Chapter

Internal Control and Cash

Chapter 8-1

Accounting Principles, Ninth Edition

Study Objectives
1. Define internal control. 2. Identify the principles of internal control.

3. Explain the applications of internal control principles to cash receipts.

4. Explain the applications of internal control principles to cash disbursements. 5. Describe the operation of a petty cash fund. 6. Indicate the control features of a bank account.

7. Prepare a bank reconciliation.

8. Explain the reporting of cash.
Chapter 8-2

Internal Control and Cash

Internal Control

Cash Controls

Control Features: Use of a Bank

Making deposits

Reporting Cash

Internal control

Principles of internal control

Limitations

Cash receipts controls Cash disbursements controls

Cash equivalents

Writing checks
Bank statements Reconciling the bank account Electronic funds transfer (EFT) system

Restricted cash
Compensating balances

Chapter 8-3

Internal Control
Internal Control
Methods and measures adopted to:
1. Safeguard assets. 2. Enhance accuracy and reliability of accounting records. 3. Increase efficiency of operations, and 4. Ensure compliance with laws and regulations.

Chapter 8-4

SO 1 Define internal control.

Internal Control
Internal Control
Internal control systems have five primary components

1.
2. 3. 4. 5.
Chapter 8-5

A control environment
Integrity values and unethical activity Risk factors to business Through policies and procedures Risk assessment Control activities Information and communication

Through internal control system

Periodically
SO 1 Define internal control.

Monitoring

Fraud and Internal Control

Principles of Internal Control Activities
Measures vary with
managements assessment of the risks faced. size and nature of the company.
Six principles of controls activities:

1. 2. 3. 4. 5. 6.
Chapter 8-6

Establishment of responsibility Segregation of duties Documentation procedures Physical controls Independent internal verification Human resource controls
SO 2 Identify the principles of internal control.

Fraud and Internal Control

Principles of Internal Control Activities
1. ESTABLISHMENT OF RESPONSIBILITY Control is most effective when only one person is responsible for a given task (e.g.: employees passcodes). 2. SEGREGATON OF DUTIES Related duties, including physical custody and record keeping, should be assigned to different individuals. 3. DOCUMENTATION PROCEDURES Companies should use prenumbered documents for all documents should be accounted for.
Chapter 8-7

SO 2 Identify the principles of internal control.

Fraud and Internal Control

Principles of Internal Control Activities
3. PHYSICAL CONTROLS
Illustration 8-2

Chapter 8-8

SO 2 Identify the principles of internal control.

Fraud and Internal Control

Principles of Internal Control Activities
4. INDEPENDENT INTERNAL VERIFICATION 1. Verify records periodically or on a surprise basis. 2. Records verified by an employee who is independent.
3. Discrepancies and
Illustration 8-3

exceptions reported to management.

SO 2 Identify the principles of internal control.

Chapter 8-9

Fraud and Internal Control

Principles of Internal Control Activities
5.HUMAN RESOURCE CONTROLS 1. Bond employees who handle cash (obtain insurance

protection against theft by employees).

2. Rotate employees duties and require vacations. 3. Conduct background checks.

Chapter 8-10

SO 2 Identify the principles of internal control.

Fraud and Internal Control

Limitations of Internal Control
1.

Costs should not exceed benefit.

Costs of establishing control procedures should not exceed their expected benefits
2.

Human element. A good system can become ineffective through employee fatigue, carelessness, or indifference. Collusion may result - two or more individuals work together to get around prescribed controls may significantly impair the effectiveness of a system.

3.

Size of the business. E.g.: Small business find it difficult to segregate duties or to provide for independent internal verification

Chapter 8-11

SO 2 Identify the principles of internal control.

