I. Internal Control A. Purpose of Internal Control A properly designed internal control system is a key part of system design, analysis, and performance. Internal controls do not provide guarantees, but they lower the company s risk of loss. B. Internal control system consists all policies and procedures managers use to: 1. Protect assets. 2. Ensure reliable accounting. 3. Promote efficient operations. 4. Urge adherence to company policies. C. Sarbanes-Oxley Act (SOX) requires manager and auditors of public companies to document and certify that company s system of internal controls. Section 404 requires that managers document and assess the effectiveness of all internal control processes that can impact financial reporting. D. Principles of Internal Control Certain fundamental internal control principles apply to all companies. Internal control procedures increase the reliability and accuracy of accounting records. The principles of internal control are to: 1. Establish responsibilities. 2. Maintain adequate records. 3. Insure assets and bond key employees. 4. Separate recordkeeping from custody of assets. 5. Divide responsibility for related transactions. 6. Apply technological controls. 7. Perform regular and independent reviews. E. Technology and Internal Control Technology provides rapid access to large quantities of data. Examples of technological impacts on internal control: 1. Reduced processing errors. 2 More extensive testing of records. 3. Limited evidence of processing. 4. Crucial separation of duties. 5. Increased E-Commerce. 6-3
F. Limitations of Internal Control 1. Internal control policies and procedures are applied by people; the human element creates several potential limitations: a. Human error resulting from negligence, fatigue, misjudgment, or confusion. II. b. Human fraud involves intent by people to defeat internal controls, such as management override, for personal gain. 2. Cost-benefit principle the costs of internal controls must not exceed their benefits. Control of Cash Basic guidelines for control of cash include: handling of cash must be separate from recordkeeping of cash, cash receipts are promptly deposited in a bank, and disbursements of cash are made by check. A. Cash, Cash Equivalents, and Liquidity 1. Liquidity refers to a company s ability to pay for its near-term obligations. Cash and similar assets are called liquid assets because they can be readily used to settle such obligations. 2. Cash includes currency and coins, deposits in bank and checking accounts, many savings accounts, and items that are acceptable for deposit in those accounts. 3. Cash equivalents are short-term, highly liquid investment assets meeting two criteria. (Note: only investments purchased within three months of their maturity dates usually satisfy these criteria.) a. Readily convertible to a known cash amount. b. Sufficiently close to their maturity date so that their market value is not sensitive to interest rate changes. B. Cash management 1. Companies must plan both cash receipts and cash payments. The goals of cash management are to plan cash receipts to meet cash payments when due and to keep the minimum level of cash necessary to operate. 2. Effective cash management involves the following principles: a. Encourage collection of receivables. b. Delay payment of liabilities. c. Keep only necessary levels of assets. d. Plan expenditures. e. Invest excess cash. 6-4
B. Control of Cash Receipts Internal control of cash receipts ensures that cash is properly recorded and deposited. 1. Over-the-counter cash receipts: a. Record on a cash register at time of sale. b. Separate custody from recordkeeping. 2. Cash Over and Short - sometimes errors in making change are discovered from differences between the cash in a cash register and the record of the amount of cash receipts. a. Record any petty cash shortages/overages in the Cash Over and Short account. b. Entry to record cash sales with an overage: debit Cash, credit Cash Over and Short, credit Sales. c. Entry to record cash sales with a shortage: debit Cash, debit Cash Over and Short, credit Sales. d. Report balance of cash over and short account, an income statement account; as part of miscellaneous expenses if it has a debit balance or as part of miscellaneous revenues if it has a credit balance. 3. Cash receipts by mail: a. Preferably, two people should open the mail and prepare a list of cash received; copies should be sent to cashier, recordkeeper in accounting area, and clerks who open mail. b. The cashier deposits the money in a bank. c. The recordkeeper records the amounts received in the accounting records. d. Bank account should be reconciled by another person (see below). D. Control of Cash Disbursements To safeguard against theft require all expenditures be made by check (except for small payments made from petty cash fund) and deny access to the accounting records to anyone, other than the owner, who has authority to sign checks. 6-5
1. A voucher system is a set of procedures and approvals designed to control cash disbursements and the acceptance of obligations. The voucher system includes procedures for: a. Verifying, approving, and recording obligations for eventual cash disbursements. b. Issuing checks for payment of verified, approved, and recorded obligations. c. Key factors in a voucher system: i. Only approved departments and individuals are authorized to incur such obligations. ii. Several business documents (purchase requisition, purchase order, invoice, receiving report, and check) are accumulated in a voucher, which is an internal document (or file) used to accumulate information to control cash disbursements. III. 2. Use a petty cash system of control as follows: a. Write and cash a check to establish petty cash fund. Entry to record establishment: debit Petty Cash, credit Cash. b. A petty cash fund is used to pay for small items such as postage, courier fees, minor repairs, and low-cost supplies. c. Assign a petty cashier (custodian) to account for the amounts expended and keep receipts. d. Entry to record reimbursement: debit the related expense and/or asset accounts for the amounts paid for with petty cash, credit Cash for the amount reimbursed to the petty cash fund. e. Sometimes, the petty cash payments reported plus the cash remaining will not total to the fund balance. i. A shortage is recorded as an expense in the reimbursing entry with a debit to the Cash Over and Short account. ii. An overage is recorded with a credit to the Cash Over and Short account in the reimbursing entry. Banking Activities as Controls A. Basic Bank Services Bank accounts permit depositing money for safeguarding and help control withdrawals. 