The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter Seven Internal Control and Accounting...

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin

Chapter Seven

Internal Control and Accounting for Cash

Key Features of Internal Control

1.1. Separation of DutiesSeparation of Duties2.2. Quality of EmployeesQuality of Employees3.3. Bonded EmployeesBonded Employees4.4. Required AbsencesRequired Absences5.5. Procedures ManualProcedures Manual6.6. Authority and ResponsibilityAuthority and Responsibility7.7. Prenumbered DocumentsPrenumbered Documents8.8. Physical ControlPhysical Control9.9. Performance EvaluationsPerformance Evaluations

Separation of Duties

When duties are separated, the work of one When duties are separated, the work of one employee can act as a check on the work of employee can act as a check on the work of another employee. The likelihood of fraud another employee. The likelihood of fraud

or theft is greatly reduced.or theft is greatly reduced.

Quality of EmployeesThe ability of cross-trained employees to The ability of cross-trained employees to

substitute for one another prevents substitute for one another prevents disruptions in the workplace. Job rotation may disruptions in the workplace. Job rotation may

help relieve boredom and increase help relieve boredom and increase productivity.productivity.

Bonded Employees

A fidelity bond provides insurance that protects a company from loss caused by

employee dishonesty. To become bonded, an employee’s background is investigated.

Required AbsencesAn employee may be able to cover up An employee may be able to cover up fraudulent activities if they are always fraudulent activities if they are always present at work. All employees should present at work. All employees should be be required required to take regular vacations to take regular vacations

and their duties should be rotated and their duties should be rotated periodically.periodically.

Procedures ManualAccounting and other important procedures should beAccounting and other important procedures should be

written in a procedures manual. Periodically,written in a procedures manual. Periodically,management should conduct an investigation to seemanagement should conduct an investigation to seethat required procedures are actually being followed.that required procedures are actually being followed.

Authority and Responsibility

General authority applies to all member of the General authority applies to all member of the organization. For example, all employees are organization. For example, all employees are required to fly coach and purchase airline required to fly coach and purchase airline tickets from a specific vendor.tickets from a specific vendor.

Specific authority applies only to a specific Specific authority applies only to a specific position within the organization. For example, position within the organization. For example, all checks must be cosigned by the Controller all checks must be cosigned by the Controller and Treasurer. and Treasurer.

Prenumbered Documents.

Prenumbered forms are used for all important Prenumbered forms are used for all important documents such as checks, purchase orders, documents such as checks, purchase orders, receiving reports, and invoices. The use of receiving reports, and invoices. The use of

prenumbered forms helps keep track of all forms prenumbered forms helps keep track of all forms issued during a particular period.issued during a particular period.

Physical Control

All companies should maintain adequate All companies should maintain adequate physical control over valuable assets that physical control over valuable assets that

may be misappropriated. For example, may be misappropriated. For example, inventory should be properly stored in a inventory should be properly stored in a

secure location. Serial numbers should be secure location. Serial numbers should be placed on all valuable assets to assist in a placed on all valuable assets to assist in a

physical count of these assets.physical count of these assets.

Performance Evaluation

•Internal controls should include independent Internal controls should include independent verification of employee performance. verification of employee performance.

•A physical inventory should be taken at least A physical inventory should be taken at least annually. An independent reconciliation between annually. An independent reconciliation between the general ledger balance and inventory should the general ledger balance and inventory should be compared to the inventory count.be compared to the inventory count.

•Auditors should evaluate the effectiveness of the Auditors should evaluate the effectiveness of the control system. control system.

LimitationsInternal controls can be circumvented by Internal controls can be circumvented by collusion among employees. Two or more collusion among employees. Two or more

employees working together can hide employees working together can hide embezzlement by covering for each embezzlement by covering for each other. No system can prevent fraud.other. No system can prevent fraud.

Accounting for Cash

ControllingCash

ControllingCash

Cash receiptsCash receipts should be recorded should be recorded immediately upon immediately upon

receipt and receipt and deposited intact deposited intact

daily.daily.

Cash receiptsCash receipts should be recorded should be recorded immediately upon immediately upon

receipt and receipt and deposited intact deposited intact

daily.daily.

Cash disbursementsCash disbursements should be made by should be made by

prenumbered prenumbered check.check.

Cash disbursementsCash disbursements should be made by should be made by

prenumbered prenumbered check.check.

Up to date Up to date signature cardsignature card

should be should be maintained.maintained.

Up to date Up to date signature cardsignature card

should be should be maintained.maintained.

A A deposit ticketdeposit ticket should be used should be used for all deposits.for all deposits.

A A deposit ticketdeposit ticket should be used should be used for all deposits.for all deposits.A monthly A monthly bank bank

reconciliation reconciliation should should be prepared by an be prepared by an independent party.independent party.

A monthly A monthly bank bank reconciliation reconciliation should should be prepared by an be prepared by an independent party.independent party.