Cash Controls
Cash Receipts Controls
Establishment of Responsibility Only designated personnel are authorized to handle cash receipts (cashiers) Segregation of Duties Different individuals receive cash, record cash receipts, and hold the cash
Illustration 8-4 Chapter 8-12

Documentation Procedures Use remittance advice (mail receipts), cash register tapes, and deposit slips Physical, Mechanical, and Electronic Controls

Independent Internal Verification Supervisors count cash receipts daily; treasurer compares total receipts to bank deposits daily Human Resource Controls Bond personnel who handle cash; require employees to take vacations; deposit all cash in bank daily

Store cash in safes and bank vaults; limit access to storage areas; use cash registers

SO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls Cash Receipts

Cash consists of coins, currency, checks, money orders, and money on hand or on deposit in a bank. Cash receipts come from: cash sales

collections on account from customers

receipt of interest, rent, and dividends investments by owners

bank loans
proceeds from the sale of noncurrent assets
Chapter 8-13

SO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls Cash Receipts

Control Procedures:

Only designated personnel should be authorized to handle or have access to cash receipts.
Different individuals should:

1. receive cash
2. record cash receipt transactions

3. have custody of cash

Chapter 8-14

SO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls Cash Receipts

Documents should include: 1. 2. 3. Remittance advices Cash register tapes Deposit slips

Cash should be stored in safes and bank vaults Access to storage areas should be limited to authorized personnel Cash registers should be used in executing over-thecounter receipts

Chapter 8-15

SO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls Cash Receipts

Daily cash counts and daily comparisons of total receipts. All personnel who handle cash receipts should be bonded and required to take vacations. Control of over-the-counter receipts is centered on cash registers that are visible to customers.

Chapter 8-16

SO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls Cash Receipts

Chapter 8-17

SO 3 Explain the applications of internal control principles to cash receipts.

Over-theCounter Receipts

Illustration 8-4

Chapter 8-18

SO 3 Explain the applications of internal control principles to cash receipts.

Mail Receipts
Control Procedures:
Mail receipts should be opened by two people, a list prepared, and each check endorsed.
Copy of the list, along with the checks and remittance advices, sent to cashiers department. Cashier adds the checks to the over-the-counter receipts and prepares a daily cash summary and makes the daily bank deposit. Copy of list sent to treasurers office for comparison with total shown on daily cash summary.
Chapter 8-19

SO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls Cash Disbursement

Cash Disbursements Controls
Generally, internal control over cash disbursements is more effective when companies pay by check, rather than by cash.

Applications:
1. 2.

Voucher system

Petty cash fund

Chapter 8-20

SO 4 Explain the applications of internal control principles to cash disbursements.

Cash Controls Cash Disbursement

Cash Disbursements Controls
Only specified individuals should be authorized to sign checks. Different departments or individuals should be assigned the duties of approving an item for payment and paying it. Prenumbered checks should be used and each check should be supported by an approved invoice or other document.
Chapter 8-21

SO 4 Explain the applications of internal control principles to cash disbursements.

Cash Controls Cash Disbursement

Cash Disbursements Controls Blank checks should be stored in a safe. 1. Access should be restricted to authorized personnel. 2. A check writer machine should be used to imprint the amount on the check in indelible ink.
Chapter 8-22

SO 4 Explain the applications of internal control principles to cash disbursements.

Cash Controls Cash Disbursement

Cash Disbursements Controls
Each check should be compared with the approved invoice before it is issued. Following payment, the approved invoice should be stamped PAID.

Chapter 8-23

SO 4 Explain the applications of internal control principles to cash disbursements.

Cash Controls Cash Disbursement

Chapter 8-24

SO 4 Explain the applications of internal control principles to cash disbursements.

Cash Controls Cash Disbursement

Cash Disbursements Controls
Establishment of Responsibility Only designated personnel are authorized to sign checks (treasurer) and approve vendors
Segregation of Duties Different individuals approve and make payments; check signers do not record disbursements
Chapter 8-25 Illustration 8-6

Documentation Procedures Use prenumbered checks; checks must have an approved invoice; require employees to use corporate credit cards for reimbursable expenses Physical Controls

Independent Internal Verification Compare checks to invoices; reconcile bank statement monthly
Human Resource Controls Bond personnel who handle cash; require employees to take vacations; conduct background checks

Store blank checks in safes, with limited access; print check amounts by machine in indelible ink

Cash Controls Cash Disbursement

Cash Disbursements Controls
Voucher System
Network of approvals, by authorized individuals, to ensure all disbursements by check are proper. A voucher is an authorization form prepared for each expenditure.
Vouchers are recorded in a journal called the voucher register.
Chapter 8-26

SO 4 Explain the applications of internal control principles to cash disbursements.

