Chapter 6 – Cash & Internal Control

What Constitutes Cash

• Cash takes many forms – Coin and currency on hand and cash on deposit in the form of checking,
savings, money market accounts, cash are checks, including undeposited checks from customers,
cashier’s checks, and certified checks.
• The key to the classification of an amount as cash is that it be readily available to pay debts.
• A certificate of deposit has a specific maturity date and carries a penalty for early withdrawal and
therefore is not included in cash.

Cash Equivalents and the Statement of Cash Flows

• Cash equivalent: an investment that is readily convertible to a known amount of cash and has an
original maturity to the investor of three months or less.
• Examples of items normally classified as cash equivalents are commercial paper issued by
corporations, Treasury bills issued by the federal government, and money market funds offered
by financial institutions.

Control Over Cash

• Companies use a variety of devices to control cash. Among them are bank reconciliations and petty
cash funds.
• Cash is universally accepted as a medium of exchange.

Cash Management
• Companies must constantly be sure that they have neither too little nor too much cash on hand.
• The need to have enough cash on hand: suppliers, employees, taxing agencies, banks, and all other
creditors must be paid on time.
• Companies should not maintain cash on hand and on deposit in checking accounts beyond the
minimal amount necessary to support ongoing operations since cash is essentially a nonearning
asset.

Reading a Bank Statement

• Two fundamental principles of internal control are applicable to cash:
1. All cash receipts should be deposited intact daily.
2. All cash payments should be made by check.
• Checking accounts at banks allow a company to carefully monitor and control cash receipts and
cash payments.
• Bank Statement: a detailed list, provided by the bank, of all activity for a particular account during
the month.
• It is important to understand the route a check takes after it is written.
• The items that appear on a bank statement – canceled checks, deposits, NSF checks, customer
note & interest, service charge, and interest earned.
• Outstanding check: a check written by a company but not yet presented to the bank for payment.
• Deposit in transit: a deposit recorded on the books but not yet reflected on the bank statement.
• Most companies deposit all checks, coin, and currency on a daily basis; this is in keeping with an
internal control principle that all cash receipts should be deposited in their entirety.
• NSF stands for “not sufficient funds.”
• The most common bank service charges are monthly activity fees and fees charged for new checks,
for the rental of a lockbox at the bank in which to store valuable company documents, and for the
collection of customer notes by the bank.
• Customer note and interest – It is often convenient to have customers pay amounts owed to a
company directly to that company’s bank. The bank simply acts as a collection agency for the
company.
• Interest earned – Most checking accounts pay interest on the average daily balance in the account.
Rates paid on checking accounts are usually significantly less than could be earned on most other
forms of investment.

Bank Reconciliation
• Bank reconciliation: a form used by the accountant to reconcile or resolve any differences between
the balance shown on the bank statement for a particular account with the balance shown in the
accounting records (format of statement at the end of the notes).
• A bank reconciliation should be prepared for each individual bank account as soon as the bank
statement is received.
• Credit memoranda: additions on a bank statement for such items as interest paid on the account
and notes collected by the bank for the customer.
• Debit memoranda: deductions on a bank statement for items such as NSF checks and various
service charges.
• The following steps are used in preparing a bank reconciliation:
1. Trace deposits listed on the bank statement to the books. Any deposits recorded on the books
but not yet shown on the bank statement are deposits in transit. Prepare a list of the deposits
in transit.
2. Arrange the canceled checks in numerical order and trace each of them to the books. Any
checks recorded on the books but not yet listed on the bank statement are outstanding. Prepare
a list of the outstanding checks.
3. List all items, other than deposits, shown as additions on the bank statement, such as interest
paid by the bank for the month and amounts collected by the bank from one of the company’s
customers. When the bank pays interest or collects an amount owed to a company by one of
the company’s customers, the bank increases, or credits, its liability to the company on its own
books. For that reason, these items are called credit memoranda. Prepare a list of credit
memoranda.
4. List all amounts, other than canceled checks, shown as subtractions on the bank statement,
such as any NSF checks and the various service charges mentioned earlier. When a company
deposits money in a bank, a liability is created on the books of the bank. Therefore, when the
bank reduces the amount of its liability for these various items, it debits the liability on its own
books. For this reason, these items are called debit memoranda. Prepare a list of debit
memoranda.
5. Identify any errors made by the bank or by the company in recording the various cash
transactions.
6. Use the information collected in Steps 1 through 5 to prepare a bank reconciliation.
• After a company completes the bank reconciliation, it must prepare a number of adjustments to
its records.
Establishing a Petty Cash Fund
• Petty cash fund: money kept on hand for making minor disbursements in coin and currency rather
than by writing checks.
• The necessary steps in setting up and maintaining a petty cash fund are as follows:
1. A check is written for a lump-sum amount. The check is cashed, and the coin and currency are
entrusted to a petty cash custodian.
2. A journal entry is made to record the establishment of the fund.
3. Upon presentation of the necessary documentation, employees receive minor disbursements
from the fund (cash is traded from the fund in exchange for a receipt).
4. Periodically, the fund is replenished by writing and cashing a check in the amount necessary to
bring the fund back to its original balance.
5. At the time the fund is replenished, an adjustment is made to record its replenishment and to
recognize the various expenses incurred.
• Rationale behind using petty cash fund: the benefits in time saved in making minor disbursements
from cash are thought to outweigh the cost associated with the risk of loss from decreased control
over cash disbursements.

