978-1133939283 Chapter 8 Lecture Note

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Chapter 8

Cash and Internal Control

Learning Objectives

1. Describe the components of internal control, control activities, and limitations on internal

control.

2. Apply internal control activities to common merchandising transactions.

3. Dene cash equivalents, and explain methods of controlling cash, including bank

reconciliations.

4. Demonstrate the use of a simple imprest (petty cash) system.

5. Identify the internal control roles of management and the auditor.

Section 1: Concepts

Concept

 Faithful representation

Lecture Outline

I. The two objectives of a good system of internal control are to ensure

A. The reliability of accounting records and nancial statements.

B. That the company’s assets are protected.

II. The need for internal controls

A. Use inventory to illustrate the need for internal controls.

B. Physical inventory

1. A physical inventory must be taken in both the periodic and the perpetual

inventory systems.

2. Inventory includes all salable goods owned by the business, regardless of

location.

3. Choice of scal year is in/uenced by the need to take a physical inventory.

4. Technology has an impact on the taking of a physical inventory.

C. Inventory losses result from theft and spoilage and are included in cost of goods

sold; these losses are easier to track under the perpetual system than under the

periodic system.

IIII. Internal control has ve components:

A. Control environment

B. Risk assessment

C. Control activities

D. Information and communication

C. Monitoring

or posted to a publicly accessible website, in whole or in part.

Chapter 8: Cash and Internal Control Instructor’s Manual, p. 2

IV. Control activities include the following:

A. Requiring authorization for all transactions

B. Recording all transactions

C. Using well-designed documents

D. Implementing physical controls, as over the accounting records

E. Establishing a system of independent periodic checks of records and assets

F. Separating duties

G. Using sound personnel procedures

1. Bonding is a valuable control procedure.

V. At least three factors can contribute to the weakening of a system of internal control:

A. Human error

B. Collusion

C. Changing conditions

Summary

Internal control is a process designed by a company to establish the reliability of the

accounting records and nancial statements in accordance with generally accepted

accounting principles (GAAP) and to insure that the company’s assets are protected.

Management must assess its needs for internal controls, establish its responsibility for them,

and engage auditors of them, if required.

Management must establish systems, procedures, and an environment (collectively known

as internal controls) designed to protect its principal assets, such as cash, accounts

receivable, and merchandise inventory. A physical inventory, which is a manual count of

all merchandise on hand, facilitates the maintenance of control over merchandising

inventory. It must be taken under both the perpetual and the periodic inventory systems.

The count is usually taken after the close of business on the last day of the scal year. The

physical count gure is then multiplied by a derived cost-per-unit gure to arrive at the cost

of ending inventory.

The merchandise inventory reported on the balance sheet includes all salable goods owned by

the company, regardless of where the goods are located. Goods in transit to which a company

has acquired title are included in ending inventory, whereas goods that the company has

formally sold are not included, even if the company has not yet delivered them. To simplify

inventory taking, many companies end their scal year during a slow season and make use

of current technology such as bar coding.

Most companies experience loss of inventory due to spoilage, employee pilferage, and

shoplifting. Under the periodic system, these losses are buried in cost of goods sold. In the

perpetual system, the amount of loss can be identied by comparing the perpetual

inventory records to the physical count. The di@erence between these two amounts,

assuming no recordkeeping errors, is the loss and is recorded as a debit to the Cost of Goods

Sold account and a credit to the Merchandise Inventory account.

Management must establish the following ve interrelated components of internal control:

the control environment, risk assessment, control activities, information and communication,

and monitoring.

1. The control environment re/ects management’s philosophy and operating style, the

company’s organizational structure, methods of assigning authority and responsibility,

and personnel policies and practices.

2. Risk assessment entails identifying areas in which risk of asset loss or inaccuracy in

accounting records is especially high.

or posted to a publicly accessible website, in whole or in part.

Chapter 8: Cash and Internal Control Instructor’s Manual, p. 3

3. Control activities are the specic procedures and policies established by

management to ensure that the objectives of internal control are met.

4. Information and communication relates to the accounting system established by

management and to the need for clear communication of each individual’s

responsibility within that system.

3. Monitoring involves management’s regular assessment of the quality of internal

control.

