Financial Accounting – Study Guide

Chapter 7: Internal Control and Cash

Internal Control System

 Internal control system: system that helps a company achieve reliable financial reporting.
 Has 5 components to it:
1. Control environment: must communicate that the company values integrity.
2. Risk assessment: must identify the factors that create risk for the company.
3. Control activities: must design policies that reduce errors.
4. Monitoring activities: must be monitored periodically to assess its adequacy.
5. Information and communication: must communicate all relevant information to users.

Control Activities

Activity Description
Assignment of  Requires that specific employees be held accountable for their
Responsibility actions.
 Can be assigned by task level or employee level.
Segregation of Duties  Requires that different types of duties be spread across multiple employees.
Documentation  Requires that transactions be supported by source documents.
Physical Controls  Requires that vaults and warehouses be used to safeguard assets.
Review and  Requires that internal reviews be conducted by managers.
Reconciliation  Requires that external reviews be conducted by auditors.

Limitations of Internal Control Systems

Limitation Description
Cost Consideration  Not effective if the value of the information provided is less than the
cost.
Human Error  Not effective if employees are careless or untrained.
Collusion  Not effective if employees collude to get around prescribed control
activities.
Management Override  Not effective if management does not enforce prescribed control activities.

Control Activities Over Cash Receipts

 Authorize only designated employees to handle cash receipts.

 Have different employees recording cash receipts and handling cash.
 Use deposit slips and cash register tapes as confirmation for bank deposits.
 Store cash in safes and vaults with limited access.
 Have an accountant compare receipts with bank deposits.

Control Activities Over Cash Payments

 Authorize only designated employees to sign cheques.

 Have different employees recording cash payments and handling cash.
  Use prenumbered cheques and account for them in sequence.
 Store cash in safes and vaults with limited access.
 Have an accountant compare cheques with invoices.

Understanding Debits and Credits

Differences Between Company Records and Bank Records

 Can result due to timing differences in recording transactions.

 Outstanding cheque: cheque that is written and dated but not yet paid by the bank.
 Deposit in transit: deposit that is recorded by the company but not yet recorded by the bank.
 Can result due to errors in recording transactions.

Reconciling Items Per Bank

 Reconciled Cash Balance = Deposits in Transits – Outstanding Cheques +/- Bank Errors.
 Deposits in Transit at End of Period = Deposits in Transit at Beginning of Period + Deposits
Recorded in Company’s Book this Period – Deposits Recorded in this Period’s Bank Statement.
 Outstanding Cheques at End of Period = Outstanding Cheques at Beginning of Period + Cheques
Recorded in Company’s Books this Period – Cheques Recorded on this Period’s Bank Statement.

Reconciling Items Per Company’s Book

 Reconciled Cash Balance = EFT Collections, Interest Earned, and Other Deposits – EFT Payments,
Service Charges, Interest Charges, and NSF Cheques +/- Bank Errors.
 EFT payment: method of transferring money electronically from one bank account to another.
 NSF cheque: check that has been deposited but returned due to insufficient funds.

Reporting Cash

 Restricted cash and cash equivalents are reported as assets on the statement of financial position.
 Restricted cash: cash that cannot be used because it is restricted for a particular purpose.
 Cash equivalents: short-term held for trading investments with little risk of changes in value.
 Bank indebtedness is reported as a liability on the statement of financial position.
 Bank indebtedness: short-term loan pre-arranged with a bank to cover shortfalls.

Managing Cash

 Collect receivables quicker.  Delay the payment of liabilities.

 Keep inventory levels low.  Plan the timing of major expenditures.
  Invest idle cash.  Prepare a cash budget.

Chapter 8: Reporting and Receiving Receivables

Allowance Method

 Estimates the uncollectible accounts at the end of each period.

 Records estimates in Allowance for Doubtful Accounts.
 Gets netted with Accounts Receivable to determine the “carrying amount”.
 Records expenses in Bad Debts Expense.
 Allowance method must be used because otherwise:
 Accounts receivable will be overstated.
 Net income will be overstated.
 Revenues with expenses will not be matched.

Estimating Uncollectible Accounts

Method Description
Percentage of Sales  Estimates the amount of bad debts based on the history of credit
sales.
Percentage of  Estimates the amount of bad debts based on the age of accounts receivable
Receivables (how much time they have been outstanding).

Notes Receivable vs. Accounts Receivable

 Have a stronger legal claim to assets than Accounts Receivable.

 Extend for time periods greater than 30 days. Require the payment of interest.
 Get accepted from customers who need to extend payment of Accounts Receivable.

Dishonored Notes Receivable

 Not paid at maturity date. No longer negotiable.

 Balance transferred to Accounts Receivable if eventual collection is expected.
 Balance written off to Bad Debts Expense if eventual collection is not expected.

Liquidity Ratios: Receivables Turnover, Average Collection Period, and Payables Turnover

Ratio Description
Accounts Receivable  Measures number of times receivables are collected.
Turnover  Receivables Turnover = Net Credit Sales / Average Accounts
Receivable.
Average Collection  Measures number of days receivables are outstanding.
Period  Average Collection Period = 365 Days / Receivables Turnover.
Accounts Payable  Measures number of times payables are collected.
Turnover  Receivables Turnover = Cost of Goods Sold / Average Accounts
Payable.