Principles of financial accounting 12e by needles crosson chapter 08

Concepts Underlying Internal Control Internal control is the process that establishes the reliability of the accounting records and financial statements and ensures that the company’

Powers

Crosson

Principles of

Accounting

12e

Cash and Internal Control

8

C H A P T E R

Concepts Underlying Internal Control

 Internal control is the process that

establishes the reliability of the accounting records and financial statements and

ensures that the company’s assets are

protected.

– Taking a physical inventory facilitates control over merchandise inventory.

 This process involves an actual count of all merchandise on hand.

 A physical inventory must be taken under both the periodic and perpetual inventory systems.

 Merchandisers usually take a physical inventory after the close of business on the last day of their fiscal year.

Components of Internal Control

(slide 1 of 2)

 An effective system of internal control has five interrelated components.

– Control environment —created by

management’s overall attitude, awareness, and actions It encompasses:

 a company’s ethics, philosophy, and operating style

 organizational structure

 method of assigning authority and responsibility

 personnel policies and practices

– Risk assessment —involves identifying areas

in which risks of loss of assets or inaccuracies

in accounting records are high.

Components of Internal Control

(slide 2 of 2)

– Control activities —the policies and

procedures management puts in place to see that its directives are carried out

– Information and communication —pertains

to the way the accounting system gathers and treats information about the company’s transactions and how it communicates

individual responsibilities within the system.

– Monitoring —management’s regular

assessment of the quality of internal control, including periodic review of compliance with all policies and procedure

Control Activities

(slide 1 of 2)

 The goal of control activities is to safeguard a

company’s assets and ensure the reliability of

the accounting records Standard controls

include:

– Authorization —the approval of certain transactions and activities

– Recording Transactions—To establish accountability

for assets, all transactions should be recorded.

– Documents and records—Well-designed documents

help ensure that transactions are properly recorded – Physical controls —limit access to assets, including cash registers and storerooms, as well as accounting records.

Control Activities

(slide 2 of 2)

– Periodic independent verification —someone other than the people responsible for the accounting records and assets should periodically check the records

against the assets.

– Separation of duties —no one person should

authorize transactions, handle assets, and keep records

of assets.

– Sound personnel practices—including adequate

supervision; rotation of key people among different

jobs; insistence that employees take vacations; and

bonding of personnel who handle cash or inventory.

 Bonding is the process of checking an employee’s background and insuring the company against theft

by that person.

Internal Control and Achieving Control

Objectives

 A system of internal control for merchandising

activities can achieve important objectives:

– Prevent losses of cash and inventory.

– Ensure that records of transactions and

account balances are accurate.

– Keep enough inventory on hand to sell to

customers without overstocking merchandise – Keep sufficient cash on hand to pay for

purchases in time to receive discounts.

– Keep credit losses as low as possible by

making credit sales only to customers who are likely to pay on time.

Internal Control over

Merchandising Transactions (slide 1 of 2)

 Maintaining control is especially difficult for a merchandiser because management must not only establish controls for cash sales, receipts, purchases, and cash

payments, but also protect its inventory.

 Most firms use the following procedures:

– Separate the functions of authorization,

recordkeeping, and custodianship of cash.

– Limit the number of people who have access

to cash, and designate who those people are.

Internal Control over

Merchandising Transactions (slide 2 of 2)

– Bond all employees who have access to cash.

– Keep the amount of cash on hand to a minimum by using banking facilities as much as possible.

– Physically protect cash on hand by using cash

registers, cashiers’ cages, and safes.

– Record and deposit all cash receipts promptly, and make payments by check rather than by currency.

– Have a person who does not handle or record cash make unannounced audits of the cash on hand.

– Have a person who does not authorize, handle, or

record cash transactions reconcile the Cash account.

Control of Purchases and

Cash Disbursements

 To avoid theft, cash payments should

be made only after they have been

specifically authorized and supported

by documents that establish the

validity and amount of the claims.

 A company should also separate the

duties involved in purchasing goods

and services and the duties involved in paying for them.

Cash Equivalents

 Management may decide to invest excess

cash in short-term interest-bearing accounts

or certificates of deposit (CDs) at banks and other financial institutions, in government

securities (such as U.S Treasury notes), or in other securities.

 If these investments have a term of 90 days

or less when they are purchased, they are

called cash equivalents because the funds revert to cash so quickly they are treated as cash on the balance sheet.

Cash Control Methods

(slide 1 of 2)

 In addition to internal control of cash transactions, other ways of controlling cash include:

– Impress systems —systems, such as petty

cash funds, used by a company for small

expenditures and cash advances and restored

to a fixed amount periodically – Banking services—which include:

 Safe depositories for cash

 Negotiable instruments and other valuable business documents, such as stocks and bonds

 Checking accounts

 Collection and payment of certain types of debt

Cash Control Methods

(slide 2 of 2)

 Exchange of foreign currencies

 Electronic funds transfer —a method of conducting business transactions in which a company electronically transfers cash from its bank

to another company’s bank

 Automated teller machine (ATM) and debit card transactions—When purchases are made using a debit card, the amount of the purchase is deducted directly from the buyer’s bank account.

– Bank reconciliations —the process of

accounting for the difference between the balance on a company’s bank statement and the balance in its Cash account

Bank Reconciliations

(slide 1 of 2)

 The following transactions commonly

appear in a company’s records but not on its bank statement:

company has issued and recorded but that do not yet appear on its bank

statement

company has sent to its bank but that the bank did not receive in time to enter on the bank statement

Bank Reconciliations

(slide 2 of 2)

 Transactions that may appear on the bank

statement but not in the company’s records include:

- Service charges—fees for the use of a checking account

- NSF (nonsufficient funds) checks —An NSF check is a check that a company has deposited but that is not paid when the bank presents it to the issuer’s bank.

- Miscellaneous debits and credits—including fees charged for other services, such as stopping payment on checks, printing checks, and collections on promissory notes

- Interest income—interest paid on a company’s average balance Accounts that pay interest are sometimes called NOW or money market accounts.

Petty Cash Funds

 It is sometimes necessary to make small

payments of cash for postage stamps,

shipping charges due, or minor purchases of office supplies.

– For situations in which it is inconvenient to pay by check, most companies set up a petty cash fund

using an imprest system, in which the fund is established for a fixed amount.

 A voucher documents each cash payment made from the fund.

 The fund is periodically reimbursed, based on the vouchers, by the exact amount necessary to restore its original cash balance.

Making Disbursements from the

Petty Cash Fund

 The custodian of the petty cash fund

should prepare a petty cash voucher ,

or written authorization, for each

expenditure, as shown below The

person who receives the payment signs the voucher.

Management’s Responsibility for

Internal Control

 Management is responsible for establishing a satisfactory system of internal controls

– This means that management must:

 safeguard the firm’s assets.

 ensure reliability of its accounting records.

 see that its employees comply with all legal requirements and operate the firm to the best advantage of its owners.

– The Sarbanes-Oxley Act requires that the chief

executive officer, the chief financial officer, and the auditors of a public company fully document and certify the company’s system of internal controls.

Independent Accountant’s Audit of

Internal Control

 Although privately owned companies usually are not required to have an independent

certified public accountant audit their

financial statements, many companies

choose to do so These companies are also

not required to have their internal control

systems audited.

 Public companies, on the other hand, are

required to not only have an independent

audit of their financial statements, but also

to have an audit of their internal control.