financial accounting dave ludwick, p.eng, mba, pmp, phd chapter 9 internal control and cash

Financial AccountingDave Ludwick, P.Eng, MBA, PMP, PhD

Chapter 9Internal Control

and Cash

In this chapter…Balance Sheet

Current Assets

Cash

Chapter

9, 19 10000

Current Liabilities

Accounts Payable 5000

Accounts Receivable 20000 Wages Payable 25000

Notes Receivable 15000 Utilities Payable 2000

Marketable Securities 25000 Long-Term Debt

Inventory 120000 Notes Payable 20000

Capital Assets Bonds Payable 600000

Equipment 250000 Owner’s Equity

Buildings 500000 Common Stock 300000

Goodwill 60000 Retained Earnings

48000

Total Assets 1000000 Total Liabilities + OE 1000000


Internal Control Systems• All policies and procedures used to:

– Protect assets

– Ensure reliable accounting

– Promote efficient operations

– Encourage adherence to company policies

• The primary purpose of internal control systems is to help extend the control an owner/manager has over the above items

• The bigger a company gets, the less hands on control managers have and so the greater the need for controlling systems to safeguard assets


Principles of Internal Control• Ensure transactions and activities are authorized

• Maintain records– Using pre-printed forms and filing procedures help to track the processes

that run under the forms

• Insure assets– Passes the risk of loss to a party willing to bear the loss (for a premium)

• Separate record keeping from custody of assets– Risk of loss or theft gets reduced when the person having control over

assets knows there is another person maintaining records

• Separate duties– Dividing responsibilities for related transactions as a safety check


Principles of Internal Control• Apply technological controls

– Use a cash register with a tape record, use time cards to track hourly wage earners’ activities

– Computerized control systems can provide more security with less paper trail and less auditing effort but still pose challenges

• Separating duties is even more critical the more technologically advanced the accounting system

• Perform internal and external audits– Regularly reviewing the records helps to ensure any issues are

reconciled within a short period of time and also tunes the auditor to look for common errors or patterns


Limitations of Internal Control• The more active people are in the internal control process,

the more likely human error and human fraud can play as a factor

• Human error results from fatigue, negligence, confusion or training issues

• Human fraud is intentionally malicious activity designed to defeat a control system

• Management can influence these by conveying a commitment and following through with processes that exercise control


Limitations of Internal Control• Cost-benefit

– Its important to note that all quality assurance processes add no discernable value to the product or process (they prevent further loss).

– Internal control is the same

– Companies then should manage the investment they make in internal controls with respect to the return they expect to get from the effort


Cash• Cash is probably one of the most important assets an

organization can have. • Cash – includes currency, coins, and amounts on deposit in

bank accounts. It also includes customers’ cheques, cashiers cheques, certified cheques, money orders, EFT deposits– Basically anything that is cash or a cash equivalent

• Liquidity refers to how easily an asset can be converted into cash for paying obligations

• Cash is the most fluid of assets and so can be easily hidden and moved. Special precautions should be in place to secure cash. The control mechanisms outlined earlier are applicable


Petty Cash• Most organizations put most of their cash in bank accounts

so that it can earn interest – but also that it is securely stored.

• For many organizations, this means that all payments can be made by cheque. These invoke a highly tuned and specialized tracking system run by banks to secure the funds controlled by cheques.

• But many small expenses are too small to pay by cheque (the cost/inconvenience of paying by cheque becomes too large)

• Petty Cash is a small store of cash used to pay small incidental costs (courier fees, repairs, supplies)


Petty Cash• A Petty Cash fund has its own periodic cycle that can be

used to control the small amount of funds on hand

• It starts by establishing the petty cash fund:

• This establishes the petty cash fund. Now that it is established, it is no longer debited or credited, unless the owner wishes to increase it or decrease it

Date Account Titles and explanation PR Debit Credit

Apr 1 Petty Cash 100

Cash 100


Petty Cash• Now that Petty Cash is established, the Petty Cashier can

use cash to pay small expenses.

• Whenever an expense is paid directly out of petty cash a receipt is issued to record the purpose of the cash disbursement.

• At the end of the period (month), all receipts are collected and examined to determine how various expense and asset accounts should be debited.

• Exhibit 9.2 shows the Petty Cash Payments Report that summarizes the period’s use of Petty Cash– Note the calculation of over/short.

• The figures in this table are used to record journal entries


Petty Cash• You can see how the report translates into a journal entry

to record the petty cash disbursements into the books– All expenses are debited (increased)

– The cash shortage is considered an “expense” and so is also debited so that cash can be used to replenish all the expenses plus the shortage.

