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Chapter 7
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• Internal controls
– Safeguards assets
• from theft, robbery & unauthorized use
– Enhance accuracy & reliability of accounting
records
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• Internal controls are both:
– Preventive,
• keep thefts from occurring
– Detective
• detect thefts once they happen
• Key internal control principles include:
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• Establishment of Responsibility
– Have one person responsible for a task
– Know who to blame
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• Segregation of Duties
– Don’t let one person do everything
– If someone does everything
• easy to do something wrong without detection.
– If more people involved
• Easier to spot irregularities
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• Example:
– One person should order goods
– Another should sign for the receipt of goods
– A third should pay for the goods
• If one person did everything
– he or she could have company pay for
inventory never received.
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• Example
– One person should make a sale
– Another should ship the goods
– Third should bill the customer
• If one person did everything
– he or she could fail to fully bill customers for
shipped goods
• kickbacks or sales to friends
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• Example
– One opens mail and endorses checks
– Another person does books accounting for checks.
• If one person receives and records payments
from customers
– he or she could pocket the receipts while telling
customers that their bills are paid and telling company
that payment isn’t received yet.
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• Example
– One person makes sales
– Another authorizes credit
• If one person does both jobs
– he or she might extend credit to inappropriate
persons in order to increase sales
commissions.
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• Documentation Procedures
– Procedures should require use of documents
– All documents should be prenumbered and
accounted for
• Prevents undocumented transactions from failing
to be recorded
• Prevents documents from being lost
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• Physical, Mechanical and Electronic Controls
– Help to safeguard assets
• Examples
– Safes and locked cash boxes – help safeguard cash
and documents
– Locked warehouses, burglar alarms, security
cameras - helps safeguard inventory
– Use of passwords on computers – helps safeguard
company assets and records
– Use of time clocks - helps to prevent employees from
coming late and leaving early
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 Independent Internal Verification
 Company checks for discrepancies in records.
 Done regularly or on surprise basis
 Done by an employee independent of the person
being checked.
 Discrepancies reported to management
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• Rotating Employees Duties & Requiring
Vacations
– Every employee should take a vacation.
– When someone else does a job it is easier to
spot discrepancies.
– Dishonest employees never take vacations
• for fear of discovery.
– For the same reason, a company should not
let the same person stay in one job for long
periods.
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 Bonding of Employees Who Handle Cash
 Bonding companies insure against losses from
employee theft
 They screens employees before insuring them
 If any loss occurs, and insurance company will
 Prosecute all offenders and
 Track them down
 This deters others
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• A voucher system should be used
– For payments on liabilities
– No check is made without voucher
• Approved by an official of the company
• Electronic funds transfer (EFT) systems
are used to keep the cost of issuing
checks down.
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• Sometimes company has to pay cash.
• Company sets up a petty cash fund.
• The journal entry is:
D.
Petty Cash
Cr.
Cash
$100
$100
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• When petty cash taken - note how funds
spent
• When petty cash fund is replenished, treat
expenditure as payment for prior uses of
petty cash:
D. Office Supplies
Store Supplies
Miscellaneous Expense
Cr. Cash
$50
40
10
$100
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• Bank Accounts
– A check register lists every check written on
the account.
– Once a month, bank sends bank statement.
– A bank statement's end-of-month balance
rarely agrees with the balance in the
company's books for that date.
– Must prepare a bank reconciliation
• account for this difference and
• locate any errors
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• The bank reconciliation begins with
– balance per books figure and
– balance per bank statement figure
• Each figure is adjusted resulting in two
adjusted cash balance figures
– which should agree.
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• The balance per books figure
– adjusted by information that the bank knew
but company did not.
• The balance per bank statement figure
– adjusted by information that the company
knew but the bank did not.
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• Examples of adjustments are as follows:
– Outstanding checks - deduction from balance per
bank statement
– Deposits in transit - addition to balance per bank
statement.
– Service charges - deduction from balance per books.
