Chapter 4:

Cash and Internal Control

Cornerstones of Financial Accounting,

Third Canadian Edition
Copyright © 2021 by Nelson Education Ltd. 4-1
 Learning Objectives

1. Discuss the purpose of internal controls.

2. Discuss five elements of a good internal control system.
3. Describe cash control procedures.
4. Describe how businesses report and account for cash.
5. Explain operating cycle and cash management principles.

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 1 Role of Internal Control
► To ensure that business activities are properly recorded
in the accounting system, management implements
procedures that collectively are called the internal control
system.
► Internal control systems include all the policies and procedures
established by top management and the board of directors to
provide reasonable assurance that the company’s objectives
are being met in the following three areas:
► effectiveness and efficiency of operations
► reliability of internal and external reporting
► compliance with applicable laws and regulations and
internal policies

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2 Elements of Internal Control

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 2 Control Environment and
Ethical Behaviour
► The foundation of the internal control system is the control
environment—the collection of environmental factors that
influence the effectiveness of control procedures.
► The control environment includes the following:
► the philosophy and operating style of management
► the personnel policies and practices of the business
► the overall integrity, attitude, awareness, and actions of the board
of directors and top management of the business concerning the
importance of control (commonly called the tone at the top).
► An important feature of the control environment is recognizing that
an individual employee's goals may differ from the goals of other
individuals and the goals of the business.
► Resolving these conflicting incentives in an ethical manner that
promotes organizational objectives is highly dependent on the tone
at the top.

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2 Risk Assessment
► Risk assessment procedures are designed to identify, analyze,
and manage strategic risks and business process risks.
► Strategic risks are possible threats to the organization's
success in accomplishing its objectives and are external to the
organization.
► These risks are often classified around industry forces such as
competitors, customers, substitute products or services, suppliers, and
threat of new competitors (known as Porter's five forces) or macro
factors such as political, economic, social, and technological factors
(also known as PEST factors).
► Business process risks arise out of the internal processes of
the company—specifically, how the company allocates its
resources to meet its objectives.

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2 Control Activities
► Control activities are the policies and procedures top
management establishes to help ensure that its objectives are
met.
► The control activities most directly related to the accounting
system and financial statements vary widely from one
business to another, but generally can be identified with one
of the following six categories:
► Authorization of transactions and other business activities
► Segregation of duties
► Documentation adequacy
► Physical controls
► Independent checks on performance
► Human resource controls
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2 Clearly Defined Authorization
of Transactions and
Other Business Activities
► The authorization of transactions is delegated to specific
individuals, and those individuals should be held responsible
for the performance of those duties
in the evaluation of their performance.
► The clear delegation of authority and responsibility motivates
individuals to perform well because they know they are
accountable for their actions.

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 2 Segregation of Duties
► Accounting and administrative duties should be performed by
different individuals, so that no one person prepares all the
documents and records for an activity.
► This segregation of duties (also called separation
of duties) reduces the likelihood that records could
be used to conceal irregularities (intentional misstatements,
theft, or fraud) and increases the likelihood that irregularities
will be discovered.
► Segregation of duties also reduces the likelihood
that unintentional record-keeping errors will remain
undiscovered.

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2 Documentation Adequacy
► Accounting records are the basis for the financial statements
and other reports prepared for managers, owners, and
others both inside and outside the business.
► Summary records and their underlying documentation must
provide information about specific activities and help in the
evaluation of individual performance.

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2 Physical Controls
► Both assets and records must be secured against theft and
destruction.
► Safeguarding requires physical protection of the assets
through, for example, fireproof vaults, locked storage facilities,
keycard access, and antitheft tags on merchandise.
► An increasingly important part of safeguarding assets
and records is access controls for computers.
► Safeguards must be provided for computer programs
and data files, which are more fragile and susceptible
to unauthorized access than manual record-keeping systems.

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 2 Independent Checks
on Performance
► Recorded amounts should be checked by an independent
person to determine that amounts are correct and that they
correspond to properly authorized activities.
► These procedures include clerical checks, reconciliations,
comparisons of asset inspection reports with recorded
amounts, computer-programmed controls, and management
review of reports.

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2 Human Resource Controls
► An internal control system cannot be perfect since it is, in part,
controlled by imperfect human beings. To protect companies
against the actions of its employees, companies usually take
several precautions.
► In the recruitment process, references are requested and
checked, providing the company with assurance that it is hiring
individuals who are honest and who exhibit integrity.
► Where employees are in a sensitive position of handling cash or
other assets of a company, it is common for the company to
rotate employees' duties during times of vacation or other
absences. Rotation of duties helps make it difficult, if not
impossible, for employees to conceal theft or fraud for a lengthy
period of time.
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 2 Monitoring
► Monitoring is the process of tracking potential and actual
problems in the internal control system.
► Monitoring is accomplished through normal supervising
activities, such as when a manager asks a subordinate how
things are going.
► However, best practices for larger organizations suggest that an
internal independent audit group monitor the effectiveness of
the internal control system.
► Some public companies outsource their internal audit function.
Normally in such cases, the firm providing those internal audit
services is precluded from providing the external audit service
because of the perception that the external audit's
independence would be impaired.
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2 Relationship between Control
Activities and the Accounting System
► The accounting system consists of the methods and records
used to identify, measure, record, and communicate
financial information about a business.
► The accounting system and the internal control system are
really one integrated system designed to meet the needs of
a particular business.
► It is difficult to generalize the relationship between internal
control activities and accounting systems because it directly
depends on the objectives of a particular business.