1. A bank account is a record set up by a bank for a customer. To limit access, all persons authorized to write checks, documents instructing the bank to pay a specified amount of money to a designated recipient, sign a signature card. Each bank deposit is supported by a deposit ticket. 2. Electronic Funds Transfer (EFT) is the electronic communication transfer of cash from one party to another. 6-6
B. Bank Statement Once a month, the bank sends each depositor a bank statement showing activities in the bank account. C. Bank Reconciliation 1. A bank reconciliation is a report explaining any differences between the checking account balance according to the depositor s records and the balance reported on the bank statement. 2. The balance reported on the bank statement rarely equals the balance in the depositor s accounting records; this is usually due to information that one party has that the other does not. Factors causing the bank statement balance to differ from the depositor's book balance are: a. Outstanding checks. b. Deposits in transit. c. Deductions for uncollectible items and for services d. Additions for collections and for interest. e. Errors. 3. Steps in preparing the bank reconciliation: a. Identify the bank statement balance of the cash account (balance per bank). b. Identify and list any unrecorded deposits and any bank errors understating the bank balance. Add them to the bank balance. c. Identify and list any outstanding checks and any bank errors overstating the bank balance. Deduct them from the bank balance. d. Compute the adjusted bank balance, also called corrected or reconciled balance. e. Identify the company's balance of the cash account (balance per book). f. Identify and list any unrecorded credit memoranda from the bank, interest earned, and errors understating the book balance. Add them to the book balance. g. Identify and list any unrecorded debit memoranda from the bank, service charges, and errors overstating the book balance. Deduct them from the book balance. h. Compute the adjusted book balance, also called corrected or reconciled balance. i. Verify the two adjusted balances from steps d and h are equal. If so, they are reconciled. If not, check for mathematical accuracy and missing data to achieve reconciliation. 6-7
4. A bank reconciliation often identifies unrecorded items that need recording. Only the items reconciling the book balance require adjustment. a. All reconciling additions to book balance are debits to cash. Credit depends on reason for addition. b. All reconciling subtractions from book balance are credits to cash. Debit depends on reason for subtraction. D. Global View 1. Internal Control Purposes, Principles and Procedures both GAAP and IFRS aim for high quality reporting. The purposes and principles of internal control systems are fundamentally the same across the globe. 2. Control of Cash Accounting definitions for cash are similar for GAAP and IFRS and the basic techniques explained in this chapter are part of those control procedures. IV. 3. Banking Activities as Controls Companies utilize banking services as part of their effective control procedures and bank statements are used along with bank reconciliations to control and monitor cash. Decision Analysis Days' Sales Uncollected A. One measure of the receivables nearness to cash is the days sales uncollected ratio (also called days' sales in receivables). B. It is calculated by dividing accounts receivable by net sales and multiplying the result by 365. C. It is used to estimate how much time is likely to pass before the current amount of accounts receivable is received in cash. V. Documentation and Verification (Appendix 6A) A. Purchase Requisition 6-8
B. Purchase Order C. Invoice D. Receiving Report E. Invoice Approval F. Voucher VI. Controls of Purchase Discounts (Appendix 6B) It is very important for a company to take advantage of purchases discounts. a. Recording inventory purchases using net method provides more control than the gross method, which was described in Chapter 4. b. The gross method of recording purchases initially records the invoice at its gross amount ignoring any cash discount. c. The net method records the invoice at its net amount of any cash discount. The net method gives management an advantage in controlling and monitoring cash payments involving purchase discounts. Any discounts not taken advantage of are recorded in a Discounts Lost expense account. Entries to record the: 1. Purchase of inventory on credit: debit Merchandise Inventory, credit Accounts Payable (for the amount of the invoice net of the discount). 2. Payment of the invoice within the discount period: debit Accounts Payable, credit Cash (for the amount of the invoice net of the discount). 3. Payment of the invoice after the discount period has expired: a. As of the date corresponding to the end of the discount period: debit Discounts Lost, credit Accounts Payable (for the amount of the discount). b. As of the date of payment: debit Accounts Payable, credit Cash for amount of the payment, gross invoice amount. 6-9
VISUAL #6-1 BANK RECONCILIATION Reasons for differences between bank statement and checkbook balance: Unrecorded deposits Outstanding checks Bank service charges Debit memos Credit memos NSF checks Interest Errors Handle as follows: Add to Bank Balance Deduct from Bank Balance Deduct from Book Balance Deduct from Book Balance Add to Book Balance Deduct from Book Balance Add to Book Balance Must analyze individually (bank errors affect bank balance and book errors affect book balance) 6-10