– Note how the Petty Cash account itself is not touched here. It is as if the Cash account “reaches over top” of the Petty Cash account to cover the expenses

– In the second journal entry, you can see how the Petty Cash account is increased. The Petty Cash account is also debited (similar to when it was opened) and that much more cash is added to the Cash credit line


Mid-chapter Demo Problem• Lets try out the Mid-chapter Demo problem

– Establish the Castillo Company’s petty cash fund

– Record transactions and replenish the fund• Use a Petty Cash Payments Report to understand how the cash has

flowed out of the account

– Independent of the second item, reduce Petty Cash by $100


Banking Activities• Mentioned earlier, banking activities serve to secure funds.

– This is done by storing funds in banks, but also by leveraging their detailed reporting system

• Bank Account – a record set up by a bank for a customer permitting that customer to deposit and withdraw funds through deposits and cheques.– Signature cards are used to authorize various people to sign

company cheques

• Bank deposits – the act of delivering cash or equivalents to the bank. The bank will issue a deposit slip as proof of deposit to the account.


Banking Activities• Cheques – documents written by the bank account

customer and given to their vendors or suppliers. – By presenting the cheque to the bank, the vendor claims the funds.

– The cheque authorizes the bank to distribute the funds to the vendor

• Electronic Funds Transfer (EFT) - this is a new fangled way of transferring money between business partners.– Far cheaper than writing and mailing cheques, plus it occurs

instantly


Banking Activities• Credit Cards – Paying by credit card is convenient for

customers, which helps to spark sales– Allowing payment by credit card allows organizations to make sales

where they otherwise may not

– Shifts the burden of collecting on credit sales to a credit card company

– The credit card company manages this assumed burden and associated expenses by charging the organization a small credit card transaction fee

– Sometimes credit card companies also charge the credit card user with fees

• The book distinguishes between a credit card and a bank credit card– The difference is the timing in payment to the retailer


Banking Activities• Debit Cards – these cards allow funds to be directly

transferred between the customer’s account and the organization’s account.– Again, the bank does charge a fee for this service to the retailer

and also sometimes to the customer


Bank Statements• Bank Statements are usually a monthly report mailed to

the business owner (accounting department), which summarizes the transactions on the bank account for the stated period (Exhibit 9.5)– Notice that Deposits are called Credits and Cheques are called

debits

– In our books, deposits are increases in cash and so are debits and cheques decrease cash accounts and so credit those accounts

– The difference is that these statements are reported from the bank’s perspective.

• A company’s bank account is a liability on the books of a bank


Bank Reconciliation• Bank reconciliation is a method used to control and

confirm the cash accounts.– Because of the fluid/liquid nature of cash, this process is extremely

critical

• In a big company, bank records may rarely match the company records for the bank account – there is just too much going on.

• Reconciliation helps to explain and reconcile the differences which can be caused mostly by timing differences….


Bank Reconciliation• Causes for differences between company and bank account

records:– Unrecorded funds – These are deposits made and recorded in the

books by the company but not yet by the bank (say, overnight deposits)

– Outstanding cheques – cheques are recorded as cash outlays by the company, but have not yet been cashed by the supplier

– Collections or interest earned – The bank may offer interest on savings accounts and so may issue interest payments to the bank account holder. These are recorded in the bank account statement unknown to the company.

– Deductions for service fees – similarly, banks will deduct for services fees directly from the bank account without informing the company.

– Errors – made by both the bank and the company


Reconciling a Bank Statement• First, note the ending date/period for the statement

• Note the beginning and ending balances

• Compare all deposits on the bank statement with those recorded by the accounting records. Identify discrepancies and determine which is correct

• Compare cancelled cheques received with those recorded on the bank statement and with those recorded in the books– Identify outstanding cheques between the books and the bank account

• Inspect all additions due to customer payments, interest earned, collections

• Inspect all deductions due to service fees, NSF cheques, etc


Reconciling a Bank Statement• Lets walk through the bank reconciliation exercise on page

456 to understand how the company reconciles its books with its bank accounts– Build a reconciliation report (which looks like Exhibit 9.9, but for

the next month) to summarize the reconciliation

– Prepare adjusting entries for any action that was outstanding


Exercises• Try Exercise 9-6

– Establish the Petty Cash account

– Prepare the Petty Cash Payments Report

– Complete the journal entries to replenish the account and record expenses


Exercises• Try Exercise 9-7. For all 3 pieces of this exercise:

– Establish the Petty Cash account

– Prepare the Petty Cash Payments Report

– Complete the journal entries to replenish the account and record expenses


Exercise• Try Problem 9-4A, 9-5A, 9-8A

• Chapter 10


financial accounting dave ludwick, p.eng, mba, pmp, phd chapter 9 internal control and cash

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