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CHAPTER 8

8-1

CHAPTER 8 Internal Control and Cash

DISCUSSION QUESTIONS (Continued)

9. a. Yes. Even though the petty cash fund is only $750, if the fund is replenished frequently, a

significant amount of cash could be stolen. For example, if the fund is replenished weekly,

$39,000 ($750 × 52 weeks) could be subject to theft.

b. Controls for petty cash include (1) designating one person who is responsible for the fund,

(2) maintaining a written record of all payments, (3) requiring support (receipts) for

payments from the fund, and (4) having an independent person periodically review the funds

b. Examples of cash equivalents include certificates of deposit, U.S. government securities,

corporate notes and bonds, and commercial paper.

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CHAPTER 8 Internal Control and Cash

PE 8-1A

1. (c) monitoring

2. (a) the control environment

3. (b) control procedures

2. (c) information and communication

3. (b) control procedures

credit memo increases

debit memo decreases

credit memo increases

debit memo decreases4

PRACTICE EXERCISES

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CHAPTER 8 Internal Control and Cash

PE 8-3A

a. $9,660, determined as follows:

Bank section of reconciliation: $14,385 + $2,125 – $6,850 = $9,660

Company section of reconciliation: $11,200 – $60 – $1,480 = $9,660

b. Accounts Receivable 1,480

Miscellaneous Expense 60

Cash 11,170

Notes Receivable 10,640

Interest Revenue 530

b. Store Supplies 780

Miscellaneous Selling Expense 280

Cash Short and Over 50

Cash 1,110

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CHAPTER 8 Internal Control and Cash

PE 8-5A

$97,200

12 months

Ratio of Cash to

Monthly Cash Expenses

Ratio of Cash to

Monthly Cash Expenses

b. The preceding computations indicate that McMasters Company has 5.4 months

of cash remaining as of December 31. McMasters Company will need to generate

positive cash flow from operations or raise additional financing from its owners

or by issuing debt.

Monthly Cash Expenses

Cash as of Year-End

Monthly Cash Expenses

6.7 months==

$8,100 per month

5.4 months

$25,700 per month

$54,270

=Cash as of Year-End

Monthly Cash Expenses

=$138,780 =

= $8,100 per month

Negative Cash Flow from Operations

12 months

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CHAPTER 8 Internal Control and Cash

Ex. 8-1

Section 404 requires management’s internal control report to:

(1) state the responsibility of management for establishing and maintaining

an adequate internal control structure and procedures for financial

reporting; and

(2) contain an assessment, as of the end of the issuer’s fiscal year, of the

effectiveness of the internal control structure and procedures of the

issuer for financial reporting.

(1) state the responsibility of management for establishing and maintaining

an adequate internal control structure and procedures for financial

reporting; and

(2) contain an assessment, as of the end of the issuer’s fiscal year, of the

effectiveness of the internal control structure and procedures of the

issuer for financial reporting.

Directs the SEC to require each issuer to disclose whether it has adopted a

code of ethics for its senior financial officers and the contents of that code.

Directs the SEC to revise its regulations concerning prompt disclosure on

Form 8-K to require immediate disclosure “of any change in, or waiver of,” an

issuer’s code of ethics.

EXERCISES

8-6

CHAPTER 8 Internal Control and Cash

Ex. 8-2

a. Agree. Jimmy has made one employee responsible for the cash drawer in

accordance with the internal control principle of assignment of responsibility.

In addition, Jimmy has segregated the operations (preparing the orders) from

the accounting (taking orders and payments).

b. Disagree. It is commendable that Jimmy has given the employee a specific

responsibility and is holding that employee accountable for it. However, after

the cashier has counted the cash, another employee (or perhaps Jimmy)

should remove the cash register tape and compare the amount on the tape

to the cash in the drawer. Also, Jimmy’s standard of no mistakes may

encourage the cashiers to overcharge a few customers in order to cover any

c. A store credit for any merchandise returned without a receipt would reduce

the possibility of theft of cash. In this case, a clerk could only issue a phony

store credit rather than taking money from the cash register. A store credit is

not as tempting as cash. In addition, salesclerks could only use a few store

credits to purchase merchandise for themselves without management getting

suspicious.

An advantage of issuing a store credit for returns without a receipt is that the

possibility of stealing cash is reduced. The store will also lose less revenue if

customers must choose other store merchandise instead of receiving a cash

refund. The overall level of returns/exchanges may be reduced because

customers will not return an acceptable gift simply because they need cash

more than the gift. The policy will also reduce the “cash drain” during the

weeks immediately following the holidays, allowing Ramona’s Clothing to keep

more of its money earning interest or use that cash to purchase spring

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CHAPTER 8 Internal Control and Cash

Ex. 8-3 (Concluded)

A disadvantage of issuing a store credit for returns without a receipt is that

preholiday sales might drop as gift-givers realize that the return policy has

tightened. After the holidays, customers wanting to return items for cash

refunds may be frustrated when they learn the store policy has changed. The

ill will may reduce future sales. It may take longer to explain the new policy

and fill out the paperwork for a store credit, lengthening lines at the return

counter after the holidays. Salesclerks will need to be trained to apply the

new policy and write up a store credit. Salesclerks also will need to be

trained to handle the redemption of the store credit on future merchandise

attempting to ring up a refund and remove cash when a customer is not

present at the sales desk. These security measures could include cameras or

additional security personnel discreetly monitoring the sales desk.

