Bank Reconciliation and Entries

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Financial & Managerial Accounting

Fifteenth Edition

Chapter 7

Internal Control and Cash

Learning Objectives (1 of 2)

Obj. 1: Describe the Sarbanes-Oxley Act and its impact on internal controls and financial reporting.

Obj. 2: Describe and illustrate the objectives and elements of internal control.

Obj. 3: Describe and illustrate the application of internal controls to cash.

Obj. 4: Describe the nature of a bank account and its use in controlling cash.

Obj. 5: Describe and illustrate the use of a bank reconciliation in controlling cash.

Learning Objectives (2 of 2)

Obj. 6: Describe the accounting for special-purpose cash funds.

Obj. 7: Describe and illustrate the reporting of cash and cash equivalents in the financial statements.

Obj. 8: Describe and illustrate the use of days’ cash on hand to assess a company’s ability to meet its cash commitments.

Sarbanes-Oxley Act (1 of 3)

The Sarbanes-Oxley Act (often referred to simply as Sarbanes-Oxley) applies only to companies whose stock is traded on public exchanges, referred to as publicly held companies.

Its purpose is to maintain public confidence and trust in the financial reporting of companies.

Sarbanes-Oxley highlighted the importance of assessing the financial controls and reporting of all companies. As a result, companies of all sizes have been influenced by Sarbanes-Oxley.

Sarbanes-Oxley Act (2 of 3)

Sarbanes-Oxley emphasizes the importance of effective internal control.

Internal control is defined as the procedures and processes used by a company to:

Safeguard its assets.

Process information accurately.

Ensure compliance with laws and regulations.

Sarbanes-Oxley requires companies to maintain effective internal controls over the recording of transactions and the preparing of financial statements.

Effect of Sarbanes-Oxley

Sarbanes-Oxley Act (3 of 3)

Sarbanes-Oxley also requires companies and their independent accountants to report on the effectiveness of the company’s internal controls.

These reports are required to be filed with the company’s annual 10-K report with the Securities and Exchange Commission.

eBay’s Report of Compliance with Sarbanes-Oxley

Management's Annual Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our management, including our principal executive officer and principal financial officer, conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on its evaluation under the framework in Internal Control—Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, ....

Source: eBay, Form 10-K, For the Fiscal Year Ended December 31, 2015.

Objectives of Internal Control

The objectives of internal control are to provide reasonable assurance that:

Assets are safeguarded and used for business purposes.

Business information is accurate.

Employees and managers comply with laws and regulations.

Objectives of Internal Control—Illustrated

Employee Fraud

A serious concern of internal control is preventing employee fraud.

Employee fraud is the intentional act of deceiving an employer for personal gain.

Elements of Internal Control

The three internal control objectives can be achieved by applying the five elements of internal control. These elements are as follows:

Control environment

Risk assessment

Control procedures

Monitoring

Information and communication

Elements of Internal Control—Illustrated

Control Environment (1 of 3)

The control environment is the overall attitude of management and employees about the importance of controls.

Control Environment (2 of 3)

Three factors influencing a company’s control environment include the following:

Management’s philosophy and operating style

Management’s philosophy and operating style relates to whether management emphasizes the importance of internal controls.

The company’s organizational structure

The business’s organizational structure is the framework for planning and controlling operations.

Control Environment (3 of 3)

The company’s personnel policies

The business’s personnel policies involve the hiring, training, evaluation, compensation, and promotion of employees.

In addition, job descriptions, employee codes of ethics, and conflict-of-interest policies are part of the personnel policies.

Control Environment

Risk Assessment

All businesses face risks such as changes in customer requirements, competitive threats, regulatory changes, and changes in economic factors.

Management should identify such risks, analyze their significance, assess their likelihood of occurring, and take any necessary actions to minimize them.

Control Procedures

Control procedures provide reasonable assurance that business goals will be achieved, including the prevention of fraud.

Control procedures include the following:

Competent personnel, rotating duties, and mandatory vacations

Separating responsibilities for related operations

Separating operations, custody of assets, and accounting

Proofs and security measures

Control Procedures—Competent Personnel, Rotating Duties, and Mandatory Vacations

Successful companies need competent employees who are able to perform the duties that they are assigned.

Procedures should be established for properly training and supervising employees.

It is advisable to rotate duties of accounting personnel and mandate vacations for all employees.

Cases of employee fraud are often discovered when a long-term employee, who never took vacations, missed work for some reason.

