Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Lesson notes
Lesson 12: Internal Controls and Business Ethics
Learning objectives
1.Explain the fundamental principles of internal control.
2.Define, explain the purpose, and identify the principles of internal accounting control.
3.Apply internal control to cash.
4.Explain and record petty cash fund transactions.
5.Identify control features.
6.Prepare a bank reconciliation7.Explain the fundamental principles of internal control.
Teaching hours
Students major in accounting: 4 hours
Others:
2 hours
Teaching contents:
1. Opening story
China Aviation Oil (Singapore) Corp., an overseas arm of China's main jet-fuel supplier,
revealed the end of 2004 that it has racked up about $550 million in trading-related losses.
2. Define internal control
Internal control is the organizational plan and all the related measures that an entity adopts
to
(1)
(2)
(3)
(4)
Safeguard assets,
Encourage adherence to company policies,
Promote operational efficiency, and
Ensure accurate and reliable accounting records.
Management has primary responsibility for the financial statements. Exhibit 7-1 is an excerpt
from the Responsibility for Consolidated Financial Statements of Lands’ End.
ERM
3. Identify the characteristics of an effective system of internal control
(1)Competent, reliable, and ethical personnel—Attract top-quality employees, train them well,
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
and supervise them.
(2)Assignment of responsibilities—Each employee is assigned certain responsibilities (often
defined in the organizational chart).
(3)Proper authorization—An organization generally has a written set of rules that outlines
approved procedures. Tasks that fall outside this set of procedures may be performed only if
properly authorized.
(4)Separation of duties—Dividing responsibilities for transactions limits the chances for
fraud and promotes accuracy of the accounting records. Separation of duties may be divided into
four parts:
Separation of operations from accounting—The entire accounting function should be
completely separate from operating departments.
Separation of custody of assets from accounting—Accountants should not have access to
assets, and those that have access to assets (such as the cashier) should not have access to the
accounting records.
Separation of authorization of transactions from the custody of related assets—People who
authorize transactions should not handle the related asset.
Separation of duties within the accounting function—Different people should perform the
various phases of accounting to minimize errors and opportunities for fraud.
(5)Internal and external audits—Internal and external auditors identify weaknesses in internal
control.
Internal auditors are employees.
External auditors are employed by accounting firms that are hired by a business to examine
the financial statements.
(6)Documents and records—Business documents should be prenumbered to call attention to
a missing document.
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
(7)Electronic devices and computer controls—Accounting systems are relying on the
computer to perform basic functions; and therefore, programmers become the focus for internal
controls. Businesses use other electronic devices to help protect assets and control operations,
such as inventory sensors.
(8)Other controls—Businesses often use controls to protect assets such as fireproof vaults (to
protect documents), burglar alarms (to protect property), point-of-sale terminals (to protect cash).
Fidelity bonds insure the company against theft by an employee.
Mandatory vacations and job rotation enhances morale and helps keep employees honest.
(9)e-Commerce creates some new risks such as protection confidential information.
1)Some pitfalls include:
a.Stolen credit-card numbers that can be used by authorized people.
b.Computer viruses (that reproduce themselves) and Trojan horses (that do not reproduce) are
vicious programs that can destroy or alter data and/or infect word-procession files.
c.Hackers can impersonate legitimate businesses on the web and solicit confidential data
from unsuspecting people.
2)Two standard techniques are used to secure e-commerce data.
a.Encryption rearranges text messages by some mathematical process so that the message
cannot be read by anyone who does not know the process.
b.Firewalls limit access to a local network by blocking intruders.
(10)There are some limitations of internal control procedures.
1)Internal control systems can be thwarted by collusion between two or more people working
together to defraud the firm.
2)An overly complex internal control system may be inefficient.
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
(12)The bank account is a control device because banks have established practices for
safeguarding cash.
1)Banks provide depositors with detailed records of cash transactions.
These records
include:
a.A signature card, to ensure that only an authorized person has access to the account.
b.Deposit tickets, to maintain a record of amounts deposited.
c.Checks, to maintain a record of monies withdrawn from the bank; includes the date of the
check, the name of the payee, and the signature of the maker.
d.Bank statements, to show the monthly activity in an account.
Canceled checks, checks that have cleared the bank, are usually included in the bank
statement.
