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Financial Accounting: Internal Control and Cash
Financial Accounting: Internal Control and Cash
Eleventh Edition
Chapter 4
Internal Control
and Cash
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Learning Objectives
4.1 Describe fraud and its impact
4.2 Explain the objectives and components of internal
control
4.3 Design and use a bank reconciliation
4.4 Evaluate internal controls over cash receipts and
cash payments
4.5 Construct and use a cash budget
4.6 Report cash on the balance sheet
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Learning Objective 4.1
Describe fraud and its impact
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Describe Fraud and Its Impact (1 of 2)
• Fraud
– Intentional misrepresentation of facts
– For the purpose of persuading another party to act
in a certain way
– Causes injury or damage
– Growing problem throughout the world with the
expansion of e-commerce
– Common examples include: insurance fraud,
check forgery, Medicare fraud, credit card fraud,
and identity theft
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Describe Fraud and Its Impact (2 of 2)
Common Types of Fraud
• Misappropriation of assets
– Committed by employees
– Theft of money or inventory
– Bribery and kickback schemes
– Overstate expense reimbursements
• Fraudulent financial reporting
– Committed by managers
– False and misleading journal entries
– Deceive investors and creditors
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Exhibit 4-1 The Fraud Triangle
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Learning Objective 4.2
Explain the objectives and components of internal
control
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Explain the Objectives and
Components of Internal Control
Internal Control
• Primary way to prevent, detect, and correct fraud
• Plan of organization and procedures implemented to
accomplish 5 objectives:
– Safeguard assets
– Encourage employees to follow company policy
– Promote operational efficiency
– Ensure accurate, reliable accounting records
– Comply with legal requirements
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Exhibit 4-2 Excerpt from Public Company
Management Report on Internal Controls
Management is responsible for establishing and maintaining adequate internal
control over financial reporting …. the company’s internal control over financial
reporting includes the maintenance of records that … accurately and fairly reflect
the transactions and … assets of the company … provide reasonable assurance
that transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles, and that
receipts and expenditures of the company are being made only in accordance
with authorization of management and directors of the company …
under the supervision and with the participation of management, including our
principal executive officer and principal financial officer, we conducted an
evaluation of the effectiveness of our internal control over financial reporting …
based on our evaluation
… management concluded that our internal control over financial reporting was
effective as of December 31, 2016.
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The Sarbanes-Oxley Act (SOX)
• SOX Provisions
‒ Passed by Congress in 2002
‒ Public companies must maintain a system of
internal control and issue an internal control report
‒ Auditors must evaluate and report on internal
controls
‒ Created Public Company Accounting Oversight
Board (PCAOB)
‒ Limits non-audit services of auditing firms
‒ Penalties for violators
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Exhibit 4-3 The Shield of Internal
Controls
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Exhibit 4-4 The Components of
Internal Control
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The Components of Internal
Control (1 of 2)
• Control Environment
– Tone at the top
– Code of ethics
• Risk Assessment
– Identify business risks
– Establish procedures to deal with risks
• Information System
– Means by which accounting info enters and exits
– Accurately track assets, profits, & losses
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The Components of Internal
Control (2 of 2)
• Control Procedures
– Means by which companies gain access to the 5
objectives of internal controls
• Monitoring of Controls
– Usually programmed into technology
– Internal and external auditors
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Internal Control Procedures (1 of 6)
• Smart Hiring Practices
‒ Background checks
‒ Training and supervision
‒ Competitive salaries
‒ Clear employee responsibility
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Internal Control Procedures (2 of 6)
• Separation of Duties
– Asset handling
– Record keeping
– Transaction approval
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Internal Control Procedures (3 of 6)
• Comparison and Compliance Monitoring
– Operating and cash budgets
– Exception reporting
– Audit
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Internal Control Procedures (4 of 6)
• Adequate Records
– Details of business transactions
– Hard copy documents or electronic
– Prenumbered documents
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Internal Control Procedures (5 of 6)
• Limited Access
– Only persons with custodial responsibilities
– Lock and key
– Lock-box system
– Physical access controls
– Password and encryption
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Internal Control Procedures (6 of 6)
• Proper Approvals
– Management’s general or specific approval
– Credit approvals
– Purchasing department
– Human resources department
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Information Technology
• Accounting systems continue to rely less on manual
procedures and more on information technology (IT).
