Chapter Seven

1. Chapter Seven Internal Control and Accounting for Cash

2. Identify the key elements of a strong system of internal control. LO 1 LO 1

3. Key Features of Internal Control • Separation of Duties • Quality of Employees • Bonded Employees • Required Absences • Procedures Manual • Authority and Responsibility • Prenumbered Documents • Physical Control • Performance Evaluations

4. Separation of Duties When duties are separated, the work of one employee can act as a check on the work of another employee. The likelihood of fraud or theft is greatly reduced.

5. Quality of Employees The ability of cross-trained employees to substitute for one another prevents disruptions in the workplace. Job rotation may help relieve boredom and increase productivity.

6. Bonded Employees A fidelity bond provides insurance that protects a company from loss caused by employee dishonesty. To become bonded, an employee’s background is investigated.

7. Required Absences An employee may be able to cover up fraudulent activities if they are always present at work. All employees should be required to take regular vacations and their duties should be rotated periodically.

8. Procedures Manual Accounting and other important procedures should bewritten in a procedures manual. Periodically, management should conduct an investigation to seethat required procedures are actually being followed.

9. Authority and Responsibility General authority applies to all member of the organization. For example, all employees are required to fly coach and purchase airline tickets from a specific vendor. Specific authority applies only to a specific position within the organization. For example, all checks must be cosigned by the Controller and Treasurer.

10. Prenumbered Documents. Prenumbered forms are used for all important documents such as checks, purchase orders, receiving reports, and invoices. The use of prenumbered forms helps keep track of all forms issued during a particular period.

11. Physical Control All companies should maintain adequate physical control over valuable assets that may be misappropriated. For example, inventory should be properly stored in a secure location. Serial numbers should be placed on all valuable assets to assist in a physical count of these assets.

12. Performance Evaluation Internal controls should include independent verification of employee performance. A physical inventory should be taken at least annually. An independent reconciliation between the general ledger balance and inventory should be compared to the inventory count. Auditors should evaluate the effectiveness of the control system.

13. Limitations Internal controls can be circumvented by collusion among employees. Two or more employees working together can hide embezzlement by covering for each other. No system can completely prevent fraud.

14. Identify special internal controls for cash. LO 2 LO 2

15. Accounting for Cash Cash receipts should be recorded immediately upon receipt and deposited intact daily. Up to date signature card should be maintained. ControllingCash A monthly bank reconciliation should be prepared by an independent party. A deposit ticket should be used for all deposits. Cash payments should be made by prenumbered check.

16. Prepare a bank reconciliation. LO 3 LO 3

17. Reconciling the Bank Statement The bank reconciliation reports on the differences between the balance on the bank statement and the balance in the general ledger cash account. The reconciliation results in the true cash balance that will appear on the balance sheet.

18. Reconciling the Bank Statement If an error is found on the bank statement, an adjustment for it is made to the unadjusted bank balance to determine the true cash balance. An error made on our books requires an adjusting journal entry to correct.

19. Bank Reconciliation • Green Shades Resorts, Inc. is preparing the bank reconciliation for the month of September. • The Sept 30th balance on the bank statement is $3,516.45, and the Cash general ledger balance on this date is $3,361.22 . • There was a deposit in transit in the amount of $724.11. • The bank erroneously deducted a $25 check drawn on the books of Green Valley Resorts from our account. • At September 30th three checks are outstanding. Check 639 dated 9/18 for $13.75; Check 646 dated 9/20 for $29.00; and Check 672 dated 9/27 for $192.50 . More Information

20. Bank Reconciliation • During the month of September the bank collected an account receivable for us in the amount of $940.00 . • A check actually written for $36.45 for supplies was erroneously recorded in our records by the bookkeeper as $63.45. • The bank assessed a service charge of $8.40 for September. • We deposited a NSF check in the amount of $289.51 . This was a check someone gave to us. Their check bounced. So we really do not have this money. Let’s prepare the bank reconciliation

21. Bank Reconciliation

22. Bank Reconciliation

23. Bank Reconciliation

24. Bank Reconciliation

25. Bank Reconciliation

26. Bank Reconciliation

27. Adjusting the Books Every reconciling item that appears on the unadjusted book balance section requires a journal entry to adjust the general ledger cash balance to the true cash balance. Acct. Rec. collected by the bank Check error NSF check Put back into A/R because they still of us the money.