Electronic funds transfer (EFT) are paperless transactions that transfer cash to or from a bank
account. The bank statement lists EFT transactions.
2)The bank reconciliation explains the differences between the bank statement balance and
the general ledger balance of cash. (Exhibit 7-5 illustrates the Cash account.)
a.Items recorded by the company but not yet recorded by the bank include:
Deposits in transit—Money that has been deposited by the company but not yet recorded by
the bank.
Outstanding checks—Checks that have been issued by the company but not yet paid by the
bank.
b.Items recorded by the bank but not yet recorded by the company include:
Bank collections—Money collected by the bank on behalf of its customers.
Some
companies use a lock-box system where customers make payments directly to the bank to reduce
theft.
EFT—The bank statement may include EFT’s that the company has not yet recorded.
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Service charges—Fees that the bank charges for certain services and are not known by the
depositor until the bank statement is received.
Interest revenue earned on the checking account—The amount of interest earned may not be
known until the bank statement is received.
Nonsufficient funds checks (NSF)—NSF checks received from customers and returned to the
payee; they are sometimes included in the bank statement
Checks collected, deposited, and returned to payee by the bank for reasons other than
NSF—The bank may return checks because the account has closed, the check is too old, the
signature is not authorized, the check has been altered, or the check form is improper.
Check printing charge—A fee that the bank charges for printing checks.
c.Errors may be made by either the bank or the company.
4. Prepare a bank reconciliation and the related journal entries
(1)The following adjustments are made to the balance per bank. (Exhibit 7-7 is an example
of a bank reconciliation.)
Balance per bank
XX
Add: Deposits in transit
XX
XX
Less: Outstanding checks
(XX)
Adjusted bank balance XX
(2)The following adjustments are made to the balance per books.
Balance per books XX
Add: EFT receipt
XX
Bank collection
XX
Interest revenue
XX
XX
Less:
Service charge XX
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
NSF XX
EFT payment XX
Check printing charge
XX
Other bank charges XX XX
Adjusted book balance
XX
(3)Errors that are made by the bank are adjustments to the balance per bank. Errors that are
made on the books are adjustments to the balance per books.
(4)Adjusting journal entries are required for every adjustment to the book’s balance and are
illustrated below:
1)
Bank collection
Cash
2)
XX
Notes Receivable
XX
Interest Revenue
XX
Interest revenue
Cash
XX
Interest Revenue
XX
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
3)
Service charge
Miscellaneous Expense
XX
Cash
4)
XX
NSF check
Account Receivable
XX
Cash
5)
XX
EFT—an EFT can be used for various transactions. The account, other than
Cash, that is involved will depend on the situation.
Receipt
Cash
XX
Various Accounts
6)
Payment
Various Accounts
XX
Cash
XX
XX
An adjusting entry for errors is made only when the error affects the book side of
the reconciliation.
(5)Owners and managers of small businesses do not have the luxury of separation of duties.
The bank reconciliation can be used to help control cash.
5. Apply internal controls to cash receipts
(1)Internal control over cash receipts ensures that all cash is deposited and that the
accounting records are correct.
(2)Point-of-sale terminals (cash registers) can provide control for cash receipts over the
counter.
1)The register should be positioned so that the customer can see the amounts entered.
2)A receipt should be issued for each sale recorded by the register.
3)The cash drawer should open only when the clerk enters an amount so that all transactions
will be recorded on the register tape.
4)The merchandise should be priced at “uneven” amounts to require that the clerk make
change from the cash drawer.
5)The cashier should deposit the cash, with the register tape being sent to the accounting
department.
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
(3)A mailroom employee who compares the amount of the check with the remittance advice
should handle cash received in the mail.
1)The remittance advices are forwarded to the accounting department and the checks are
forwarded to the cashier.
2)The controller then compares the cash receipts with the control tape from the mailroom, the
bank deposit slip from the cashier, and the debit to Cash from the accounting department.
3)Many companies use a lock-box system to separate cash duties and establish control over
receipts. Customers send their checks directly to the bank.
(4)A Cash Short and Over account is used to record shortages or overages in the daily cash
sales. The balance of this account should be small.
6. Apply internal controls to cash payments
(1)Internal control over cash payments is at least as important as controlling cash receipts.
