CHAPTER 7. Internal Control and Cash. Chapter Overview

CHAPTER 7 Internal Control and Cash Chapter Overview Chapter 7 discusses the purposes and characteristics of an effective system of internal control. The text describes four objectives that a company hopes to achieve with a good system of internal control. The five components of internal control are identified, including monitoring of controls, information system, control procedures, control environment, and risk assessment. Basic characteristics of an effective system of internal control are listed, including competent, reliable, and ethical personnel; assignment of responsibilities; separation of duties; internal and external audits; documents; electronic devices; and other controls. The need for internal controls for companies engaged in e-commerce is explained. Several limitations of internal control are mentioned. The chapter also discusses the Sarbanes-Oxley Act (SOX) and its effect on corporate governance and the accounting profession. The bank account is introduced as a control device related to cash. The discussion of the bank account includes the documents used to control a bank account; the signature card, deposit ticket, checks, bank statement, and electronic funds transfers are discussed. The bank reconciliation is illustrated and described in detail. Various reconciling items discussed include deposits in transit, outstanding checks, bank collections, EFTs, service charges, interest revenue, NSF checks, and various errors. The adjusting entries required by the reconciliation are presented followed by a discussion of how owners and managers use the reconciliation. A mid-chapter summary problem allows students to prepare a reconciliation and the entries based on the reconciliation. The chapter continues with an explanation of internal control over cash receipts and cash payments. The section covering cash receipts emphasizes over-the-counter receipts and receipts by mail. The section covering controls over cash payments emphasizes purchasing controls, approval of purchases, and petty cash payments. The chapter concludes with discussions about reporting cash on the balance sheet and ethics in accounting. Decision guidelines help establish a framework for making ethical judgments. A summary problem reviews internal control weaknesses and petty cash. Instructor s Edition Special Section Page 1 of 26 Chapter 7

Chapter 7: Teaching Outline 1) Define internal control and its objectives. a) Safeguard assets b) Encourage employees to follow company policy c) Promote operational efficiency d) Ensure accurate, reliable accounting records 2) Discuss the Sarbanes-Oxley Act (SOX). a) Effect on corporate governance b) Effect on accounting profession c) Exhibit 7-1 The Shield of Internal Control 3) Identify the components of internal control. a) Monitoring of Controls i) Internal Auditors ii) External Auditors b) Information System c) Control Procedures i) Competent, Reliable, Ethical Personnel ii) Assignment of Responsibilities iii) Risk Assessment iv) Separation of Duties - Separate operations from accounting - Separate custody of assets from accounting v) Audits vi) Documents Chapter 7 Instructor s Edition Special Section Page 2 of 26

vii) Electronic Devices viii) Other Controls d) Control Environment i) Tone at the Top e) Risk Assessment 4) Explain control concerns and procedures unique to e-commerce. a) Stolen Account Numbers and Password b) Computer Viruses and Trojans c) Phishing Expeditions d) Security Measures 5) Discuss the limitations of internal control. a) Collusion b) Costs Versus Benefits 6) Identify the bank account as a control device. a) Signature Card b) Deposit Ticket c) Check i) Exhibit 7-2 Check with Remittance Advice d) Bank Statement ii) Exhibit 7-3 Bank Statement e) Electronic Funds Transfer (EFT) 7) Demonstrate the preparation of a bank reconciliation and the adjusting entries required. a) Exhibit 7-4 Smart Touch s Cash T-account b) Exhibit 7-5 Bank Reconciliation c) Exhibit 7-6 Adjusting Entries from Bank Reconciliation d) Exhibit 7-7 Online Banking Account History (like a Bank Statement) Instructor s Edition Special Section Page 3 of 26 Chapter 7

8) Discuss the internal controls over cash receipts and cash disbursements. a) Exhibit 7-8 Cash Receipts over the Counter b) Exhibit 7-9 Cash Receipts by Mail c) Use of a lockbox for cash receipts d) Exhibit 7-10 Cash Payments by Check e) Exhibit 7-11 Payment Packet f) Exhibit 7-12 Voucher 9) Explain the use of a petty cash fund. a) Internal controls over fund b) Journal entry to set up the imprest fund c) Exhibit 7-13 Petty Cash Ticket d) Replenishing the fund Chapter 7 Instructor s Edition Special Section Page 4 of 26