An Introduction to Internal Control

• Internal control system: policies and procedures necessary to ensure the safeguarding of an
entity’s assets, the reliability of its accounting records, and the accomplishment of overall
company objectives.

The Sarbanes-Oxley Act of 2002

• Sarbanes-Oxley Act: an act of Congress in 2002 intended to bring reform to corporate
accountability and stewardship in the wake of a number of major corporate scandals.
• Internal control report: a report required by Section 404 of the Sarbanes-Oxley Act to be included
in an annual report – management assesses effectiveness of the internal control structure.
• Public Company Accounting Oversight Board: the five-member body created by the Sarbanes-
Oxley Act that was given the authority to set auditing standards in the United States.
• Board of directors: a group composed of key officers of a corporation and outside members
responsible for general oversight of the affairs of the entity.
• Audit committee: a board of directors subset that acts as a direct contact between the
stockholders and the independent accounting firm.
• SOX’s provision: a company’s CEO and CFO must sign a statement certifying that the information
in the financial statements fairly presents the financial condition and results of operations of the
company. This provision places the responsibility for the information in the financial statements
directly in the hands of the company’s CEO and CFO.

The Control Environment

• Success of an internal control system begins with the competence of the people in charge of it.
• Management’s operating style will have a major impact on the effectiveness of various policies.
• Personnel policies and practices form another factor in the internal control of a business.
• No internal control system will work very well if employees who are dishonest or poorly trained
are on the payroll.
• Too few people doing too many tasks defeats the purpose of an internal control system.
• The effectiveness of internal control in a business is influenced by the board of directors,
particularly its audit committee.
The Accounting System
• Accounting system: methods and records used to accurately report an entity’s transactions and to
maintain accountability for its assets and liabilities.
• An accounting system can be completely manual; fully computerized; or as is often the case, a
mixture of the two.
• Internal controls are important to all businesses regardless of the degree of automation of the
accounting system.
• The system must be capable of handling the volume and complexity of transactions entered into
by a business.
• Businesses use computers because they are ideally suited to the task of processing large numbers
of repetitive transactions efficiently and quickly.

Internal Control Procedures

• Management establishes policies and procedures on a number of different levels to ensure that
corporate objectives will be met.
• Administrative controls: procedures concerned with efficient operation of the business and
adherence to managerial policies.
• Accounting controls: procedures concerned with safeguarding the assets or the reliability of the
financial statements.
• Some of the most important internal control procedures: proper authorizations, segregation of
duties, independent verification, safeguarding of assets & records, independent review &
appraisal, and the design & use of business documents.

Proper Authorizations
• Management grants specific departments the authority to perform various activities – along with
the authority comes responsibility.
• By specifically authorizing certain individuals to carry out specific tasks for the business,
management is able to hold those same people accountable for the outcome of their actions.