Control Procedures—Separating Responsibilities for Related Operations (1 of 2)

The responsibility for related operations should be divided among two or more people.

If the same person orders supplies, verifies the receipt of the supplies, and pays the supplier, the following abuses may occur.

Orders may be placed on the basis of friendship with a supplier, rather than on price, quality, and other factors.

Control Procedures—Separating Responsibilities for Related Operations (2 of 2)

Quantity and quality of supplies received may not be verified; thus, the company may pay for supplies not received or that are of poor quality.

Supplies may be stolen by the employee.

For those reasons, the responsibilities for purchasing, receiving, and paying for supplies should be divided among three persons or departments.

Control Procedures—Separating Operations, Custody of Assets, and Accounting

The responsibility for operations, custody of assets, and accounting should be separated.

In this way, the accounting records serve as an independent check on the operating managers and the employees who have custody of assets.

To illustrate, employees who handle cash receipts should not record cash receipts in the accounting records.

To do so would allow employees to borrow or steal cash and hide the theft in the accounting records.

Control Procedures—Proofs and Security Measures

Proofs and security measures are used to safeguard assets and ensure reliable accounting data.

Proofs involve procedures such as authorization, approval, and reconciliation.

Documents used for authorization and approval should be prenumbered, accounted for, and safeguarded.

Prenumbering of documents helps prevent transactions from being recorded more that once or not at all.

Internal Control Procedures

Monitoring

Monitoring the internal control system is used to locate weaknesses and improve controls.

Monitoring often includes observing employee behavior and the accounting system for indicators of control problems.

Warning Signs of Internal Control Problems

Information and Communication

Information about the control environment, risk assessment, control procedures, and monitoring is used by management for guiding operations and ensuring compliance with reporting, legal, and regulatory requirements.

Management also uses external information to assess events and conditions that impact decision making and external reporting.

Check Up Corner: Internal Controls (1 of 4)

Identify the control procedure violated in each of the following scenarios:

Todd Leone is the accounting clerk for Home Chic, a small boutique retail store that is owned and operated by Al Dente. Al does not care much for the accounting side of the business and allows Todd to make all payments to the company’s suppliers. Todd pays all invoices that Home Chic receives. Al does not review the payments Todd makes.

Check Up Corner: Internal Controls (2 of 4)

Jose Muldoon’s Mobile Foods is a food truck with two trusted employees. One employee stocks the food truck each day, prepares the orders, and cleans up the kitchen at the end of the day. The other employee takes orders, collects payment from customers, counts the cash at the end of the day, records the cash receipts, and deposits the cash in the night depository slot at the bank.

Tad is the treasurer and chief financial officer of a local bank in Wisteria, California. Tad was born and raised in the community and has never had a desire to travel. As a result, he has not taken a vacation or a day off of work in over 6 years.

Check Up Corner: Internal Controls (3 of 4)

Solution:

Separating operations, custody of assets, and accounting. The responsibility for maintaining the accounting records, operations, and custody of assets should be separated. This is a violation of this control procedure because the payments do not require approval by an independent party.

Check Up Corner: Internal Controls (4 of 4)

Separating operations, custody of assets, and accounting. The responsibility for maintaining the accounting records, operations, and custody of assets should be separated. This is a violation of this control procedure because the same employee collects the cash (operations and custody of assets), records the cash receipts (accounting records), and deposits the cash (custody of assets).

Competent personnel, rotating duties, and mandatory vacations. Procedures should be established to rotate duties of accounting personnel and mandate vacations for all employees. This is a violation of this control procedure.

Limitations of Internal Control

Internal control systems can provide only reasonable assurance for safeguarding assets, processing accurate information, and compliance with laws and regulations.

In other words, internal controls are not a guarantee.

This is due to the following factors:

The human element of controls

Cost-benefit considerations

Cash

Cash includes coins, currency (paper money), checks, and money orders.

Money on deposit with a bank or other financial institution that is available for withdrawal is also considered cash.

Cash is the asset most likely to be stolen or used improperly in a business.

Control of Cash Receipts

To protect cash from theft and misuse, a business must control cash from the time it is received until it is deposited in a bank.

Businesses normally receive cash from two main sources:

Customers purchasing products or services

Customers making payments on account

Cash Received from Cash Sales (1 of 4)

An important control to protect cash received in over-the-counter sales is a cash register.

Cash Register as a Control

Cash Received from Cash Sales (2 of 4)

Salespersons may make errors in making change for customers or in ringing up cash sales. As a result, the amount of cash on hand may differ from the amount of cash sales. Such differences are recorded in a cash short and over account.