Chapter 7: Summary Handout for Students 1. Internal control is designed to do the following: o Safeguard assets. o Encourage employees to follow company policy. o Promote operational efficiency. o Ensure accurate, reliable accounting records. 2. The Sarbanes-Oxley Act (SOX) was passed by Congress to promote corporate governance and to oversee the auditors of public companies. 3. Five Components of Internal Control: o Monitoring of Internal Controls Internal Auditors External Auditors o Information System o Control Procedures Competent, reliable, ethical personnel Assignment of responsibilities Separation of duties Separate operations from accounting Separate custody of assets from accounting Audits Documents Electronic devices Other controls o Control Environment o Risk Assessment 4. Concerns over internal controls for e-commerce include the following: o Stolen account numbers and passwords o Computer viruses and Trojans o Phishing expeditions o Security measures in place to address concerns over internal control include the following: Encryption Instructor s Edition Special Section Page 5 of 26 Chapter 7

Firewalls 5. Limitations of internal control are as follows: o Collusion between two or more people to circumvent internal control o Examine the costs and benefits of internal controls 6. The bank account can be used as a control over cash. o Documents include the signature card, deposit tickets, checks, electronic funds transfer (EFT), the bank statement, and the bank reconciliation. o Bank reconciliations reconcile the differences between the bank balance and the book balance: Bank side includes items not yet recorded by the bank or errors made by the bank (e.g., deposits in transit, outstanding checks) Book side includes items recorded by the bank but not yet recorded by the company (e.g., collections made by the bank on behalf of the company, service charges, interest revenue, NSF checks) Journal entries are required to record items on the book side of the reconciliation. 7. Internal controls over cash receipts and cash payments: o Cash receipts: Over the Counter use of receipts By Mail separation of duties o Cash payments: By check with proper authorizations Use of a voucher system voucher, purchase order, receiving report, invoice, copy of check 8. Use of an imprest petty cash fund for small cash payments. 9. Work sheets to print for in-class practice (bookmatch), as specified by your instructor. 10. Myaccountinglab.com homework algorithmic assignments: o E7-17; E7-19; E7-23; E7-24; P7-25A; P7-26A; P7-28A Chapter 7 Instructor s Edition Special Section Page 6 of 26

Lecture Outline Tips: Key Topics When beginning a discussion of internal control, ask students to provide examples of theft and abuse they have witnessed. Many students will have work experience, especially in some type of retail setting, and my understanding is that they are eager to provide real-world examples. These examples can then lead to a discussion of the types of controls that may have prevented or detected the examples provided. By the same token, ask students for examples of internal controls their employers have in place and match these to the controls discussed in the textbook. Point out that an internal control system may not be 100% effective. It may not prevent theft, abuse, and errors, but hopefully can detect them very quickly so corrective action can be taken. Employees can attempt to circumvent the system through collusion. A discussion of the costs versus the benefits of an internal control system as well as the requirements for public companies under the Sarbanes-Oxley Act can help students better understand the importance of a good internal control system. A bank account is an asset for the company and a liability for the bank. Some students may have trouble thinking about this from the bank s perspective. It may be helpful to provide journal entries for the company and the bank side by side for a deposit transaction to display the difference. By the same token, the bank statement is from the bank s perspective the bank account is a liability to the bank and increases with a credit and decreases with a debit. When reconciling the bank statement, errors should be adjusted by the party that made them. A bank error should be adjusted through the bank statement balance and a book error should be adjusted through the book balance. The increase or decrease of the adjustment depends on whether too much or too little was added or taken from the balance. Journal entries are required for the book balance section ONLY. These transactions have been recorded by the bank, but not the company. If journal entries are not posted, the ledger accounts will not be up to date. The company will have a reconciled bank statement but out of date account balances. The balance in petty cash does not change unless the original established amount is increased or decreased. The replenishment entry credits cash in bank, not petty cash. Cash is taken from the regular bank account and placed into the petty cash box. The petty cash account is not maintained on a perpetual basis; it is adjusted periodically when it is replenished, similar to the periodic system for inventory. Instructor s Edition Special Section Page 7 of 26 Chapter 7

