Solution Manual for Principles of Financial

Accounting 11th Edition by Needles

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Solution Manual for Principles of Financial Accounting 11th Edition by Needles

CHAPTER 7
Internal Control

PLANNING MATRIX
Enhancing Your
Building Your Basic Knowledge and Knowledge, Skills, and
Learning Objective Skills Critical Thinking
1. Identify the management issues SE 1 E1 C3
related to internal control. C5
2. Describe the components of SE 2, 3, 6 E 1, 2, 3, 4, 5P 1, 2, 3, 5, C1
internal control, control activities, 6, 8 C2
and limitations on internal control. C4
C6
3. Apply internal control activities to SE 4, 5, 6, 7 E 2, 4, 5, 6, 7P 2, 3, 5, 6, 8 C1
common merchandising C2
transactions. C4

Supplemental Objective
4. Demonstrate the use of a simple SE 8 E 8, 9 P 4, 7
(petty cash) system.

MEMORANDA:
SE: Short Exercises
E: Exercises
P: Problems (Each problem has a User Insight question.)

All questions are in the text with related Learning Objectives (Stop, Think, and Apply).

SUGGESTED INSTRUCTIONAL STRATEGY

Output Skills Developed:
Technical, Communication, Interpersonal, Personal/Self

Related Learning Objectives:

1, 2

Instructional Strategy
Learning activity: Individual field trip, group field trip, or class project
Learning environment: Active, outside class
Learning tool: Textbook assignment Case 4

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 Chapter 7: Internal Control 81

Steps to Implement
1. This research activity can be done individually or in teams of three. If teams are used, each
member of the team can visit a different business, and the information gathered can be pooled in
the final report.
2. Go over the activity in class to make sure students understand what is required. The briefing
should include the following:
a. The type of business to be visited
b. The professional behavior expected of students during the visit
c. The nature of the data to be gathered
d. The form of the report
3. This activity can be turned into a class research project. If it is, tabulate in class the data gathered
by the groups (e.g., the percentage of the businesses that use computers to take a physical
inventory and the frequency with which they take inventory).
4. Another class project for this activity is to have the groups compile the tables and reproduce them
for the class.

Assessment
Technical skills: Grade summary table for content and technical accuracy.
Communication skills: Grade summary table for professional presentation.
Interpersonal skills: Assess indirectly a student’s or group’s ability to interview and communicate in a
business setting.
Personal/self skills: This activity is intended to build personal/self skills, such as confidence and
planning ability. Each student could complete a short questionnaire, answering questions like the
following: What did you find easiest about this assignment? What did you find most difficult? What
would you do differently next time?

RESOURCE MATERIALS AND OUTLINES

OBJECTIVE 1: Identify the management issues related to internal control.
Summary Statement
Internal control is a process designed by a company to establish the reliability of the accounting records
and financial statements in accordance with generally accepted accounting principles (GAAP) and to
insure that the company’s assets are protected. Management must assess its needs for internal controls,
establish its responsibility for them, and engage auditors of them, if required.
Management must establish systems, procedures, and an environment (collectively known as internal
controls) designed to protect its principal assets, such as cash, accounts receivable, and merchandise
inventory. A physical inventory, which actually counts all merchandise on hand, facilitates the
maintenance of control over merchandising inventory. It must be taken under both the perpetual and the
periodic inventory systems. The count is usually taken after the close of business on the last day of the
fiscal year. The physical count figure is then multiplied by a derived cost-per-unit figure to arrive at the
cost of ending inventory. The beginning inventory is removed from the inventory account, and the
ending inventory is entered into the inventory account by means of closing entries.

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82 Chapter 7: Internal Control

The merchandise inventory reported on the balance sheet includes all salable goods owned by the
company, regardless of where the goods are located. Goods in transit to which a company has acquired
title are included in ending inventory, whereas goods that the company has formally sold are not
included, even if the company has not yet delivered them. To simplify inventory taking, many
companies end their fiscal year during a slow season and make use of current technology such as bar
coding.
Most companies experience loss of inventory due to spoilage, employee pilferage, and shoplifting.
Under the periodic system, these losses are buried in cost of goods sold. In the perpetual system, the
amount of loss can be identified by comparing the perpetual inventory records to the physical count.
The difference between these two amounts, assuming no recordkeeping errors, is the loss and is
recorded as a debit to the Cost of Goods Sold account and a credit to the Merchandise Inventory
account.
In all companies, management is responsible for establishing an adequate system of internal controls.
For public companies, the Sarbanes-Oxley Act of 2002 requires that the chief executive, the chief
financial officer, and the auditors of the company certify the company’s system of internal controls.

New Concepts and Terminology

internal control, physical inventory

Related Text Illustration

Focus on Business Practice: Will Sarbanes-Oxley Stop Fraud?

