BASIC ACCOUNTING Internal Control and Cash Learning Objectives: After studying this chapter, you should be able to: Define internal control and identify its purposes and principles. Define cash and state how it is valued and classified. Apply internal control over cash receipts and disbursements. Understand why businesses use a petty cash fund. Make entries under the imprest fund system. Understand the reason for preparing bank reconciliation statements. Prepare a bank reconciliation ‘and the related entries after finding the reconciling items. INTERNAL CONTROL gy Rey ~ Management must plan, direct and control operations of an entity. The elements of control encompass all aspects of an entity's operations. Internal control should be a management priority so that it may achieve goals for the entity. Internal control is the plan of organization and all the methods and measures used by a business to: Safeguard assets; Minimize errors and prevent fraud for reliability of accounting records; Promote operational efficiency; and Ensure compliance with laws and established managerial policies. vvvy Internal control extends to functions beyond the accounting and finaricial departments. Accounting controls encompass safeguarding assets and the accuracy of financial records. They are designed to give assurance that transactions are properly authorized and are recorded to allow for financial statement preparation in accordance with generally accepted accounting principles. Further, accounting controls deal with maintaining accountability for assets, proper authorization to access assets, and periodic reconciliation between recorded assets on the books and the physical assets that exist, Scanned with CamScanner12-2 | Basic Accounting Administrative or managerial controls deal with operational efficiency, adherence to managerial policies, and management's authorization of transactions. Examples are quality control and employee performance reports. Accounting and administrative controls are not mutually exclusive since some procedures and records falling under accounting control may also be used for administrative control. Principles of internal Control ‘Competent and Reliable Personnel Employees should be carefully selected. The duties assigned to them should be related to their talents, intelligence. and training. The employees should be properly supervised as they perform their jobs. In addition, an employee must realize the importance of following procedures prescribed by management. S. Assignment of Responsibi Each person should thoroughly understand his function and its relationship to other functions in the organizational structure. The plan of organization “should. fix responsibility for functions and confer the authority necessary to perform them. Responsibility and authority for a given function should not be shared for it may result to duplication of effort or a job not being done at all. When only one person is responsible for a function, praise or blame can be clearly assigned for specific results. ‘Segregation of Duties In general, employee assignments should be divided so that related operations are not performed by the same individual. Stated in another manner, no single individual should have complete control over a sequence of related transactions. Such division of responsibilities limits ‘the chances for errors and fraud; and promotes employee specialization and efficiency. 5 The significant components of internal control may be divided as follows: > Segregation of operations from accounting. ‘The entire accounting filnction should be completely separated-from the operating departments. For example, accountants not -sales personnel should keep inventory records. } Segregation of custody of assets from accounting. An employee should not be ablé to convert assets for personal use and cover up the conversion by falsifying the records. For example, the accountant should not handle cash and the cashier, should not have access to the accounting records. > Segregation of authorization of transactions from the custody of related assets. Except in cases where the owner is involved, persons who authorize transactions should not handle the related asset. For example, an individual should not authorize payment of a supplier's invoice and also sign the check, An individual who handles cash receipts should not have the authority to write off accounts receivable. Scanned with CamScanner———— Internal Control and Cosh_| 12-3 > Segregation of duties within the accounting function. Independent performance of various phases of accounting helps minimize errors and the opportunities for fraud. For ‘example, different personnel should be responsible for recording cash receipts and cash