Review
Match each of the following principles of internal control with the Appropriate description below. A. Establishment of responsibility B. Segregation of duties C. Documentation procedures D. Physical, mechanical, and electronic controls E. Independent internal verification F. Other controls _____ 1.Involves the review, comparison, and reconciliation of data prepared by other employees. _____ 2.Provide evidence that transactions and events have occurred. _____ 3.Includes the authorization and approval of transactions. _____ 4.Rotating employees' duties and requiring employees to take vacations. _____ 5.Related activities should be assigned to different individuals. _____ 6.Using garment sensors to deter theft.
Chapter 8-27

Review Solutions
1. 2. E C 3. 4. A F 5. 6. B D

Chapter 8-28

Cash Controls Cash Disbursement

Petty Cash Fund - Used to pay small amounts.
Involves:
1. establishing the fund, 2. making payments from the fund, and

3. replenishing the fund.

Replenishing the petty cash fund means the petty cash custodian requests and receives cash from the companys regular checking account in order to have the cash on hand equal to the amount reported in the general ledger account, Petty Cash. http://blog.accountingcoach.com/replenish-petty-cash/
Chapter 8-29

SO 5 Describe the operation of a petty cash fund.

Petty Cash vs. Cash

Petty Cash Petty cash is a small amount of discretionary funds in the form of cash used for expenditures where it is not sensible to make any disbursement by check, because of the inconvenience and costs of writing, signing and then cashing the check. People use them when they want to use it other than a cheque because cheques have a surcharge attached, so petty cash vouchers can be used for small office needs.
http://en.wikipedia.org/wiki/Petty_cash
Chapter 8-30

Cash Cash refers to money in the physical form of currency, such as banknotes and coins. In bookkeeping and finance, "cash" refers to current assets comprising currency or currency equivalents that can be accessed immediately or nearimmediately (as in the case of money market accounts). Cash is seen either as a reserve for payments, in case of a structural or incidental negative cash flow or as a way to avoid a downturn on financial markets.
http://en.wikipedia.org/wiki/Cash

SO 5 Describe the operation of a petty cash fund.

Cash Controls Cash Disbursement

Cash Disbursements Controls
Petty Cash Fund

Accounting entries are required when:

1. The fund is established 2. The fund is replenished 3. The amount of the fund is changed

Chapter 8-31

SO 5 Describe the operation of a petty cash fund.

Cash Controls Cash Disbursement

Established Fund

Two essential steps in establishing a petty cash fund are:

1.

appointing a petty cash custodian who will be responsible for the fund, and determining the size of the fund.

2.

Chapter 8-32

SO 5 Describe the operation of a petty cash fund.

Cash Controls Cash Disbursement

Illustration: If Laird Company decides to establish a $100 fund on March 1, the journal entry is: Mar. 1 Petty cash Cash 100 100

Chapter 8-33

SO 5 Describe the operation of a petty cash fund.

Cash Controls Cash Disbursement

Replenishing Fund

When the money in the petty cash fund reaches a minimum level, the fund is replenished.
The request for reimbursement is initiated by the petty cash custodian. The petty cash custodian prepares a schedule of the payments that have been made and sends the schedule, with supporting documentation, to the treasurers office.

Chapter 8-34

SO 5 Describe the operation of a petty cash fund.

Cash Controls Cash Disbursement

Illustration: Assume that on March 15 Lairds petty cash custodian requests a check for $87. The fund contains $13 cash and petty cash receipts for postage $44, freight-out $38, and miscellaneous expenses $5. The general journal entry to record the check is:

Mar. 15

Postage expense
Freight-out Miscellaneous expense Cash

44
38 5 87

Chapter 8-35

SO 5 Describe the operation of a petty cash fund.