Lecture Outline
I. The two objectives of a good system of internal control are to ensure
A. The reliability of accounting records and financial statements
B. That the company’s assets are protected
II. The need for internal controls
A. Use inventory to illustrate the need for internal controls
B. Physical inventory
1. A physical inventory must be taken in both the periodic and the perpetual inventory
systems.
2. Inventory includes all salable goods owned by the business, regardless of location.
3. Choice of fiscal year is influenced by the need to take a physical inventory.
4. Technology has an impact on the taking of a physical inventory.
C. Inventory losses result from theft and spoilage and are included in cost of goods sold; these
losses are easier to track under the perpetual system than under the periodic system.
III. Management’s responsibility for internal control
A. Responsibility applies to management of all companies, large and small.
B. The Sarbanes-Oxley Act of 2002 (SOX) applies to all public companies.
C. SOX requires certification of internal controls by the CEO, CFO, and auditor.

Teaching Strategy
Students are interested in anecdotes that illustrate the effectiveness of internal control. They have often
had experience in work settings in which there was a lack of control. Ask for examples of experiences
students have had in organizations in which controls were in place. Allow discussion and storytelling.
Case 3 is a good introduction case for this topic.

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 Chapter 7: Internal Control 83

OBJECTIVE 2: Describe the components of internal control, control activities, and

limitations on internal control.
Summary Statement
Management must establish the following five interrelated components of internal control: the control
environment, risk assessment, information and communication, control activities, and monitoring.
1. The control environment reflects management’s philosophy and operating style, the company’s
organizational structure, methods of assigning authority and responsibility, and personnel policies
and practices.
2. Risk assessment entails identifying areas in which risk of asset loss or inaccuracy in accounting
records is especially high.
3. Information and communication relates to the accounting system established by management and
to the need for clear communication of each individual’s responsibility within that system.
4. Control activities are the specific procedures and policies established by management to ensure
that the objectives of internal control are met.
5. Monitoring involves management’s regular assessment of the quality of internal control.
Management must establish control activities to ensure the safeguarding of assets and the reliability of the
accounting records. Examples of control activities are (1) requiring authorization for all transactions; (2)
recording all transactions; (3) using well-designed documents; (4) implementing physical controls, as
over the accounting records; (5) establishing a system of periodic independent checks of records and
assets; (6) separating duties; and (7) using sound personnel procedures. Bonding an employee (an
example of a good control activity) reduces or eliminates the risk of theft by that individual against the
company.
To be effective, a system of internal control must rely on the people who implement it. Thus, the
effectiveness of internal control is limited by the people involved. Human error, collusion, changing
conditions—all can weaken a system of internal control.

New Concepts and Terminology

control environment; risk assessment; information and communication; control activities; monitoring;
authorization; physical controls; periodic independent verification; separation of duties; bonding

Related Text Illustration

Focus on Business Practice: Which Frauds Are Most Common?
Focus on Business Practice: Shoplifters: Beware!

Lecture Outline
I. Internal control has five components:
A. Control environment
B. Risk assessment
C. Information and communication
D. Control activities
E. Monitoring
II. Control activities include the following:
A. Requiring authorization for all transactions
B. Recording all transactions
C. Using well-designed documents

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84 Chapter 7: Internal Control

D. Implementing physical controls, as over the accounting records

E. Establishing a system of independent periodic checks of records and assets
F. Separating duties
G. Using sound personnel procedures
1. Bonding is a valuable control procedure.
III. At least three factors can contribute to the weakening of a system of internal control:
A. Human error
B. Collusion
C. Changing conditions

Teaching Strategy
Internal accounting controls should be introduced as a driving force behind any accounting system.
Students are interested in anecdotes that illustrate the effectiveness of internal control. Students have
often had experience in work settings in which there was a lack of control. Ask also for examples of
experiences students have had in organizations in which controls were in place. Allow discussion and
storytelling. This brings the topic of internal control to a human level.
Internal control is one of the few topics in accounting where there is an allowance for human frailty.
Although this is a short segment of the text, students seem to enjoy a discussion of both human error
and collusion. This discussion reinforces the idea of internal control through a focus on its limitations.
As an alternative, it may help to describe a prepared case, asking students to identify problems in
internal control in the situation described.
The specific terminology used in the text is important. Terminology should be memorized.
Case 2 (Starbucks) provides an excellent real-world learning application for students.

OBJECTIVE 3: Apply internal control activities to common merchandising transactions.