Management must establish control activities to ensure the safeguarding of assets and the

reliability of the accounting records. Examples of control activities are (1) requiring authorization

for all transactions; (2) recording all transactions; (3) using well-designed documents; (4)

implementing physical controls, as over the accounting records; (5) establishing a system of

periodic independent veri”cation of records and assets; (6) separating duties; and (7)

using sound personnel practices. Bonding an employee (an example of a sound personnel

practice) reduces or eliminates the risk of theft by that individual against the company.

To be e@ective, a system of internal control must rely on the people who implement it. Thus,

the e@ectiveness of internal control is limited by the people involved. Human error,

collusion, and changing conditions can all weaken a system of internal control.

Teaching Strategy

Students are interested in anecdotes that illustrate the e@ectiveness of internal control.

They have often had experience in work settings in which there was a lack of control. Ask for

examples of experiences students have had in organizations in which controls were in place.

Allow discussion and storytelling. This brings the topic of internal control to a human level.

Case 1 is a good introduction case for this topic.

Internal accounting controls should be introduced as an important consideration of any

accounting system.

Internal control is one of the few topics in accounting where there is an allowance for human

frailty. Although this is a short segment of the text, students seem to enjoy a discussion of

both human error and collusion. This discussion reinforces the idea of internal control

through a focus on its limitations. As an alternative, it may help to describe a prepared case,

asking students to identify problems in internal control in the situation described.

The specic terminology used in the text is important. Terminology should be memorized.

Case 2 (Starbucks) provides an excellent real-world learning application for students.

Section 2: Accounting Applications

Accounting Applications

 Account for merchandising transactions

 Implement control of cash

 Prepare a bank reconciliation

 Use petty cash

Lecture Outline

I. Internal control activities help prevent theft and fraud and promote accuracy in cash

records.

or posted to a publicly accessible website, in whole or in part.

Chapter 8: Cash and Internal Control Instructor’s Manual, p. 4

IV. Internal controls also help management by

A. Keeping enough inventory on hand to sell to customers without overstocking

merchandise

B. Keeping suDcient cash on hand to pay for purchases in time to receive discounts

C. Keeping credit losses as low as possible by making credit sales only to customers

who are likely to pay on time

V. Control of cash

A. Administrative controls such as a cash budget help maintain adequate inventory

and cash levels and minimize credit losses.

B. Generally, the following are necessary for good control of cash:

1. Separate the functions of authorization, recordkeeping, and custodianship of

cash.

2. Limit the number of people who have access to cash, and designate who

those people are.

3. Bond all employees who have access to cash.

4. Keep the amount of cash on hand to a minimum by using banking facilities as

much as possible.

5. Physically protect cash on hand by using cash registers, cashiers’ cages, and

safes.

6. Record and deposit all cash receipts promptly, and make payments by check

rather than by currency.

7. Have a person who does not handle or record cash make unannounced audits

of the cash on hand.

8. Have a person who does not authorize, handle, or record cash transactions

reconcile the Cash account each month.

IVI. Control of cash receipts

A. Two or more persons should handle cash received by mail.

B. Cash received over the counter should be controlled with cash registers and

prenumbered sales tickets.

V. The following documents should be used when making a purchase:

A. Purchase requisition

B. Purchase order

C. Invoice

D. Receiving report

E. Check authorization

F. Check

G. Bank statement

VI. Cash equivalents (e.g., CDs, U.S. Treasury notes) are any security with a term of 90

days or less in which idle cash is invested.

VVII. Cash control methods

A. Cash on hand should be kept in a fund, such as a petty cash fund, operated on an

imprest system.

B. Funds may be transferred from one account to another without writing checks

using electronic funds transfer.

or posted to a publicly accessible website, in whole or in part.

Chapter 8: Cash and Internal Control Instructor’s Manual, p. 5

VIII. Explain why a bank reconciliation is necessary

A. Transactions possibly in company’s records only:

1. Outstanding checks

2. Deposits in transit

B. Transactions possibly in bank’s records only:

1. Service charge (SC)

2. NSF checks

3. Miscellaneous charges and credits

4. Interest income

C. Transactions that were on bank records only need to be journalized after

reconciliation.

IX. Discuss the mechanics of a petty cash fund as well as the internal control that should

be exercised over it.