– Improved accuracy and speed
– Examples:
Electronic sensors
Bar codes
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Safeguard Controls
• Important documents in fireproof vaults
• Burglar alarms and security cameras
• Loss prevention specialists
• Fidelity bonds on cashiers
• Mandatory vacations and job rotation
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Internal Controls for E-Commerce
• E-commerce creates additional risks, including:
– Stolen credit card numbers
– Computer viruses and Trojan Horses
– Phishing expeditions
• Security measures to combat these risks include:
– Encryption
– Firewalls
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Firewalls
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The Limitations of Internal
Control – Cost and Benefits
• Ways to circumvent internal controls:
‒ Collusion: two or more people working together
‒ Management override
‒ Human limitations: fatigue and negligence
Benefits of internal controls should always outweigh the
costs
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Learning Objective 4.3
Design and use a bank reconciliation
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Design and Use a Bank
Reconciliation (1 of 7)
• Documents used to control a bank account
include:
– Signature card
– Deposit ticket
– Check
– Bank Statement
– Bank Reconciliation
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Design and Use a Bank
Reconciliation (2 of 7)
• Signature Card
‒ Banks require each person authorized to sign on
an account to provide a signature card
‒ Protects against forgery
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Design and Use a Bank
Reconciliation (3 of 7)
• Deposit Ticket
‒ Banks supply standard deposit tickets
‒ Customer fills out deposit ticket and receives a
receipt as proof of the transaction
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Design and Use a Bank
Reconciliation (4 of 7)
Check
• Three parties to a check
– Maker → signs check
– Payee → whom the check is paid
– Bank → check drawn from
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Design and Use a Bank
Reconciliation (5 of 7)
• Bank Statement
‒ Sent to customer monthly
‒ Reports customer’s cash activity
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Exhibit 4-6 Bank Statement
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Design and Use a Bank
Reconciliation (6 of 7)
• Bank Reconciliation
‒ Explanation for the differences between the book
(company’s cash records) and bank balance
‒ Differences due to time lag in recording
transactions
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Design and Use a Bank
Reconciliation (7 of 7)
Preparing the Bank Reconciliation
• Bank Side • Book Side
– Deposits in transit – Bank collections
– Outstanding checks – Electronic funds transfers
– Bank errors – Service charge
– Interest revenue
– NSF checks
– Cost of printed checks
– Book errors
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Exhibit 4-8 Bank Reconciliation (1 of 3)
Bank side:
1. Deposit in transit, $ 1,600.
2. Bank error: the bank deducted $ 100 for a check written by another
company. Add $ 100 to the bank balance.
3. outstanding check-total of $ 1,340
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Exhibit 4-8 Bank Reconciliation (2 of 3)
Book side:
4. EFT receipt of your dividend revenue earned on an investment, $900
5. Bank collection of your account receivable, $2,100.
6. interest revenue earned on your bank balance, $30.
7. Book error: you recorded check no. 333 for $510. the amount you
actually paid on account was $150. add $360 to your book balance.
8. Bank service charge, $20.
9. NSF check from a customer, $50. subtract $50 from your book
balance.
10. EFT payment of insurance expense, $400.
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Exhibit 4-8 Bank Reconciliation (3 of 3)
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Journalizing Transactions from the
Bank Reconciliation
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Summary of Various Reconciling
Items
• Bank Balance—Always
‒ Add deposits in transit.
‒ Subtract outstanding checks.
‒ Add or subtract corrections of bank errors.
• Book Balance—Always
‒ Add bank collection, interest revenue, and EFT
receipts.
‒ Subtract service charges, NSF checks, and EFT
payments.
‒ Add or subtract corrections of book errors.
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Exhibit 4-9 Online Banking—Account
History
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Learning Objective 4.4
Evaluate internal controls over cash receipts and cash
payments
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Evaluate Internal Controls Over Cash
Receipts and Cash Payments
Cash requires specific internal controls because it is
easy to steal and convert to other forms of wealth.
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Cash Receipts Over the Counter
• Point-of-sale terminals
– Provide control over cash receipts
– Record sale, cost of item sold, and reduction to
inventory
– Effective inventory control
• Customer issued a receipt as proof of purchase
• Sales associate turns in cash drawer at end of shift
– Combined with other cash and deposited
• Accounting department reconciles sales per terminal to
cash in drawer
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Exhibit 4-11 Cash Receipts by Mail
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Controls Over Payment by Check (1 of 3)
• Companies make most payments by check or EFT.
This in an important internal control because:
‒ Provides record of payment
‒ Must be signed by authorized official
‒ Payment supported by evidence
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Controls Over Payment by Check (2 of 3)
Controls over Purchase and Payment
• Split the following duties
– Purchasing goods
– Receiving goods
– Preparing check or EFT for payment
– Approval of payment
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Exhibit 4-12 Cash Payments by
Check or EFT
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Exhibit 4-13 Payment Packet
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Controls Over Payment by Check (3 of 3)
• Petty Cash
– Used to pay for minor expenses
– Opened with a particular amount of cash
– Custodian prepares a petty cash voucher list
– Imprest system – sum of fund plus vouchers paid
should equal specified balance
– Debit cards may be used
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Learning Objective 4.5
Construct and use a cash budget
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Construct and Use a Cash Budget
• Budget – financial plan that helps coordinate
business activities
• Cash budget – helps a company manage cash by
planning receipts and payments
– Start with beginning cash balance
– Add budgeted receipts and subtract budgeted
payments
– Equals cash available before new financing
– Compare cash available before new financing to
budgeted cash at end of period
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Exhibit 4-14 Cash Budget
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Learning Objective 4.6
Report cash on the balance sheet
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Report Cash on the Balance Sheet (1 of 3)
• Cash and Cash Equivalents
– Time deposits
– Certificates of deposit
– High-grade U.S. or foreign government securities
(close to maturity)
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Report Cash on the Balance Sheet (2 of 3)
Most public companies will include a footnote to their
financial statements such as the following:
Cash equivalents…
All highly liquid investment with maturities of three
months or less at the date of purchase are classified as
cash equivalents.
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Report Cash on the Balance Sheet (3 of 3)
Compensating Balance Agreements
• Cash – liquid assets available for day-to-day use
– Balance should not be restricted in any way,
restricted amounts separately disclosed
• Compensating Balance Agreements
– Borrowing company agrees to maintain minimum
balance in checking account at all times
– Long-term asset, not cash
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Copyright
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