Accounting MEMO (Writing Assignment)

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Financial & Managerial Accounting

Fifteenth Edition

Chapter 7

Internal Control and Cash

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, and

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.

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.

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.

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

Control Environment

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

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

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.

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.

Limitations of Internal Control

Internal control systems can provide only reasonable assurance for safeguarding assets, processing accurate information, and compliance with laws and regulations. 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 2)

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

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 (2 of 2)

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.

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

Cash Received by EFT (2 of 3)

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

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 EFT.

Cash Paid by EFT

Cash can also be paid by EFT systems.

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 (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 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 EFT

Service charges

Customer checks returned for not sufficient funds

Correction (if any) of bank errors

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 EFT

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 the 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

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 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.

Petty Cash Fund (1 of 3)

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 3)

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 3)

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.

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 2)

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 2)

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 2)

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 2)

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

Expenses

Operating

Cash

Daily

Investment

Term

Short

and

Cash

Hand

Cash

Days’