Internal Control and Managing Cash Chapter 4

Set up an effective system of internal control.

Internal Control
It is the organizational plan and all the related measures that an entity adopts. Encourage Adherence to company policies. Safeguard assets. Ensure Accurate and reliable accounting records. Promote operational efficiency.

Components of an Effective System

Competent, reliable, and ethical personnel Assignment of responsibilities Authorization Recording Custody Separation of duties

Separation of Duties

Separation of the Authorization of transactions from the Recording of transactions from the Custody of assets

Internal and External Audits

An audit is an examination by an outside party of the companys financial statements, accounting systems, and internal controls. An internal auditor is an employee of the business. An external auditor is an independent auditor.

Documents and Records

Business documents and records include: invoices (bills) paid checks accounting journals accounting ledgers

Electronic and Computer Controls

Businesses use electronic devices to safeguard assets.

The Onion Model of E-Commerce System Security

Encryption Firewalls Intrusion detection devices Incident response procedures Audits by external specialists Sensitive Hardware, Software, and Data

Encryption
It is the transformation of data by a mathematical process into a form that is unreadable by anyone who does not have the secret decryption key.
Same key

Clear message Encryption

Encoded message Decryption

Clear message

Firewall
It is a technique that limits access to hardware, software, or data to persons within a network.

Inquirers Inquirers Customers Customers Hackers Firewall 1 Firewall 2 Firewall 3 Customers

Other Controls

Fireproof vaults Burglar alarms Point of sale terminals Frequent bank deposits Mandatory vacations Job rotation

The Limitations of Internal Control

Systems designed to thwart one persons fraud can be beaten by two or more employees working together colluding to defraud the firm. A system of internal control that is too complex can be inefficient.

Use a bank reconciliation as a control device.

The Bank Reconciliation

There are two records of a businesss cash: the companys cash account on its own books, and the bank statement, which shows the actual amount of cash in the bank.

The Bank Reconciliation

Two common items that cause differences between the bank balance and the book balance. 1. Items recorded by the company but not yet recorded by the bank: Deposits in transit Outstanding checks

The Bank Reconciliation

2. Items on a bank statement and not recorded by the business: Bank collections Electronic funds transfers Service charge Interest revenue earned on account NSF checks Errors

Bank Reconciliation Illustrated

The bank statement of Business Research, Inc., shows a balance of $5,931.51 on January 31. The company Cash account on the books has a balance of $3,294.21. The following reconciling items explain why the two balances differ:

The Bank Reconciliation Illustrated

1. The January 30 deposit of $1,591.63 does not appear on the bank statement. 2. The bank erroneously charged to the account a $100 check (No. 656) not written by Business Research Associates. 3. Five company checks issued late in January and recorded in the journal have not been paid by the bank.

The Bank Reconciliation Illustrated

Check No. 337 338 339 340 341 Total Date Jan. 27 28 28 29 30 Amount $ 286.00 319.47 83.00 203.14 458.53 $1,350.14

The Bank Reconciliation Illustrated

4. The bank received $904.03 by EFT on behalf of Business Research, Inc. 5. The bank collected on behalf of the company a note receivable, $2,114 (including interest revenue of $214). 6. The bank statement shows interest revenue of $28.01.

The Bank Reconciliation Illustrated

7. Check number 333 for $150 paid to Brown Company on account was recorded as a cash payment of $510. 8. The bank service charge for the month was $14.25. 9. The bank statement shows an NSF check for $52. 10. Business Research pays insurance expense by EFT and has not recorded this $361 payment.

The Bank Reconciliation Illustrated

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

The Bank Reconciliation Illustrated

Balance per books, January 31 Add: ETF receipt of rent revenue Collection of note receivable Interest revenue earned Correction of book error Less: Service charge NSF check Payment of insurance expense Adjusted book balance $ 14.25 52.00 361.00 $3,294.21 904.03 2,114.00 28.01 360.00 $6,700.25

427.25 $6,273.00

Apply internal controls to cash receipts and cash payments.

Controlling and Managing Cash

Internal control over cash receipts ensures that all cash receipts are deposited in the bank and no collections are lost.

Over the Counter Receipts

The point-of-sale terminal (cash register) offers control over the cash received in a store.

Mail Receipts
All incoming mail should be opened by a mailroom employee. This person should compare the check received with the remittance advice. The mailroom clerk keeps a running total of cash receipts for the day.

Mail Receipts
Many companies use a lock-box system. Customers send checks directly to an address that is essentially a bank account.

Internal Controls Over Cash Receipts

Element of Internal Control Competent, reliable, ethical personnel Proper authorization Internal Controls over Cash Receipts Carefully screen and train employees. Only designated employees can grant exceptions for customers.

Internal Controls Over Cash Receipts

Separation of duties Internal and external audits Electronic and computer controls Employees who handle cash do not have access to accounting records. Internal: management policies External: control over cash receipts Match receipts with remittances and bank deposit ticket daily.

Internal Control: Payments Purchasing Process

Business Document Purchase request (requisition) Purchase order Invoice (bill) Receiving report Disbursement packet Prepared by Sales department Purchasing department Supplier Receiving department Accounting department Sent to Purchasing department Supplier Accounting department Accounting department Officer who signs the check

Internal Control: Payments Disbursement Packet

Purchase Request Purchase Order Receiving Report Invoice

Disbursement

Packet

Internal Controls Over Cash Payments

Element of Internal Control Competent, reliable, ethical personnel Proper authorization Internal Controls over Cash Payments Payments entrusted to high level employees and the treasurer. Large expenditures must be authorized by top management.

Internal Controls Over Cash Payments

Separation of duties Internal and external audits Electronic and computer controls Employees who handle checks have no access to accounting records. Internal: management policies External: control over cash payments Computer programmers do not operate the computers.

Use a budget to manage cash.

Using a Budget to Manage Cash

A budget is a financial plan that helps coordinate business activities. A cash budget helps a company, or an individual, manage cash by planning the receipt and payment of cash during a future period.

Cash Budget Example

Cash Budget For the Year Ended January 31, 20x3 1. Cash balance, February1, 20x2 Estimated cash receipts: 2. Collections from customers 3. Interest and dividends on investments 4. Sale of store fixtures Estimated cash payments: 5. Purchases of inventory $1,906.2 6. Operating expenses 561.0 7. Expansion of existing stores 206.4 8. Opening of new stores 344.6 9. Payment of long-term debt 148.7 10. Payment of dividends 219.0 11. Net cash position at January 31, 20x3 12. Budgeted / Desired cash balance, January 31, 20x3 13. Additional cash needed to meet desired 1/31/x3 balance (In millions) $ 202.6 2,858.3 6.2 4.9 $3,072.0

3,385.9 (111.3) 200.0 $ 311.3

Reporting Cash on the Balance Sheet

Companies usually combine all cash amounts into a single total called Cash and Cash Equivalents on the balance sheet. Cash equivalents include liquid assets Time deposits Certificates of deposit

Reporting Cash on the Balance Sheet

America Online, Inc. Consolidated Balance Sheet December 31 Excerpts
(In Millions) 2000

Assets Current assets: Cash and cash equivalents Short-term investments Accounts receivable

$2,610 886 464

Weigh ethical judgment in business.

Ethics and Accounting

Most large companies have a code of ethics designed to encourage ethical and responsible behavior by employees. Accountants have additional incentives to behave ethically. AICPA Code of Professional Conduct Standards of Ethical Conduct for Management Accountants

Ethics and Accounting

Conflict of Interest

Enron Corporation A. Fastow, CEO

Business transactions

Outside Partnership A. Fastow, Principal

End of Chapter 4