chapter
8
Sarbanes-Oxley, Internal
Control, and Cash
______________________________________________
OPENING COMMENTS
In recent years, events have occurred that have resulted in increased emphasis on proper financial
reporting and on ensuring that controls are in place to accomplish this. Chapter 8 introduces background
on the Sarbanes-Oxley Act of 2002, which has significantly increased the outside demand for assuring
proper financial reporting. The chapter also addresses the development of internal control frameworks for
a business and the financial accounting practices relating to recording cash transactions. Cash is
highlighted in this chapter because it is the asset most vulnerable to manipulation. The chapter ends with
an explanation of the ratio of cash to monthly cash expenses.
After studying the chapter, your students should be able to:
1. Describe the Sarbanes-Oxley Act and its impact on internal controls and financial reporting.
2. Describe and illustrate the objectives and elements of internal control.
3. Describe and illustrate the application of internal controls to cash.
4. Describe the nature of a bank account and its use in controlling cash.
5. Describe and illustrate the use of a bank reconciliation in controlling cash.
6. Describe the accounting for special-purpose cash funds.
7. Describe and illustrate the reporting of cash and cash equivalents in the financial statements.
8. Describe and illustrate the use of the ratio of cash to monthly cash expenses to assess the ability of a
company to continue in business.
140 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
KEY TERMS
bank reconciliation
bank statement
cash
cash equivalents
cash short and over account
compensating balance
control environment
electronic funds transfer (EFT)
elements of internal control
employee fraud
internal control
petty cash fund
ratio of cash to monthly cash expenses
Sarbanes-Oxley Act
special-purpose funds
voucher
voucher system
STUDENT FAQS
• Where do I go to get more information about working with Sarbanes-Oxley when I graduate? I also
need to make sure I take the correct courses in college.
• When a person doesn’t work all the hours they are supposed to during the day, are they defrauding
the company?
• Why must I learn to balance the cash account when I put the money in the bank to protect it?
• Do I have a legal obligation to give cash back to someone when I have no idea who that person is?
• Why do we spend so much time on internal control for cash receipts and disbursements? Shouldn’t
we be just as concerned over other assets? Expenses? Revenue? Liabilities?
• Why don’t we make journal entries for bank errors?
• Why do we worry about deposits in transit and outstanding checks? Won’t they fiwork themselves
out” the following month?
• Why do we need a new asset account called petty cash? Can’t we use the cash account?
• If we use the account petty cash when we establish a petty cash fund, why don’t we use petty cash
when we replenish the fund?
• What is the normal balance of the ficash short and over” account? Why is this account treated as an
expense or revenue account on the income statement rather than an asset account on the balance
sheet? After all, isn’t it a cash account?
Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 141
OBJECTIVE 1
Describe the Sarbanes-Oxley Act and its impact on internal controls and financial
reporting.
SYNOPSIS
This chapter begins with the effects of the Sarbanes-Oxley Act. This act, passed by Congress, was to
strengthen the internal controls of publicly held companies. Internal control defines the processes meant
to safeguard assets, process information accurately, and ensure compliance with laws and regulations.
Key Terms and Definitions
• Internal Controls – The policies and procedures used to safeguard assets, ensure accurate
business information, and ensure compliance with laws and regulations.
• Sarbanes-Oxley Act (SOX) – Act passed by Congress to restore public confidence and trust in
the financial statements of companies.
Relevant Example Exercises and Exhibits
• Exhibit 1 – Effect of Sarbanes-Oxley
• Exhibit 2 – Sarbanes-Oxley Report of Nike
SUGGESTED APPROACH
Chapter 8 discusses the Sarbanes-Oxley Act of 2002 (the most important law affecting publicly held
companies in recent history). Although the law applies only to publicly traded companies, it really has
become the standard for assessing the financial controls and reporting of all companies. In essence, it
emphasizes the importance of effective internal control. Internal control procedures and processes have
been greatly emphasized and increased under Section 404 requirements. The Committee of Sponsoring
Organizations (COSO) is the widely accepted standard by which companies design, analyze, and evaluate
internal controls.
OBJECTIVE 2
Describe and illustrate the objectives and elements of internal control.