Segregation of Duties
• Without segregation of duties, an employee is able not only to perpetrate a fraud but also to
conceal it.
• A good system of internal control requires that the physical custody of assets be separated from
the accounting for those same assets.
• Many smaller businesses don’t have adequate personnel to achieve complete segregation of key
functions.
• In certain instances, small businesses need to rely on the direct involvement of the owners and on
independent verification.

Independent Verification
• Independent verification means the work of one department should act as a check on the work of
another.
Safeguarding of Assets and Records
• Adequate safeguards must be in place to protect assets and the accounting records from losses of
various kinds.
• Cash registers, safes, and lockboxes are important safeguards for cash.
• Secured storage areas with limited access are essential for the safekeeping of inventory.
• Protection of the accounting records against misuse is equally important.
• Access to a computerized accounting record should be limited to those employees authorized to
prepare journal entries.

Independent Review and Appraisal

• A well-designed system of internal control provides for periodic review and appraisal of the
accounting system as well as the people operating it.
• The group primarily responsible for review and appraisal of the system is the internal audit staff
• The primary concern of the independent public accountants (or external auditors) is whether the
financial statements have been presented fairly.
• Internal auditors focus more on the efficiency with which the organization is run. They are
responsible for periodically reviewing both accounting and administrative controls. The internal
audit staff also helps to ensure that the company’s policies and procedures are followed.

Design and Use of Business Documents

• Business documents are the crucial link between economic transactions entered into by an entity
and the accounting record of those events.
• They are often called source documents and may be generated by computer or completed
manually.
• Business documents must be designed to capture all relevant information about an economic
event and to ensure that related transactions are properly classified.
• Business documents must be properly controlled – sequential numbering systems, multiple
copies, etc.

Limitations on Internal Control

• No system of internal control is totally foolproof.
• An entity’s size affects the degree of control that it can obtain.
• Large organizations are able to devote a substantial amount of resources to safeguarding assets
and records – installation and maintenance of controls can be costly; an internal audit staff is a
luxury that many small businesses cannot afford.
• Segregation of duties can be effective in preventing collusion, but no system of internal control
can ensure that it will not happen.
• It does no good to have one employee count the cash at the end of the day and another to record
it if the two act in concert to steal from the company. Rotation of duties can help lessen the
likelihood of such problems.
• A system of authorizations is meaningless if management continually overrides or fails to support
it.
• Human errors can weaken a system of internal control – misunderstood instructions, carelessness,
fatigue, and distraction can all lead to errors.
• A well-designed internal control system should result in the best possible people being hired to
perform the various tasks, but no one is perfect.
Computerized Business Documents and Internal Control
Control Over Cash Receipts
• Most merchandisers receive checks and currency from customers in two ways:
1. Cash received over the counter from cash sales.
2. Cash received in the mail from credit sales.
• Each type of cash receipt poses its own control problems.
• Cash received over the counter has these control mechanisms to handle cash payments:
1. Cash registers allow the customer to see the display, which deters the salesclerk from ringing
up a sale for less than the amount received from the customer and pocketing the difference.
2. A locked-in cash register tape – any difference between the amount of cash remitted to the
cashier and the amount on the tape submitted to the accounting department is investigated.
3. prenumbered customer receipts, prepared in duplicate – any differences between the amount
of cash remitted to the cashier and the amount collected per the receipts should be explainable.
• Any form of cash received in the mail from customers should be applied to their account balances.
• The customer wants assurance that the account is appropriately reduced for the amount of the
payment.
• When cash/checks are received in the mail, to achieve a reasonable degree of control, two
employees should be present when the mail is opened.
 Because the two employees acting in concert could circumvent the control process, rotation of
duties is important.
• Monthly customer statements act as an additional control device for customer payments received
in the mail.
• The use of customer statements as a control device will be effective only if the employees
responsible for the custody of cash received through the mail, for record keeping, and for
authorization of adjustments to customers’ accounts are not allowed to prepare and mail
statements to customers.
• Cash Discrepancies occur occasionally due to theft by dishonest employees and to human error.

