CB2100_L6_Ch4_Cash and Internal Controls

Internal Controls

Incorrect Financial Statement

- Reasons:

 Error – accidental errors in recording transactions or applying accounting rules

 Fraud – a person intentionally deceives another person for personal gain to damage that

person

---Occupational fraud: the use of one’s occupation for personal enrichment through

the deliberate misuse or misapplication of the employer’s resources

Fraud Triangle: Opportunity, Motivation, Rationalization

Opportunity — the situation allows the fraud to occur.

Motivation — someone feels the need to commit fraud, such as the need for money.

Rationalization — justification for the deceptive act by the one committing the fraud.
Internal Controls

• Internal controls attempt to eliminate the opportunity element of fraud

• Internal controls represent plans to:

 Safeguard the company’s assets

 Improve the accuracy and reliability of accounting information

the impact of accounting scandals and the passage of the Sarbanes-Oxley Act.

Accounting Scandals and Response by Congress

• Managers are entrusted with the resources of both the company’s lenders and owners

• Managers act as stewards or caretakers of the company’s assets

• Some managers have shirked their ethical responsibilities

 Top executives misused or misreported the company’s funds

Accounting Fraud in U.S. History

Sarbanes-Oxley Act of 2002

• Passed by Congress

• Also known as the Public Company Accounting Reform and Investor Protection Act of

2002

• Applies to all companies that are required to file financial statements with the SEC

• Established guidelines related to:

 Internal control procedures

 Auditor-client relations

Major Provisions of the Sarbanes-Oxley Act of 2002

Key Point

The accounting scandals in the early 2000s prompted passage of the Sarbanes-Oxley Act (SOX).

Among other stipulations, SOX sets forth a variety of guidelines related to auditor-client

relations and additional internal controls.

Section 404, in particular, requires company management and auditors to document and assess

the effectiveness of a company’s internal controls.

Identify the components, responsibilities, and limitations of internal control.

Components of Internal Control: Methods for collection of relevant information and

communication in a timely manner, enabling people to carry out their responsibilities.

Live Nation’s Discussion of Internal Controls Over Financial Reporting

Components of Internal Control

• The overall attitudes and actions of management greatly affect the control

environment.

• Risk assessment includes careful consideration of internal and external risk

factors.

• Control activities include a variety of policies and procedures used to protect a

company’s assets.

• Monitoring of internal controls needs to occur on an ongoing basis.

• Information and communication depend on the reliability of the accounting

information system itself.

Control Activities – Preventative Controls

• Separation of duties – A set of procedures intended to separate employees’

duties for authorizing transactions, recording transactions, and controlling the

related assets.

• Physical controls – A set of procedures that ensure assets and accounting records

are kept safe.

• Proper authorization – A set of procedures designed to prevent improper use of

the company’s resources.

• Employee management – Providing employees with appropriate guidance to

ensure they have the knowledge necessary to carry out their job duties.

• E-commerce controls – A set of procedures specifically designed to ensure only

authorized personnel are able to conduct e-commerce transactions.

Control Activities – Detective Controls

• Reconciliations – Management should periodically determine whether the

amount of physical assets of the company (cash, supplies, inventory, and other

property) agree with the accounting records.

• Performance reviews – The actual performance of individuals or processes

should be checked against their expected performance.

• Audits – Hire an independent auditor to assess the internal control procedures to

detect any deficiencies or fraudulent behavior of employees.

Responsibilities for Internal Control

• Top Executives:

 Everyone in a company has an impact on the operation and effectiveness of

internal controls.

 The top executives are the ones who must take final responsibility for their

establishment and success.

Excerpt from Regal Entertainment’s Auditor’s Report Related to Effectiveness of Internal

Controls
Limitations of Internal Control

• Even with the best internal control systems, financial misstatements can occur.

• Internal control systems are especially susceptible to collusion.

 Collusion: Two or more people acting in coordination to circumvent internal

controls

• Top-level employees who can override internal control procedures also have opportunity

to commit fraud.

• Effective internal controls and ethical employees alone cannot ensure a company’s

success, or even survival.

