Principles of Financial Accounting - Chapter 4: Internal Control and Cash

Internal Control System

Policies and procedures established by top management and the board of directors to provide reasonable assurance that company objectives are being met.

Three Objectives of Internal Control

Operations objectives, reporting objectives, and compliance objectives.

Operations Objectives

Effectiveness and efficiency of operations.

Reporting Objectives

Reliability of financial reporting.

Compliance Objectives

Compliance with applicable laws and regulations.

Why Are Internal Controls Necessary?

Management often delegates business activities and accounting responsibilities to employees, so controls help ensure company objectives are achieved.

Reasonable Assurance

Internal controls provide reasonable, rather than absolute, assurance that objectives will be achieved.

Sarbanes-Oxley Act of 2002

A law that increased management's responsibility for internal controls and reliable financial reporting at publicly traded corporations.

Sarbanes-Oxley Internal Control Report

Management must acknowledge responsibility for internal controls and assess their effectiveness.

Sarbanes-Oxley Certification

Principal executive and financial officers must certify responsibility for the company's internal control over financial reporting.

Purpose of Sarbanes-Oxley Certification

To prevent top management from denying knowledge or understanding of deceptive financial reporting.

Why Is Cash Especially Important for Internal Control?

Cash is a company's most vulnerable asset because it is highly liquid and easily stolen.

Fraud

An activity involving deception in order to achieve a gain.

Fraud Triangle

Financial pressure, opportunity, and rationalization.

Financial Pressure in the Fraud Triangle

A personal or financial motivation that creates pressure to commit fraud.

Opportunity in the Fraud Triangle

A situation allowing someone to commit fraud without being easily detected.

Rationalization in the Fraud Triangle

A justification a person gives themselves for committing fraud.

Management Override

When management bypasses or ignores established internal controls.

Why Are Smaller Companies More Vulnerable to Management Override?

They often have fewer employees and less segregation of duties.

Reasons Management May Override Controls

Bonuses, debt covenants, manipulating stock price, sale or refinancing of the company, or taking shortcuts.

COSO

Committee of Sponsoring Organizations of the Treadway Commission.

COSO Framework

The commonly used framework for assessing a company's system of internal control.

Five Components of Internal Control

Control environment, risk assessment, control activities, information and communication, and monitoring activities.

Control Environment

The environmental factors that influence the effectiveness of control procedures.

Tone at the Top

The integrity, attitude, awareness, and actions of management and others concerning the importance of internal control.

Examples of Control Environment Factors

Management philosophy and operating style, personnel policies, integrity, attitudes, awareness, and actions regarding control.

Risk Assessment

Procedures designed to identify, analyze, and manage strategic risks and business process risks.

Enterprise Risk Management (ERM)

Another term associated with procedures used to identify, analyze, and manage risks.

Strategic Risks

External threats to an organization's ability to accomplish its objectives.

Examples of Strategic Risks

Competitors, customers, substitute products, suppliers, new competitors, and political, economic, social, and technological factors.

Business Process Risks

Threats to the internal processes of a company.

Examples of Business Processes

Materials acquisition, production, logistics, distribution, branding, marketing, and human resources.

Control Activities

Policies and procedures established by management to help ensure company objectives are met.

Main Control Activities

Clearly defined authority, segregation of duties, adequate documents and records, safeguards over assets and records, and checks on recorded amounts.

Segregation of Duties

Accounting and administrative duties are divided among different people so one person does not control an asset and all related records.

Purpose of Segregation of Duties

To reduce the opportunity for errors and fraud by preventing one individual from controlling an entire transaction.

Collusion

When two or more people work together to deceive or defraud.

Collusion vs. Segregation of Duties

Collusion can defeat segregation of duties because multiple employees cooperate to bypass controls.

Safeguarding

Physical protection of assets and records.

Examples of Safeguarding

Fireproof vaults, locked storage, keycard access, and anti-theft tags.

Information and Communication

The internal control component requiring relevant information to be identified, gathered, and communicated to appropriate employees on a timely basis.

Why Is Timely Information Important?

Management may not discover problems until it is too late if information is not gathered and communicated.

Monitoring

The process of tracking potential and actual problems in the internal control system.

Internal Audit Group

A group that helps monitor the effectiveness of an organization's internal controls.

Purpose of Monitoring

To identify weaknesses in internal controls before they create larger problems.

Accounting System

The methods and records used to identify, measure, record, and communicate financial information about a business.

Relationship Between Accounting and Internal Control Systems

They operate as one integrated system designed to meet the needs of the business.

Wire Transfer

A transfer of cash from one bank account to another to pay for products, services, or other transactions.