disbursements. Rotation of Personnel Some entities rotate the positions of certain operating personnel to serve some purpose. Rotation familiarizes the employees with all areas of the unit such’ that no personnel is deemed indispensable. This practice also strengthens the control system by helping discover errors and irregularities caused by lapses and dishonesty. Documents and Records Each function within the organization should have a thorough documentation of its activity so that each transaction can be traced and verified. Business documents should be prenumbered and the sequence of forms accounted for. No forms should be discarded even if damaged or completed incorrectly. Such form should be filed and voided for future reference. The entries in the records are the results of analyses of the source documents. The records should identify the source of the entries to ensure the establishment of an adequate audit trail. Internal and External Audits It is not economically feasible for auditors to examine all the transactions during a period. The accounting system as a matter of principle should produce accurate records. However, before an accounting system can be'relied upon to produce reliable records, the auditors evaluate its system of internal controls. ‘Audits are either internal or external. Internal auditors are staff personnel of the entity who reports to the audit committee, to a high-ranking executive, or to the owner. To be effective, the internal audit staff should work independently of the accounting and operating functions. Throughout the year, they audit various segments of the organization to appraise the entity's financial and operational activities. The internal auditor attempts to ensure the accuracy. of business records, uncover internal control problems and identify operational difficulties. External auditors are entirely independent of the business. They are hired to audit the entity as a whole and to express an opinion on the fairness of the financial statements. Physical and Electronic Controls Management initiates a number of physical and electronic controls to safeguard assets. Such controls include the following: - Scanned with CamScanner12-4 | Basic Accounting > Only minimal amounts of cash or negotiable assets are kept in the business premises and these amounts are stored in a vault. Use of bank safety deposit boxes for important business papers. f Warehouses for inventories that are secured. Fencing of business premises. Hiring of security personnel and use of electronic burglar alarm systems. Insurance against losses from fire, flood and similar events. Bonding of employees who have access to cash and the like. Use of cash registers and point-of-sale scanners; and attachment of electronic sensors to merchandise to deter theft. Employment of program controls that reject invalid transaction input data and produce exception reports. vyvvyvvy v Limitations of Internal Control An entity's system of internal control is generally designed to provide reasonable, but not absolute, assurance that assets are properly safeguarded and that the accounting records are reliable. The concept of reasonable assurance rests on the premise that the costs of establishing internal control procedures should not exceed their expected benefits. The effectiveness of an internal control structure can be diminished by employee errors caused by fatigue, carelessness and indifference. Moreover, collusion between two or more employees to circumvent prescribed controls may significantly impair the system. CASH Nature Cash or Cash on Hand and In Banks in the balance sheet includes the following: > Currency or cash items on hand such as cash in working funds and cash items awaiting deposit including ordinary checks, travelers’ checks, cashier's or manager's checks, bank drafts and money orders; ” > Peso or foreign currency deposits in banks that are unrestricted and immediately available for use in the current operations. Valuation and Classification Cash is valued at face value; foreign currency is valued at the current exchange rate. Cash is usually presented as the first item among the current assets in the balance sheet. Short-term or temporary placements of excess cash such as time deposits and deposit substitutes, which can be pre-terminated, may be shown as part of cash. Amounts representing post-dated checks, advances to employees, returned checks or cash received after the balance sheet date should not form part of the cash account. Unreleased checks should not be treated as outstanding checks but should be restored to the cash balance. Scanned with CamScannerInternal Controls over Cash The need to safeguard cash is crucial. Cash is easy to conceal and transport, carries