SYNOPSIS
The objectives of internal control are described in this section. Internal control has three objectives:
making sure those assets are safeguarded and used for business purposes, ensuring that all accounting and
business information is accurate, and making sure that employees and managers comply with laws and
regulations. The objectives can be achieved by using the five elements of internal control. The control
environment is the overall attitude of the company, including management, personnel policies, and
organizational structure. Exhibit 5 shows how these interact to complete the control environment. Risk is
142 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
the second element: all risks should be identified, analyzed, and assessed and actions taken to minimize
their occurrence. Control procedures provide assurance that goals will be met and include the prevention
of fraud. Exhibit 6 shows how procedures protect the business. Monitoring is the fourth element and is
used to assess weaknesses and improve controls. Exhibit 6 explains some of the warning signs of internal
control problems. Information and communications is the fifth and final element of internal control. It is
the link that allows all the other elements to work together. Internal control is not a guarantee that assets
are safeguarded, all information is accurate, and no laws are broken. Internal controls are only as good as
the human element that provides them, and they are limited by cost-benefit considerations.
Key Terms and Definitions
• Control Environment – The overall attitude of management and employees about the importance
of controls.
• Elements of Internal Control – The control environment, risk assessment, control activities,
information and communication, and monitoring.
• Employee Fraud – The intentional act of deceiving an employer for personal gain.
Relevant Example Exercises and Exhibits
• Example Exercise 8-1 Internal Control Elements
• Exhibit 3 – Objectives of Internal Control
• Exhibit 4 – Elements of Internal Control
• Exhibit 5 – Control Environment
• Exhibit 6 – Internal Control Procedures
• Exhibit 7 – Warning Signs of Internal Control Problems
SUGGESTED APPROACH
The text lists the three objectives of internal control as reasonable assurance that (1) assets are
safeguarded and used for business purposes, (2) business information is accurate, and (3) employees and
managers comply with laws and regulations. The five elements of internal control are (1) control
environment, (2) risk assessment, (3) control procedures, (4) monitoring, and (5) information and
communication. To stimulate interest in these topics, use the following Lecture Aid.
LECTURE AID—Internal Control
Ask the following questions (also shown on Transparency Master [TM] 8-1):
If you owned a business, would you expect your employees to:
1. Work to achieve the business goals and objectives you establish?
2. Use business assets (such as machinery or automobiles) only for legitimate business purposes
and avoid wasting business resources?
3. Record accurate data regarding business transactions so you could accurately judge how well
your business is doing?
4. Refrain from stealing your cash, supplies, inventory, or property, plant, and equipment?
In theory, you should be able to expect these things. In practice, however, you must establish an internal
control framework to make sure your business objectives are achieved, assets are protected from theft and
misuse, and financial data are recorded accurately.
TMs 8-2 through 8-4 include information to use in reviewing the elements of internal control.
Possible solution to TM 8-3: 1) Salespersons on commission also approved to grant credit represent a
conflict of interest. Denial of credit to a potential sale would take money out of the pocket of the
salesperson, creating an opportunity to grant credit to customers not worthy of credit in order to make a
sale. Separation of duties to have a non-commissioned individual to approve credit would be the preferred
method. 2) Having a single individual responsible for all of these duties creates an opportunity to easily
order goods, check them in, approve payment, and allow that individual to carry the inventory away.
Again, separation of duties will not eliminate this possibility of theft; however, it will make the process
more difficult to perform. 3) Although the size of the possible theft is greatly diminished in this scenario
and many donut shops would follow this model, a better model would be to separate the responsibilities
here, having one employee take the order, a second fill the order, and a third accept the payment. In all
three instances, separation of duties is the ultimate model whenever possible.
Possible response to TM 8-4: Allowing the clerk to accept cash and update customer account records
gives a single individual an opportunity to accept the cash, pocket it, and provide the customer record
with the credit. Requiring a second individual to balance the bank deposit against the customer account
credits could make this model workable, but separation of duties would be a preferred model. 2) Allowing
a single individual to approve invoices, prepare checks, mail them, and update hospital records provides
an opportunity to create fictitious vendors and to prepare checks to these fictitious vendors that can then
be cashed by the employee for personal use. In both scenarios, separation of duties would have made the
potential fraud more difficult to execute.