(2)Checks are an important control because a check acts as a source document and requires
an authorized signature.
(3)The purchasing process, requires the following steps.
1)Sales department prepares a purchase requisition.
2)
The purchasing department locates the merchandise and prepares a purchase order.
3)The supplier fills the order, ships the goods, and mails an invoice to the purchaser.
4)When the goods arrive, a receiving report is prepared.
5)The accounting department combines all the documents, checks them for accuracy, and
forwards this disbursement packet to the appropriate officer for approval and payment.
6)Before payment, the documents should be compared to ensure that the business pays cash
only for the goods ordered and received. A voucher, a document that authorizes payment, is
prepared.
(4)Establishing a petty cash fund allows control over expenditures too small to pay by
check.
Introduction to the Current Situations
(How Do Those Ethic Issues Stand Out in Modern Business World?)
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
There is such an unprecedented sense of distrust in the business community today, on the part
of the American public, perhaps it is best to ask why there was such a level of trust in the legal
ethics of business during the boom period of the 1990s. Of course, the escalating profits investors
were reaping may seem to be the main reasons for this misplaced trust and confidence, but there
was also a sense that American business was comprehensible and amenable to the ordinary
investor. The widespread allegations regarding insider trading and accounting fraud, as well as
revelations that corporations such as Enron (and indeed, many of the poorly conceived internet
bomb website creations) were in fact profitable and extant only on paper have created a sense that
no one in the ordinary populace can either understand or trust business without specialized insider
information and advice. Revelations of the abuse of executive perks at Tyco have also attracted the
world’s focus on the issues of business and accounting ethics.
Some quotes from the celebrities
At this moment, America’s highest economic need is higher ethical standards --- standards
enforced by strict laws and upheld by responsible business leaders.
George W. Bush, Corporate Responsibility speech July 9,2002
There are two levers to set a man in motion, fear and self-interest.
Napoleon B.
What does PROFESSIONAL AND ACCOUNTING ETHICS mean to us?
The boom of the 90's has changed the business environment in ways that will require a
reshaping of corporate leadership. Financial scandals and out-of-hand executive compensation
demonstrate not only a lapse of ethics and unprecedented greed, but also a disdain for the rule of
law. Thus, the most pressing leadership issue for today is how to ensure that corporate officers
behave in an ethical manner.
Because investors and creditors place great reliance on financial statements in making their
investment and credit decisions, it is imperative that the financial reporting process be truthful and
dependable. Accountants are expected to behave in an entirely ethical fashion, and this is
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
generally the case. To help insure integrity in the reporting process, the profession has adopted a
code of ethics to which its licensed members must adhere. In addition, checks and balances via
the audit process, government oversight, and the ever vigilant "plaintiff's attorney" all serve a vital
role in providing additional safeguards against the errant accountant. If you are preparing to enter
the accounting profession, you should do so with the intention of behaving with honor and
integrity; if you are not planning to enter the profession, you will come to expect that the
accountants who you hire and entrust with your most confidential financial information to act in a
completely ethical way.
Two key legal steps that must be taken to reestablish trust in the business community upon
investors are limiting the ability of insiders to profit from insider trading tips and greater
accountability in the accounting field.
CEO focuses on boosting the corporation's daily share price or concentrates on building
long-term corporate value. Current compensation practices encourage not only short-term
behavior but also promote excessive risk-taking and aggressive accounting methods that overstate
earnings to boost pay. Legislation is at least trying to tackle the accounting irregularities issues
caused by unethical executives. President Bush signed into law the Sarbanes-Oxley Act of 2002 in
July.
Functions and Purposes of Accounting Ethics
No matter how many regulations are imposed, unethical individuals and organizations will
find new and innovative ways to circumvent them.
Professional and accounting ethics can direct business people to abide by a code of conduct
that facilitates, if not encourages, public confidence in their products and services. In the
accounting field, professional organizations such as the AICPA, IMA, maintain and enforce a code
of professional conduct for public accountants. They recognize the accounting profession's
responsibility to provide ethical guidelines to its members.