Key Point

Internal control refers to a company’s plan to improve the accuracy and reliability of accounting

information and safeguard the company’s assets.

Five key components to an internal control system are (1) control environment, (2) risk

assessment, (3) control activities, (4) monitoring, and (5) information and communication.

Control activities include those designed to prevent or detect fraudulent or erroneous behavior.
Cash

Define cash and cash equivalents.

Components of the Total Cash Balance

Key Point

Cash includes:

• Coins and currency, checks received, and balances in savings and checking accounts,

• Credit card and debit card sales, and

• Cash equivalents, defined as investments that mature within three months from the date

of purchase (such as money market funds, Treasury bills, and certificates of deposit).
Understand controls over cash receipts and cash disbursements.

Collections of Payments from Customers

• Cash and checks (“paper”)

• Credit cards and debit cards (“plastic”)

• Mobile payments

• Electronic funds transfers (EFTs)

• Prepaid cards

• Cryptocurrencies

Controls over Receipt of Cash and Checks

1. Open mail each day, and make a list of cash and checks received, including the amount

and payer’s name.

2. Designate an employee to deposit cash and checks into the company’s bank account each

day, different from the person who receives cash and checks.

3. Have another employee record cash receipts in the accounting records as soon as

possible. Verify cash receipts by comparing the bank deposit slip with the accounting

records.

4. Accept credit cards or debit cards, to limit the amount of cash employees handle.
Acceptance of Credit Cards

• The acceptance of credit cards provides an additional control by reducing employees’

need to directly handle cash.

• Meanwhile, the credit card company deposits cash in the company’s bank for the amount

of the sale, less service fees.

Record Credit Card Sales

Acceptance of Debit Cards

• Like credit cards, debit cards offer customers a way to purchase goods and services

without a physical exchange of cash.

• They differ, however, in that most debit cards (sometimes referred to as check cards)

work just like a check and withdraw funds directly from the cardholder’s bank account at

the time of use.

• Similar to credit cards, the use of debit cards by customers results in a fee being charged

to the retailer.

• However, the fees charged for debit cards are typically much lower than those charged

for credit cards.

Common Mistake

• The term debit card can cause some confusion for someone in the first accounting course.

• Throughout this course, we refer to an increase in cash as a debit to cash. However, using

your debit card will result in a decrease in your cash account.

• The term debit card refers to the bank’s liability to the company being decreased

(debited) when the company uses a debit card. Don’t let this confuse you.
Controls Over Cash Disbursements (1 of 2)

1. Make all disbursements, other than very small ones, by check, debit card, or credit card.

This provides a permanent record of all disbursements.

2. Authorize all expenditures before purchase and verify the accuracy of the purchase itself.

The employee who authorizes payment should not also be the employee who prepares the

check.

3. Make sure checks are serially numbered and signed only by authorized employees.

Require two signatures for larger checks.

4. Periodically compare amounts shown in the debit card and credit card statements with

purchase receipts. The employee verifying the accuracy of the debit card and credit card

statements should not also be the employee responsible for actual purchases.

5. Set maximum purchase limits on debit cards and credit cards. Give approval to purchase

above these amounts only to upper-level employees.

6. Employees responsible for making cash disbursements should not also be in charge of

cash receipts.

Record Purchase of Advertising with Cash, Check, or Debit Card

Record Purchase of Advertising with Credit Card

Key Point

• Because cash is the asset of a company most susceptible to employee fraud, controls over

cash receipts and cash disbursements are an important part of a company’s overall

internal control system.

• Important controls over cash receipts include separation of duties for those who handle

cash and independent verification of cash receipts.

• Important controls over cash disbursements include payment by check, credit card, or

debit card, separation of duties, and various authorization and documentation procedures.
Bank Reconciliation:

The balance of cash in the company’s records may not equal the balance of cash in the bank’s

records.

A bank reconciliation matches the balance of cash in the bank with the balance of cash in the

company’s own records.

Timing differences in cash occur when the company records transactions before or after the

bank records the same transactions.