When reviewing the control environment, give an illustration of a poor control environment and a good
control environment. For example, in a poor control environment, you have a dominating management
staff that pressures employees to meet budgets and projections at all costs, regardless of circumstances. A
good control environment is established by a management that encourages employees to adhere to control
policies and procedures and an employee code of conduct.
Under proof and security measures, you may want to emphasize that businesses should protect their
accounting records by using off-site backup computer files and fireproof file cabinets. Companies have
gone out of business because fire or theft destroyed their accounting records. For example, the destruction
of accounts receivable files could result in significant losses to a business.
Exhibit 4 in the text presents a good list of the fired flags” that may indicate employee fraud or
embezzlement. Refer your students to this list for helpful tips in monitoring internal controls.
144 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
GROUP LEARNING ACTIVITY—Internal Control Structure
Ask your students to assume that they have decided to open a bookstore that sells textbooks and competes
with the campus bookstore (TM 8-5). With students in small groups, instruct them to list the internal
control procedures they would implement in their store. After giving the groups a few minutes to work,
ask each group to share a couple of their ideas.
Potential response to TM 8-5: Students might focus on the physical layout of the store. The doors
should be protected with scanning devices that detect removal of inventory that has not been security
deactivated. Security cameras, one-way mirrors, and limited access are also good ideas. Restricting
students from bringing backpacks into the store is also a good security measure. Students should also
address the employee’s duties. They should discuss the process of cash-register safeguarding of cash
using a head cashier and the validation of cash drawers and end-of-day reconciliation. See TM 8-6 for an
overview. The discussion of inventory should include ordering, receiving, and payment of invoices.
Mention should be made about the limitations of internal control and that internal control systems are not
guarantees, due to the human element inherent in their practices as well as consideration of the cost–
benefit of safeguards.
OBJECTIVE 3
Describe and illustrate the application of internal controls to cash.
SYNOPSIS
The control of cash is important to a business because it is the asset most likely to be stolen or used
improperly. To protect cash from being stolen or misused, a business must record cash form the time it is
received to its deposit in a bank account. Cash received from cash sales must be safeguarded by cash
register controls. There are nine steps in the cash register control, which are listed on page 378 in the text.
Differences in the cash sales process are accounted by using the cash short and over account. Cash
received in the mail, usually in the form of checks or money orders, is controlled according to the steps
listed on page 379 in the text. Separating the duties of the department that handles cash and the
accounting department that records cash is a key control. Cash may also be received from customers
through an electronic fund transfer. This is encouraged by most businesses because it costs less, enhances
control, and reduces late payments. The payment of cash must also be controlled. The voucher system
may be used for authorizing and recording cash payments. A voucher serves as proof of authorization to
pay cash. When authorized, cash may be paid by check or electronic fund transfer. After payment, a
voucher is filed and is proof of payment for accounts payable.
Key Terms and Definitions
• Cash – Coins, currency (paper money), checks, money orders, and money on deposit that is
available for unrestricted withdrawal from banks and other financial institutions.
• Cash Short and Over Account – An account which has recorded errors in cash sales or errors in
making change causing the amount of actual cash on hand to differ from the beginning amount of
cash plus the cash sales for the day.
Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 145
• Electronic Funds Transfer (EFT) – A system in which computers rather than paper (money,
checks, etc.) are used to effect cash transactions.
• Voucher – A special form for recording relevant data about a liability and the details of its
payment.
• Voucher System – A set of procedures for authorizing and recording liabilities and cash
payments.
Relevant Example Exercises and Exhibits
• Exhibit 8 – Cash Register as a Control
SUGGESTED APPROACH
Remind your students that cash includes anything a bank would accept for deposit in your account. This
includes coins, currency, checks, and money orders. A good system of internal controls is necessary to
protect all of these forms of cash.
The topic of internal controls can be used to stimulate a lively class discussion. Suggestions for leading
that discussion follow.
The cash change fund and the cash short and over account are simple topics that can be covered
appropriately in a lecture format.
CLASS DISCUSSION—Internal Controls
Protecting business assets is an important concern for any manager or owner. TM 8-6 reviews the typical
controls for protecting cash received at the cash register. Review these controls with your class. Point out
how the principle of separation of accounting, custody of assets, and operations is applied in this scenario.