Cash Received from Cash Sales (3 of 4)

For example, the cash register total for cash sales for May 3 totaled $35,690. However, cash receipts from cash sales totaled $35,668. The cash sales, receipts, and shortage would be recorded as follows:

Cash Received from Cash Sales (4 of 4)

If there is a cash shortage, the Cash Short and Over account is debited for the shortage.

If there is a cash overage, the Cash Short and Over account is credited for the overage.

At the end of the accounting period, a debit balance in Cash Short and Over is included in miscellaneous expense on the income statement.

Alternatively, a credit balance is included in the Other Income section of the income statement.

Cash Received in the Mail

Cash is received in the mail when customers pay their bills. This cash is usually in the form of checks and money orders.

Most companies design their invoices so that customers return a portion of the invoice, called a remittance advice, with their payment.

This document helps to control cash received in the mail.

Cash Received by EFT (1 of 3)

Cash may also be received from customers through electronic funds transfers (EFT).

For example, customers may authorize automatic electronic transfers from their checking accounts to pay monthly bills for such items as cell phone, Internet, and electric services.

Cash Received by EFT (2 of 3)

In such cases, the company sends the customer’s bank a signed form from the customer authorizing the monthly electronic transfers.

Each month, the company notifies the customer’s bank of the amount of the transfer and the date the transfer should take place.

On the due date, the company records the electronic transfer as a receipt of cash to its bank account and posts the amount to the customer’s account.

Cash Received by EFT (3 of 3)

Companies encourage customers to use EFT for the following reasons:

EFTs cost less than receiving cash payments through the mail.

EFTs enhance internal controls over cash, since the cash is received directly by the bank without any employees handling cash.

EFTs reduce late payments from customers and speed up the processing of cash receipts.

Control of Cash Payments

The control of cash payments should provide reasonable assurance that:

Payments are made for only authorized transactions.

Cash is used effectively and efficiently. For example, controls should ensure that all available purchase discounts are taken.

Voucher System (1 of 3)

A voucher system is a set of procedures for authorizing and recording liabilities and cash payments. It may be either manual or computerized.

A voucher is any document that serves as proof of authority to pay cash or issue an electronic funds transfer.

Voucher System (2 of 3)

In a manual system, a voucher is normally prepared after all necessary supporting documents have been received.

For the purchase of goods, a voucher is supported by the supplier’s invoice, a purchase order, and a receiving report.

After a voucher is prepared, it is submitted for approval.

Once approved, the voucher is recorded in the accounts and filed by the due date.

Upon payment, the voucher is recorded in the same manner as the payment of an account payable.

Voucher System (3 of 3)

In a computerized system, data from the supporting documents (such as purchase orders, receiving reports, and suppliers’ invoices) are entered directly into computer files.

At the due date, the checks are automatically generated and mailed to creditors.

At that time, the voucher is electronically transferred to a paid voucher file.

Cash Paid by EFT

Cash can also be paid by electronic funds transfer (EFT) systems.

Examples include the following:

A withdrawal of cash from a bank account using an ATM machine

A payment of wages or salaries (payroll check) by an employer directly to an employee’s checking account

A payment to a supplier or other vendor from a company

Bank Accounts

A major reason that businesses use bank accounts is for internal control.

Some of the control advantages of using bank accounts are as follows:

Bank accounts reduce the amount of cash on hand.

Bank accounts provide an independent recording of cash transactions. Reconciling the balance of the cash account in the company’s records with the cash balance according to the bank is an important control.

Use of bank accounts facilitates the transfer of funds using EFT systems.

Bank Statement (1 of 5)

Banks maintain a record of all checking account transactions.

A summary of all transactions, called a bank statement, is mailed, usually each month, to the company (depositor) or made available online.

A bank statement shows the beginning balance, additions, deductions, and the ending balance.

Bank Statement

Bank Statement (2 of 5)

The company’s checking account balance in the bank records is a liability. Thus, in the bank’s records, the company’s account has a credit balance.

Because the bank statement is prepared from the bank’s point of view, a credit memo entry on the bank statement indicates an increase (a credit) to the company’s account.

Likewise, a debit memo entry on the bank statement indicates a decrease (a debit) in the company’s account.