ASSIGNMENT GRID Estimated Level Learning Time in of Assignment Topic(s) Objective(s) Minutes Difficulty Short Exercises S7-1 Definition of internal control 1 5 Easy S7-2 Sarbanes-Oxley Act 2 5 Easy S7-3 Characteristics of internal control 3 5 10 Easy S7-4 Pitfalls of e-commerce 4 5 Easy S7-5 Bank account controls 5 5 10 Easy S7-6 Preparing a bank reconciliation 6 10 Easy S7-7 Recording transactions from a bank reconciliation 6 5 Easy S7-8 Control over cash receipts 7 5 Easy S7-9 Control over cash receipts by mail 7 5 10 Easy S7-10 Internal control over cash payments by check 8 5 Easy S7-11 Petty cash 9 10 Easy S7-12 Making an ethical judgment 10 5 Easy Exercises E7-13 Sarbanes-Oxley Act; Identifying internal control strengths and weaknesses 1, 2, 3 10 15 Easy E7-14 Identifying internal controls 3 10 Easy E7-15 E-commerce control procedures 4 10 15 Easy E7-16 Using a bank reconciliation as a control device 5 10 Easy E7-17 Classifying bank reconciliation items 6 5 Easy E7-18 Preparing a bank reconciliation 6 10 20 Easy E7-19 Preparing a bank reconciliation 6 20 25 Easy E7-20 Evaluating internal control over cash receipts 7 10 Easy E7-21 Evaluating internal control over cash payments 8 10 Easy E7-22 Accounting for petty cash 9 10 15 Easy E7-23 Control over petty cash 9 10 Easy E7-24 Evaluating the ethics of conduct by government legislators 10 15 20 Medium Problems (Group A) P7-25A Internal control, components, procedures, and laws 1, 2, 3, 4 20 25 Easy P7-26A Correcting internal control weaknesses 3, 5, 7, 8 10 20 Easy P7-27A Preparing a bank reconciliation and journal entries 6 20 25 Medium P7-28A Preparing a bank reconciliation and journal entries 6 20 Medium P7-29A Identifying internal control weakness in cash receipts 7 10 15 Easy P7-30A Accounting for petty cash transactions 9 20 30 Easy P7-31A Accounting for petty cash transactions 9 20 30 Medium Chapter 7 Instructor s Edition Special Section Page 8 of 26

P7-32A Making an ethical judgment 10 15 30 Medium Problems (Group B) P7-33B Internal control, components, procedures, and laws 1, 2, 3, 4 20 25 Easy P7-34B Correcting internal control weaknesses 3, 5, 7, 8 10 20 Easy P7-35B Preparing a bank reconciliation and journal entries 6 20 25 Medium P7-36B Preparing a bank reconciliation and journal entries 6 20 Medium P7-37B Identifying internal control weaknesses in cash receipts 7 10 15 Easy P7-38B Accounting for petty cash transactions 9 20 30 Easy P7-39B Accounting for petty cash transactions 9 20 30 Medium P7-40B Making an ethical judgment 10 15 30 Medium Continuing Exercise E7-41 Accounting for petty cash transactions 9 10 Easy Continuing Problem P7-42 Preparing a bank reconciliation and journal entries 6 20 25 Medium Practice Set P7-43 Preparing a bank reconciliation and journalize entries 6 20 25 Medium Decision Cases Case 1 Sarbanes-Oxley Act; Internal controls 1, 2 20 30 Medium Case 2 Correcting an internal control weakness 3, 5, 8 15 30 Medium Case 3 Using the bank reconciliation to detect a theft 5, 6 20 30 Difficult Ethical Issue Financial Statement Case Internal controls and cash 1 10 20 Medium Team Project End of Chapter Exercises and Problems Available in Alternate Accounting Software Programs: Excel Templates: P7-28A; P7-30A; P7-31A QuickBooks: P7-28A; P7-30A; P7-31A Peachtree: E7-22; P7-30A; P7-31A General Ledger: E7-22; P7-30A; P7-31A Instructor s Edition Special Section Page 9 of 26 Chapter 7

Pre-Test Questions on MyAccountingLab: S7-4 (4); S7-5 (5); S7-6 (6); S7-8 (7); S7-10 (8); S7-11 (9); S7-12 (10); E7-13 (1,2,3) Post-Test Questions on MyAccountingLab: P7-33B (1, 2, 3, 4); P7-34B (3, 5, 7, 8); P7-36B (6) Answer Key to Chapter 7 Quiz 1. D 2. C 3. A 4. B 5. A 6. A 7. B 8. B 9. A Chapter 7 Instructor s Edition Special Section Page 10 of 26

Name Date Section Circle the letter of the best response. CHAPTER 7 TEN-MINUTE QUIZ 1. Which of the following is not a purpose of internal control? A. To encourage employees to follow company policy B. To promote operational efficiency C. To ensure accurate, reliable accounting records D To ensure that management makes good decisions The Data, Co., has asked you to assist in the preparation of a bank reconciliation at the end of July. Answer questions 2 4 using the following code letters to indicate how the item described would be reported on the bank reconciliation. A. Add to the bank statement balance B. Deduct from the bank statement balance C. Add to the book balance D. Deduct from the book balance E. Does not belong on the bank reconciliation 2. Note and interest collected by the bank for the company, $500 (plus $25 interest). 3. Deposit in transit, $400. 4. Check No. 662 written for $730 was incorrectly recorded by the bank as $370. 5. If a bank reconciliation includes an NSF check for $45, the journal entry to record this reconciling item would include A. a credit to Cash. B. a debit to Cash. C. a credit to Accounts receivable. D. No entry is required. 6. All of the following are procedures that should be followed for cash received by mail except: A. All incoming mail should be opened by a high-level, trusted employee. B. The debit to the Cash account should match the bank deposit. C. The controller should compare the day s cash receipts to the bank deposit. D. The remittance advices are sent to the accounting department. Instructor s Edition Special Section Page 11 of 26 Chapter 7

