Chapter 6
Cash and Internal Control
After studying this chapter, students should be able to:
◼ Identify and describe the various forms of cash reported on a balance sheet (Module 1–LO1).
◼ Describe the various techniques that companies use to control cash (Module 1–LO2).
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Chapter Outline
MODULE 1 ACCOUNTING AND CONTROLLING FOR CASH
Module 1
LO 1
Accounting and Controlling for Cash
Classification as cash indicates that an item is readily available to pay debts.
◼ Cash includes coin, currency, cash on hand, checking and savings accounts, cashier checks,
certified checks and undeposited checks from customers.
Cash Equivalents and the Statement of Cash Flows
◼ Cash equivalents are investments that are readily convertible to a known amount of cash and have
an original maturity to the investor of three months or less.
Module 1
LO 2
Control Over Cash
Control over cash is critical for any size business, since cash is universally accepted as a medium of
exchange.
Cash Management
◼ Internal control over cash is needed to guard against theft and other abuses of cash.
◼ Also necessary to guarantee that neither too much nor too little cash is on hand.
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Reading a bank statement
◼ Two fundamental principles of internal control apply to cash:
• Bank statement provides a detailed list of all activity for a particular account during the
month.
• See Exhibit 6-2 for a typical bank statement.
◼ Canceled checks – checks that have cleared the company’s bank account during the month
◼ Outstanding check – check written by a company but not yet presented to the bank for payment
and therefore is not on statement.
The Bank Reconciliation
The bank reconciliation is a form used by the accountant to reconcile or resolve any differences between
the balance shown on the bank statement for a particular account with the balance shown in the accounting
records.
◼ Should be prepared as soon as the bank statement is received, by someone independent of custody,
record-keeping, and authorization.
• See Example 6-2 for a bank reconciliation.
◼ Steps used in preparing a bank reconciliation:
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• (3) List all items, other than deposits, shown as additions on the bank statement. These items
are called credit memoranda.
Includes additions on a bank statement for such items as interest paid on the account and
notes collected by the bank for the company.
The Need for Adjustments to the Records
◼ The additions and deductions to the Cash account on the books should be the basis for the
adjustments.
Establishing a Petty Cash Fund
◼ Money kept on hand for making minor disbursements in coin and currency rather than by check
◼ The petty cash fund is an exception to the “all expenditures by check” rule for minor amounts.
◼ See Example 6-4 for the journal entry analysis for a petty cash fund.
◼ Steps to set up and maintain a petty cash fund:
• (1) A check is written for a lump-sum amount and cashed, and the coin and currency are
entrusted to a petty cash custodian.
CHAPTER 6 CASH AND INTERNAL CONTROL
• (4) Periodically replenish the fund by writing and cashing a check in the amount necessary to
bring the fund back to its original balance.
MODULE 2 INTERNAL CONTROL
Module 2
LO 3
Internal Control
An internal control system includes the policies and procedures necessary to ensure the safeguarding of
an entity’s assets, the reliability of its accounting records, and the accomplishment of overall company
objectives.
◼ Three assets are especially critical to the operation of merchandising companies: cash, accounts
receivable, and inventory.
The Sarbanes-Oxley (SOX) Act of 2002
◼ An act of Congress intended to bring reform to corporate accountability and stewardship in the
wake of a number of major corporate scandals (WorldCom, Enron, etc.)
◼ Provisions:
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• Access the effectiveness of its internal control structure and procedures for financial
reporting.
First paragraph states management’s responsibility for its system of internal control.
Second paragraph indicates that management believes internal control over financial
reporting is effective.
• Public Company Oversight Board (PCAOB) – The five member body created by SOX that
was given the authority to set auditing standards in the U.S.
The Control Environment
◼ Management’s operating style will have a major impact on the effectiveness of various policies.
• Autocratic style – few key officers tightly control operations.
• Decentralized organization – departments have more freedom to make decisions.
The Accounting System
◼ An accounting system consists of the methods and records used to accurately report an entity’s
transactions and to maintain accountability for assets and liabilities.
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Module 2
LO 4
Internal Control Procedures
◼ Management establishes policies and procedures (either written or oral) to ensure that corporate
objectives will be met.
• Administrative controls are procedures concerned with the efficient operation of the
business and adherence to managerial policies.
◼ Some of the most important internal control procedures include:
• Proper Authorizations – the authority and responsibility delegated by management to
departments and individuals to carry out specific tasks for the business; management can hold
authorized persons responsible for the outcomes of their actions.
Some authorizations are general ( ringing up a sale).
Other authorizations are specific (approval by management of a sales return).
• Independent Verification – the procedure where one department verifies or checks the work
of another department.
Accounting department maintains inventory records, another department counts the
inventory.
Bank reconciliation performed by someone who has no responsibility for custody or the
recordkeeping of cash.