– A customer's non-sufficient funds (NSF) check deducted from balance per books.
– Interest earned on a checking account - added to
balance per books.
– Miscellaneous charges - deducted from balance per
books
• miscellaneous credits - added to balance per books.
– If the bank is collecting promissory notes
• Collection added to balance per books.
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• After bank reconciliation - adjusting
entries must be made
– To reflect new information supplied by the
bank statement.
• Promissory Note collected by bank:
D.
Cash
Cr. Note Receivable
$100
$100
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• Check returned from bank "Not Sufficient
Funds":
D.
Accounts Receivable
Cr.
Cash
$100
$100
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• Service Charge for month:
D. Bank Service Charge Expense
Cr.
Cash
$100
$100
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• Interest accrued on bank account:
D.
Cash
Cr. Interest Income
$100
$100
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• Recorded amount of check received lower
than actual amount (Book Error – Need to
reduce Cash and Account Payable by
more):
D.
Cash
Cr.
$100
Accounts Payable
$100
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• Cash and cash equivalents include
– coin, currency, checks, money orders, and
money on deposit with banks and similar
financial institutions.
– Money on deposit
• Unrestricted withdrawal
• Deposits restricted for under 90 days considered
cash.
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• Companies with excess cash
– Invested in cash equivalents.
• short-term, highly liquid investments
• Cash Equivalents are both:
– Readily convertible to cash; and
– So near to maturity that market value
insensitive to interest rate changes
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• Examples of cash equivalents
– Treasury bills,
– Commercial paper (short-term corporate notes), and
– Money market funds.
• Cash and cash equivalents do not include
restricted cash
– E.g. landfill companies are required to maintain a fund
of restricted cash to ensure that they will have
adequate resources to cover closing and clean-up
costs at the end of a landfill site’s useful life.
– Restricted cash is reported on a balance sheet as
“Restricted Cash” not part of “Cash and Cash
Equivalents”.
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• Managing and Monitoring Cash
– A business needs to make sure that it has
enough cash to meet its needs
– Treasurers or chief financial officers need to
manage their cash receipts and payments
effectively.
– The following are basic principles of cash
management:
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• Increase the speed of collection on receivables
– (e.g., offer sales discounts).
• Inventory ties up resources. Keep inventory
levels low
– (e.g., just in time inventory practices).
• Delay payment of liabilities,
– but don’t pass up purchase discounts.
• Plan timing of major expenditures so
– still have adequate cash to meet current needs.
• Invest idle cash to earn interest.
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• Cash Budgeting
– Need to forecast future cash receipts and
needs
• to manage its cash effectively.
– Use a cash budget.
• Usually covers a one-year or two-year period.
• Shows cash inflows, cash outflows, and cash from
financing
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Cash Budget
Beginning Balance of Cash
$38,000
Add: Cash Receipts (itemized)
Collections from customers
Sale of Securities
Total Cash Receipts
Total Available Cash
$168,000
2,000
170,000
$208,000
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Cash Budget (continued)
Total Available Cash
$208,000
Less: Cash Disbursements
Materials
$23,200
Salaries
62,000
Cash Selling & Adm. Expenses
94,300
Truck Purchase
30,000
Income Tax Expense
Total Cash Disbursements
Cash Deficiency
3,000
-212,500
-$4,500
Add: Financing
Borrowings
10,000
Ending Cash Balance
$5,500
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• Financial analysts study how effectively a
company manages its cash flow using two
ratios:
– Ratio of Cash to Daily Cash Expense
– Free Cash Flow
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• Ratio of Cash to Daily Cash Expense
– Gives number of days that company can
operate without additional infusion of cash:
Cash and Cash Equivalents
------------------------------------------------Average Daily Cash Expenses
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• Free Cash Flow
– Provides an assessment of a company’s
liquidity and financial flexibility – its cash
cushion
– It is a raw number
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Cash Provided by Operations
Capital Expenditures
Cash Dividends
Free Cash Flow