Bank Statement (3 of 5)

A bank makes credit entries (issues credit memos) for the following:

Deposits made by electronic funds transfer (EFT)

Collections of notes receivable for the company

Proceeds for a loan made to the company by the bank

Interest earned on the company’s account

Correction (if any) of bank errors

Bank Statement (4 of 5)

A bank makes debit entries (issues debit memos) for the following:

Payments made by electronic funds transfer (EFT)

Service charges

Customer checks returned for not sufficient funds

Correction (if any) of bank errors

Checking Account: Company and Bank Perspectives

Bank Statement (5 of 5)

The following types of credit or debit memo entries are found on a bank statement:

EC: Error correction to correct bank error

NSF: Not sufficient funds check

SC: Service charge

ACH: Automated clearing house entry for electronic funds transfer

MS: Miscellaneous item such as collection of a note receivable on behalf of the company or receipt of a loan by the company from the bank

Using the Bank Statement as a Control over Cash

The cash balance shown by a bank statement is usually different from the company’s cash balance.

Differences between the company balance and the bank balance may arise because of the following:

A delay by either the company or bank in recording transactions

The bank has debited or credited the company’s account for transactions that the company will not know about until the bank statement is received

Errors, such as an incorrect posting, made by either the company or the bank

Power Networking’s Bank Statement and Records

Bank Reconciliation (1 of 3)

A bank reconciliation is an analysis of the items and amounts creating the difference between the cash balance reported in the bank statement and the balance of the cash account in the ledger

The adjusted cash balance determined in the bank reconciliation is reported on the balance sheet.

Bank Reconciliation (2 of 3)

A bank reconciliation is usually divided into two sections as follows:

The bank section begins with the cash balance according to the bank statement and ends with the adjusted balance.

The company section begins with the cash balance according to the company’s records and ends with the adjusted balance.

The adjusted balance from bank and company sections must be equal.

Bank Reconciliation (3 of 3)

The format of the bank reconciliation follows:

How to Prepare a Bank Reconciliation (1 of 4)

Bank Section of Reconciliation

Step 1. Enter the Cash balance according to bank from the ending cash balance according to the bank statement.

Step 2. Add deposits not recorded by the bank. Identify deposits not recorded by the bank by comparing each deposit listed on the bank statement with unrecorded deposits appearing in the preceding period's reconciliation and with the current period's deposits.

Examples: Deposits in transit at the end of the period.

How to Prepare a Bank Reconciliation (2 of 4)

Step 3. Deduct outstanding checks that have not been paid by the bank. Identify outstanding checks by comparing paid checks with outstanding checks appearing on the preceding period's reconciliation and with recorded checks. Examples: Outstanding checks at the end of the period.

Step 4. Determine the Adjusted balance by adding Step 2 and deducting Step 3.

How to Prepare a Bank Reconciliation (3 of 4)

Company Section of Reconciliation

Step 5. Enter the Cash balance according to company from the ending cash balance in the ledger.

Step 6. Add credit memos that have not been recorded.

Identify the bank credit memos that have not been recorded by comparing the bank statement credit memos to entries in the journal. Examples: A note receivable and interest that the bank has collected for the company.

Step 7. Deduct debit memos that have not been recorded.

Identify the bank debit memos that have not been recorded by comparing the bank statement debit memos to entries in the journal.

How to Prepare a Bank Reconciliation (4 of 4)

Examples: Customers' not sufficient funds (NSF) checks; bank service charges.

Step 8. Determine the Adjusted balance by adding Step 6 and deducting Step 7.

Verify That Adjusted Balances Are Equal

Step 9. Verify that the adjusted balances determined in Steps 4 and 8 are equal.

Bank Reconciliation for Power Networking (1 of 3)

The bank statement shows a balance of $3,359.78 as of July 31. The cash balance in Power Networking’s ledger on the same date is $2,549.99.

Bank Reconciliation for Power Networking (2 of 3)

The following reconciling items were identified:

In addition, Check No. 879 for $732.26 to Taylor Co., on account, was recorded in the company’s journal as $723.26.

Bank Reconciliation for Power Networking

Bank Reconciliation for Power Networking (3 of 3)

The journal entries for Power Networking, based on the bank reconciliation, are as follows:

After the preceding journal entries are recorded and posted, the cash account will have a debit balance of $2,630.99. This cash balance agrees with the adjusted balance shown on the bank reconciliation.

Bank Reconciliation

The objective of reconciling bank accounts is to control cash by reconciling the company’s records with the bank statement. In doing so, errors or misuse of cash may be detected.

To enhance internal control, the bank reconciliation should be prepared by an employee who does not take part in or record cash transactions. Otherwise, mistakes may occur, and it is more likely that cash will be stolen or misapplied.

