Chapter 7: Internal Control and Cash – Financial Accounting 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 and procedures adopted by a company to help achieve reliable financial reporting, effective and efficient operations, and compliance with relevant laws and regulations. These systems also help prevent and detect errors and fraud.

• Reliable financial reporting: Ensures accuracy and completeness of accounting records.

• Effective and efficient operations: Promotes operational success and resource optimization.

• Compliance: Adheres to laws and regulations.

• Prevention and detection: Reduces risk of errors and fraud.

Components of Internal Control

• Control environment: The overall attitude, awareness, and actions of management and employees regarding internal controls.

• Risk assessment: Identifying and analyzing risks that may prevent achievement of objectives.

• Control activities: Policies and procedures to address risks.

• Information and communication: Systems for recording, processing, and communicating information.

• Monitoring activities: Ongoing evaluations of the effectiveness of controls.

Control Activities

Types of Control Activities

Control activities are the specific actions taken to address risks and achieve objectives. The main types include:

• Assignment of responsibility: Assigning tasks to specific employees to ensure accountability.

• Segregation of duties: Separating responsibilities for authorization, recording, and custody of assets among different individuals.

• Documentation: Maintaining evidence that transactions and events have occurred.

• Physical controls: Safeguarding assets and enhancing accuracy of records (e.g., passwords, safes, alarms).

• Review and reconciliation: Independent review and comparison of documents (e.g., bank reconciliations).

The specific control activities used depend on the risks faced and the size and nature of the company.

Assignment of Responsibilities

• Responsibility should be assigned to specific employees, making them accountable for tasks.

• Example: Each cashier is responsible for their own cash drawer.

Segregation of Activities

• Authorization, recording, and custody of assets should be assigned to different individuals.

• Example: All purchasing activities (ordering, approving, receiving, authorizing payment) should not be performed by the same employee.

Documentation

• 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 accuracy and reliability of accounting records.

• Examples: Computer passwords, building alarms, security cameras, safes, vaults.

Review and Reconciliation

• All controls should be subject to independent review, both internal and external.

• Reconciliation involves comparing two or more documents (e.g., bank reconciliations).

Brief Exercise 7.2: Matching Control Activities

Control Activity	Description
Assignment of responsibility	Responsibility for related activities should be assigned to specific employees.
Segregation of duties	Cheque signers are not allowed to record cash transactions.
Documentation	All transactions should include original, detailed receipts.
Physical controls	Undeposited cash should be stored in the company safe.
Review and reconciliation	Surprise cash counts are performed by internal audit.

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 carelessness, misunderstanding, or fatigue.

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

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

Fraud

Definition and Examples

Fraud is an intentional act to misappropriate assets or 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 of Cash

• Cash is highly susceptible to theft.

• Includes coins, currency, cheques, money orders, and money on hand or in bank.

• General rule: If a bank will accept it for deposit, it is considered cash.

Cash Receipts

Cash receipts can be received over-the-counter, by cheque, or by electronic funds transfer (EFT). Internal control is more effective when receipts are deposited daily or by EFT.

Control Activity	Application to Cash Receipts
Assignment of Responsibility	Authorize only designated personnel to handle cash receipts.
Segregation of Duties	Have different individuals recording and handling cash receipts.
Documentation	Use remittance register, POS register, cash receipts, and deposit slips or confirmations.
Physical Controls	Store cash in safes with limited access; deposit all cash in bank daily.
Review and Reconciliation	Conduct surprise cash counts and reconcile receipts with deposit slips and bank records daily.

Cash Payments

Control activities over cash payments are more effective when payments are made by cheque or EFT rather than in cash.

Control Activity	Application to Cash Payments
Assignment of Responsibility	Authorize only designated personnel to sign cheques or approve electronic payments.
Segregation of Duties	Have different individuals preparing cheques and recording payments; separate approval from recording.
Documentation	Use prenumbered cheques and document each payment with invoices, receipts, and supporting documents.
Physical Controls	Store cheques in safes with limited access; use bank accounts with electronic security features.
Review and Reconciliation	Compare payments with bank statement monthly.

Use of a Bank

Using a bank helps safeguard cash by acting as a depository and clearinghouse for cheques. It minimizes the amount of currency kept on hand and provides a second record of transactions, which can be reconciled with company records.

Understanding Debits and Credits

	Bank (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

A bank statement is a summary of account activity provided by the bank, listing deposits, withdrawals, and the ending balance.

Differences Between Company Records and Bank Statement

• Timing differences: Outstanding cheques and deposits in transit cause discrepancies.

• Errors: Mistakes by either party in recording transactions.

Reconciling the Bank Account

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

Formula:

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

Bank Reconciliation Procedures

Reconciling Items per Bank

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

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

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

Reconciling Items per Books

• EFT collections, interest earned, and other deposits (+): Additions not yet recorded by the company.

• EFT payments, service charges, interest charges, and other payments (–): Deductions not yet recorded by the company.

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

Bank Reconciliation Journal Entries

• Each reconciling item affecting the books must be journalized and posted.

• No entries are made for reconciling items on the bank side.

Journal Entries for Bank Reconciliation

• To record electronic receipts on account:

  • Debit Cash, Credit Accounts Receivable

• To record NSF cheque:

  • Debit Accounts Receivable, Credit Cash

• To record bank service charges:

  • Debit Bank Charges Expense, Credit Cash

• To record book error:

  • Debit Accounts Receivable, Credit Cash

Reporting Cash

Financial Statement Presentation

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

• 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 investments subject to insignificant risk of changes in value.

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

Managing Cash

Principles of Cash Management

Effective cash management ensures a company has sufficient cash to meet its needs. Key principles include:

• Increase the speed of receivables collection

• Keep inventory low

• Monitor payment of liabilities

• Invest idle cash

• Plan timing of major expenditures

• Prepare a cash budget