no mark of ownership, and is universally valued. The risk of theft is directly related to the ability of individuals to access the accounting system and obtain custody of cash. A sound internal control system for cash should include the following: Control of Cash Receipts : Internal control over cash receipts ensures that all cdsh receipts are deposited in the bank and that the accounting records are correct. These minimum procedures'should be applied: > © Separate the responsibilities for handling cash, for recording cash transactions and for reconciling cash balances. This separation reduces the possibility of theft and of concealment through false recording. , > Assign handling and recording responsibilities to different personnel to ensure an uninterrupted flow of cash from receipt to deposit. This contro! requires immediate counting, recording, timely deposit of all cash received. > Maintain close supervision of handling and recording functions. This control includes routine and surprise cash counts, internal audits, and daily reporting of cash receipts, disbursements and balances. Control of Cash Disbursements > Separate the responsibilities for cash disbursement documentation, check writing, signing, distribution and recording. > Except for internal cash funds like petty cash, make all cash disbursements by check. > If petty cash funds are employed, develop tight controls and authorization procedures for their use. > Prepare and sign checks only when supported by adequate documentation and verification. > Supervise all cash disbursements and recording functions. Petty Cash Fund Petty cash is the amount of money established and kept on hand by a business entity to meet routine small expenditures. The petty cash fund eliminates the need for writing numerous checks for insignificant amounts of money. The size of the fund depends on the number and the amounts of minor expenditures. The individual amounts paid through the petty cash fund may be small but the total amount over an accounting period may be significant. An entity can maintain more than one petty cash fund, each for a specific location or purpose. Scanned with CamScanner12-6 | Basic Accounting a The fund is intended to handle various types of small, payments, including postage, employee transportation costs, minor purchases of supplies, expenses related to delivery and miscellaneous expenses. Internal controls are necessary to maintain the fund for its intended purpose. An employee should administer the fund as its custodian. The custodian should place the fund in a secured location. The replenishment of the fund should be done using the normal cash disbursement procedures. There are two methods of handling petty cash—imprest or fluctuating system. The imprest fund system is the more preferable system since it clearly identifies the amount for which the custodian is responsible. The following steps illustrate a typical petty cash fund operation: Establishing the Fund Disbursements from the fund are made in currency and coins. The establishment of the fund though is covered by a check drawn against the bank account of the entity. The balance of the petty cash account, which is part of the total cash balance changes only when the fund is established, changed in amount or discontinued. ‘Assume that on June 1, Bernal Foods, an exporter of quality pili nuts based in Naga City, decided to set up a petty cash fund of P5,000, The journal entry is as follows: June a | Petty Cash 5,000 ‘Cash In Bank 5,000 To establish a petty cash fund. Making Payments from the Fund The custodian reviews authorization on vouchers for cash'requests and dispenses the required cash in accordance with management policies. A prenumbered petty cash voucher along with the pertinent source document supports every disbursement from the fund. At any time, the cash on hand ahd the total of the vouchers should equal the original total of the petty cash fund—in this case, P5,000, No entries are made for petty cash disbursements until-the fund is replenished. At that time, all petty cash payments will be recorded in a summary entry. This procedure eliminated the need to journalize numerous'payments for small amounts. Replenishing the Fund Disbursements reduce the amount of cash in the fund so the fund should be replenished _ at periodic intervals or when the cash balance is already at a minimum. Suppose that on June 12, the fund has cash of P250 only and expense vouchers totaling P4,750. Edwin Bernal, the owner, issued a check for P4,750 and had it encashed to bring the cash Scanned with CamScanner—— Internal Control and Cash_| 42-7 balance in the fund to P5,000. The entry to record the replenishment of the fund follows: June 12 | Postage