Check Up Corner: Bank Reconciliation (1 of 3)

The following data related to the bank account of Apex Company were gathered on December 31, 20Y9, the end of the fiscal year:

The following additional information was provided to help reconcile the company’s bank account:

Check Up Corner: Bank Reconciliation (2 of 3)

Prepare a bank reconciliation for Apex Company on December 31, 20Y9.

Check Up Corner: Bank Reconciliation (3 of 3)

Petty Cash Fund (1 of 6)

It is not practical for a business to write checks to pay small amounts for such items as postage, office supplies, or minor repairs.

Thus, it is desirable to control such payments by using a special cash fund, called a petty cash fund.

Petty Cash Fund (2 of 6)

A petty cash fund is established by estimating the amount of payments needed from the fund during a period, such as a week or a month.

A check is then written and cashed for this amount.

The money obtained from cashing the check is then given to an employee, called the petty cash custodian, who disburses monies from the fund as needed.

Petty Cash Fund (3 of 6)

The petty cash fund is normally replenished at periodic intervals, when it is depleted, or when it reaches a minimum amount.

When a petty cash fund is replenished, the accounts debited are determined by summarizing the petty cash receipts. A check is then written for this amount, payable to Petty Cash.

Petty Cash Fund (4 of 6)

To illustrate, assume a petty cash fund of $500 is established on August 1. The entry to record the transaction is as follows:

The only time Petty Cash is debited is when the fund is initially established or when the fund is being increased.

The only time Petty Cash is credited is when the fund is being decreased.

Petty Cash Fund (5 of 6)

At the end of August, there is $30 of petty cash on hand and petty cash receipts for the following items:

If the amount to replenish the petty cash fund does not equal the total of the petty cash receipts, the difference is recorded as Cash Short and Over.

Petty Cash Fund (6 of 6)

In the preceding example, $470 ($500 less cash on hand of $30) is needed to replenish the petty cash fund. Since the total of the petty cash receipts is $467, Cash Short and Over is debited for $3, as shown in the following entry to replenish the petty cash fund.

Special-Purpose Funds

Companies often use other cash funds for special needs, such as payroll or travel expenses. Such funds are called special-purpose funds.

Financial Statement Reporting of Cash (1 of 3)

Cash is normally listed as the first asset in the “Current assets” section of the balance sheet.

A company may temporarily have excess cash. In such cases, the company normally invests in highly liquid investments in order to earn interest. These investments are called cash equivalents.

Examples of cash equivalents include the following:

U.S. Treasury bills

Notes issued by major corporations (referred to as commercial paper)

Money market funds

Financial Statement Reporting of Cash (2 of 3)

Companies that have invested excess cash in cash equivalents usually report Cash and cash equivalents as one amount on the balance sheet.

Financial Statement Reporting of Cash (3 of 3)

Banks may require that companies maintain minimum cash balances in their bank accounts. Such a balance is called a compensating balance and is normally disclosed in notes to the financial statements.

A compensating balance is often required by the bank as part of a loan agreement or line of credit.

A line of credit is a preapproved amount the bank is willing to lend to a customer upon request.

Analysis for Decision Making: Days’ Cash on Hand (1 of 4)

Days’ cash on hand measures how long a company could survive if its sources of revenue were to decline significantly.

Days’ cash on hand is calculated as follows:

Analysis for Decision Making: Days’ Cash on Hand (2 of 4)

The cash and short-term investments are taken from the year-end balance sheet and represent the most liquid assets.

The daily cash operating expenses are computed from income statement information, as follows:

Daily Cash Operating Expenses = (Operating Expenses −– Depreciation Expense) ÷ 365 days

Analysis for Decision Making: Days’ Cash on Hand (3 of 4)

The following information is provided from three recent annual financial statements for eBay (in millions):

	Year 3	Year 2	Year 1
Cash (end of year)	$1,816	$1,832	$4,105
Short-term investments (end of year)	5,333	4,299	3,730
Operating expenses	4,647	4,624	4,651
Depreciation expense	682	687	682

Analysis for Decision Making: Days’ Cash on Hand (4 of 4)

The days’ cash on hand for all three years is computed as:

	Year 3	Year 2	Year 1
Cash and short-term investments:
$1,816 + $5,333	$7,149
$1,832 + $4,299		$6,131
$4,105 + $3,730			$7,835
Daily cash operating expenses:*
($4,647 — $682) ÷ 365 days	$ 10.9
($4,624 — $687) ÷ 36