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2 Relationship between the
Accounting System and
Control Procedures

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 3 Cash Controls
► Internal controls are designed to protect all assets.
► But the more “liquid” an asset, the more easily it is
converted into cash, and the more likely it is to be stolen.
► The three most important areas where the accounting
system interacts with the internal control system to
strengthen cash controls include
►bank reconciliations
►cash over and short
►petty cash

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3 You Decide
Internal Control over Cash
in a Student University Pub

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 3 Reconciliation of Accounting
Records to Bank Statement
► The use of a bank is one of the most important controls over
cash.
► The bank duplicates the company’s accounting by keeping its
own accounting records of your account. Unfortunately, the
bank’s accounting records and the company’s accounting
records often disagree because the transactions are not
recorded at the same time.
► Therefore, to ensure that the company’s accounting records
are consistent with the bank’s accounting records, any
differences must be “reconciled.”
► This process is called the bank reconciliation.
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 3 Reconciliation of Accounting
Records to Bank Statement (Continued)
► Reconciliation of these separately maintained records serves two purposes:
► It serves a control function by identifying errors and providing an
inspection of detailed accounting records that deters theft.
► It serves a transaction detection function by identifying transactions
performed by the bank, so that the business can make the necessary
journal entries in its accounting records.
► In general, differences between the cash account balance and the bank
statement balance develop from three sources:
► transactions recorded by the business, but not recorded by the bank in
time to appear on the current bank statement
► transactions recorded by the bank, but not yet recorded by the business
► errors in recording transactions on either set of records

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 Transactions Recorded by
3
the Business but Not Yet
Recorded by the Bank
► There are generally two types of transactions recorded by the
business but not recorded by the bank in time to appear on the
current statement:
► An outstanding cheque is a cheque issued and recorded by the
company that has not been “cashed” by the recipient of the cheque.
►Outstanding cheques cause the bank balance to be higher than
the business's cash account balance.
► A deposit in transit is an amount received and recorded by the
company but that has not been recorded by the bank in time to
appear on the current bank statement.
►Deposits in transit cause the bank's balance to be smaller than
the company's general ledger cash account balance.

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 Transactions Recorded by
3
the Bank but Not Yet
Recorded by the Business
► Several types of transactions are recorded by the bank but not yet
recorded by the business:
► Service charges are fees charged by the bank for chequing account
services.
►The amount of the fee is not known to the business (and therefore
cannot be recorded) until the bank statement is received.
► A nonsufficient funds (NSF) cheque is a cheque that has been returned
to the depositor because funds in the issuer's account are not sufficient
to pay the cheque (called a bounced cheque).
► A debit memo might result if the bank makes a prearranged deduction
from the business's account to pay a bill.
► A credit memo could result if the bank collected a note receivable for
the business.

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 3 Errors
► The previous differences between the accounting records
and the bank's account balances are the result of time lags
between the recording of a transaction by the company and
the recording by the bank.
► Errors in recording transactions represent yet another source
of difference between a company's general ledger cash
account balance and the bank's balance.
► Errors are inevitable in any accounting system and should be
corrected as soon as discovered.
► In addition, an effort should be made to determine the cause
of any error as a basis for corrective action.

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3 Performing a
Bank Reconciliation
► To begin the reconciliation, start with the “cash balance from
the bank statement” and the “cash balance from company
records.”
► These two balances are then adjusted as necessary to
produce identical “adjusted cash balances” by following four
steps.
► These steps are explained in the following slides with the
help of an example.

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3 Performing a
Bank Reconciliation (Continued)
• Step 1: Compare the deposits on the bank statement to the
deposits debited to the cash account.
• Step 2: Compare the paid (often called cancelled) cheques
returned with the bank statement to the amounts credited to
the cash account and the list of outstanding cheques from
prior months.
• Step 3: Look for items on the bank statement that have not
been debited or credited to the general ledger cash account.
• Step 4: If the “adjusted cash balances” are still not the same,
search for errors.

