Chapter 7: Internal Control and Cash – Study Notes

Internal Control and Cash

Learning Objectives

• Explain the components of an internal control system, including its control activities and limitations.

• Apply key control activities to cash receipts and payments.

• Prepare a bank reconciliation.

• Explain the reporting and management of cash.

Internal Control

Definition and Purpose

Internal control refers to the systems adopted within a company to help achieve:

• Reliable financial reporting

• Effective and efficient operations

• Compliance with relevant laws and regulations

Internal controls also help prevent and detect errors and fraud, which can cause unintentional misstatements or intentional manipulation of financial information.

Components of Internal Control

• Control environment: The overall attitude, awareness, and actions of directors and management regarding the internal control system and its importance.

• Risk assessment: The process of identifying and analyzing risks that may prevent the achievement of objectives.

• Control activities: The policies and procedures that help ensure management directives are carried out.

• Information and communication: Systems that support the identification, capture, and exchange of information in a timely manner.

• Monitoring activities: Ongoing or periodic assessment of the quality of internal control performance over time.

Control Activities

Types of Control Activities

Control activities are specific policies and procedures designed to address risks and achieve objectives. They include:

• Assignment of responsibility: Assigning tasks to specific employees to ensure accountability. Example: Each cashier is responsible for their own cash drawer.

• Segregation of duties: Separating responsibilities for authorization, recording, and custody of assets among different individuals. Example: No single employee should handle all aspects of a transaction (e.g., ordering, approving, receiving, and authorizing payment).

• Documentation: Maintaining evidence that transactions and events have occurred at specified times and amounts. Example: Shipping documents indicating goods have been shipped.

• Physical controls: Safeguarding assets and enhancing the accuracy and reliability of accounting records. Examples: Computer passwords, building alarms, security cameras, safes, vaults.

• Review and reconciliation: Independent review of controls, both internal and external, including comparison between documents (e.g., bank reconciliations).

The specific control activities used by a company depend on the risks it faces, management's assessment, and the size and nature of the company.

Limitations of Internal Control

Internal control systems can only provide reasonable assurance that assets are safeguarded and records are reliable. Limitations include:

• Cost/benefit considerations: Controls should not cost more than the benefits they provide.

• Human error: Mistakes can occur due to misunderstanding, fatigue, or carelessness.

• Collusion: Two or more employees may work together to circumvent controls.

• Management override: Management may override prescribed controls for personal gain.

Fraud

Definition and Examples

Fraud is an intentional act to misappropriate (steal) assets or to misstate financial information. Common examples include:

• Recording expenses as assets

• Overstating useful lives of assets

• Recording revenues that do not exist

Fraud typically involves three elements: Opportunity, Pressure, and Rationalization.

Cash Controls

Definition and Importance

Cash is highly susceptible to theft. Cash includes coins, currency, cheques, money orders, and money on hand or in the bank. The general rule is: if the bank will accept it for deposit, it is considered ca

Purpose and Benefits

• Safeguards cash by using a bank as a depository and clearinghouse for cheques received and written.

• Minimizes the amount of currency that must be kept on hand.

• Provides a second record of transactions (one by the business, one by the bank).

• Allows for reconciliation of the two accounts.

Understanding Debits and Credits

	Bank (Your Cash Account is a Liability to the Bank)	Books (Cash is an Asset to the Company)
Cheque	Debit (decrease)	Credit (decrease)
Deposit	Credit (increase)	Debit (increase)

Bank Statement

Purpose

A bank statement is a summary of account activity provided by the bank, listing all transactions and the ending balance for a period.

Differences Between Company Records and Bank Statement

• Timing differences:

  • Outstanding cheques: Cheques written and dated but not yet presented to or paid by the bank.

  • Deposits in transit: Receipts recorded by the company but not yet recorded by the bank.

• Errors by either party in recording transactions.

Reconciling the Bank Account

Purpose and Process

Reconciling the bank account matches the balance per the company's bank account with the cash balance per the general ledger ("books"). Both balances are reconciled to their adjusted (correct) cash balance:

$\text{Adjusted cash balance} = \text{Reconciled balance}$

Bank Reconciliation Procedures

Reconciling Items per Bank

• Deposits in transit (+): Deposits recorded by the company but not yet by the bank.

• Outstanding cheques (-): Cheques recorded by the company but not yet cleared by the bank.

• Bank errors (+/-): Corrections for errors made by the bank.

Reconciling Items per Books

• EFT collections, interest earned, and other deposits (+): For example, EFT collection from customer on account if not previously recorded.

• EFT payments, service charges, interest charges, and other payments (-): For example, bank service charges.

• Book errors (+/-): Corrections for errors made by the company.

Bank Reconciliation Journal Entries

• Each reconciling item in determining the adjusted balance per books must be journalized and posted.

• No entries are made on the bank side.

Reporting Cash

Financial Statement Presentation

• Cash is reported in both the statement of financial position and the statement of cash flows.

• The statement of cash flows shows the receipts and payments of cash.

• Cash is the most liquid asset and is listed first in the current assets section of the statement of financial position.

Cash Equivalents

• Cash can be combined with cash equivalents: short-term, highly liquid held-for-trading investments subject to insignificant risk of changes in value.

• If cash is in a deficit or overdraft at year-end, it is reported as a current liability called bank indebtedness.

Managing Cash

Principles of Cash Management

Ensuring that a company has sufficient cash to meet its needs is a major challenge. Basic principles include:

• Increase the speed of receivables collection

• Keep inventory low

• Monitor payment of liabilities

• Plan timing of major expenditures

• Invest idle cash

• Prepare a cash budget