Reconciling the Bank Statement

Unadjusted bank balance

Add + Deposits in transit

Deduct - Outstanding checks

Equals = True cash balance

Adjustment to the Bank Balance

The bank reconciliation reports on the The bank reconciliation reports on the differences between the balance on the bank differences between the balance on the bank

statement and the balance in the general statement and the balance in the general ledger cash account. The reconciliation results ledger cash account. The reconciliation results

in the in the true cash balancetrue cash balance that will appear on that will appear on the balance sheet.the balance sheet.

The bank reconciliation reports on the The bank reconciliation reports on the differences between the balance on the bank differences between the balance on the bank

statement and the balance in the general statement and the balance in the general ledger cash account. The reconciliation results ledger cash account. The reconciliation results

in the in the true cash balancetrue cash balance that will appear on that will appear on the balance sheet.the balance sheet.

Unadjusted book balance

Add + Accounts receivable collections

Add + Interest earned

Deduct - Bank service charges

Deduct - Non-sufficient funds (NSF) check

Equals = True cash balance

Adjustments to the Book Balance

Reconciling the Bank Statement

If an error is found on the bank If an error is found on the bank statement, an adjustment for it is made statement, an adjustment for it is made

to the unadjusted bank balance to to the unadjusted bank balance to determine the true cash balance. An determine the true cash balance. An error made on our books requires an error made on our books requires an

adjusting journal entry to correct.adjusting journal entry to correct.

Bank ReconciliationMatrix, Inc. is preparing the bank reconciliation for

the month of June.

1. The June 30th balance on the bank statement is $4,892.56, and the Cash general ledger balance on this date is $4,240.54.

2. There was a deposit in transit in the amount of $475.

3. The bank erroneously deducted a $200 check drawn on the books of Matters, Inc. from our account.

4. At June 30th there were three checks outstanding. Check 1078 dated 6/28, for $372.33; Check 1080 dated 6/29, for $402.41; and Check 1081 dated 6/30, for $66.89.

More InformationMore InformationMore InformationMore Information

Bank Reconciliation5. During the month of June the bank collected an

account receivable for us in the amount of $875.

6. A check actually written for $146.88 for supplies was erroneously recorded in our records by the bookkeeper as $173.88.

7. Matrix earned interest of $9.25 on its checking account.

8. The bank assessed a service charge of $12.75 for June and we deposited a NSF check in the amount of $413.11.

Let’s prepare the bank reconciliationLet’s prepare the bank reconciliationLet’s prepare the bank reconciliationLet’s prepare the bank reconciliation

Bank Reconciliation

Unadjusted bank balance, June 30 4,892.56$ Add: Deposits in transit 475.00 Bank error 200.00 Less: Outstanding checks Check No. 1078 - June 28 372.33 Check No. 1080 - June 29 402.41 Check No. 1081 - June 30 66.89 (841.63) True Cash balance, June 30 4,725.93$

Unadjusted Book Balance, June 30 4,240.54$ Add: Account collected by bank 875.00 Bookkeeping error 27.00 Interest earned on checking account 9.25 Less: Bank service charge (12.75) NSF Check (413.11) True Cash balance, June 30 4,725.93$

Matrix, Inc.Bank Reconciliation Statement

June 30, 2006

Bank Reconciliation

Unadjusted Bank Balance, June 30 4,892.56$ Add: Deposits in transit 475.00 Bank error 200.00 Less: Outstanding checks Check No. 1078 - June 28 372.33 Check No. 1080 - June 29 402.41 Check No. 1081 - June 30 66.89 (841.63) True Cash balance, June 30 4,725.93$

Unadjusted Book Balance, June 30 4,240.54$ Add: Account collected by bank 875.00 Bookkeeping error 27.00 Interest earned on checking account 9.25 Less: Bank service charge (12.75) NSF Check (413.11) True Cash balance, June 30 4,725.93$

Matrix, Inc.Bank Reconciliation Statement

June 30, 2006

Account Title Debit CreditCash 911.25 Accounts receivable 875.00 Supplies expense 27.00 Interest revenue 9.25

Bank service charge expense 12.75 Accounts receivable 413.11 Cash 425.86


Adjusting the BooksEvery reconciling item that appears on the unadjusted book balance section requires a

journal entry to adjust the general ledger cash balance to the true cash balance.


Bank service charge expense 12.75 Accounts receivable 413.11 Cash 425.86

Cash Short and OverWhen using a cash register, employees sometimes make mistakes in collecting cash or making change for customers. If the cash register does not reconcile by a

small amount at the end of the day, we use an account called cash short and over to

force a balance.Assume a cashAssume a cash

register was to haveregister was to havea balance of $500,a balance of $500,but contained onlybut contained only$499 at the end of$499 at the end of

the day.the day.

Assume a cashAssume a cashregister was to haveregister was to havea balance of $500,a balance of $500,but contained onlybut contained only$499 at the end of$499 at the end of

the day.the day.

Account Title Debit CreditCash 499.00 Cash short and over 1.00 Sales 500.00

Using Petty Cash FundsA petty cash fund is used to make small A petty cash fund is used to make small

expenditures that cannot wait for the formal expenditures that cannot wait for the formal check- writing process. The fund is operated check- writing process. The fund is operated on an imprest basis. This means that when on an imprest basis. This means that when the fund gets low on cash it is replenished. the fund gets low on cash it is replenished.