Next, ask your class to identify the people who have the opportunity to steal cash. The candidates are the
clerk and the cashier, because they are the only ones who actually handle cash. Ask your students to
identify ways in which these individuals can steal cash and, more importantly, what procedures can be
instituted to prevent theft by these means.
Because many of your students will have worked in businesses that use a cash register, they probably will
have heard stories about employees who discovered a way to steal cash from a register. Therefore, your
class discussion will probably focus on the clerk. It should point out the internal control reason for many
of the policies and procedures your students have experienced in their clerk positions. To summarize the
discussion, remind your students that business owners/managers must constantly be alert for ways in
which employees and customers could steal cash and establish controls to prevent theft before it occurs.
The following lists some of the ways for the clerk in TM 8-6 to steal cash and some procedures to
prevent/detect this theft:
146 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
Means to Steal Cash
Ways to Prevent/Detect Theft
1. Don’t ring the sale on the cash
register, and pocket the cash.
1. Odd pricing—clerk must make change.
Require receipts for refunds.
Put coupons on backs of receipts so the customer
will ask for a receipt.
Offer customers a bonus if they are not handed a
receipt (e.g., a free beverage).
Have one employee ring up customer orders and
another fill orders from a receipt.
Proper supervision—watch for employees who do
not ring up orders.
2. Enter the sale on the register, then
void the sale and pocket the cash.
2. Only managers can ring voids.
Use cash registers that require a key to void a sale.
Require all voids to be documented and authorized
by a manager.
3. Enter a cash refund on the register and
pocket the cash.
3. Require a manager to authorize all refunds in the
presence of the customer.
Only managers can issue refunds.
4. If more than one clerk uses the
register, simply take the cash when no
one is looking and hope that someone
else will be blamed.
4. Have a separate register for each clerk.
Each clerk must balance register at the end of each
shift.
TM 8-7 presents procedures related to the receipt of cash through the mail. Use this illustration to point
out how good internal controls (mainly separation of accounting, custody of assets, and operations) will
reduce theft and errors. For example, pose the following questions to the class:
1. Assume that the employee who opens the mail steals a customer payment. How will this theft be
detected?
Possible response: The deposit amount from the cashier will not match the remittance report
from the AR clerk.
2. Assume that the accounting clerk posts the payment to the wrong customer’s account. How will
this error be detected?
Possible response: This error must be challenged by the customer not receiving credit for
payment on account.
3. Assume that the accounting clerk posts a customer’s payment for the wrong amount, giving the
customer credit for less than he or she actually paid. How will this error be detected?
Possible response: The AR report will not match the cash deposit or the payments received total.
4. Assume that an employee in the cashier’s department loses a check. (Maybe it was placed in the
customer’s file rather than deposited in the bank.) How will this error be detected?
Possible response: The AR report will not match the cash deposit or the payments received total.
TM 8-7 can also be used to explain collusion. Collusion occurs when two or more employees work
together to embezzle cash or conceal errors. For example, if the accounting clerk and the employee who
opens the mail decide to work together, one can steal customer payments and the other can fidoctor” the
accounting records. To prevent collusion, companies will institute nepotism policies, job rotation, and
mandatory vacations.
Point out to students that cash may also be received by EFT. Companies encourage customers to use EFT
because it is more cost efficient than processing payments received through the mail, it enhances internal
controls by avoiding the human factor of cash handling, it reduces late payments and it speeds up the
processing of cash receipts.
LECTURE AID—Cash Change Fund and Cash Short and Over Account
Objective 3 also presents the cash change fund and the cash short and over account. Ask students who
have worked as cashiers to share what amount of cash was in their cash register at the beginning and end
of the day. This represents a cash change fund.
Remind students that a cash change fund is required for any business that receives cash from its
customers. Someone must be accountable for that change fund at all times. It should be locked in a
company vault when not in use.
The cash short and over account is used when the cash on hand at the end of the day does not equal the
amount in the beginning cash change fund plus the day’s cash sales. It is used to record discrepancies due
to errors in recording sales or making change. The cash short and over account is needed because
employees will not be accurate 100 percent of the time.
As long as the cash short and over account shows only small discrepancies, management should not be
concerned. If the account shows large discrepancies or continuous shortages, however, management
should investigate these differences. Ask your students who have worked as cashiers to describe their
employers’ policies regarding cash overages and shortages. If a cashier consistently has large cash short
and over amounts, he or she probably needs additional training.
