Internal Control, Cash, and Banking

Key Terms and Definitions

This section introduces essential terminology for understanding internal controls, cash management, and related banking activities in financial accounting.

• Artificial intelligence (AI): Computer systems performing tasks that require human intelligence, such as data processing and algorithmic decision-making.

• Bank reconciliation: A report explaining the difference between the book balance and the bank statement balance, used to compute the adjusted cash balance.

• Bank statement: A periodic report from the bank showing the depositor's beginning and ending cash balances, as well as all changes during the period.

• Canceled checks: Checks that the bank has paid and deducted from the depositor's account.

• Cash: Currency, coins, and amounts on deposit in bank checking or savings accounts.

• Cash equivalents: Short-term investments that are readily convertible to a known cash amount, typically within 90 days.

• Cash over and short: An income statement account used to record cash overages or shortages resulting from errors in receipts or payments.

• Check: A document signed by the depositor instructing the bank to pay a specified amount to a designated recipient.

• Check register: A cash disbursements journal that includes a column for check numbers.

• Cloud storage: Digital storage solutions for backing up and encrypting accounting records.

• COSO: The Committee of Sponsoring Organizations, which provides frameworks for enterprise risk management, internal control, and fraud deterrence.

• Days' sales uncollected: A liquidity measure calculated as (Accounts Receivable ÷ Net Sales) × 365.

• Deposit ticket: A document listing currency, coins, and checks deposited, along with their dollar amounts.

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

• Electronic funds transfer (EFT): The use of electronic communication to transfer cash between parties.

• Enterprise resource planning (ERP): Software programs that manage a company's vital operations, from order-taking to accounting.

• Fraud triangle: The three factors that drive fraud: opportunity, pressure, and rationalization.

• Internal control system: All policies and procedures designed to protect assets, ensure reliable accounting, promote efficient operations, and urge adherence to company policies.

• Invoice: An itemized record of goods provided by a vendor, listing the customer name, items, prices, and terms.

• Invoice approval: A checklist of steps for approving and recording an invoice; also called check authorization.

• Liquid assets: Resources such as cash that are easily converted to other assets or used to pay obligations.

• Liquidity: The availability of resources to meet short-term cash requirements.

• Outstanding checks: Checks written and recorded by the depositor but not yet paid by the bank at the statement date.

• Petty cash: A small cash fund used to pay minor expenses, managed using an imprest system.

• Principles of internal control: Key principles include establishing responsibility, maintaining records, insuring assets, separating recordkeeping from custody, dividing responsibility, applying technological controls, and performing reviews.

• Purchase order: A document used by the purchasing department to place an order with a vendor.

• Purchase requisition: A document listing merchandise a department needs and requesting its purchase.

• Receiving report: A form reporting that ordered goods were received, including quantity and condition.

• Sarbanes-Oxley Act (SOX): Legislation that created the PCAOB, regulated analyst conflicts, imposed governance, enhanced disclosures, and expanded penalties.

• Signature card: A card containing the signatures of all persons authorized to sign checks on the bank account.

• Vendee: The buyer of goods or services.

• Vendor: The seller of goods or services.

• Voucher: An internal file storing documents to control cash disbursements and ensure proper authorization and recording.

• Voucher register: A journal in which all approved vouchers are recorded.

• Voucher system: Procedures and approvals designed to control cash disbursements and acceptance of obligations.

Internal Control System

Internal controls are essential for protecting assets, ensuring reliable accounting, promoting efficient operations, and upholding company policies.

• Establish Responsibility: Assign each task to a specific person for clear accountability. For example, each clerk has their own cash drawer and login credentials. Mandatory vacations can help uncover fraud.

• Maintain Adequate Records: Good records protect assets and help managers monitor activity. Examples include detailed equipment records, prenumbered forms, and point-of-sale (POS) systems that automatically record transactions. Records should be backed up and encrypted.

• Insure Assets and Bond Key Employees: Insure assets against loss and bond employees who handle cash. Bonding discourages theft, as insurance companies investigate losses.

• Separate Recordkeeping from Custody: The person handling an asset should not also record it. This separation prevents solo theft and requires collusion for fraud to occur.

• Divide Responsibility for Related Transactions: Split transaction steps among multiple people (separation of duties). For example, in inventory purchases: one person requests, another approves, another pays, and another records.

• Apply Technological Controls: Use cash registers, time clocks, ID scanners, VPNs, two-factor authentication, and biometric locks to enhance security.