Summary Statement
Accounting controls over merchandising transactions help prevent losses from theft or fraud. They also
help ensure accurate records of cash receipts, cash disbursements, and cash balances. Administrative
controls over merchandising transactions serve to maintain appropriate inventory levels; to ensure that
there is enough cash on hand to pay debts when due and, through timely payments, to take advantage of
purchases discounts; to avoid credit losses; and to earn a reasonable return on excess cash.
Several controls can be used to achieve effective internal control over sales and the exchange of cash.
One is the cash budget, which allows management to better predict future cash receipts and
disbursements. Another is the separation of duties that involve the handling of cash; many safeguards
can be implemented to prevent an individual from stealing or misusing cash.
Two or more employees should handle cash received by mail. Cash received from sales over the
counter should be controlled through the use of cash registers and prenumbered sales tickets. At the end
of each day, Cash is debited for cash receipts, and Sales is credited for the amount on the cash register
tape. If the two amounts do not agree, any differences must be explained.
All cash disbursements for purchases should be made by check. Before employees disburse cash, they
should obtain authorization in the form of signed documents. The system of authorization and the
documents used differ among companies. The most common documents are described below.
1. A purchase requisition is a formal request for a purchase that a department submits to the
company.

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 Chapter 7: Internal Control 85

2. The department responsible for purchasing activities completes a purchase order and sends it to
the vendor.
3. An invoice is the bill that the vendor sends to the buyer.
4. A receiving report, completed by the receiving department, contains information about the
quantity and condition of goods received.
5. A check authorization is a document showing that the purchase order, invoice, and receiving
report are in agreement and that payment is therefore approved.
6. When payment is approved, a check is issued to the vendor for the amount of the invoice, less any
appropriate discount. A remittance advice should be attached to the check, describing what the
check is for.
7. When the vendor deposits the check, then the canceled check appears on the bank statement. IF
the check amount is incorrect or has been altered, it will show up here.

New Concepts and Terminology

purchase requisition; purchase order; invoice; receiving report; check authorization

Related Text Illustrations

Focus on Business Practice: How Do Computers Promote Internal Control?
Figure 1: Internal Controls in a Large Company: Separation of Duties and Documentation
Figure 2: Internal Control Plan for Purchases and Cash Disbursements

Lecture Outline
I. Internal control activities help prevent theft and fraud and promote accuracy in cash records.
II. Internal controls also help management by
A. Keeping enough inventory on hand to sell to customers without overstocking merchandise
B. Keeping sufficient cash on hand to pay for purchases in time to receive discounts
C. Keeping credit losses as low as possible by making credit sales only to customers who are
likely to pay on time
III. Control of cash
A. Administrative controls such as a cash budget help maintain adequate inventory and cash
levels and minimize credit losses.
B. Generally, the following are necessary for good control of cash:
1. Separate the functions of authorization, recordkeeping, and custodianship of cash.
2. Limit the number of people who have access to cash, and designate who those people
are.
3. Bond all employees who have access to cash.
4. Keep the amount of cash on hand to a minimum by using banking facilities as much as
possible.
5. Physically protect cash on hand by using cash registers, cashiers’ cages, and safes.
6. Record and deposit all cash receipts promptly, and make payments by check rather
than by currency.
7. Have a person who does not handle or record cash make unannounced audits of the
cash on hand.
8. Have a person who does not authorize, handle, or record cash transactions reconcile the
Cash account each month.
IIV. Control of cash receipts
A. Two or more persons should handle cash received by mail.

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86 Chapter 7: Internal Control

B. Cash received over the counter should be controlled with cash registers and prenumbered
sales tickets.
V. The following documents should be used when making a purchase:
A. Purchase requisition
B. Purchase order
C. Invoice
D. Receiving report
E. Check authorization
F. Check
G. Bank statement

Teaching Strategy
Point out which assets are most vulnerable to theft or fraud. Detail in presenting this topic gives
students an inside look at why businesses do what they do to protect themselves from theft and fraud by
employees as well as by outsiders. Refer to safety measures taken to protect inventory and cash.
Figures 1 and 2 are useful in clarifying the material in the text. Students should familiarize themselves
with these illustrations. Short Exercises 6 and 7 and Exercises 6 and 7 are good reviews of this subject
matter.

SUPPLEMENTAL OBJECTIVE 4: Demonstrate the use of a simple imprest (petty cash)

system.
Summary Statement
Although it is good practice for a company to pay for everything by check, an exception should be
made for items of small value. When paying for postage, shipping charges, and small purchases of
items like pens and paper, many firms use a petty cash fund. One of the best ways of controlling a petty
cash fund is through an imprest system. Under this system, a petty cash fund is established for a fixed
amount. When payment is made from the fund, the fund’s custodian prepares a petty cash voucher
showing the date, amount, and purpose of the expenditure. The person who receives payment signs the
voucher. The petty cash fund is replenished periodically and at the end of an accounting period. At
those times, all the expenses since the last replenishment are debited and Cash is credited.
Discrepancies are recorded as Cash Short or Over.
The following journal entries are introduced in this learning objective:
Petty Cash XX (amount established for)
Cash XX (amount established for)
To establish the petty cash fund

Postage Expense XX (amount incurred)

Supplies Expense XX (amount purchased)
Freight-In XX (amount incurred)
Cash Short or Over XX (amount short)
Cash XX (amount replenished)
To replenish the petty cash fund

New Concepts and Terminology

petty cash fund; imprest system; petty cash voucher

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 Chapter 7: Internal Control 87

Related Text Illustration

Figure 3: Petty Cash Voucher

Lecture Outline
I. Discuss the mechanics of a petty cash fund as well as the internal control that should be exercised
over it.
II. Journalize the establishment of a petty cash fund.
III. Journalize the replenishment of a petty cash fund, using Cash Short or Over if necessary.