Wire Transfer Initiator (Preparer)

Enters the wire request and prepares supporting documents but cannot approve or release the transaction.

Wire Transfer Approver (Authorizer)

Reviews the request and supporting documents and approves or rejects it, but cannot initiate or release it.

Wire Transfer Releaser (Executor)

Releases the approved wire transfer but has no involvement in initiating or approving it.

Wire Transfer Segregation of Duties

Initiating, approving, and releasing a wire transfer should be performed by different individuals.

Knowledge Check: Segregation of Duties

Initiators and approvers must not also have access to record and release wire transfers.

Cash

Currency, coins, savings and checking accounts, and negotiable instruments such as checks and money orders.

Cash Received

Increase Cash with a debit.

Cash Paid Out

Decrease Cash with a credit.

Payment by Check

The accounting system treats a payment by check the same as a transfer of currency.

Where Is Cash Reported?

On both the balance sheet and statement of cash flows.

Cash on the Balance Sheet

Reports cash and equivalents available at the balance sheet date.

Cash on the Statement of Cash Flows

Reports the sources and uses of cash during the period.

Cash Equivalents

Short-term, highly liquid investments readily convertible to cash with original maturities of three months or less.

Characteristics of Cash Equivalents

Easily converted to known amounts of cash and relatively insensitive to changes in interest rates.

Why Are Liquid Assets More Vulnerable?

The more liquid an asset is, the easier it generally is to steal or misuse.

Basic Cash Control: Authority

Authority to collect, hold, and pay cash should be clearly assigned to specific individuals.

Basic Cash Control: Segregation

Cash handling and cash recordkeeping should be assigned to different individuals whenever possible.

Basic Cash Control: Independent Review

Cash records should frequently be examined by an objective party.

Basic Cash Control: Recordkeeping

Controls should be supported by an appropriately designed recordkeeping system.

Basic Cash Control: Safeguarding

Cash should be protected in places such as vaults and banks.

Bank Reconciliation

The process of reconciling differences between a company's accounting records and the bank's records.

Two Functions of Bank Reconciliation

Control function and transaction detection function.

Bank Reconciliation Control Function

Identifies errors and provides independent inspection of records, helping deter theft.

Bank Reconciliation Transaction Detection Function

Identifies transactions performed by the bank that the company has not yet recorded.

Three Main Causes of Bank Reconciliation Differences

Business-recorded items not yet recorded by bank, bank-recorded items not yet recorded by business, and errors.

Outstanding Check

A check issued and recorded by the company that has not yet been cashed or recorded by the bank.

Deposit in Transit

A deposit recorded by the company that has not yet been recorded by the bank.

Outstanding Check: Bank Reconciliation Treatment

Subtract from the bank statement balance.

Deposit in Transit: Bank Reconciliation Treatment

Add to the bank statement balance.

Do Outstanding Checks Require a Journal Entry?

No. The company has already recorded them.

Do Deposits in Transit Require a Journal Entry?

No. The company has already recorded them.

Service Charge

A fee charged by a bank for services provided.

Examples of Bank Service Charges

Maintenance fees, minimum balance fees, and foreign transaction fees.

Bank Service Charge: Company Adjustment

Subtract from the company's cash balance.

Bank Service Charge Journal Entry

Debit Bank Service Charges Expense; credit Cash.

NSF Check

A check returned because the issuer does not have sufficient funds; also called a bounced check.

NSF Check: Company Adjustment

Subtract from the company's cash balance.

NSF Check Journal Entry

Debit Accounts Receivable; credit Cash.

Why Is an NSF Check Recorded as Accounts Receivable?

The customer still owes the company the money.

Debit Memo

A bank notification of a deduction from a company's bank account.

Debit Memo Example

A bank automatically paying a company's utility bill.

Debit Memo: Company Adjustment

Subtract from the company's cash balance.

Credit Memo

A bank notification of an addition to a company's bank account.

Credit Memo Example

The bank collects a note receivable for the business and deposits the money.

Credit Memo: Company Adjustment

Add to the company's cash balance.

Interest Earned on Bank Account

Add to the company's cash balance and record interest income.

Interest Revenue Journal Entry

Debit Cash; credit Interest Income.

Errors in Bank Reconciliation

Recording mistakes by either the company or the bank that cause the two cash balances to differ.

What Should Be Done With Bank Reconciliation Errors?

Correct the error and investigate its cause.

Step 1 of Bank Reconciliation

Compare deposits on the bank statement with deposits recorded in the cash account.

Step 2 of Bank Reconciliation

Compare paid checks with amounts recorded in the cash account and prior outstanding checks.

Step 3 of Bank Reconciliation

Identify bank statement items not yet recorded in the company's cash account.