Internal Control, Cash, and Receivables – Financial Accounting Study Notes

Internal Control

Fraud Triangle

The Fraud Triangle explains the three factors that contribute to fraudulent behavior in organizations:

• Motive: Need or greed drives individuals to commit fraud.

• Opportunity: Weak internal controls provide the chance for fraud to occur.

• Rationalization: Distorted thinking allows individuals to justify their actions.

The Importance of Internal Control

Internal control systems are essential for organizations to:

• Prevent, detect, and correct fraud and unintentional errors.

• Are planned and implemented by management and the Board of Directors.

• Designed to accomplish five objectives:

  1. Safeguard assets

  2. Encourage employees to follow policy

  3. Promote operational efficiency

  4. Ensure accurate, reliable records

  5. Comply with legal requirements

Information Technology (IT) and Internal Control

• Modern accounting systems rely heavily on IT (e.g., inventory sensors, barcode scanning).

• While the basic attributes of internal control remain unchanged, implementation procedures differ with technology.

• Computers can greatly improve the speed and accuracy of accounting processes.

Internal Controls for Cash

Applying Internal Controls to Cash Receipts and Payments

• Cash is highly susceptible to theft and easy to convert to other forms of wealth.

• All transactions ultimately affect cash, making it a critical area for internal controls.

• Cash receipts should be deposited quickly to minimize risk.

Internal Control for Purchasing

• Companies must ensure they receive the goods ordered and pay only for goods received (approval process).

• Key documents: Purchase Order, Receiving Report, Invoice, and Check.

• Duties should be split among purchasing, receiving, and approving/paying for goods to reduce fraud risk.

Costs and Benefits of Internal Control

• Internal controls can be circumvented by collusion, management override, or negligence.

• Stricter controls increase costs; benefits should outweigh costs.

• Example: A part-time security guard costing $28,000/year prevents $50,000 in theft, resulting in net savings of $22,000.

Bank Reconciliation

The Bank Statement

• Reports cash receipts and payments.

• Includes Electronic Funds Transfers (EFT) for electronic payments.

Bank Reconciliation Process

Bank reconciliation explains differences between the bank statement and the cash account in the general ledger due to timing differences and errors.

• The person preparing the reconciliation should have no other cash duties to prevent fraud.

Summary of Reconciling Items

BANK BALANCE – ALWAYS	BOOK BALANCE – ALWAYS
Add deposits in transit	Add bank collections, interest revenue, and EFT receipts
Subtract outstanding cheques	Subtract service charges, NSF cheques, EFT payments
Add or subtract correction of bank errors	Add or subtract correction of book errors

Cash Budget

Using a Budget to Manage Cash

• Budget: A financial plan to coordinate business activities.

• Cash budget: Plans cash receipts and payments to manage liquidity.

• Steps to prepare a cash budget:

  1. Start with beginning cash balance

  2. Add budgeted receipts and subtract budgeted payments

  3. Equals cash available before new financing

  4. Compare cash available to budgeted cash at period end

Receivables and Uncollectible Receivables

Receivables

• Monetary claims against others, acquired mainly by selling goods/services (accounts receivable) or lending money (notes receivable).

• Two major types: accounts receivable and notes receivable.

Accounts Receivable Subsidiary Ledger

• Tracks individual customer balances.

• Total of subsidiary ledger equals the general ledger accounts receivable balance.

Computing Cash Collections from Customers

• Formula: $\text{Beginning balance} + \text{Sales on credit} - \text{Ending balance} = \text{Cash collections from customers}$

• Example: If beginning balance is $200, sales on credit are $1,800, and ending balance is $500, then cash collections are $1,500.

Managing Risk of Not Collecting

• Benefit of selling on credit: Increases sales and profits by allowing customers to buy without immediate cash.

• Cost of selling on credit: Some customers may not pay, resulting in uncollectible account expense (also called doubtful-account or bad debt expense).

Direct Write-Off Method

• Wait until a specific account is uncollectible to record the expense.

• Inferior to the allowance method because receivables are reported at full amount, overstating assets.

• Journal entry: Debit: Uncollectible-account Expense Credit: Accounts Receivable

Allowance Method

• Estimates uncollectible accounts expense in the period of sale.

• Sets up Allowance for Uncollectible Accounts (a contra-account to Accounts Receivable).

• Shows the amount of receivables expected not to be collected.

Net Realizable Value

• Accounts receivable are reported at net realizable value on the balance sheet:

$\text{Net Realizable Value} = \text{Accounts Receivable} - \text{Allowance for Uncollectible Accounts}$

• Example: If Accounts Receivable is $10,000 and Allowance is $900, Net Realizable Value is $9,100.

Methods to Estimate Uncollectibles: Aging-of-Receivables

• Focuses on the valuation of accounts receivable based on time outstanding.

• Individual customer balances are analyzed and grouped by age category.

• Allowance for Uncollectible Accounts is adjusted to equal the amount from the aging schedule.

Customer	Not yet due	1-30 days overdue	31-60 days overdue	Over 60 days overdue	Total Balance
Customer A	$400				$400
Customer B	100	100			200
Customer C			600	600	1,200
All others	11,060	1,363	370	1,093	13,886

• Estimated percent uncollectible increases with age of receivable.

Writing Off Uncollectible Accounts

• When an account is determined to be uncollectible, it is written off against the allowance account.

• Journal entry: Debit: Allowance for Uncollectible Accounts Credit: Accounts Receivable

• No impact on the income statement at the time of write-off.

Adjusting Ending Allowance for Doubtful Receivables

• At period end, adjust the allowance account to the desired balance based on estimated uncollectibles.

• Formula: $\text{Ending Allowance} = \text{Beginning Allowance} - \text{Receivables Write-offs} + \text{Bad Debt Expense}$

Notes Receivable

Definition and Key Terms

• More formal than accounts receivable; involves a written promise to pay a definite sum plus interest at maturity.

• Also called promissory notes.

Term	Definition
Creditor	Party to whom money is owed; lender
Debtor	Party that borrowed and owes money; maker, borrower
Interest	Cost of borrowing money; stated as annual percentage rate
Maturity date	Date when debtor must pay note
Maturity value	Sum of principal and interest
Principal	Amount borrowed by debtor
Term	Length of time from when note was signed to when payment must be made

Interest Computation

• Interest rates are annual unless otherwise stated.

• Interest for a period less than a year is prorated:

$\text{Interest} = \text{Principal} \times \text{Rate} \times \frac{\text{Time}}{12}$

• For periods in days, denominator is 365 or 360 days (depending on convention).

Accounting for Notes Receivable

• Journal entries record the creation of the note, accrual of interest, and collection at maturity.

• Example: On Aug 31, a $1,000 note is issued at 9% interest for 6 months. At Dec 31, interest revenue is accrued for 4 months:

$1,000 \times 0.09 \times \frac{4}{12} = 30$

• Journal entry on Dec 31: Debit: Interest Receivable $30 Credit: Interest Revenue $30

Key Ratios for Evaluating a Business

Current (Acid-Test) Ratio

• Measures liquidity by comparing total current assets to total current liabilities.

$\text{Current Ratio} = \frac{\text{Total Current Assets}}{\text{Total Current Liabilities}}$

Receivable Turnover

• Measures how efficiently a company collects its receivables.

$\text{Receivable Turnover} = \frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}$

• Day's Sales in Receivables indicates the average number of days to collect receivables.

$\text{Day's Sales in Receivables} = \frac{365}{\text{Receivable Turnover}}$

Additional info: Academic context and formulas have been expanded for clarity and completeness.