Finally, an employee on the following work shift could be assigned the

responsibility of restocking returned merchandise and reconciling the returns

to a refund list for the department.

Allowing the bank president to have sole authority to grant large loans can lead

to the president granting loans to friends and business associates without the

required due diligence. This can result in a bank becoming exposed to very poor

credit risks. Indeed, this scenario is one of the causes of the savings and loan

failures of the past.

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CHAPTER 8 Internal Control and Cash

Ex. 8-5

The Societe Generale trading losses show how small lapses in internal control can

have large consequences. When the losses became so large that they could no

longer be hidden, it was too late. The loss could have been avoided using a number

of internal controls. First, the separation of duties control was overcome by the

trader’s intimate knowledge of the monitoring software. This knowledge of the

monitoring system allowed the trader to hide trades effectively. The design of the

monitoring software would need to be improved and access prohibited by traders.

If traders have access to the monitoring software, the separation of duties control

is violated. Second, the trader should be under managerial oversight. For example,

trades that exceed a certain amount of exposure should require management

approval. In this way, a trader would be forced to slow down or stop once trades

reached a certain limit. This would avoid the trader’s tendency to try to “make up”

losses with even larger bets. Finally, if the trader had had to take required vacation

time, managers may have been alerted then to the hidden losses once the trader

discovered that the claim was fictitious. However, the very nature of the process was to

resolve small claims quickly without excessive control. Finally, corrupt lawyers were

brought into the fraud to act as attorneys for the claimants. This gave the claims even

more credibility. In actuality, the lawyers had done legitimate business with the trucking

company, so all appeared normal. This fraud was discovered when the fraudulent

employee’s bank noticed irregularities in his bank account and notified authorities.

As the saying goes, “Follow the money!”

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CHAPTER 8 Internal Control and Cash

Ex. 8-7

All-Around Sound Co. should not have relied on the unusual nature of the vendors and

frequency of deliveries to uncover this fraud. The purchase and payment cycle is one

of the most critical business cycles to control because the potential for abuse is so

great. Purchases should be initiated by a requisition document. This document should

be countersigned by a superior so that two people agree as to what is being purchased.

The requisition should initiate a purchase order to a vendor for goods or services. The

vendor responds to the purchase order by delivering the goods. The goods should be

formally received using a receiving document. An accounts payable clerk matches

the requisition, purchase order, and invoice before any payment is made. Such “triple

matching” prevents unauthorized requests and payments. In this case, the requests

were unauthorized, suggesting that the employee has sole authority to make a request.

Another issue is that this employee had access to the invoices. This access allowed the

employee to change critical characteristics of the invoice to hide the true nature of the

goods being received. The invoice should have been delivered directly to the accounts

payable clerk to avoid corrupting the document. There apparently was no receiving

document (common for smaller companies); thus, only the invoice provided proof of

what was received and needed to be paid. If there had been a receiving report, the

invoice could not have been doctored and gone undetected because it would not

have matched the receiving report.

b. Overall, this type of fraud can be stopped if there is a strong oversight of senior

management, such as an audit committee of the board of directors. Individual

whistle-blowers in the company can make their concerns known to the independent

or internal auditors who, in turn, can inform the audit committee. The audit

committee should be independent of management and have the power to monitor

the actions of management.

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CHAPTER 8 Internal Control and Cash

Ex. 8-9

a. The salesclerks should not have access to the cash register tapes.

b. The cash register tapes should be locked in the cash register and the key

retained by the cashier. An employee of the cashier’s office should remove

the cash register tape, record the total on the memo form, and note

discrepancies.

If another employee cannot be added, the weakness in internal control could be

improved with more thorough supervision. The restaurant manager should be

directed to keep a watchful eye on the drive-through area in order to detect when

a clerk takes an order without ringing up the sale.

Another option is for Big & Bad Burgers to implement a policy that any customer who

does not receive a receipt is entitled to a free burger and advertise this policy at the

cash register and drive-through window. This approach uses the customer as an

internal control.

Ex. 8-11

a. The remittance advices should not be sent to the cashier.

b. The mailroom employees should send the remittance advices directly to the

Accounting Department.

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CHAPTER 8 Internal Control and Cash

Ex. 8-12

Cash 25,538

Cash Short and Over 132

Sales 25,670

Ex. 8-13

Cash 66,670

Sales 66,341

Cash Short and Over 329

Ex. 8-14

The use of the voucher system is appropriate, the essentials of which are outlined

below. (Although invoices could be used instead of vouchers, vouchers more

satisfactorily provide for account distribution, signatures, and other significant data.)