Cash Controls Cash Disbursement

Illustration: Occasionally, the company may need to recognize a cash shortage or overage. Assume that Lairds petty cash custodian has only $12 in cash in the fund plus the receipts as listed. The request for reimbursement would, therefore, be for $88, and Laird would make the following entry:

Mar. 15

Postage expense
Freight-out Miscellaneous expense Cash over and short Cash

44
38 5 1 88

Chapter 8-36

SO 5 Describe the operation of a petty cash fund.

Review
The petty cash fund of $200 for Walsh Company appeared as Follows on December 31, 2005: Cash $95.60 Petty cash vouchers Freight in $19.40 Postage 40.00 Balloons for a special occasion 18.00 Meals 25.00 Instructions 1. Briefly describe when the petty cash fund should be replenished. Because there is cash on hand, is there a need to replenish the fund at year end on December 31? Explain. 2. Prepare in general journal form the entry to replenish the fund. 3. On December 31, the office manager gives instructions to increase the petty cash fund by $100. Make the appropriate journal entry.
Chapter 8-37

Review Solutions
1. Petty cash should be replenished on a periodic basis or when the cash is low. It must be replenished on the balance sheet date so that the expenses represented by the petty cash vouchers can be recorded in the proper accounting period. 2. Freight-in Postage Expense Miscellaneous Expense Meals Expense Cash Over and Short Cash 3. Petty Cash Cash
Chapter 8-38

19.40 40.00 18.00 25.00 2.00 100.00

104.40
100.00

Review
On October 1, 2005, Foster Company establishes an *imprest petty cash fund by issuing a check for $150 to Jill Nott, the custodian of the petty cash fund. On October 31, 2005, Jill Nott submitted the following paid petty cash receipts for replenishment of the petty cash fund when there is $7 cash in the fund: Freight-in Office Supplies Expense Entertainment of Clients Postage Expense $25 35 60 20

Instructions Prepare the journal entries required to establish the petty cash fund on October 1 and the replenishment of the fund on October 31.
Chapter 8-39

Review Solutions
Oct. 1 Petty Cash 150 Cash (To establish a petty cash fund) 150

31

Cash Over and Short 3 Freight-in 25 Office Supplies Expense 35 Entertainment Expense 60 Postage Expense 20 Cash 143 (To record expenses for October and to replenish the petty cash fund)

Chapter 8-40

Review
Imprest system on petty cash

Imprest system is a form of financial accounting system. The most common imprest system is the petty cash system. The base characteristic of an imprest system is that a fixed amount is reserved, which will be replenished at the end of a period or when the circumstances request it. This replenishment is not credited on the imprest account, but from another source. When a sufficient amount is used, the imprest account will never be credited again. As such, it can be seen as a permanent debt.

Chapter 8-41

Review

Petty cash imprest system allows only to replenish the spending. So, if you start the month with 100 in your petty cash float and spend 90 of that cash in the month, an amount of 90 will be then placed in your petty cash float to bring the balance of your petty cash float back to 100. The replenishment is credited to the primary cash account and the debits will go to the respective expense accounts, based on the petty cash receipts.

Source: http://en.wikipedia.org/wiki/Imprest_system

Chapter 8-42

Control Features: Use of a Bank

Contributes to good internal control over cash.
Minimizes the amount of currency on hand.
Creates a double record of bank transactions. Bank reconciliation.

Chapter 8-43

SO 6 Indicate the control features of a bank account.

Control Features: Use of a Bank

A check is a written order signed by the depositor directing the bank to pay a specified sum of money to a designated recipient.

Three parties to a check are:

1. 2. 3.
Chapter 8-44

Maker (drawer) issues the check Bank (payer) on which check is drawn Payee to whom check is payable
SO 6 Indicate the control features of a bank account.

Control Features: Use of a Bank

Making Bank Deposits
Authorized employee should make deposit.
Illustration 8-8

Bank Code Numbers

Front Side
Chapter 8-45

Reverse Side
SO 6 Indicate the control features of a bank account.