The Role of Computerized Business Documents in Controlling Cash

Disbursements
• A company makes cash payments to purchase merchandise, supplies, plants, and equipment; to
pay operating expenditures; and to cover payroll expenses.
• Merchandising companies rely on a smooth and orderly inflow of quality goods for resale to
customers.
• Suppliers must be paid on time so that the companies can continue to make goods available.
• Business documents play a vital role in the purchasing function.

Purchase Requisition
• Purchase requisition form: a form a department uses to initiate a request to order merchandise.
• Stores review their stock weekly to determine if any items need replenishing – on the basis of its
needs, the supervisor of the store fills out the purchase requisition form.
• The purchasing department makes the final decision on a vendor. The purchasing department is
thus held accountable for acquiring the goods at the lowest price, given certain standards for
merchandise quality.
• The original and a copy of the purchase requisition are sent to the purchasing department.
Purchase Order
• Purchase order: a form sent by the purchasing department to the supplier.
• Most companies have purchased software or have developed software internally to perform such
functions as purchasing, sales, and payroll.
• The software is capable not only of increasing the speed and accuracy of the process but also of
generating the necessary documents.
• Purchase orders are prenumbered; any missing numbers should be investigated periodically.
• The purchasing department uses its copy of the purchase requisition as a basis for preparing the
purchase order.
• You should trace all of the information for at least one of the three items ordered from the
purchase requisition to the purchase order.
• The system generates the original purchase order (sent to the supplier after a supervisor in the
purchasing department approves it) and three copies – one for the accounting department, one
to the store that requested the purchase, and one for the purchasing department).
• A purchase order is not the basis for recording a purchase and a liability.
 Legally, the order is merely an offer by the company to purchase goods from the supplier.
 The receipt of goods from the supplier is the basis for the purchaser’s recognition of a liability.

Invoice
• Invoice: a form sent by the seller to the buyer as evidence of a sale.
• When the supplier ships the merchandise, it also mails/ships with the merchandise, an invoice to
the company requesting payment according to the agreed-upon payment terms.
• The supplier calls this a sales invoice; it is the basis for recording a sale and an account receivable.
• The buyer calls this a purchase invoice, which is the basis for recording a purchase and an account
payable.

Receiving Report
• Blind receiving report: a form used by the receiving department to account for the quantity and
condition of merchandise received from a supplier.
• The accounting system generates an original receiving report (for the accounting department) and
three copies – one for the receiving department, one for the purchasing department and one for
the store that requested the purchase.

Invoice Approval Form

• Invoice approval form: a form the accounting department uses before making payment to
document the accuracy of all information about a purchase. Also called a Voucher.
• The invoice is compared to the purchase requisition to ensure that the company is billed for goods
that it requested.
• The receiving report is compared with the invoice to verify that all goods for which the company
is being billed were received.
• An accounting department employee must also verify the mathematical accuracy of the amounts
that appear on the invoice.
• The date the invoice must be paid to take advantage of the discount is noted so that the finance
department will be sure to send the check by this date.
• The invoice approval form and the invoice are then sent to the finance department.
• Some businesses do not use a separate invoice approval form; they simply note approval directly
on the invoice.
Check with Remittance Advice
• Upon receipt of the invoice approval form from the accounting department, a clerk in the finance
department of the buyer processes a check with a remittance advice attached.
• Before the check is signed, the documents referred to on the invoice approval form are reviewed
and canceled to prevent reuse.
• The clerk then forwards the check to one of the company officers authorized to sign checks.
• To maintain separation of duties, the finance department should mail the check.
• The remittance advice informs the supplier as to the nature of the payment and is torn off by the
supplier before cashing the check.

Company’s Name
Bank Reconciliation
Date

Balance per Bank Statement, date $xxxx

Add: Deposit in Transit xxx
Deduct: Outstanding Checks
No. xxx $xx
No. xxx xx (xxx)
Adjusted Balance, date $xxx
Balance per Books, date $xxx
Add: Customer Note Collected $xx
Interest on customer note xx
Interest earned during June xx
Error in recording check xxx xx xxx
Deduct: NSF check $xx
Collection fee on note xx
Service charge for (service, e.g. lockbox) xx (xxx)
Adjusted Balance, date $xxxx