7. All of the following are internal controls over cash payments except: A. All payments should be made by check. A. Before payment is made, it should first be authorized by the treasurer. C. The invoice should be compared with a copy of the purchase order and receiving report. D. Small payments should be made from a petty cash fund. 8. A petty cash fund has been established for $200. A count of the petty cash fund at the end of the month reveals that there is $44 in the fund and petty cash tickets for the following amounts: Postage expense $ 75 Office supplies 42 Delivery expense 39 The journal entry to replenish the petty cash fund would be which of the following: A. Petty cash 156 Cash 156 B. Office supplies 42 Delivery expense 39 Postage expense 75 Cash 156 C. Cash 160 Petty cash 160 D. Cash 44 Petty cash 44 9. Decisions for ethical judgments should include all of the following steps except to A. determine the facts. B. assess the possible outcomes. C. identify the economic consequences. D. identify the ethical issues. Chapter 7 Instructor s Edition Special Section Page 12 of 26

Reference Document 7-1 SARBANES-OXLEY Sarbanes-Oxley was important legislation with which students should be familiar. This document provides supplemental information to assess the ramifications of inappropriate behavior. Sarbanes-Oxley Act (SOX) There have been serious consequences to the stakeholders as a result of the Enron (and other) corporate financial misstatements. The company s outside auditor, Arthur Andersen closed its doors. Executives lost their high paying positions. Enron employees suffered serious financial consequences to their retirement accounts, largely containing Enron stock. Congress passed legislation increasing the penalties to management for misstating financial results and financial condition. Instructor s Edition Special Section Page 13 of 26 Chapter 7

Reference Document 7-2 ETHICS Since ethics is such a hot topic, we should have some more realistic situations to present to students so that they can practice the ethical decision guidelines. Ethical Decision Guidelines: Let us use the guidelines on page 404 to respond to the following two situations. I) A fellow student who you have become friendly with has asked you to help him cheat on the second exam. He failed the first exam and needs to pass the class with at least a C so he can graduate next semester. You like him, but as an A student, you are worried about getting caught. 1. Identify the ethical issue: Decide whether you should help your peer cheat. 2. Specify the alternatives: Either go along with what he wants or refuse. 3. Assess the possible outcomes: If I help him cheat and do not get caught, he will like me more because he will get a better grade. Then I will be happy that he can graduate on time and it will be done. If I help him cheat and he gets a better grade, he may ask me to help him cheat again. Each time I do this I am at risk of getting caught. If I refuse, he might be mad and not like me anymore. I might feel guilty if he does not pass the course. We might get caught. We would both get zeroes for this exam and might even be dismissed from the class or college. It would ruin my average, reputation, and the chance of getting a recommendation from faculty. I would be embarrassed and mad at myself. 4. Make the decision: What DO you do? It is a personal choice. II) You work as a cashier at a liquor store. Your friend tells you that she will be shopping there and wants you to forget to ring up the case of beer that she will have on the bottom of the cart. 1. Identify the ethical issue: Decide whether you should ring up the purchase or not. 2. Specify the alternatives: Either go along with what she wants or refuse. 3. Assess the possible outcomes: If I forget to ring up the beer and no one notices, she will like me. If I help her get away with this, she may ask me to do it again and again. If I refuse, she might be mad and not like me anymore. I will miss her. We might get caught. I could get fired from this job. I like the job and my co-workers and I need the money for college. We might both be arrested. My family and I would be upset and embarrassed. 4. Make the decision: What DO you do? It is a personal choice. Chapter 7 Instructor s Edition Special Section Page 14 of 26

Think About It What if the student in situation (I) offered to pay you $100 for your help? Would that affect your answer to step 4? What if you needed the extra money to pay this month s rent? What if your child needed formula and diapers, and you did not have the money or a credit card? Would that alter your decision? Ask students to suggest other ethical dilemmas and go through the four step decision process together with them. Instructor s Edition Special Section Page 15 of 26 Chapter 7