The purpose of ethics in business is to direct business people to abide by a code of conduct
that facilitates, if not encourages, public confidence in their products and services. In the
accounting field, the AICPA maintains and enforces a code of professional conduct for public
accountants. The Institute of Management Accountants (IMA) and the Institute of Internal
Auditors (IIA) also maintain a code of ethics. Professional accounting organizations recognize the
accounting profession's responsibility to provide ethical guidelines to its members.
Can One Person Make A Difference?
A Japanese proverb states: "The reputation of a thousand years may be determined by the
conduct of one hour." The actions of just one person have even changed the course of a nation.
Edward Everett Hale wrote:
I am only one.
But still I am one.
I cannot do everything,
But still I can do something;
And because I cannot do everything
I will not refuse to do the something that I can do.
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Summary of This Lesson
1. Ethical issues have become an unprecedented topic of business community today.
2. The most pressing leadership issue for today is how to ensure that corporate officers behave in
an ethical manner.
3. Professional and accounting ethics can direct business people to abide by a code of conduct
that facilitates, if not encourages, public confidence in their products and services.
Case for Open Discussion
HOW DO YOU MEASURE SUCCESS?
A popular story recounts a meeting that took place at the Edgewater Beach Hotel in Chicago
in 1923. Attending this meeting were nine of the richest men in the world at that time: (1) Charles
Schwab, President of the world's largest independent steel company; (2) Samuel Insull, President
of the world's largest utility company; (3) Howard Hopson, President of the largest gas firm; (4)
Arthur Cutten, the greatest wheat speculator; (5) Richard Whitney, President of the New York
Stock Exchange; (6) Albert Fall, member of the President's Cabinet; (7) Leon Frazier, President of
the Bank of International Settlements; (8) Jessie Livermore, the greatest speculator in the Stock
Market; and (9) Ivar Kreuger, head of the company with the most widely distributed securities in
the world.
Twenty-five years later, (1) Charles Schwab had died in bankruptcy, having lived on
borrowed money for five years before his death. (2) Samuel Insull had died virtually penniless
after spending some time as a fugitive from justice. (3) Howard Hopson was insane. (4) Arthur
Cutten died overseas, broke. (5) Richard Whitney had spent time in Sing-Sing. (6) Albert Fall was
released from prison so he could die at home. (7) Leon Fraizer, (8) Jessie Livermore, and (9) Ivar
Kreuger each died by suicide. Measured by wealth and power these men achieved success, at least
temporarily. Making a lot of money may be an acceptable goal, but money most assuredly does
not guarantee a truly successful life.
Many people think of fame and fortune when they measure success. However, at some point
in life, most people come to realize that inner peace and soul-deep satisfaction come not from
fame and fortune, but having lived a life based on integrity and noble character. President Lincoln
put it this way: “Honor is better than honors.” At a Congressional Hearing on ethics in July 2002,
Truett Cathy, founder of Chik-Fil-A, quoted Proverbs 22:1: "A good name is more desirable than
great riches; to be esteemed is better than silver or gold." In the final analysis, living an honorable
life really is more satisfying than fame and fortune. How do you measure success?
Suggested questions:
1) What ethic lessons can you infer from this case story?
2) How can an accountant give a well-balanced treatment to the ethic issues in his or her
professional practices?
3) What is the relationship(s) between the ethic quality and the professional ability and the
actual performances of an accountant?
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
2)The entry to establish the fund is:
Petty Cash
Cash in Bank
XX
XX
3)A petty cash ticket whenever a disbursement is made from petty cash. No journal
entry is made at this time.
4)When the fund is replenished, all petty cash payments are recorded in a summary entry
such as the one illustrated below:
Office Supplies
XX
Postage Expense XX
Delivery Expense XX
Cash Short and Over XX
Cash in Bank
XX
7. Make ethical judgements in business
(1)Most large companies have a code of ethics designed to encourage employees to act
ethically.
(2)Accountants who are members of the AICPA must also abide by the AICPA Code of
Professional Ethics. Accountants who are members of the IMA must also abide by the Standards
of Ethical Conduct for Management Accountants.
(3)The following framework, found in the Decision Guidelines, is a guide to making ethical
decisions.
1)Determine the facts.
2)Identify the ethical issues.
3)Specify the alternatives.
4)Identify the people involved.
5)Assess the possible outcomes.
6)Make the decision.
(4)External controls, such as IRS audits, loan agreements, U.S. laws, also encourage ethical
behavior.