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3 Bank Statement

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3 T-Account for Cash,
Prior to Reconciliation

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3 Cornerstone 4-1
Performing a Bank Reconciliation

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3 Cornerstone 4-1
Performing a Bank Reconciliation (Continued)

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3 Making Journal Entries as a
Result of the Bank Reconciliation
► Once the bank reconciliation is completed, some adjustments
to the accounting records may be necessary.
► No adjustments are necessary for outstanding cheques or
deposits in transit because the accounting records have
correctly recorded these amounts.
► Adjustments are necessary for any company errors or items
such as bank charges or interest that the company does not
find out about until receiving the bank statement.

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 Cornerstone 4-2
3
Making Journal Entries as
a Result of the Bank Reconciliation

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 Cornerstone 4-2
3
Making Journal Entries as
a Result of the Bank Reconciliation (Continued)

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 3 Cash Over and Short
► Another important control activity requires that cash receipts be
deposited in a bank daily.
► At the end of each day, the amount of cash received during the
day is debited to the cash accounts to which it has been
deposited.
► The amount deposited should equal the total of cash register
tapes.
► If it does not (and differences will occasionally occur even when
cash-handling procedures are carefully designed and executed),
the discrepancy is recorded in an account called cash over and
short.
► One common source of cash over and short is errors in making
change for cash sales.
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 Cornerstone 4-3
3
Recording Cash Over and Short

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 Cornerstone 4-3
3
Recording Cash Over and Short
(Continued)

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 3 Petty Cash
► Cash controls are more effective when companies pay with
a cheque for the following reasons:
►Only certain people have the authority to sign the
cheque.
►Those authorized to sign do not keep the accounting records
and only sign the cheque with the proper documentation
supporting the payment (e.g., evidence that the goods being
paid for were properly ordered and received).
►Supporting documents are marked paid to avoid
duplicate payment.
►Cheques are prenumbered, which makes it easy to
identify any missing cheques.

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 3 Petty Cash (Continued)
► Unfortunately, issuing cheques to pay small amounts is
usually more costly than paying cash.
► For this reason, a company may establish a petty cash fund
to pay for items such as stamps or a cake for an employee
birthday party.
► The petty cash fund is overseen by a petty cash custodian,
who both pays for small dollar amounts directly from the
fund and reimburses employees who have receipts for items
they’ve bought with their own money.

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 Cornerstone 4-4
3
Accounting for Petty Cash

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3
Cornerstone 4-4
Accounting for Petty Cash
(Continued)

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4 Accounting and
Reporting Cash
► Cash is not only currency and coins but also includes savings
and chequing accounts and negotiable instruments like
cheques and money orders.
► When cash is received, a general ledger cash account is
increased by a debit; and when cash is paid out, a general
ledger cash account is decreased by a credit.
► Cash is reported on both the statement of financial position
and the statement of cash flows.
► The balance sheet typically reports the amount of cash and
cash equivalents available at the balance sheet date.

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5 The Operating Cycle

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5 You Decide
Operating Cycle and Capital Requirements

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 5 Cash Management
► The activities of the operating cycle transform cash
into goods and services and then back, through sales,
into cash.
► This sequence of activities includes a continual process
of paying cash out of and receiving cash in the business.
► Cash management principles at a high level entail the following:
► minimizing inventory investment (to conserve cash)
► delaying paying suppliers to the extent possible without jeopardizing
supplier relationships or purchase cost (so that a company can earn
as much interest on their cash as possible)
► speeding up collection from customers (in order to obtain and invest
the cash sooner)
► earning the greatest return on any excess cash

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 5 Buying Inventory
► The first stage of the operating cycle is buying inventory.
► Money that is tied up in inventory sitting on the shelves is not
earning any return.
► As such, an important aspect of cash management is to keep
inventory levels low.
► This decreases the need for cash.

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 5 Paying for Inventory
► The second stage of the operating cycle is paying for the
inventory.
► As with all payments, a good cash management principle is
to delay payments as long as possible while maintaining a
good relationship with the payee.
► The longer a company keeps cash, the more interest it can
collect.

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 5 Selling Inventory
► The third stage is selling the inventory, which usually
produces accounts receivable.
► Good cash management suggests increasing the speed of
accounts receivable collections.
► In fact, many companies sell their accounts receivable rather
than wait for their customers to pay.
► Of course, they sell the accounts receivable for less than
they would have received (which represents interest income
and return for the buyer), but it also allows the company to
receive the cash sooner and to avoid hiring employees to
service the accounts receivable.

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 5 Short-Term Investments
► Beyond delaying payments and speeding up collections,
businesses try to keep their bank cash balances to a
minimum because most bank accounts earn relatively small
amounts of interest income.
► Accordingly, short-term investments are purchased with
temporary cash surpluses.
► The value and composition of short-term investment
portfolios may change continually in response to seasonal
factors and other shifts in the business environment.

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5 You Decide
Cash Management

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5 Significant Differences
between IFRS and ASPE

►There are no significant differences between IFRS

and ASPE with respect to cash and cash
equivalents.

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