Control Features: Use of a Bank

Writing Checks
Illustration 8-9

Written order signed by depositor directing bank to pay a specified sum of money to a designated recipient.
Maker Payee Payer

Chapter 8-46

SO 6 Indicate the control features of a bank account.

Control Features: Use of a Bank

Bank Statement shows:

Checks paid and other debits charged against the account

Deposits and other credits made to the account Account balance after each days transactions

Chapter 8-47

SO 6 Indicate the control features of a bank account.

Control Features: Use of a Bank

Memorandum:

Bank debit memorandum

Indicate charges against the depositors account. Example: ATM service charges

Bank credit memorandum

Indicate amounts that will increase the depositors account. Example: interest income on account balance

Chapter 8-48

SO 6 Indicate the control features of a bank account.

Control Features: Use of a Bank

Bank Statements
Debit Memorandum
Bank service charge NSF (not sufficient funds)
Illustration 8-10

Credit Memorandum
Collect notes receivable.

Interest earned.
Chapter 8-49

SO 6 Indicate the control features of a bank account.

Control Features: Use of a Bank

Reconciliation

Necessary as the balance per bank and balance per books are seldom in agreement due to time lags and errors.
Bank Reconciliation Should be prepared by an employee who has no other responsibilities pertaining to cash.

Chapter 8-50

SO 7 Prepare a bank reconciliation.

Control Features: Use of a Bank

Reconciling the Bank Account
Reconcile balance per books and balance per bank to their adjusted (corrected) cash balances.
Reconciling Items:
1. Deposits in transit.
2. Outstanding checks. 3. Errors. 4. Bank memoranda.
Chapter 8-51

SO 7 Prepare a bank reconciliation.

Control Features: Use of a Bank

Reconciliation Procedures
Illustration 8-11

+ Deposit in Transit Outstanding Checks

+ Notes collected by bank NSF (bounced) checks Check printing or other service charges

+- Bank Errors

+- Company Errors CORRECT BALANCE

Chapter 8-52

CORRECT BALANCE
SO 7 Prepare a bank reconciliation.

Control Features: Use of a Bank

Chapter 8-53

SO 4 Explain the applications of internal control principles to cash disbursements.

Control Features: Use of a Bank

Illustration: The bank statement for Laird Company (Illustration 8-10), shows a balance per bank of $15,907.45 on April 30, 2010. On this date the balance of cash per books is $11,589.45. Using the four reconciliation steps, Laird determines the following reconciling items.

Chapter 8-54

Control Features: Use of a Bank

Illustration: a) Prepare a bank reconciliation at April 30.
Cash balance per bank statement Add: Deposit in transit Less: Outstanding checks Adjusted cash balance per bank Cash balance per books Add: Error in recording check no. 443 Collection of notes + interest - fee $15,907.45 2,201.40 (5,904.00) $12,204.85 $11,589.45 36.00 1,035.00

Less:

NSF check
Bank service charge

(425.60)
(30.00) $12,204.85
SO 7 Prepare a bank reconciliation.

Adjusted cash balance per books

Chapter 8-55 Illustration 8-12

Control Features: Use of a Bank

The company records each reconciling item used to determine the adjusted cash balance per books. Collection of Note Receivable: Assuming interest of $50 has not been accrued and collection fee is charged to Miscellaneous Expense, the entry is:

Apr. 30

Cash
Miscellaneous expense Notes receivable Interest revenue

1,035.00
15.00 1,000.00 50.00

Chapter 8-56

SO 5 Describe the operation of a petty cash fund.

Control Features: Use of a Bank

Book Error: The cash disbursements journal shows that check no. 443 was a payment on account to Andrea Company, a supplier. The correcting entry is: Apr. 30 Cash Accounts payable 36.00 36.00

Chapter 8-57

SO 5 Describe the operation of a petty cash fund.

Control Features: Use of a Bank

NSF Check: As indicated earlier, an NSF check becomes an account receivable to the depositor. The entry is: Apr. 30 Accounts receivable 425.60

Cash

425.60

Bank Service Charges: Depositors debit check printing charges (DM) and other bank service charges (SC) to Miscellaneous Expense. The entry is:

Apr. 30
Chapter 8-58

Miscellaneous
Cash

30.00
30.00

SO 5 Describe the operation of a petty cash fund.