You may want to review the journal entry illustrated on page 379 of the text with your class and remind
them that a debit balance in the cash short and over account is treated as a miscellaneous administrative
expense. A credit balance is included in the Other Income section of the income statement.
INTERNET ACTIVITY—Internal Controls over Cash
Instruct your students to search the Web using fiinternal controls” and ficash management” as their search
criteria. At the time this manual was written, the following sites offered some interesting information:
148 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
http://www.coso.org/IC-IntegratedFramework-summary.htm
http://www.securitymanagement.com/library/000304.html
These sites discuss the importance of establishing internal controls over petty cash and many other areas.
The voucher system will require a detailed explanation in lecture format. TM 8-8 will help you present
this topic. After discussing the voucher system, use the Writing Exercise shown below to test your
students’ comprehension of the system.
Objective 3 also addresses electronic funds transfers. Most students will be familiar with electronic funds
transfers (EFT) through direct experience with automated teller machines (ATMs), payroll direct deposit,
or point-of-sale systems. Use this opportunity to point out the control risks of EFTs and make students
aware of the internal control procedures that must be implemented when EFTs are used. To achieve this
goal, stimulate a Class Discussion on control issues related to point-of-sale systems. Next, assign a Group
Learning Activity that requires your students to implement EFT control procedures.
LECTURE AID—The Voucher System
TM 8-8 is a flowchart-style illustration of the voucher system, putting the textbook description in picture
format. Review this exhibit with your class, stressing the control aspects of the voucher system. A
Writing Exercise to reinforce your coverage of this topic follows.
WRITING EXERCISE—The Voucher System
After reviewing the voucher system, ask your class to write answers to the following questions (TM 8-9):
1. How does the voucher system ensure that management is paying only valid obligations?
Possible response: Comparing purchase orders, receiving reports, and invoices will provide
assurance that only valid obligations are being presented for payment.
2. How does the voucher system help a company maintain a favorable credit standing by aiding
management in paying all invoices on time?
Possible response: By filing unpaid vouchers by due date, the accounts payable clerk can make
sure obligations are paid on time.
3. How would a company using a voucher system investigate a supplier’s complaint that an invoice
has not been paid?
Possible response: There are two possible ways to verify payment. Cancelled checks will show
payment amount, date, and invoice being paid. The paid voucher file should contain those
vouchers for which checks have been issued.
Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 149
CLASS DISCUSSION—Control of Point-of-Sale Systems
The following two scenarios (TM 8-10) relate to point-of-sale systems. In a classroom discussion, ask
your students to identify the control risk associated with each system and name procedures that can be
implemented to counterbalance the risk.
1. A grocery store decides to install a point-of-sale system that will allow the customer to use his or her
ATM card to pay for merchandise at the checkout line. Previously, the grocery store has accepted
only cash and checks as payment.
Control Risk: In the past, the clerks would have reconciled their cash registers by comparing the sales on
the register tape to the total of the cash and checks in the register drawer. Under the new system, a clerk
could steal the cash taken for a customer’s order and claim that the customer paid by EFT. The clerk also
could allow friends and family to leave the store without paying for their merchandise and claim they paid
with an EFT. In addition, a customer might mistakenly (or intentionally) authorize the wrong payment
amount when using the point-of-sale device.
Solution: A receipt from the point-of-sale device must be placed in the cash register drawer as evidence
of the customer’s payment. In reconciling the cash drawer, sales on the register tape would be verified
against the total of cash, checks, and point-of-sale receipts. In addition, the point-of-sale receipts must be
used to verify actual bank deposits from the EFT system.
2. A self-service gas station decides to install a point–of-sale device at the gasoline pump. This will
speed the time it takes a customer to fill his or her gas tank, since payment can be made right at the
pump, eliminating the time spent waiting in line for a clerk to accept payment.
Control Risk: Whenever a customer puts gasoline in the car and drives off, the clerk will assume that the
customer paid with the point-of-sale device. In reality, the customer may not have paid at all.
Solution: The clerk must have a device that clearly indicates which customers have chosen to pay with
the point-of-sale device. This will immediately alert the clerk to any customers who simply drive off.
Installing cameras to capture the license plate number of cars with drivers who did not pay is also an
important control.