Expense 1,380 Office Supplies Expense S80) Delivery Expense a 7 Miscellaneous Expense 70. Cash In Bank ant To replenish the petty cash fund. The entry is recorded by the accounting department and not by the custodian. After review of the petty cash disbursements, the responsible personnel should perforate the supporting documents to prevent them from being used again as a basis for reimbursement. Note that the Petty Cash account is not affected by the replenishment. Replenishment changes the composition of the fund by replacing the petty cash vouchers with cash, but it does not change the balance in the fund. Assume instead that the cash in the fund is only P150. The replenishment should have been for P4,850. The shortage of P100 should be debited to the Cash Short or Over account. Cash short or over is an expense or a revenue account depending on the balance. Recording or disbursing errors may cause a shortage or overage. Unusually material or regularly occurring shortages should be investigated promptly. ‘The petty cash fund should be replenished at the end of a reporting period regardless of the cash in the fund. Replenishment at this time is necessary to recognize the effects of the petty cash payments in the financial statements. Control of Cash through a Bank Account Nature Cash is the most common means of exchange so that most transactions ultimately-affect cash. Because of the very nature of cash, the entity should keep cash in a bank account as an internal control measure, Banks, on their part, have established practices for safeguarding cash. They provide depositors with separate detailed record of cash transactions. The handling of cash within the business premises and the risks of theft are-aiso minimized. Therefore, it is to'the best interest of the entity to deposit all cash receipts to the bank account and make all cash payments through it by issuing checks, Procedures and Documents Opening a bank checking or current account is relatively simple. The bank requires the business proprietor to present the business registration papers. The new depositor is now required to sign a signature card. The card contains specimen signatures of each person authorized to sign checks in the account. The bank employees use this eard to Scanned with CamScanner12-8 | Basic Accounting validate signatures on checks presented for payment; and thus, protect the bank and the depositor against forgery use of this card. " As soon as the account is opened, the bank will provide the depositor with a book of serially numbered checks and some deposit slips. These business documents have been presented in Chapter 8. Deposit slips are printed forms which when validated evidence actual deposits of cash. To draw money from the account, the depositor writes a. check, ‘A check is a written order to the bank by a depositor to pay a specified'sum of money to a designated person. : It is important for the depositor to know the balance in the current account at all times; this is to avoid issuing checks not covered by sufficient funds at the specified payment date. Note that issuance of a bouncing check constitutes a criminal act punishable under Batas Pambansa Bilang 22, otherwise known as the Bouncing Checks Law. To keep the balance current, each deposit and check issued should be entered in running balance. A summary form for this is provided for in the chéckbook. The form has columns for the following details: date of check issue, check number, particulars of payment, deposit, withdrawal and balance. The bank provides monthly statements to the depositor. The bank statement shows the account's beginning cash balance, all additions and deductions for the month, and the ending cash balance. In addition, the bank returns the paid or cancelled checks for the month along with the credit and debit memoranda explaining the other credits and debits made by the bank to the account. Reconciliation of Bank and Book Cash Balances The bank and the depositor maintain independent records of the entity’s current account. It might be presumed that the respective balances will always agree; but in reality, the two balances often do not reflect the same amount. The difference arises because of time lags in recording certain transactions and errors by either party. It is therefore necessary to reconcile the cash balance per books with the balance per bank statément to ensure that all cash transactions are accounted for and that both records are correct. This process is called the bank reconciliation. The reconciliation should yield the adjusted cash balance to be reported in the balance sheet. Bank reconciliation is used for the following purposes: > Determine whether the bank account and the entity's cash balance