Internal Control and Managing Cash

Internal Control and Managing Cash Chapter 4

Learning Objective 1 Set up an effective system of internal control.

Internal Control Organizational plan and all related measures that an entity adopts • Safeguard assets from theft or loss • Encourage adherence to company policies • Promote operational efficiency • Ensure accurate and reliable accounting records

Components of anEffective System • Competent, reliable, and ethical personnel • Assignment of responsibilities • Proper authorization of transactions • Separation of duties • Operations or authorization of transactions • Custody of assets • Data entry function for those transactions

Audit • Examination of company’s financial statements, accounting systems, and internal controls, by an objective party • Internal auditors • employees of the company • An aspect of the company’s internal controls • External auditors • Independent of the company • Issue audit reports on the company’s financial statements for benefit of investors and creditors

Limitations of Internal Control • Collusion - two or more employees, whose duties should be segregated, working together to defraud the firm • All systems of internal control have “inherent limitations:” • Management can always override controls, as management establishes and is above many system controls • Breakdowns can occur due to mistakes, carelessness, fatigue • No system of controls can be perfect in an imperfect world! • A system of internal control that is too complex can hurt efficiency and control • Frequently small businesses have control deficiencies. Why?

Learning Objective 2 The bank reconciliation as a control device.

The Bank Reconciliation Items that cause differences between bank balance and book balance • Items recorded by the company but not yet recorded by the bank: • Deposits in transit • Outstanding checks

The Bank Reconciliation Items that cause differences between bank balance and book balance • Items on a bank statement, but not yet recorded by the business: • Bank collections on behalf of the company, e.g. a note receivable • Electronic funds transfers (EFT’s) for • payments of cash by the company • collections of cash on behalf of the company • Service charges • Interest revenue earned on account • NSF checks • Errors made by the company or the bank. Examples: • The bank charges someone else’s check to the company’s account • The company writes a check for $420, but makes a journal entry for $240

There Is a Reciprocal Relationship between the Bank’s Records and the Company’s Records • When the company receives cash: • The company debitscash on their books • However, the bank credits the company’s account on the bank’s books • This is because the bank has a liability to the company in the amount of the cash balance held at the bank

There Is a Reciprocal Relationship between the Bank’s Records and the Company’s Records (con.) • When the company issues a check: • The company credits cash on their books • However, the bank debits (charges) the company’s account on the bank’s books • This is because the bank’s liability to the company is reduced by disbursing the check amount to the payee

Bank Reconciliation Illustration Business Research, Inc., shows a balance on its bank statement of $5,931.51 on January 31. The company Cash account has a balance of $3,294.21. • The January 30 deposit of $1,591.63 does not appear on the bank statement. • The bank erroneously charged (debited) to the account a $100 check (No. 656) written by a similarly named company, Business Research Associates.

The Bank Reconciliation Illustrated • Five company checks, totaling $1,350.14, issued late in January and recorded in the journal have not been paid by the bank. • The bank received $904.03 by EFT on behalf of Business Research, Inc. • The bank collected on behalf of the company a note receivable, $2,114 (including interest revenue of $214). • The bank statement shows interest revenue of $28.01.

The Bank Reconciliation Illustrated • Check number 333 for $150 paid to Brown Company on account was recorded as a cash payment of $510, a transposition error. • The bank service charge for the month was $14.25. • The bank statement shows an NSF check for $52. • Business Research pays insurance expense by EFT and has not recorded this $361 payment.

The Bank Reconciliation Illustrated Balance per bank, January 31 $5,931.51 Add deposit in transit 1,591.63 Check erroneously charged 100.00 $7,623.14 Less outstanding checks (1,350.14) Adjusted bank balance $6,273.00

The Bank Reconciliation Illustrated Balance per books, January 31 $3,294.21 Add: ETF receipt of rent revenue 904.03 Collection of note receivable 2,114.00 Interest revenue earned 28.01 Correction of error: check no. 333 360.00 $6,700.25 Less: Service charge $ 14.25 NSF check 52.00 Payment of insurance expense 361.00 ( 427.25) Adjusted book balance $6,273.00

Note That the Adjusted Bank Balance and Book Balance Must Be Equal in Amount in a Proper Reconciliation

Learning Objective 3 Apply internal controls to cash receipts and cash payments.

Basic Cash Controls Concepts • Essential to segregate cash recording and custody functions! • Persons having data entry functions for disbursement or receipt of cash should not have access to physical cash (e.g. write checks or handle checks received in mail) • Persons having custody of physical cash should not make entries to the books for cash • The Merrill Lynch employee described in the chapter had both cash custody and data entry functions, causing the embezzlement • The bank account should always be reconciled by persons with no cash recording or custody functions, e.g. the business owner or other competent employee

Basic Cash Controls Concepts (con.) • Smart small business owners will want to: • Insist on signing checks after preparation by an employee, or Quick Books, etc. [This controls cash disbursements effectively.] • Compare total of daily cash collected (as prepared by the mail opener) to validated deposit slip from the bank [This is a good control over cash collections.] • Prepare, or at least carefully review, the bank reconciliation

Imprest Petty Cash Fund A small amount of cash kept on hand to pay for minor expenses.

Learning Objective 4 Use a budget to manage cash.

Using a Budget to Manage Cash • A financial plan that helps coordinate business activities • Cash budget - helps an entity manage cash by planning receipt and payment of cash during a future period

Using a Budget to Manage Cash Cash balance, beginning + Budgeted (expected) cash receipts - Budgeted (expected) cash payments Expected cash balance, ending If the expected cash balance is < budgeted (necessary) cash balance, the company will need to seek additional financing

Reporting Cash onthe Balance Sheet • Companies usually combine all cash amount into single total called “Cash and Cash Equivalents” on the balance sheet. • Cash equivalents include liquid assets • Time deposits • Certificates of deposit • Restricted cash pledged as collateral should be reported separately from cash, as shown on the Merrill Lynch excerpted balance sheet (pg. 192 in your text) • It’s not really available to the company for daily use

Learning Objective 5 Weigh ethical judgment in business.

Ethics and Accounting • Larger companies often have written codes of ethical and responsible behavior by employees • Smaller companies will have less formal means of conveying ethical values • In either case, management must establish the proper “tone at the top” • AICPA Code of Professional Conduct • Standards of Ethical Conduct for Management Accountants and Institute of Internal auditors

Internal Control and Managing Cash