The petty cashier is always responsible for the The petty cashier is always responsible for the cash in the fund. This is an excellent internal cash in the fund. This is an excellent internal

control.control.

A petty cash fund is used to make small A petty cash fund is used to make small expenditures that cannot wait for the formal expenditures that cannot wait for the formal check- writing process. The fund is operated check- writing process. The fund is operated on an imprest basis. This means that when on an imprest basis. This means that when the fund gets low on cash it is replenished. the fund gets low on cash it is replenished.

The petty cashier is always responsible for the The petty cashier is always responsible for the cash in the fund. This is an excellent internal cash in the fund. This is an excellent internal

control.control.

Using Petty Cash FundsEstablishing a $500 petty cash fund.Establishing a $500 petty cash fund.

Account Title Debit CreditPetty cash 500.00 Cash 500.00

Treasurer Treasurer prepares a $500 prepares a $500 check payable to check payable to the petty cashier.the petty cashier.Petty cashier Petty cashier

takes the check takes the check to the bank and to the bank and gets $500 cash gets $500 cash

for the fund.for the fund.

Using Petty Cash FundsDuring the month the petty cashier paid out $217 for FedEx deliveries, $34.50 for late-

working employee meals, $27 for cab fare to the airport for a salesperson, and $187.60 for

office postage stamps. The petty cashier asked for and received a receipt for each

disbursement made this month. The fund is getting low on cash so the petty cashier requests that the fund be replenished.

Using Petty Cash Funds

Here is an analysis of the impact of the reimbursement.

Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

(466.10) = NA + (466.10) NA – 466.10 = (466.10) (466.10) OA

Account Title Debit CreditDelivery Expense 217.00 Employee Meal Expense 34.50 Taxi Expense 27.00 Postage Expense 187.60 Cash 466.10

The journal entry to record the reimbursement would be:

Using Petty Cash Funds

Treasurer Treasurer prepares a prepares a

$466.10 check $466.10 check payable to the payable to the petty cashier.petty cashier.Petty cashier Petty cashier

takes the check takes the check to the bank and to the bank and

gets $466.10 gets $466.10 cash for the fund.cash for the fund.

The fund is now returned to its $500 The fund is now returned to its $500 balance.balance.

Current Versus NoncurrentCurrent assets are expected to be converted to

cash or consumed within one year or an operating cycle, whichever is longer. Current

assets include:•CashCash•Marketable SecuritiesMarketable Securities•Accounts ReceivableAccounts Receivable•Short-Term Notes ReceivableShort-Term Notes Receivable•Interest ReceivableInterest Receivable•InventoryInventory•SuppliesSupplies•PrepaidsPrepaids

•CashCash•Marketable SecuritiesMarketable Securities•Accounts ReceivableAccounts Receivable•Short-Term Notes ReceivableShort-Term Notes Receivable•Interest ReceivableInterest Receivable•InventoryInventory•SuppliesSupplies•PrepaidsPrepaids

Current Versus NoncurrentCurrent liabilities are due within one year or an operating cycle, whichever is longer. Current

liabilities include:

•Accounts PayableAccounts Payable•Short-Term Notes PayableShort-Term Notes Payable•Wages PayableWages Payable•Taxes PayableTaxes Payable•Interest PayableInterest Payable

•Accounts PayableAccounts Payable•Short-Term Notes PayableShort-Term Notes Payable•Wages PayableWages Payable•Taxes PayableTaxes Payable•Interest PayableInterest Payable

Current Assets Cash 20,000$ Accounts Receivable 35,000 Inventory 230,000 Prepaid Rent 3,600 Total Current Assets 288,600$ Property, Plant, and Equipment Office Equipment 80,000$ Less: Accumulted Depreciation (25,000) 55,000 Building 340,000 Less: Accumulted Depreciation (40,000) 300,000 Land 120,000 Total Property, Plant, and Equipment 475,000 Total Assets 763,600$

Current Liabilities Accounts Payable 32,000$ Notes Payable 120,000 Salaries Payable 32,000 Unearned Revenue 9,800 Total Current Liabilities 193,800$ Long-Term Liabilities Notes Payable 100,000 Total Liabilities 293,800 Stockholders' Equity Common Stock 200,000 Retained Earnings 269,800 469,800 Total Liabilities and Stockholders' Equity 763,600$

Liabilities and Stockholders' Equity

Limbaugh CompanyClassified Balance SheetAs of December 31, 2006

Assets

ClassifiedClassifiedBalanceBalanceSheetSheet

Current Ratio

CurrenCurrentt

RatioRatio

==Current AssetCurrent Asset

Current Current LiabilitiesLiabilities

For Limbaugh Company the current ratio is:

CurrentRatio

=$288,600$193,800

= 1.49:11.49:1

End of Chapter Seven

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter Seven Internal Control and Accounting...

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