GROUP LEARNING ACTIVITY—Electronic Funds Transfers
TM 8-11 presents information regarding a company that has decided to use EFT to pay vendor invoices.
Divide the class into small groups and ask them to define procedures for paying vendor invoices via EFT.
Their procedures should include any documentation, authorization, or reconciliation required and who
should be made responsible for those tasks. TM 8-12 presents a suggested solution.
150 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
OBJECTIVE 4
Describe the nature of a bank account and its use in controlling cash.
SYNOPSIS
Using a bank account is another way to enhance internal control. Bank accounts reduce cash on hand,
provide an independent recording of cash, and can be used to electronically transfer funds. Banks
maintain a record of all checking account transactions and provide a bank statement on a monthly basis.
The bank shows a credit balance in the cash account because it is a liability to the bank; it is a debit for
the business. A copy of the bank statement is shown in Exhibit 9. Exhibit 10 shows the debits and credits
from the perspectives of both the business and the bank. Differences between the bank statement and a
company’s books may arise due to timing issues, errors, NSF checks, etc. Reconciling the bank statement
with the business’s books is an important part of cash control.
Key Terms and Definitions
• Bank Statement – A summary of all transactions mailed to the depositor or made available
online by the bank each month.
Relevant Example Exercises and Exhibits
• Example Exercise 8-2 Items on Company’s Bank Statement
• Exhibit 9 – Bank Statement
• Exhibit 10 – Checking Account: Company and Bank Perspectives
• Exhibit 11 – Power Networking’s Records and Bank Statement
SUGGESTED APPROACH
Objective 4 explains the use of the bank account and the associated bank statement as a tool for internal
control over cash. The bank statement provides an independent report of deposits and withdrawals of the
company cash. This independent report provides an important tool for safeguarding cash. Debit and credit
memos are explained. This provides an important foundation for Objective 5, completing the bank
reconciliation. See TM 8-13 for a summary of possible debit and credit memos in preparation of the bank
reconciliation.
OBJECTIVE 5
Describe and illustrate the use of a bank reconciliation in controlling cash.
SYNOPSIS
Reconciling the amounts in the business’s cash account with the amount in the bank account is called
bank reconciliation. The bank reconciliation is divided into two parts. They are the bank section and the
company section. The adjusted balances from these two sections must equal. To check this equality, eight
Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 151
steps are outlines in Exhibit 12. In Exhibit 13, a bank reconciliation is shown for Power Networking.
Outstanding checks and deposits have to be accounted for in the bank balance. The reconciliation process
then checks the balance in the company’s cash account, adds any amounts that need to be added, such as
interest or notes collected, and deducts NSF checks and bank services charges, and accounts for any
errors. If the balances do not yet equal, the process must be repeated. Journal entries may have to be made
to update the amount in the business’s cash account. After the journal entries are made, the company’s
cash account balance should equal the bank balance for the checking account. To enhance internal
control, the reconciliation should be prepared by an employee who does not handle or record any cash
transactions.
Key Terms and Definitions
• Bank Reconciliation – The analysis that details the items responsible for the difference between
the cash balance reported in the bank statement and the balance of the cash account in the ledger.
Relevant Example Exercises and Exhibits
• Example Exercise 8-3 Bank Reconciliation
• Exhibit 12 – How to Prepare a Bank Reconciliation
• Exhibit 13 – Bank Reconciliation for Power Networking
SUGGESTED APPROACH
The bank reconciliation is usually an easy task for students who have their own checking accounts.
Depending on your student body, you may discover that many of your students do not have a checking
account.
Begin this topic with a Class Discussion that establishes the relevance of the bank reconciliation. Next,
give your students the opportunity to practice a bank reconciliation using the Group Learning Activity.
Finally, demonstrate the journal entries required by a bank reconciliation.
CLASS DISCUSSION—Establishing Relevance of the Bank Reconciliation
An interesting way to begin your coverage of the bank reconciliation is to ask your students to indicate
(by a show of hands) whether they have a checking account. Next, ask if their bank has ever made an
error in their checking account. You will probably find that your students will volunteer to describe the
bank’s error and the wrong they suffered. After listening to these details, ask your students how they
discovered the bank’s error. The usual responses are either through a bank reconciliation or notification
that they were bouncing checks. If the response is bouncing checks, pose this question: What if you had
an extra $1,000 (or more) in your account so that your checks would not have bounced as a result of the
error? How could you have discovered the error in this case? Now the answer must be through some sort
of reconciliation process.