28. Assume a cashregister was to havea balance of $500,but contained only$499 at the end ofthe day. Cash Short and Over When using a cash register, employees sometimes make mistakes in collecting cash or making change for customers. If the cash register does not reconcile by a small amount at the end of the day, we use an account called cash short and over to force a balance.

29. Explain the use of a petty cash fund. LO 4 LO 4

30. Using Petty Cash Funds A petty cash fund is used to make small expenditures that cannot wait for the formal check- writing process. The fund is operated on an imprest basis. This means that when the fund gets low on cash it is replenished. The petty cashier is always responsible for the cash in the fund. This is an excellent internal control.

31. Using Petty Cash Funds Establishing a $300 petty cash fund. Treasurer prepares a $300 check payable to the petty cashier. Petty cashier takes the check to the bank and gets $300 cash for the fund.

32. Using Petty Cash Funds During the month the petty cashier paid out $78.40 for FedEx deliveries, $43.60 for late-working employee meals, $28 for cab fare to the airport for a salesperson, and $66.00 for office postage stamps. The petty cashier asked for and received a receipt for each disbursement made this month. The fund is getting low on cash so the petty cashier requests that the fund be replenished.

33. Using Petty Cash Funds Record expenses paid from the petty cash fund. Treasurer prepares a $216.00 check payable to the petty cashier. Petty cashier takes the check to the bank and gets $216.00 cash for the fund. The fund is now returned to its $300 balance.

34. Prepare a classified balance sheet. LO 5 LO 5

35. Operating Cycle The average time it takes a business to convert cash to inventory, inventory to accounts receivable, and accounts receivable to cash. Smith Co. sells silk articles mostly on account. Smith Co. takes an average of 85 days to sell its inventory and an average of 31 days to collect the account receivable. What is the length of Smith Co. operating cycle? Cash  Inventory  A/R  Cash = 85+31= 116 days 7-35

36. Current Versus Noncurrent Current assets are expected to be converted to cash or consumed within one year or an operating cycle, whichever is longer. Current assets include: • Cash • Marketable Securities • Accounts Receivable • Short-Term Notes Receivable • Interest Receivable • Inventory • Supplies • Prepaids

37. Current Versus Noncurrent Current liabilities are due within one year or an operating cycle, whichever is longer. Current liabilities include: • Accounts Payable • Short-Term Notes Payable • Wages Payable • Taxes Payable • Interest Payable

39. Liquidity and Solvency Liquidity describes the ability to generate sufficient short-term cash flows to pay obligations as they come due. Solvency is the ability to repay liabilities In the long run. Which is more important? 7-40

40. Use the current ratio to assess the level of liquidity. LO 6 LO 6

41. CurrentRatio Current AssetCurrent Liabilities = For Limbaugh Company the current ratio is: CurrentRatio $288,600$193,800 = = 1.49:1 Current Ratio Since current assets normally exceeds current liabilities, the ratio is usually greater than 100 percent. A low ratio suggests that the company may have difficulty paying its short term obligations. A high ratio suggest that a company is not maximizing its earnings potential because investments in liquid assets usually do not earn as much money as investments in other assets. Companies must try to maintain an effective balance between liquid assets (so they can pay bills) and nonliquid assets (so they can ear a good return)

42. Use the debt ratio to assess the level of solvency. LO 6 7-43

43. Debt Ratio Total Debt Total Assets Ocean Contracting had Assets of $205,000 and owed the bank $105,000 105,000/205,000=.512 or 51% The lower the better for measuring solvency and debt risk. 7-44

44. End of Chapter Seven