will agree after considering unrecorded items. > Isolate recording errors and other problems in the bank records or entity’s accounting system. > _ Establish the adjusted ending cash balance. > Provide information for adjusting entries. Scanned with CamScannerInternal Control and Cash_| 1: ee ———— eee It should be noted that the entity’s current account is a liability in the bank’s balance sheet. When the bank reduces the current account for a service charge, the bank will debit the account. A debit memo will support this deduction. Deposits acknowledged by the bank are credited to the account. The bank’s treatment of the deposit liability is the exact opposite of the entity's treatment of the current account. Reconciling Items The bank balance is adjusted for items reflected in the books that are not in the statement. On the other hand, the book balance is adjusted for items shown in the bank statement that are not reflected in the books. Common items that cause differences between the bank balance and the book balance are as follows: 1, Items recorded by the entity but not yet recorded by the bank: a, Deposits in Transit. Cash receipts already recorded in the cash receipts journal that reached the bank too late to be credited in the current statement. b. Outstanding Checks. These checks are already issued by the entity but not yet cleared or paid by the bank. It is listed in the cash payments journal or check register for the month but not included in the bank statement for that month. 2, Items recorded by the bank but not yet recorded by the entity: a. Bank Collections. The bank at times serves as the depositor’s collecting agent. Businesses with widely dispersed customer origins may avail of this. b. Returned Items. Banks return checks when drawn against uncleared deposits (DAUD) or drawn against insufficient funds (DAIF). These checks are received by the depositor as payment for accounts; these are deposited and accepted by the bank on the assumption that the checks are good or have sufficient funds to cover the amounts specified in the checks. During clearing, the checks are rejected by the customers’ banks due to insufficiency of funds. The depositor’s bank will reverse the initial credit by a debit due to DAUD or DAIF. ©. Service Charge. This is the amount charged by the. bank for servicing specific transactions on behalf of the depositor. 3. Errors by either the entity or the bank. Procedures The procedures are applied to the Marasigan Consulting, owned by Nick Marasigan. The following should reveal all the reconciling items that caused the difference between the two balances and establish the adjusted ending cash balance: 1. Enter the ending balance per bank statement of P365,601.78 and the ending balance per books of P388,047.00 (from the T-account at the end of this chapter). Scanned with CamScanner12-10 | Basic Accounting 2. Compare the individual deposits credited in the bank statement with the receipts deposited per books. Deposits not recorded by the bank represent deposits in transit. This item is added to the bank balance. In addition, check whether deposits in transit from the preceding month have appeared in the current bank statement. A check mark ( /) has been placed next to the amounts that appeared in both records. Note that the P25,850 deposit made on April 30, 2014 did not appear in the bank statement. This is a deposit in transit for the current month. A deposit in transit of P15,897 (marked with “#” in the bank statement) for the previous month has been credited by the bank; this is not a cash receipt per books for the current month. The deposit in transit amount can also be derived using a schedule: Deposits in transit, 3/31/2014 P 15,897.00 Add: Cash deposited per books for April 2014 253,200.00 Total amount that should have been deposited 269,097.00 Less: Deposits credited by the bank (268,247 — 25,000) 243,247.00 Deposits in transit, 4/30/2014 3. Compare the paid or cancelled checks returned with the bank statement with checks outstanding from the preceding bank reconciliation and with the checks recorded in the check register by the entity during the current period. Issued checks that remain unpaid are called outstanding checks and are subtracted from the balance per bank. Check no. 269 marked with “#” in the bank statement is an outstanding check of the previous month but has been processed by the bank in the current month. Checks that have cleared in the bank are marked “+” in both records. Only check no. 278 is without a mark; thus, the check is still outstanding. The outstanding checks amount can also be computed as follows: Outstanding checks, 3/31/2014 P 25,378.95 ‘Add: Checks issued per books for April 2014 142,476.83 Total checks