• Perform Regular and Independent Reviews: Regularly check controls using people not involved in daily activities. Independent auditors test records and evaluate controls.

COSO Framework

The COSO framework outlines five components of internal control, providing a comprehensive structure for organizations to manage risk and ensure effective controls.

• Control Environment: The company’s structure, ethics, and integrity that support internal control.

• Risk Assessment: Identifying, analyzing, and managing risk factors.

• Control Activities: Policies and procedures to reduce the risk of loss.

• Information & Communication: Providing relevant reports to internal and external parties.

• Monitoring: Regular review of internal control effectiveness.

Fraud Triangle and Limitations of Internal Control

Internal controls have inherent limitations, and understanding the fraud triangle helps organizations recognize and mitigate fraud risks.

• Human Error: Mistakes due to carelessness, confusion, or poor judgment.

• Human Fraud: Intentional override of controls, including management override.

• Fraud Triangle: Consists of Opportunity (ability to commit fraud with low detection risk), Pressure (financial or personal), and Rationalization (justifying the act).

• Cost-Benefit Constraint: Controls should not cost more than the benefits they provide; consider costs, benefits, and employee morale.

Voucher System Flow

The voucher system is a set of procedures and approvals designed to control cash disbursements and acceptance of obligations.

• Vendee: Buyer

• Vendor: Seller

• Voucher Register: Book of original entry for all approved vouchers

• Check Register: Cash disbursements journal with check number column

Petty Cash Rules

Petty cash is a small fund for minor expenses, managed using specific accounting rules to ensure control and accuracy.

• Rule 1: Only adjust the "Petty Cash" account when establishing or changing the fund's official size.

• Rule 2: When replenishing, debit individual expenses and credit the main Cash account. Do not touch the Petty Cash account.

• Rule 3: Use the Cash Over and Short account to balance discrepancies (debit for shortages/expense, credit for overages/revenue).

Step-by-Step Replenishment Entry:

1. Debit all individual expense categories (e.g., postage, entertainment).

2. Credit Cash for the amount of the replacement check (Fund total − Remaining currency).

3. If receipts do not match cash missing, use Cash Over and Short to balance.

"Lockbox" Rule: The Petty Cash ledger account reflects the fund's official capacity, not the physical cash on hand.

Bank Reconciliation

Bank reconciliation ensures that the company's book balance matches the bank statement balance by accounting for timing differences and errors.

Key Rule: Adjusted bank balance must equal adjusted book balance.

Common Journal Entries (Book Side):

• Interest earned: Dr. Cash / Cr. Interest Revenue

• Note collected: Dr. Cash / Cr. Notes Receivable (+ Interest Revenue)

• NSF check: Dr. Accounts Receivable / Cr. Cash

• Bank service fee: Dr. Bank Fee Expense / Cr. Cash

• Book error (under-recorded): Dr. Expense / Cr. Cash

Example: (GUCCI Dec 31 Bank Reconciliation)

Banking Activities as Controls

Banks provide several controls to help safeguard company cash and ensure accurate recordkeeping.

• Signature card: Verifies the identity of authorized check signers.

• Deposit ticket: Lists all currency, coins, and checks deposited, with amounts.

• Check components: Maker (signer), Payee (recipient), Bank/Payer (bank honoring check).

• Companies may maintain multiple bank accounts for different operational needs.

Electronic Funds Transfer (EFT): Used for payroll, rent, utilities, insurance, and interest payments. EFT reduces paper checks and speeds up transactions.

Mobile Banking Controls:

• 24/7 account access

• Phone alerts for transactions

• Mobile deposit (photograph checks)

• Mobile payment (e.g., Zelle)

Bank Statement Controls: The bank sends a monthly statement with all withdrawals, deposits, and the ending balance. For control, the statement should be sent to a party with no access to cash or recordkeeping responsibilities, ensuring independent verification.

Formula & Quick Reference

Days' Sales Uncollected is a liquidity measure indicating how quickly receivables are collected.

• Formula:

• The fraction represents the portion of the year's sales still uncollected.

• Multiplying by 365 converts this to the number of days sales remain uncollected.

Quick Reference Facts

• Sarbanes-Oxley Act (SOX): Created the Public Company Accounting Oversight Board (PCAOB).

• COSO: A joint initiative of five private sector organizations to provide internal control frameworks.

• ERP: Manages operations from order-taking to accounting.

• AI: Uses algorithms and large data sets for pattern recognition and problem-solving.