Appendix: Internal Controls

7 • Appendix: Internal Controls

1 • Explain the importance of internal control.

Importance Of Internal Control • Good internal control helps ensure: • Reliable and timely records • Asset management and protection • Rules and procedures followed by employees • Accurate reporting of information

Importance Of Internal Control • Sarbanes-Oxley Act (SOX) • Applies to all publicly held companies • Requires annual reporting on the effectiveness of internal control over financial reporting • Has resulted in many non-publicly held companies evaluating their internal control quality

2 • Define internal control and describe its key components.

Internal Control • A system developed by a company to provide reasonable assurance of achieving: • Effective and efficient operations • Reliable financial reporting • Compliance with laws and regulations

Key Components Of Internal Control • The most widely accepted framework in the U.S. contains five components: • Control environment • Risk assessment • Control activities • Information and communication system • Monitoring processes

Key Components Of Internal Control • CONTROL ENVIRONMENT • Includes: • The organization structure • Management’s philosophy and operating style • Integrity and ethical values • Commitment to competent, trustworthy employees

Key Components Of Internal Control • RISK ASSESSMENT • The process for identifying, analyzing, and responding to business risks • Examples of internal business risks: • Errors • Fraud • Obsolete inventory • High employee turnover

Key Components Of Internal Control • CONTROL ACTIVITIES • Policies and procedures established to help management meet its control objectives • Four types of control activities: • Segregation of duties • Authorization procedures and related responsibilities • Adequate documents and records • Protection of assets and records

Segregation Of Duties • Different employees should be responsible for different parts of a transaction • Provides a built-in check by one employee on another • Employees who account for transactions should not also have custody of the assets • One employee cannot obtain goods for personal use without being caught by another employee

Authorization Procedures And Related Responsibilities • Every business activity should be properly authorized • It should be possible to identify who is responsible for every activity that has occurred

Adequate Documents And Records • All business transactions should be supported by a document that is: • Prenumbered • Used in sequence • Subsequently accounted for • In this way, the business can be sure that it has made a record of each transaction

Protection Of Assets And Records • Assets generally need physical protection • Examples: • Vaults for cash, securities, etc. • Secure storage rooms for inventory • Records need both physical and logical protection • Examples: • Secure storage of journals, ledgers, and key documents • Password protection of data files and processing programs

Key Components Of Internal Control • INFORMATION AND COMMUNICATION SYSTEM • Set of procedures, processes, and records established to: • Initiate, process, record, and report business transactions • Accounts for the related assets and liabilities • Includes journals and ledgers

Key Components Of Internal Control • MONITORING PROCESSES • Methods used by management to determine that controls are operating properly • Example of ongoing process: • Comparisons of financial results with expectations • Example of separate process: • Tests of internal control procedures by internal auditors

3 • Describe selected internal controls over cash receipts.

Internal Controls For Cash Receipts • TO PROTECT CASH RECEIVED DIRECTLY: • The use of a cash register or terminal with a printed receipt is essential • Only authorized employees should operate registers • The registers generate internal record of all transactions • Cash and register records are reconciled • Differences are investigated • Cash receipts should be deposited daily • The total deposited and the total cash receipts according to the register should be reconciled and any differences investigated Securing cash is one of the most important goals of internal controls.

Internal Controls For Cash Receipts • MAIN PURPOSES OF INTERNAL CONTROLS: • To make sure: • All cash received by the business is recorded in the accounts • The cash is promptly deposited in the business bank account One purpose is concerned with the accounting records and the other is concerned with physical control of the cash.

Internal Controls For Cash Receipts • TO PROTECT CASH/CHECKS RECEIVED ON ACCOUNT: • The mail room should be supervised • Employees handling the cash/check should have no access to the accounting records • A remittance list should be prepared when mail is opened • The list shows all amounts received and from whom • The list is sent to the accounting department for use in recording collections

Internal Controls For Cash Receipts • Employees who handle the cash/checks should not have access to the accounting system, and those who have access to the accounting system should not have access to the cash/checks.

Internal Controls For Cash Receipts • TO PROTECT CASH/CHECKS RECEIVED ON ACCOUNT (continued): • Checks should be immediately endorsed “For deposit” to the business bank account • Cash/checks are sent to the cash receipts department to deposit in the business bank account • The totals of the remittance list and the amount of the bank deposit should be independently verified and any differences investigated

Internal Controls For Cash Receipts • TO SAFEGUARD ALL CASH/CHECKS RECEIVED: • An independent bank reconciliation should be done monthly • Any differences should be investigated

Internal Controls For Cash • GOALS OF MANAGEMENT: • Maintain enough cash to meet current obligations • Failure to have enough cash available can result in bankruptcy • Ensure cash is not idle • Extra cash should “work” for the company by earning through investment

4 • Describe selected internal controls over cash payments and the use of a voucher system.