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• Design and Use of Business Documents – provides the crucial link between the transactions
and the accounting record of those events.
Business documents are often called source documents.
Limitations on Internal Control
◼ No system of internal control is totally foolproof.
◼ Installation and maintenance of internal controls are costly and many small companies may not be
able to afford a system of internal controls.
Module 2
LO 5
Computerized Business Documents and Internal Control
Specific internal controls are necessary to control cash receipts and cash disbursements.
◼ Separate the custodianship of cash from its recording in the accounts.
◼ Cash must be deposited daily and intact.
Control Over Cash Receipts
Most merchandisers receive checks and currency from customers either by cash received over the counter
from cash sales or cash received in the mail from credit card sales. Each type of receipt poses its own
control problems.
CHAPTER 6 CASH AND INTERNAL CONTROL
◼ Cash Received Over the Counter control mechanisms:
• Cash registers that allow the customer to see the display.
Deters clerk from ringing up a sale for less than the amount received and pocketing the
difference.
◼ Cash received in the mail control mechanisms:
• Most customers send checks, not currency, through the mail.
• Controls should be in place to ensure all cash received is deposited and the proper customer
account is credited for the payment.
• Two employees should be present when mail is opened:
One employee opens the mail in the presence of the other employee, counts the money,
and prepares a control list of cash received.
• Monthly customer statements act as an additional control device.
Customer should inform the company of any problems in application of customer
payments.
Only effective if the employees responsible for the custody of cash, for the record
keeping, and for the authorization of adjustments to customers’ accounts are not allowed
to prepare and mail the statements to customers.
◼ Cash Discrepancies.
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The Role of Computerized Business Documents in Controlling Cash Disbursements
◼ Companies make payments for a variety of purposes: merchandise, supplies, plant, equipment,
services, operating expenditures, payroll, etc.
◼ Business documents play a vital role in the purchasing function.
◼ Exhibit 6-6 is an illustration of the purchasing process with the appropriate business documents
identified:
• Purchase Order (Exhibit 6-8):
Form sent by the purchasing department to the supplier.
Purchase orders are usually prenumbered; any missing numbers should be investigated.
Purchase requisition is the source of information for the purchase order.
• Legally, the order is merely an offer by the company to purchase the goods.
• Invoice (Exhibit 6-9):
Form sent by the seller to the buyer as evidence of a sale. Requests payment according to
the negotiated terms.
• Sales invoice to the seller and the basis for recording a sale and an account receivable
• Purchase invoice to the buyer and the basis for recording the purchase and account
payable
• Receiving Report (Exhibit 6-10):
When goods are received and unpacked, the receiving department inspects and counts the
items.
• Invoice Approval Form (Exhibit 6-11):
Form the accounting department uses before making payment to document the accuracy
of all information about a purchase; also called a voucher.
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Documents the accuracy of the information on the purchase requisition, the purchase
order, the invoice, and the receiving report.
Accounting department employee must also verify the mathematical accuracy of the
invoice. Also notes date invoice must be paid to take advantage of any discounts.
Accounting department prepares the journal entry to increase the inventory and accounts
payable accounts.
Invoice approval form and the invoice are sent to finance department.
• Check with Remittance Advice (Exhibit 6-12):
Generally finance department is responsible for issuing checks.
• This helps segregate the custody of cash (signed check) from record keeping (the
updating of the ledger).
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Lecture Suggestions
Module 1
LO 1
Discuss the various cash equivalents that may be held by a company.
Module 1
LO 2
Most students have at least a basic understanding of what is involved in balancing a checkbook. If
the bank reconciliation is tied to this, you remove it from the new, complex accounting task
category. If a number of students do not have checking accounts, copy the reconciliation form
from the back of a personal checking statement for distribution. Use it to prepare an example in
class. Focus on how reconciling a bank account is an important control for both businesses and in
personal life.
Module 2
LO 3
Discuss the differences between what is management’s responsibility versus what is the
responsibility of the outside auditor. Focus on the auditor’s responsibility for issuing an opinion
versus management’s broader responsibilities.
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Module 3
LO 4
Review basic examples of internal control procedures. Examine how smaller companies may
employ mitigating controls to prevent fraud and abuse when the more traditional methods would
prove to be too costly.
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Projects and Activities
Module 1
LO 1
Forms of Cash
In-class discussion: PepsiCo cash and investments
PepsiCo, Inc., in a recent Annual Report, lists among their assets the following
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($ millions):
Cash and cash equivalents $6,134
Short term investments 2,592
◼ What is the difference between cash and cash equivalents?
◼ What is the difference between cash equivalents and short term investments? Could any of the
short term investments become cash equivalents in a future period?