that should have been cleared P 167,855.78 Less: Checks debited by the bank (P189,451 — P245 - P26,649 = P248 - P55) 162,254.00 Outstanding checks, 4/30/2014 P_ 5,601.78 4. Trace bank statement items covered by credit and debit memoranda to the entity's cash records. These items were already considered in the bank statement but remain unrecorded per books. An item that is reported in a credit memo is added to the book balance while that in a debit memo is subtracted. Laguna Savings Bank collected notes with a face value of P25,000 for the entity and a service charge of P248 related to the collection is deducted. ‘In addition, a P26,649 DAUD check was returned by the bank. Also, the company was charged P245 for the cost of two checkbooks and P55 for certain services. Scanned with CamScannerInternal Control and Cash_| 12-11 Laguna Savings Bank San Pablo City Bank Statement. Marasigan Consulting Statement Date: April 30, 2014 ‘Sampaloc Ave., San Pablo City * Account No.: 1585-0542-1 Account Type: Current Currency: Peso a th 3/31/2014 Total Credits Total Debits 4/30/2014 Balance Balance 286,805.78 268,247.00 189,451.00 365,601.78 No.of Credits | 9 | No. No. of Checks | 9 Description Check Credits Balance No. Beginning Bal. 286,805.78 Check Deposit 15,897.00 # 302,702.78 Cash Deposit 35,000.00 / 337,702.78 Inclearing Check 25,378.95 # 312,323.83 Inclearing Check 16,554.20 + 295,769.63 Cash Deposit 12,600.00 / 308,369.63 Cost of Checkbooks 245,00 308,124.63 Inclearing Check 20,000.00 + 288,124.63 Check Encashment_ 25,000.00 + 263,124.63 Check Encashment 9,500.00 + 253,624.63 Check Deposits 60,101.00 / 313,725.63 Check Encashment 25,565.00 + 288,160.63 Check Deposit. 26,649.00 / 314,809.63 Returned Items 26,649.00 288,160.63 Inclearing Check 5,855.85 + 282,304.78 Bank Credit Memo. 25,000.00 / 307,304.78 Service Charges 248,00 307,056.78 Cash Deposit 27,500.00 / 334,556.78 Check Encashment. 25,000.00 + 309,556.78 Service Charges, 55.00 309,501.78 Cash Deposit 15,500.00/ | 325,001.78 Check Deposits 50,000.00 / 375,001.78 Check Encashment_ 9,400.00 365,601.78 Ending Balance I: 365,601.78 Working forthe Filipino Entrepreneur Scanned with CamScanner12-12 | Basic Accounting 5. Note any errors discovered in the foregoing steps and consider them in the appropriate section of the bank reconciliation statement. 6. Compute the adjusted bank balance and the adjusted book balance. The two adjusted balances should equal. The adjusted cash balance is P385,850. - Marasigan Consulting Partial Cash Receipts Journal April 2014 Cash Description Receipts Laguna College 35,000.00 / Prudential Guarantee and Assurance Inc. 12,600.00 / Burger King Corporation 60,101.00 / Equitable Banking Corporation 26,649.00 / Philtranco Bus Company 27,500.00 / Jocker’s Food Industries , 50,000.00 / Nissan San Pablo 15,500.00/ | J. Ty Construction and Development Corp. 25,850.00 253,200.00 Marasigan Consulting Partial Cash Disbursements Journal April 2014 , Cash Description Payments MicroGates Software 16,554.20+ Bureau of Internal Revenue 25,565.00+ | First World Realty Company 20,000.00 + Payroll | 25,000.00 + Replenishment of Petty Cash Fund 9,500.00 + First San Pablo Electric Cooperative 5,855.85 + Payroll 25,000.00 + Replenishment of Petty Cash Fund 9,400.00 + ‘Smart Communications, inc. |__ 5,601.78 Scanned with CamScannerInternal Control and Cash_| 12-13 SSS Bank Reconciliation Statement Marasigan Consulting Bank Reconciliation Statement April 30, 2014 Unadjusted Balance per Bank P 365,601.78 Add: Deposits In Transit, 4/30 25,850.00 Total P 391,451.78 Less: Outstanding Checks, 4/30 5,601.78 Adjusted Balance " p385,850.00 Unadjusted Balance per Book P 388,047.00 Add: Notes Collected (net of P248 service charge) 24,752.00 Total P 412,799.00 Less: DAUD Check P 26,649.00 * Bank Charges 300.00 26,949.00 + Adjusted Balance P 385,850.00 Entries The bank reconciliation does not directly affect the journals or the ledgers. ° Like the worksheet, the reconciliation is only an accountant’s tool. Each reconciling item per books should be journalized and posted by the depositor. ‘Apr. 30 | Cash In Bank 24,752 | Miscellaneous Expense 248 Notes Receivable 25,000 To record note collected by bank less charges. ‘Accounts Receivable 26,649 (Cash In Bank 26,649 To reclassify DAUD check. Miscellaneous Expense 7 S00) Cash In Bank 300 I To record various bank charges. + After the adjusting entries, the T-account for cash in bank will be as follows: Cash In Bank 3/31 Adjusted Balance 277,323.83 | Book Receipts, April 253,200.00. 530,523.83 142,476.83 Book Payments, April 142,476.83 Unadjusted Balance "388,047.00 26,649.00 ANE W2 AE ML 24,752.00 300.00 ANE HS 412,799.00 26,949.00 4/30 Adjusted Balance 385,850.00 Scanned with CamScanner