X. Journalize the establishment of a petty cash fund.

XVIII. Journalize the replenishment of a petty cash fund, using Cash Short or Over if

necessary.

Summary

Accounting controls over merchandising transactions help prevent losses from theft or fraud.

They also help ensure accurate records of cash receipts, cash disbursements, and cash

balances. Administrative controls over merchandising transactions serve to maintain

appropriate inventory levels; to ensure that there is enough cash on hand to pay debts when

due and, through timely payments, to take advantage of purchases discounts; to avoid

credit losses; and to earn a reasonable return on excess cash.

Several controls can be used to achieve e@ective internal control over sales and the

exchange of cash. One is the cash budget, which allows management to better predict

future cash receipts and disbursements. Another is the separation of duties that involve the

handling of cash; many safeguards can be implemented to prevent an individual from

stealing or misusing cash.

Two or more employees should handle cash received by mail. Cash received from sales over

the counter should be controlled through the use of cash registers and prenumbered sales

tickets. At the end of each day, Cash is debited for cash receipts, and Sales is credited for

the amount on the cash register tape. If the two amounts do not agree, any di@erences must

be explained.

All cash disbursements for purchases should be made by check. Before employees disburse

cash, they should obtain authorization in the form of signed documents. The system of

authorization and the documents used di@er among companies. The most common

documents are described below.

1. A purchase requisition is a formal request for a purchase that a department submits

to the purchasing department.

2. The purchasing department completes a purchase order and sends it to the vendor.

3. An invoice is the bill that the vendor sends to the buyer.

4. A receiving report, completed by the receiving department, contains information

about the quantity and condition of goods received.

5. A check authorization is a document showing that the purchase order, invoice, and

receiving report are in agreement and that payment is therefore approved.

or posted to a publicly accessible website, in whole or in part.

Chapter 8: Cash and Internal Control Instructor’s Manual, p. 6

6. When payment is approved, a check is issued to the vendor for the amount of the

invoice, less any appropriate discount. A remittance advice should be attached to the

check, describing what the check is for.

7. When the vendor deposits the check, then the canceled check appears on the bank

statement. If the check amount is incorrect or has been altered, it will show up there.

Cash equivalents are combined with cash on most companies’ balance sheets. Cash

equivalents comprise bank certicates of deposit, U.S. government securities, and any

other security with a term of 90 days or less in which a company temporarily has invested

idle cash.

Most companies keep coins and currency on hand for cash registers, to cover certain

expenses, or to advance cash to sales representatives for travel expenses and other such

daily services. One way to control a cash fund or cash advances is through an imprest

system. A common form of this system is a petty cash fund, which is established at a xed

amount; all expenditures are documented, and the fund periodically is restored to its original

balance.

Control over cash can be improved with electronic funds transfer (EFT). In this system,

funds are transferred directly from one company’s bank account to another company’s bank

account.

Banks provide a variety of services to their customers, as well as convenient means for

conducting their banking transactions. In recent years, the use of automated teller machines

(ATMs), banking by phone, and debit cards have become commonplace. When a purchase is

made with a debit card, the purchase amount is deducted directly from the customer’s bank

account and deposited in the business’s bank account.

Certain transactions shown in a company’s records may not have been recorded by a bank,

and certain bank transactions may not appear in a company’s records. A bank

reconciliation is the process of accounting for the di@erences between the balance that

appears on the bank statement and the balance of Cash according to the company’s

records.

Examples of transactions that may be in the company’s records but not recorded in the

bank’s records include:

7. Outstanding checks

8. Deposits in transit

Examples of transactions that may appear on the bank statement but might not have been

recorded by the company include:

1. Service charges (SC)

2. NSF (nonsu/cient funds) checks

3. Miscellaneous charges and credits

4. Interest income

Although it is good practice for a company to pay for everything by check, an exception

should be made for items of small value. When paying for postage, shipping charges, and

small purchases of items like pens and paper, many rms use a petty cash fund. One of

the best ways of controlling a petty cash fund is through an imprest system. Under this

system, a petty cash fund is established for a xed amount. When payment is made from

the fund, the fund’s custodian prepares a petty cash voucher showing the date, amount,

and purpose of the expenditure. The person who receives payment signs the voucher. The

petty cash fund is replenished periodically and at the end of an accounting period. At those

or posted to a publicly accessible website, in whole or in part.