Review
Using the code letters below, indicate how each of the items listed would be handled in preparing a bank reconciliation. Code A B C D E Items:

Add to cash balance per books Deduct from cash balance per books Add to cash balance per bank Deduct from cash balance per bank Does not affect the bank reconciliation 1. 2. 3.
4. 5. 6. 7. 8. 9. 10.

Chapter 8-59

Outstanding checks. Bank service charge. Check for $320 correctly written and paid by the bank but incorrectly entered in the cash payments journal for $230. Deposit in transit. Bank returns deposited check marked NSF. Bank collects notes receivable and interest for depositor. Bank debit memorandum for check printing fees. Petty cash custodian has $86 in paid petty cash vouchers that have not been reimbursed. Bank charged a check against the company which should have been charged to another company. A check for $236 was correctly paid by the bank but was incorrectly entered in the cash payments journal for $263.

Review Solutions
1. 2. 3. 4. 5. D B B C B 6. 7. 8. 9. 10. A B E C A

Chapter 8-60

Review
Milner Boat Company's bank statement for the month of September showed a balance per bank of $7,000. The company's Cash account in the general ledger had a balance of $5,459 at September 30. Other information is as follows: (1) Cash receipts for September 30 recorded on the company's books were $5,200 but this amount does not appear on the bank statement. (2) The bank statement shows a debit memorandum for $40 for check printing charges. (3) Check No. 119 payable to Kohl Company was recorded in the cash payments journal and cleared the bank for $248. A review of the accounts payable subsidiary ledger shows a $36 credit balance in the account of Kohl Company and that the payment to them should have been for $284. (4) The total amount of checks still outstanding at September 30 amounted to $6,000. (5) Check No. 138 was correctly written and paid by the bank for $409. The cash payment journal reflects an entry for Check No. 138 as a debit to Accounts Payable and a credit to Cash in Bank for $490. (6) The bank returned an NSF check from a customer for $560. (7) The bank included a credit memorandum for $1,260 which represents collection of a customer's note by the bank for the company; principal amount of the note was $1,200 and interest was $60. Interest has not been accrued. Instructions (a) Prepare a bank reconciliation for Milner Boat Company at September 30. (b) Prepare any adjusting entries necessary as a result of the bank reconciliation.
Chapter 8-61

Review Solutions
(a) MILNER BOAT COMPANY Bank Reconciliation September 30 $ 7,000 5,200 12,200 6,000 $ 6,200 $ 5,459 $ 81 1,260 40 560 $ 6,200 1,341 6,800 600

Cash balance per bank Add: (1) Deposit in transit Less: (4) Outstanding checks Adjusted cash balance per books Cash balance per books Add: (5) Accounts Payable Error (7) Collect $1,200 note and interest $60 Less: (2) Check printing (6) NSF Check Adjusted cash balance per books Note: Item (3) is not a reconciling item.
Chapter 8-62

Review Solutions
(b) Sept. 30 Cash Accounts Payable 81 (To correct error in recording Check No. 138) Cash Notes Receivable 1,200 Interest Revenue 60 (To record collection of note receivable and interest by the bank) Miscellaneous Expense 40 Cash (To record check printing charges) Accounts Receivable Cash (To record NSF check) 560 40 1,260 81

30

30

30

560

Chapter 8-63

Control Features: Use of a Bank

Electronic Funds Transfers (EFT)
Disbursement systems that uses wire, telephone, or computers to transfer cash balances between locations. EFT transfers normally result in better internal control since no cash or checks are handled by company employees.

Chapter 8-64

SO 7 Prepare a bank reconciliation.

Reporting Cash
Cash consists of coins, currency (paper money), checks, money orders, and money on hand or on deposit in a bank or similar depository.
Illustration 8-14

Cash equivalents Restricted cash Compensating balances

Chapter 8-65

SO 8 Explain the reporting of cash.