152 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
BRAINSTORMING ACTIVITY—Developing the Format for a Bank
Reconciliation
After establishing the relevance of a bank reconciliation, you can discuss how one is prepared. One
approach is to direct your students to the form and content of the bank reconciliation on page 384 of the
text and discuss the contents of that illustration. Another approach is to ask your class to use
brainstorming to determine the items that must be included on the bank reconciliation, thereby allowing
them to discover how to prepare a reconciliation. Write fiCash Balance on Bank Statement” and fiCash
Balance on Depositor’s Records” on opposing sides of the board. Ask your class what items can cause
these two totals to disagree when the bank statement is received. As they call out reconciling items, ask
whether these items are adjustments to the bank statement balance or the depositor’s balance, and whether
they are additions or deductions. You may need to fill in a few gaps at the end, but collectively your class
should derive a format similar to the one shown in TM 8-14.
Many students find the following hint helpful in completing a bank reconciliation successfully: If a bank
reconciliation does not balance, check any bank errors and/or depositor’s errors first. Students frequently
add items that should be deducted, and vice versa.
It is interesting to point out that the amount of cash on deposit in a bank represents a liability to the bank.
As a result, customers’ accounts have credit balances. A bank credit memo is issued for items that
increase a customer’s balance. Debit memorandums are issued for service charges or other items that
decrease the customer’s account balance.
GROUP LEARNING ACTIVITY—Preparing a Bank Reconciliation
TM 8-15 presents the information for a bank reconciliation. Ask your students to work in small groups to
prepare that bank reconciliation. TM 8-16 is the solution, which you can share after the groups have
finished. Emphasize that the adjusted balance on the bank reconciliation is the amount that is reported on
the balance sheet.
DEMONSTRATION PROBLEM—Journal Entries Required by a Bank
Reconciliation
Using TM 8-16, demonstrate the following journal entries required as a result of the bank reconciliation.
Remind your students that any adjustments made to the depositor’s records must be journalized.
To record the note collected by bank:
Cash………………………… 1,260
Notes Receivable…… 1,200
Interest Revenue……. 60
To record the NSF check:
Accounts Receivable—J. Lane 100
Cash…………………. 100
To correct the error on Check No. 548:
Utility Expense……………… 27
Cash…………………. 27
Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 153
OBJECTIVE 6
Describe the accounting for special-purpose cash funds.
SYNOPSIS
Small sums of money often need to be paid out in the course of doing business. It is inconvenient to write
a check for numerous small sums. Postage, minor repairs, and office supplies are some of these minor
expenses. Most businesses establish a petty cash fund to account for these expenses. The fund is
established by estimating the cash needed from the fund for a period of time. A check is written to the
petty cash and cashed, the cash is placed in a secure location, and control of the fund is given to the petty
cash custodian. The custodian is then responsible for outgoing monies from the petty cash fund and
records each expense in the petty cash journal. At the end of the period, each expense is recorded and the
fund replenished.
Key Terms and Definitions
• Petty Cash Fund – A special cash fund to pay relatively small amounts.
• Special-Purpose Funds – Cash funds used for a special business need.
Relevant Example Exercises and Exhibits
• Example Exercise 8-4 Petty Cash Fund
DEMONSTRATION PROBLEM—Petty Cash
In some cases, it is impractical to pay an expense by check, either because the expense is very small or
payment is required sooner than a check can be processed. Petty cash is used to cover these types of
expenses. When discussing petty cash in class, you will want to address both the journal entries and the
internal controls related to the fund.
The following example can be used to illustrate the journal entries for petty cash (TM 8-17). Emphasize
that expenses paid from a petty cash fund are recorded when the fund is replenished, not when the cash is
disbursed. Therefore, the petty cash fund should be replenished at the end of the accounting period to
bring the accounts up to date.
Allied Plumbing Supply decides to establish a petty cash fund of $150 on January 1. The petty cash fund
will be replenished whenever the fund reaches a balance of $20 or less. On February 10, the fund is
replenished and the following receipts for items paid out of the petty cash fund are recorded: office
supplies, $34; postage, $28; store supplies, $12; a minor repair on office equipment, $52; and the cost
paid to Federal Express to send an urgent letter, $10.