Voucher System • A voucher system is a control technique requiring that every acquisition and subsequent payment be supported by an approved voucher • A voucher is a document that shows an acquisition is proper and that payment is authorized

The Purchasing Process USER DEPTS. Purchase Requisition Authorized person prepares requisition

The Purchasing Process USER DEPTS. PURCH. DEPT. Purchase Requisition Purchase Order • Purchasing department: • Reviews and approves the purchase requisition • Prepares a purchase order to send to the supplier

The Purchasing Process USER DEPTS. PURCH. DEPT. RECEIVING DEPT. Purchase Requisition Purchase Order Receiving Report When the goods are received, a receiving report is prepared

The Purchasing Process USER DEPTS. ACCTG. DEPT. PURCH. DEPT. RECEIVING DEPT. Purchase Requisition Purchase Order Receiving Report A copy of the purchase requisition, purchase order, and receiving report is sent to the vouchers payable section in the accounting department

The Purchasing Process USER DEPTS. ACCTG. DEPT. PURCH. DEPT. MAIL-ROOM RECEIVING DEPT. Purchase Requisition Purchase Order Purchase Invoice Receiving Report The supplier sends the purchase invoice, which is received by the mailroom and sent to the accounting department.

The Purchasing Process USER DEPTS. ACCTG. DEPT. PURCH. DEPT. MAIL-ROOM RECEIVING DEPT. Purchase Requisition Purchase Order Purchase Invoice Receiving Report • The accounting department reviews the purchase invoice to determine if it is: • For the goods ordered • At the correct price • For the correct quantity If any aspect of the purchase is improper, it will be caught when the voucher is prepared.

The Purchasing Process USER DEPTS. ACCTG. DEPT. PURCH. DEPT. MAIL-ROOM RECEIVING DEPT. Purchase Requisition Purchase Order Voucher Purchase Invoice Receiving Report The accounting department prepares a voucher, which is the basis for paying the invoice on the due date NO payment may be made without an approved voucher.

The Purchasing Process USER DEPTS. ACCTG. DEPT. PURCH. DEPT. MAIL-ROOM RECEIVING DEPT. Purchase Requisition Purchase Order Voucher Purchase Invoice Receiving Report Enter in Voucher Register The voucher is entered into the voucher register (a special journal).

The Purchasing Process USER DEPTS. ACCTG. DEPT. PURCH. DEPT. MAIL-ROOM RECEIVING DEPT. Purchase Requisition Purchase Order Voucher Purchase Invoice Receiving Report Enter in Voucher Register The voucher is filed by the due date. Unpaid Voucher File

Voucher System • Incorporates three of the four elements of internal control: • Duties are segregated • Different employees order, receive, and record the purchases • Authorization • Required to order the goods and to prepare the voucher • Documents and Records • Every purchase is supported by a voucher, purchase invoice, receiving report, purchase order, and purchase requisition

Voucher System—Payment Process Cashier Vouchers Payable Unpaid Vouchers File Voucher (with Supporting Documents) Step #1 Pull Voucher and Supporting Documents; Send to Cashier.

Voucher System—Payment Process Cashier Vouchers Payable Unpaid Vouchers File Voucher Voucher (with Supporting Documents) Check Step #2 Review Voucher and Documents; Prepare and Sign Check.

Voucher System—Payment Process Cashier Vouchers Payable Unpaid Vouchers File Voucher Voucher (with Supporting Documents) Check Supplier Step #3 Send Check to Supplier.

Voucher System—Payment Process Cashier Vouchers Payable Unpaid Vouchers File Voucher Voucher (with Supporting Documents) Check Supplier Cancel Voucher and Supporting Documents Step #4 Cancel Voucher and Documents.

Voucher System—Payment Process Cashier Vouchers Payable Unpaid Vouchers File Voucher Voucher (with Supporting Documents) Check Supplier Step #5 Return Voucher and Documents to Vouchers Payable; Record Payment in Voucher Register. Enter in Voucher Register Cancel Voucher and Supporting Documents

Voucher System—Payment Process Cashier Vouchers Payable Unpaid Vouchers File Voucher Voucher (with Supporting Documents) Check Supplier Step #6 File Voucher And Documents in Paid Vouchers File. Enter in Voucher Register Cancel Voucher and Supporting Documents Paid Vouchers File

Voucher System—Payment Process Cashier Vouchers Payable Unpaid Vouchers File Voucher Voucher (with Supporting Documents) Check Supplier Step #7 Record Payment in Check Register. Enter in Voucher Register Cancel Voucher and Supporting Documents Enter in Check Register Paid Vouchers File

Appendix: Internal Controls