1. Each voucher should be approved for payment by a designated official only

after completion of the following verifications: (a) that prices, quantities, terms,

etc., on the invoice are in accordance with the provisions of the purchase order;

(b) that all quantities billed have been received in good condition, as indicated

each day of the month. Each voucher should be filed in the compartment

representing the last day of the discount period or the due date if the invoice is

implementation and use of a computerized system would also reduce the chance

that any available cash discounts are missed. For example, when invoices are

received and approved for payment, they are automatically scheduled for payment

within the discount period. However, even in a computerized system, the use of

an approval process that requires supporting documents and indicating “paid”

on these supporting documents is an important control for avoiding duplicate

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CHAPTER 8 Internal Control and Cash

Ex. 8-15

To prevent the fraud scheme described, Paragon Tech must separate responsibilities

for related operations. As in the past, all service requisitions should be submitted

to the Purchasing Department. After receiving the service request, Purchasing

should complete a Service Verification form stating the service that has been

ordered and the name of the company that will provide the service. This form

should be delivered via intercompany mail to the person responsible for verifying

that the service was performed. This person should have firsthand knowledge of

whether the service was performed. This person, who must be someone other than

the manager requesting the service, should fill in the date and time the service was

received and sign the form. In addition, the vendor providing the service should

sign the form before leaving the premises. When completed, the Service Verification

form should be forwarded to the Accounting Department. Accounting will authorize

payment of the vendor’s invoice after the Service Verification form has been

compared with the invoice.

Ex. 8-16

a. Addition to the balance per bank: (5)

b. Deduction from the balance per bank: (4), (6)

c. Addition to the balance per company’s records: (7)

d. Deduction from the balance per company’s records: (1), (2), (3)

Ex. 8-17

(1), (2), (3), (7)

The preceding additions and deductions to the cash balance according to the

company’s records require journal entries in the company’s records. Additions

and deductions to the cash balance according to the bank’s records do not require

8-13

CHAPTER 8 Internal Control and Cash

Ex. 8-18

Cash balance according to bank statement $48,250

Add deposit in transit, not recorded by bank 6,450

Deduct outstanding checks (4,460)

Adjusted balance $50,240

Cash balance according to company’s records $49,910

Add error in recording check as $950 instead of $590 360

Deduct bank service charge (30)

Adjusted balance $50,240

c. Yes. The bank reconciliation must always balance (reconcile) to an adjusted

balance.

Ex. 8-19

31 Cash 360

Accounts Payable 360

31 Miscellaneous Expense 30

Cash 30

Ex. 8-20

Cash 15,120

Notes Receivable 14,000

Interest Revenue 1,120

Nakajima Co.

Bank Reconciliation

July 31

July

8-14

CHAPTER 8 Internal Control and Cash

Ex. 8-21

Cash balance according to bank statement $20,300

Add deposit in transit on August 31 7,200

Deduct outstanding checks (3,585)

Adjusted balance $23,915

Cash balance according to company’s records $11,100

Add: Error in recording Check No. 1056 as $950

instead of $590 $ 360

Note for $12,000 collected by bank, including

interest 12,480 12,840

Deduct bank service charges (25)

Adjusted balance $23,915

4. Service charges should be deducted from the balance per company’s records.

5. The error in recording the June 17 deposit of $7,150 as $1,750 should be

added to the balance per company’s records.

6. The adjusted balances ($12,590 and $9,010) are not equal.

Chesner Co.

Bank Reconciliation

August 31

8-15

CHAPTER 8 Internal Control and Cash

Ex. 8-22 (Concluded)

b. A correct bank reconciliation would be as follows:

Cash balance according to bank statement $16,185

Add deposit of June 30, not recorded by bank 6,600

Deduct outstanding checks:

No. 1067 $ 575

1106 470

1110 1,050

1113 910 (3,005)

Adjusted balance $19,780

Cash balance according to company’s records $ 8,985

Add: Note and interest collected by bank $6,300

Error in recording June 17 deposit as $1,750

instead of $7,150 5,400 11,700

Deduct: Check returned because of insufficient funds $ 890

Service charges 15 (905)

Adjusted balance $19,780

Poway Co.

Bank Reconciliation

June 30

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CHAPTER 8 Internal Control and Cash

Ex. 8-23

a. The amount of cash receipts stolen by the salesclerk can be determined by

attempting to reconcile the bank account. The bank reconciliation will not

reconcile by the amount of cash receipts stolen. The amount stolen by the

salesclerk is $4,135, determined as follows:

Cash balance according to bank statement $13,275

Deduct outstanding checks (3,670)

Adjusted balance $ 9,605

Cash balance according to company’s records $11,680

Add note and interest collected by bank 2,100

Deduct bank service charges (40)

Adjusted balance $13,740

Daily reconciliation of the amount of cash receipts—comparing the cash register

tapes to a receipt from the bank as to the amount deposited (a duplicate deposit

ticket)—would also discourage theft of the cash receipts. In this latter case, if

the reconciliation were prepared by an employee independent of the cash

function, any theft of cash receipts from the daily deposit would be discovered

immediately. That is, the daily deposit would not reconcile against the daily

cash receipts.

Alaska Impressions Co.

Bank Reconciliation

October 31

8-17