Teaching Strategy
Although this is a simple topic to define, students have a difficult time understanding an imprest
system. To clarify how a petty cash fund is reimbursed, start at the beginning by demonstrating how a
petty cash fund is established. Continue the demonstration to replenishment. (It may be helpful to have
preprinted petty cash vouchers as handouts.) Point out that the Petty Cash account is debited or credited
only to reflect changes in the size of the fund. Demonstrate the use of Cash Short or Over in the context
of maintaining the fund.
Short Exercise 8, Exercises 8 and 9 and Problems 4 and 7 apply these concepts.

REVIEW QUIZ

True-False
1. T F In a good system of internal control, the treasurer should not be responsible for both
check authorization and issuing checks.
2. T F An outstanding check that was also outstanding the previous month should still be
included in the reconciliation of the bank statement for the current month.
3. T F Collusion can overcome the advantage of separation of duties.
4. T F The use of prenumbered sales tickets can strengthen a store’s system of internal
control.
5. T F A company orders goods by sending the supplier a purchase requisition.
6. T F Section 404 of the Sarbanes-Oxley Act requires more scrutiny of internal controls of
public companies.
7. T F A company’s independent auditor has primary responsibility for a company’s internal
controls.

Multiple Choice
8. Each of the following is an example of a control procedure, except
a. making payments with currency rather than by check.
b. bonding all employees who have access to cash.
c. limiting the number of employees who have access to cash.
d. depositing all cash receipts promptly.
e. using banking facilities as much as possible.

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88 Chapter 7: Internal Control

9. Which of the following is not a primary concern of internal accounting control?

a. Efficiency of company operations
b. Accuracy of the accounting records
c. Maximization of profits
d. Adherence of transactions to policy
e. Safeguarding of assets

10. Each of the following is an example of a control activity, except

a. full responsibility by one employee.
b. limited access to assets.
c. periodic independent verification.
d. separation of duties.
e. sound personnel procedures.

11. The independent auditor of a public company

a. does not specifically assess a company’s system of internal controls
b. is primarily responsible for evaluating a company’s system of internal controls.
c. is responsible for documenting a company’s system of internal controls.
d. evaluates management’s assessment of internal controls over financial reporting
e. certifies that no embezzlements or fraud have occurred in the company.

12. Which of the following is least likely to lead to a breakdown in internal control?
a. Human errors and mistakes
b. Employees carrying out their duties as prescribed
c. Management taking full control of an operation
d. Two employees working together to steal assets
e. Few forms to support transactions

13. Which of the following documents should be checked to ensure that they agree before a check
authorization is prepared?
a. Purchase requisition and purchase order
b. Purchase order and receiving report
c. Purchase requisition, purchase order, and invoice
d. Purchase order, invoice, and receiving report
e. Purchase requisition and receiving report

14. All of the following are good practices for controlling cash except
a. Separate the functions of authorization, recordkeeping, and custodianship of cash.
b. Limit the number of people who have access to cash, and designate who those people are.
c. Have the person who authorizes and records cash transactions reconcile the Cash account
each month
d. Physically protect cash on hand by using cash registers, cashiers’ cages, and safes
e. Record and deposit all cash receipts promptly, and make payments by check rather than by
currency.

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Solution Manual for Principles of Financial Accounting 11th Edition by Needles

Chapter 7: Internal Control 89

15. The entry to replenish a $50 petty cash fund that has $20 cash and a receipt for $30 of postage
would include a credit to
a. Cash.
b. Petty Cash.
c. Postage Expense.
d. Prepaid Postage.
e. Supplies.

16. A company’s control environment includes all the following except the company’s
a. ethics, philosophy, and operating style
b. customer profile
c. organizational structure
d. method of assigning responsibilities
e. personnel policies and procedures

17. The process of identifying areas in which the possibility of loss of assets or inaccuracies in the
accounting records is high is most closely related to
a. control environment.
b. information and communication.
c. risk assessment.
d. control activities.
e. monitoring

ANSWERS TO REVIEW QUIZ

True-False Multiple Choice
1. T 8. a
2. T 9. c
3. T 10. a
4. T 11. d
5. F 12. b
6. T 13. d
7. F 14. c
15. a
16. b
17. c

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