Solution
◼ Cash is self-explanatory. Remind students that cash includes the petty cash fund, which may be a
separate ledger account but is not separately listed on the balance sheet. Many students think that
Module 1
LO 2
Control Over Cash
In-class discussion: Accuracy of reconciliation
You are busy reconciling your checking account statement. Noting that you are carrying all your
calculations to the penny, your friend is surprised. She keeps her checkbook in whole dollars, and
reconciles the account the same way. As long as her checkbook ties to the bank’s balance to within a dollar
or two, why worry?
◼ What do you think of this method for a personal checkbook?
◼ Would a whole dollar approach be appropriate for a company? Would it matter if it is a large or
small company?
CHAPTER 6 CASH AND INTERNAL CONTROL
Solution
◼ For a personal account, this probably would not present any particular problem, as long as the
In class- discussion: Ethical questions – Petty cash
Determine and defend the proper action for each situation below:
◼ The custodian of the petty cash fund for a small company routinely “borrows” a couple of dollars
from the box when she is short of train fare, or needs to pick up groceries on the way home and is
short of cash. She is always very careful to leave a scrap of paper in the box indicating how much
she has borrowed, and always repays the money within a day or two, or at least on a Friday when
she gets paid.
◼ A company maintains enough cash in the petty cash box so that they can cash small personal
checks for employees, up to $20. Any employee is allowed to use this service.
◼ A small company, in an attempt to separate custody of the petty cash fund from the accounting and
reconciliation of the balances, has given responsibility for the cash box to the company’s
receptionist, who has no accounting experience but is mature and responsible, and has worked for
the company for five years.
Solution
◼ This situation is alarmingly common, especially in small companies where everyone is “one big
family.” The issue is one of control as much as ethics. No matter how honest the custodian of the
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In-class discussion: What constitutes “petty” cash?
The professional staff of a consulting firm travels extensively, often on very short notice, to distant
locations throughout the world. The staff has expressed the opinion that they much prefer their travel
advances (which again vary from a couple of hundred dollars to four or five thousand dollars, depending
upon the trip) in cash rather than a check. They do not always find it convenient, or even possible, to cash a
check before they leave. The company does not think this is an unreasonable position and is trying to
decide how they will accomplish it.
◼ Is this a petty cash item?
◼ Should the balance of petty cash be increased to accommodate these requests?
◼ What are some things that the company should consider when honoring these requests? In
considering a solution, you should be aware that, because of the locations of some of the
customers, credit cards are not always an option. Credit cards are still not used everywhere you
want to go.
Solution
◼ This is a petty cash item. The size of petty cash varies with the size and needs of the company.
Module 2
LO 3
Internal Control
In–class discussion: The “Tone at the Top”
According to an article in the Fraud Magazine
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, “An organization’s leadership creates the tone at the top –
an ethical (or unethical) atmosphere in the workplace. Management’s tone has a trickle-down effect on
employees. If top managers uphold ethics and integrity, so will employees. But if upper management
appears unconcerned with ethics and focuses solely on the bottom line, employees will be more prone to
commit fraud and feel that ethical conduct isn’t a priority. In short, employees will follow the examples of
their bosses.”
◼ Do you think an autocratic or democratic management style set a better tone at the top?
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◼ What management style does the company you work for have? Is there a good tone at the top?
◼ If you observed unethical conduct or fraud in your workplace would you report it? Why or why
not?
Solution
A proper tone at the top is an important part of a good internal control system.
◼ A democratic management style sets a better tone at the top. Departments and individuals have
more freedom to make decisions and they feel that they are an integral part of the company.
Module 2
LO 4
Internal Control Procedures
In-class discussion: Skimming
Skimming occurs when an employee steals incoming funds from their company.
“Roger was the controller for a midsize soft drink bottler and distributor. Roger perpetrated a very simple
skimming scheme. The daily bank deposits that arrived on his desk had already been prepared by a
bookkeeper. Attached to the deposit slip was documentation in two forms: The bookkeeper prepared a list
of payments on accounts receivable and each route salesman prepared a deposit for the cash he had
collected. Roger left the accounts receivable alone. But for the route deposits (cash sales) he kept a handy
supply of blank forms in his desk. After everyone went home, Roger simply removed cash from one of the
route deposits and prepared a new form showing the lower deposit amount. Then he’d throw away the
deposit slip prepared by the bookkeeper and fill out another in his own handwriting. In an effort to avoid
detection, Roger rotated the route salesman he shorted and he took cash on an irregular basis.”
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Just before he was fired, Roger made a journal entry for over $380,000 debiting cost of sales and crediting
inventory. The reason for the journal entry was noted “To adjust inventory to actual value.”
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What are some controls that could have been put into place to prevent this from happening?
Solution
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There are three principal skimming targets: revenue, refunds, and accounts receivable. Anyone who comes
in contact with cash can perpetrate a skimming scheme. With a skimming scheme, revenues will be lower