Entry to establish the petty cash fund:
Jan. 1 Petty Cash………………… 150
Cash………………. 150
154 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
Entry to replenish the petty cash fund:
Feb. 10 Office Supplies……………. 34
Postage Expense ($28 + $10) 38
Store Supplies …………….. 12
Repairs Expense…………… 52
Cash……………….. 136
In reviewing the internal controls related to petty cash, you will want to mention the following:
1. A trusted employee must be named custodian of the petty cash fund. That employee is responsible
for disbursements from the fund.
2. Guidelines should be established for the types of expenses that may be paid from petty cash. In
addition, restrictions should be placed on the maximum amount that can be withdrawn from the fund
in any one transaction.
3. Whenever a disbursement is made from the fund, the custodian records the details on a petty cash
receipts form.
4. The fund custodian should submit receipts documenting all fund expenditures before receiving
money to replenish the fund.
CLASS DISCUSSION—Internal Controls over Petty Cash
Ask your students how the custodian of a petty cash fund could steal cash. (Answer: by forging a
signature on a petty cash receipt)
Next, ask them how this theft could be detected. Your students’ ideas may include the following: (1) a
periodic audit of the petty cash fund, (2) randomly checking signatures on receipts, or (3) comparing petty
cash expenditures with normal or expected amounts. Point out that the small amounts of cash in a petty
cash fund normally do not justify elaborate control procedures.
OBJECTIVE 7
Describe and illustrate the reporting of cash and cash equivalents in the financial
statements.
SYNOPSIS
On the financial statements, cash and cash equivalents are usually presented together as one amount. Cash
equivalents are highly liquid investments used by companies that temporarily have extra cash to earn
interest. Examples of cash equivalents are treasury bonds, notes, and money market funds. A
compensating balance is the minimum balance that is required by the bank for a business.
Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 155
Key Terms and Definitions
• Cash Equivalents – Highly liquid investments that are usually reported with cash on the balance
sheet.
• Compensating Balance – A requirement by some banks requiring depositors to maintain
minimum cash balances in their bank accounts.
SUGGESTED APPROACH
This topic can be covered quickly, but thoroughly, through a brief lecture.
LECTURE AID—Cash on the Balance Sheet
To cover this objective, you need only remind students of the following points:
1. Cash is the first asset listed on the balance sheet because it is the most liquid.
2. Funds placed in highly liquid investments such as Treasury bills, money market funds, and
commercial paper, are called cash equivalents. Since these investments can be sold quickly and
easily, funds in these investments can be accessed as easily as cash held in a bank. Therefore, they
are considered fiequivalent” to cash.
Readers of the financial statements normally assume that a company may use its cash at any time for any
purpose. If this is not true, the amount of funds not available for withdrawal must be disclosed in the
notes to the financial statements. For example, any compensating balance required by a bank as part of a
loan agreement or line of credit must be disclosed.
OBJECTIVE 8
Describe and illustrate the use of the ratio of cash to monthly cash expenses to assess the
ability of a company to continue in business.
SYNOPSIS
This chapter establishes how important cash and control of cash is to the successful operation of a
business. The ratio of cash to monthly cash expenses is useful is assessing how long a business can pay its
bills without additional financing or generating positive cash flows. It is calculated as: ratio of cash to
monthly cash expense = cash as of year-end/monthly cash expenses. The cash is the total cash from the
balance sheet including any cash equivalents. The monthly cash expenses are estimated from the
operating section of the income statement.
156 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
Key Terms and Definitions
• Ratio of Cash to Monthly Cash Expenses – Ratio that helps assess how long a company can
continue to operate without additional financing or generating positive cash flows from
operations.
Relevant Example Exercises and Exhibits
• Example Exercise 8-5 Ratio of Cash to Monthly Cash Expenses
SUGGESTED APPROACH
Explain to students that this computation is most critical for companies in financial distress and quite
often startup companies that haven’t had enough operating time to generate positive cash flows. It can be
used as a measure of when a company may need additional financing.
Ask students to suggest ways for companies to raise cash (loans, owner investment, sell unnecessary
assets, offer incentives to customers to make purchases).
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