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 achieve:

• Reliable financial reporting

• Effective and efficient operations

• Compliance with relevant laws and regulations

Internal controls also help prevent and detect errors and fraud, reducing the risk of unintentional misstatements and intentional misappropriation of assets.

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: Identifying and analyzing risks that may prevent the achievement of objectives.

• Control activities: 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: Regular evaluations of the internal control system's effectiveness.

Control Activities

Types of Control Activities

Control activities are specific actions taken 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: Dividing responsibilities for authorizing transactions, recording them, and maintaining custody of assets among different individuals. Example: No single employee should handle all aspects of purchasing (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, including comparison between documents (e.g., bank reconciliations).

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

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 controls provide reasonable assurance but cannot guarantee absolute protection. Limitations include:

• Cost/benefit considerations: Controls should not exceed their benefits.

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

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

• Management override: Senior management may override established controls.

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 and includes:

• Coins, currency, cheques, money orders

• Money on hand or in bank

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

Cash Receipts

Cash receipts may be received over-the-counter, by cheque, or by electronic funds transfer (EFT). Internal control is most 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 records, POS receipts, cash register tapes, 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 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 EFTs.
Segregation of Duties	Have different individuals signing cheques and recording payments.
Documentation	Use prenumbered cheques and document each payment with invoices, receipts, and authorization.
Physical Controls	Store cheques in safes with limited access; reconcile bank statements monthly.
Review and Reconciliation	Compare payments with invoices and reconcile with bank statement monthly.

Use of a Bank

Benefits of Using a Bank

• Safeguards cash by acting as a depository and clearinghouse for cheques.

• Minimizes the amount of currency kept on hand.

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

• Allows for reconciliation of accounts.

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

Purpose and Content

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

Differences Between Company Records and Bank Statement

• Timing differences:

  • Outstanding cheques: Cheques written but not yet cleared by the bank.

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

• Errors by either party in recording transactions.

Reconciling the Bank Account

Purpose

Bank reconciliation 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.

Formula:

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

Bank Reconciliation Procedures

Reconciling Items per Bank	Reconciling Items per Books
Deposits in transit (+) Outstanding cheques (-) Bank errors (+/-)	EFT collections, interest earned, and other deposits (+) EFT payments, service charges, interest charges, and other payments (-) Book errors (+/-)

Bank Reconciliation Journal Entries

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

• No entries are made on the bank side.

Bank Reconciliation Illustrated

Laird Ltd. Bank Reconciliation (April 30, 2021)
Cash balance per bank statement	$14,604.73
Add: Deposits in transit	$1,210.40
Less: Outstanding cheques	($3,000.00 + $1,031.00 + $1,502.00 = $5,533.00)
Reconciled cash balance per bank	$10,904.13
Cash balance per books	$8,437.55
Add: Electronic receipts from customers	$6,787.18
Less: Returned NSF cheque, service charges, bank error	($465.60 + $165.00 + $360.00 = $990.60)
Reconciled cash balance per books	$10,904.13

Journal Entries for Reconciliation

• To record electronic receipts on account: $\text{Cash} \quad 6,787.18$ $\text{Accounts Receivable} \quad 6,787.18$

• To record NSF cheque: $\text{Accounts Receivable} \quad 465.60$ $\text{Cash} \quad 465.60$

• To record bank service charges: $\text{Bank Charges Expense} \quad 165.00$ $\text{Cash} \quad 165.00$

• To record book error: $\text{Accounts Receivable} \quad 360.00$ $\text{Cash} \quad 360.00$

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 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 levels low

• Monitor payment of liabilities

• Plan timing of major expenditures

• Invest idle cash

• Prepare a cash budget

Reviewing IFRS and ASPE

Key Differences	International Financial Reporting Standards (IFRS)	Accounting Standards for Private Enterprises (ASPE)
No significant differences

Practice Exercises

Exercise 7.8

• Prepare a bank reconciliation using provided balances, deposits in transit, electronic receipts, outstanding cheques, and errors.

• Prepare any journal entries required from the reconciliation.

Exercise 7.10

• Identify which items should be reported as cash and cash equivalents in the statement of financial position.

• Determine the combined amount to report as cash and cash equivalents.

• Indicate in which financial statement and account(s) the items not included as cash/cash equivalents should be reported.