check that tells the payee the reason why
the check was issued.

The information is written either on the
check itself or on a detachable stub.
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Voucher Register
 The
voucher register is the book of
original entry in which vouchers are
recorded after they have been approved.
 All
expenditures are recorded in a
voucher register.
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Check Register
 The
check register is used in a voucher
system as the journal in which checks are
listed as they are written.
 The
incurrence of a liability is recorded
in the voucher register and its payment is
recorded in the check register.
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Front and Back of a Typical Voucher Form
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Discussion
Q.
What are the four components of a
typical voucher system?
A.
(1) Vouchers.
(2) Voucher checks.
(3) Voucher register.
(4) Check register.
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Operation of a Voucher
System
SUPPLEMENTAL OBJECTIVE 7
Describe and carry out the five steps
in operating a voucher system.
Operation of a Voucher
System
Steps:
1. Preparing the voucher.
2. Recording the voucher.
3. Paying the voucher.
4. Posting the voucher and check
registers.
5. Summarizing unpaid vouchers.
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Operation of a Voucher
System
Step
1: Preparing the voucher.
 A voucher is
prepared for each
expenditure.
 All
supporting documents should be
attached to the voucher (e.g., purchase
orders, invoices, receiving reports).
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Operation of a Voucher
System
(continued…)
 Step
2: Recording the voucher.
 All
approved vouchers are recorded in the
voucher register.
 There
is always a credit entry in the
Vouchers Payable column.
 Vouchers
without required supporting
documents are investigated immediately.
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Operation of a Voucher
System
(continued…)
 Step
3: Paying the voucher.
 After
recording the voucher, it is placed in an
unpaid voucher file.
 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.
 After signing, the payment is recorded in the
check register.
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Operation of a Voucher
System
(continued…)
 Step
4: Posting the voucher and the check
registers.
 This
step is very similar to posting the
purchases journal and cash payments
journal.
 The only difference is that the Vouchers
Payable account is substituted for the
Accounts Payable account.
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Operation of a Voucher
System
(continued…)
 Step
5: Summarizing unpaid vouchers.
 The
total of unpaid vouchers should always
equal the credit balance in the Vouchers Payable
account.
 At
the end of the period, a reconciliation should
be performed to be sure that these two amounts
agree.
 On
the balance sheets, Vouchers Payable is
usually shown as part of Accounts Payable.
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64
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.
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65
CONTINUING OUR REVIEW…
3. Apply internal control activities to
common merchandising
transactions.
4. Demonstrate the control of cash by
preparing a bank reconciliation.
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66
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.
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67