Errors can be made either by the company or its bank and may be accidental or intentional.
Company Records of Cash Activities

Bank Statement
Reconciling the Bank Account

Reconciling the bank account involves the following three steps:

1. Reconcile the bank’s cash balance.

2. Reconcile the company’s cash balance.

3. Update the company’s Cash account by recording items identified in step 2.

Step 1:

Reconcile the Bank’s Cash Balance

• Cash transactions recorded by the company, but not yet recorded by its bank:

 Deposits outstanding: Cash receipts of the company that have not been added to

the bank’s record of the company’s balance

 Checks outstanding: Checks the company has written that have not been

subtracted from the bank’s record of the company’s balance

 Bank errors
Differences in Cash Collections

Differences in Cash Payments

Bank Reconciliation

COMMON MISTAKE
Step 3: Update the Company’s Cash Account

Update the balance in the company’s Cash account to adjust for items used to reconcile the

company’s cash balance (bank reconciliation).

• Debit Cash for items that add to the balance.

• Credit Cash for items that subtract from the balance.

 • In the uncommon event that the two balances at the end of the bank reconciliation

schedule are not equal, management investigates the discrepancy to check for

wrongdoing or errors by company employees or the bank.

• If the company cannot resolve the discrepancy, it records the difference to either

Miscellaneous Expense or Miscellaneous Revenue, depending on whether it has a debit

or credit balance.

Common mistake
Summary of Items Included in the Bank Reconciliation

Key Point

• In a bank reconciliation we reconcile the bank’s cash balance for:

1) Cash transactions already recorded by the company but not yet recorded

by the bank and

2) Bank errors.

• Similarly, we reconcile the company’s cash balance for:

1) Cash transactions already recorded by the bank but not yet recorded by the

company and
 2) Company errors.

• After we complete the reconciliations, the amounts for the bank balance and the company

balance should be equal.

• Any adjustments to the company’s balance need to be recorded.

Account for employee purchases.

Employee Purchases

• Petty cash fund: small amount of cash kept on hand to pay for minor purchases

 Accounting for the petty cash fund involves:

• Establishing the fund

• Recognizing expenditures from the fund

• Replenishing the fund

• Company-issued debit and credit cards

 Debit cards (and checks) captured in the bank reconciliation

 Credit card purchases need to be recorded

Establish a Petty Cash Fund

• Establish a petty cash fund of $200.

• Remove cash from the bank and place it on hand at the company.

Employee Purchases
Key Point

• To make purchases on behalf of the company, some employees are allowed to use debit

cards and credit cards (purchase cards), write checks, and spend available cash on hand

(petty cash fund).

• At the end of the period, all employee purchases are recorded, and the petty cash fund is

replenished.

Internal Controls over Employee Expenditures

• Employees should be required to provide receipts and justification for those receipts on a

timely basis.

• A separate employee reviews receipts and supporting documents to ensure all

expenditures are made appropriately.

• Credit card receipts are reconciled to credit card statements.

• Spending limits are placed on employees who are authorized to use a company credit

card or have access to company cash. Major expenditures require pre-approval through

formal purchasing procedures.

• Only those employees that need to make timely business expenditures should receive

authorization.
STATEMENT OF CASH FLOWS

Major inflows and outflows of cash

Reporting Cash

Statement of cash flows

• Operating activities

 Cash transactions involving revenues and expenses

 Examples: Cash received from customers, cash paid for rent, utilities, supplies,

and salaries

• Investing activities

 Cash investments in long-term assets and investment securities

  Examples: Purchase or sale of land, equipment, and buildings for cash

• Financing activities

 Transactions designed to finance the business through borrowing and owner

investment

 Examples: Issue common stock or pay dividends; borrow or repay debt

External Transactions of Eagle Soccer Academy

Statement of Cash Flows for Eagle Soccer Academy

Key Point

The statement of cash flows reports all cash activities for the period.

• Operating activities include those transactions involving revenue and expense activities.

• Investing activities include cash investments in long-term assets and investment

securities.

• Financing activities include transactions designed to finance the business through

borrowing and owner investment.