Chapter 8: Cash and Internal Control Instructor’s Manual, p. 7

times, all the expenses since the last replenishment are debited and Cash is credited.

Discrepancies are recorded as Cash Short or Over.

The following journal entries are introduced in this section:

Petty Cash XX (amount established)

Cash XX (amount established)

To establish the petty cash fund

Postage Expense XX (amount incurred)

Supplies Expense XX (amount purchased)

Freight-In XX (amount incurred)

Cash Short or Over XX (amount short)

Cash XX (amount replenished)

To replenish the petty cash fund

Relevant Examples and Exhibits

 Exhibit 1 Internal Controls in a Large Company: Separation of Duties and

Documentation

 Exhibit 2 Internal Control Plan for Purchases and Cash Disbursements

 Exhibit 3 Bank Reconciliation

 Exhibit 4 Petty Cash Voucher

 Exhibit 5 Reconciliation of Cash Is an Important Factor in Internal Control

Teaching Strategy

Point out which assets are most vulnerable to theft or fraud. Detail in presenting this topic

gives students an inside look at why businesses do what they do to protect themselves from

theft and fraud by employees as well as by outsiders. Refer to safety measures taken to

protect inventory and cash.

Exhibits 1 and 2 are useful in clarifying the material in the text. Students should familiarize

themselves with these illustrations. Short Exercises 5 and 7 and Exercises 3A and 4A are

good reviews of this subject matter.

Distinguish between cash and cash equivalents.

Discuss a petty cash system and explain how it works. Ask students what their experience

has been with petty cash. This is a good place to tie in internal controls as they relate to

petty cash.

Relate to students’ personal experience with checking accounts by asking the following

questions:

3. How many of you have a checking account?

4. How many of you reconcile your account each month?

5. What problems do you have reconciling the account?

6. Why is reconciling the account important?

Short Exercises 8 and 9 and Exercises 6A and 7A apply concepts from this section.

Although this is a simple topic to dene, students have a diDcult time understanding an

imprest system. To clarify how a petty cash fund is reimbursed, start at the beginning by

demonstrating how a petty cash fund is established. Continue the demonstration to

replenishment. (It may be helpful to have preprinted petty cash vouchers as handouts.)

or posted to a publicly accessible website, in whole or in part.

Chapter 8: Cash and Internal Control Instructor’s Manual, p. 8

Point out that the Petty Cash account is debited or credited only to re/ect changes in the

size of the fund. Demonstrate the use of Cash Short or Over in the context of maintaining

the fund.

Short Exercise 10, Exercises 8A and 9A, and Problem 5 apply these concepts.

Section 3: Business Applications

Business Applications

 Management’s responsibility

 Independent auditor’s audit

Lecture Outline

I. Management’s responsibility for internal control

A. Responsibility applies to management of all companies, large and small.

B. The Sarbanes-Oxley Act of 2002 (SOX) applies to all public companies.

C. SOX requires certication of internal controls by the CEO, CFO, and auditor.

Summary

In all companies, management is responsible for establishing an adequate system of internal

controls. For public companies, the Sarbanes-Oxley Act of 2002 requires that the chief

executive, the chief nancial oDcer, and the auditors of the company certify the company’s

system of internal controls.

Teaching Strategy

Reiterate management’s responsibility for internal control and discuss the auditors’

requirement to assess the internal control environment of the corporation.

Student Engagement Tactics

1. This research activity can be done individually or in teams of three. If teams are used,

each member of the team can visit a di@erent business, and the information gathered

can be pooled in the nal report.

2. Go over the activity in class (Case 3) to make sure students understand what is

required. The brieng should include the following:

a. The type of business to be visited

b. The professional behavior expected of students during the visit

c. The nature of the data to be gathered

d. The form of the report

or posted to a publicly accessible website, in whole or in part.

Chapter 8: Cash and Internal Control Instructor’s Manual, p. 9

3. This activity can be turned into a class research project. If it is, tabulate in class the

data gathered by the groups (e.g., the percentage of the businesses that use

computers to take a physical inventory and the frequency with which they take

inventory).

4. An alternative for this activity is to have the groups compile the tables and reproduce

them for the class.

or posted to a publicly accessible website, in whole or in part.