Internal Control and Cash Notes

Sarbanes-Oxley Act (Learning Objective 1)

The Sarbanes-Oxley Act aims to maintain public confidence in companies' financial reporting.
It applies to publicly held companies (those whose stock is traded on public exchanges).
The act emphasizes effective internal control, defined as procedures and processes to:
- Safeguard assets.
- Process information accurately.
- Ensure compliance with laws and regulations.
Management is responsible for establishing and maintaining internal control over financial reporting.

Internal Control (Learning Objective 2)

Internal Control—Integrated Framework is the standard for designing, analyzing, and evaluating internal controls.
Internal control safeguards assets by preventing theft, fraud, misuse, or misplacement.
Employee fraud is a serious concern, defined as deceiving an employer for personal gain.

Objectives of Internal Control

Safeguarding assets.
Accurate information.
Compliance with laws and regulations.

Elements of Internal Control

Control environment.
Risk assessment.
Control procedures.
Monitoring.
Information and communication.

Risk Assessment

Businesses face risks like changes in customer requirements, competitive threats, regulatory changes, and economic factors.
Management should identify, analyze, and minimize these risks.

Internal Control Procedures

Competent personnel, rotating duties, and mandatory vacations.
Separating responsibilities for related operations.
Separating operations, custody of assets, and accounting.
Proofs and security measures.

Competent Personnel, Rotating Duties, and Mandatory Vacations

A successful company needs competent employees who are able to perform the duties that they are assigned.
Procedures should be established for properly training and supervising employees.
It is also advisable to rotate duties of accounting personnel and mandate vacations for all employees.

Separating Responsibilities for Related Operations

The responsibility for related operations should be divided among two or more people.
This decreases the possibility of errors and fraud.

Separating Operations, Custody of Assets, and Accounting

The responsibilities for operations, custody of assets, and accounting should be separated.
In this way, the accounting records serve as an independent check on the operating managers and the employees who have custody of assets.

Monitoring

Monitoring the internal control system is used to locate weaknesses and improve controls.
Monitoring often includes observing employee behavior and the accounting system for indicators of control problems.

Information and Communication

Information and communication is an essential element of internal control.
Management also uses external information to assess events and conditions that impact decision making and external reporting.

Limitations of Internal Control

Internal control systems provide only reasonable assurance due to:
- The human element of controls.
- Cost-benefit considerations (costs should not exceed benefits).

Warning Signs of Internal Control Problems

Missing documents or gaps in transaction numbers.
An employee refusing to take a vacation.
A sudden increase in slow payments of accounts receivable.
An accounting employee working a lot of overtime at year-end isn't a warning sign because Accounting personnel often need to work long hours during year-end due to adjusting entries, the closing process, and other steps in the accounting cycle. All of the other answers are warning signs of potential internal control problems and should not be ignored.

Cash Controls over Receipts and Payments (Learning Objective 3)

Cash includes coins, currency (paper money), checks, and money orders.
Money on deposit with a bank or other financial institution that is available for withdrawal is also considered cash.
Normally, you can think of cash as anything that a bank would accept for deposit in your account.

Control of Cash Receipts

Protect cash from theft and misuse from receipt until deposit.
Cash is received from:
- Customers purchasing products or services.
- Customers making payments on account.

Cash Received from Cash Sales

Use a cash register as an important control.
Differences between cash on hand and sales are recorded in a cash short and over account.

Example

Cash register total for cash sales: $35,690$
Cash receipts from cash sales: $35,668$
Shortage: $22$ (35,690 – $35,668)

Cash Received in the Mail

Customers pay bills via checks and money orders.
Companies use a remittance advice (portion of invoice returned with payment).

Cash Received by EFT

Cash may also be received from customers through electronic funds transfer (EFT).
Companies encourage customers to use EFT for the following reasons:
- EFTs cost less than receiving cash payments through the mail.
- EFTs enhance internal controls over cash, since the cash is received directly by the bank without any employees handling cash.
- EFTs reduce late payments from customers and speed up the processing of cash receipts.

Control of Cash Payments

Ensure payments are authorized and cash is used effectively.
In large businesses, different employees handle purchasing, inspecting goods, and verifying invoices.

Voucher System

A voucher system is a set of procedures for authorizing and recording liabilities and cash payments.
A voucher is any document that serves as proof of authority to pay cash or issue an electronic funds transfer.

Cash Paid by EFT

Companies use EFT systems to pay employees, suppliers, and other vendors.
Voucher package consists of documents that serve as proof of authority to pay. This would include the purchase order, receiving report, and supplier’s invoice.

Bank Accounts (Learning Objective 4)

Bank accounts provide internal control by:
- Reducing cash on hand.
- Providing an independent recording of cash transactions.
- Facilitating EFTs.

Bank Statement

Banks provide a bank statement summarizing checking account transactions.
Credit memo entries increase the company’s account.
Debit memo entries decrease the company’s account.

Credit Memos

Deposits made by electronic funds transfer (EFT).
Collections of notes receivable for the company.
Proceeds for a loan made to the company by the bank.
Interest earned on the company’s account.
Correction (if any) of bank errors.

Debit Memos

Payments made by electronic funds transfer (EFT).
Service charges.
Customer checks returned for not sufficient funds.
Correction (if any) of bank errors.

Using the Bank Statement as a Control over Cash

The bank statement is a primary control that a company uses over cash.
Differences between the company balance and bank balance may arise because of a delay by either the company or bank in recording transactions.

Check Kiting

Check kiting is an illegal activity that involves writing a check from a bank account that does not have sufficient funds, then “covering” that account by depositing a check from another bank account that also does not have sufficient funds.

Bank Reconciliation (Learning Objective 5)

A bank reconciliation analyzes differences between the bank statement and the company's ledger.
The adjusted cash balance is reported on the balance sheet.
The reconciliation has two sections:
1. Bank section: Begins with the bank statement balance and ends with the adjusted balance.
2. Company section: Begins with the company’s records balance and ends with the adjusted balance.
The adjusted balance from bank and company sections must be equal.

Steps to Prepare a Bank Reconciliation

Bank Section

Enter the cash balance according to the bank statement.
Add deposits not recorded by the bank (deposits in transit).
Deduct outstanding checks that have not been paid by the bank.
Determine the adjusted balance.

Company Section

Enter the cash balance according to the company's records.
Add credit memos not recorded (e.g., note receivable collected by the bank).
Deduct debit memos not recorded (e.g., NSF checks, service charges).
Determine the adjusted balance.

Verify that the adjusted balances from both sections are equal.
The company’s records must be updated for any items in the company section of the bank reconciliation.

Special-Purpose Cash Funds (Learning Objective 6)

Petty cash funds are used for small payments (postage, supplies, minor repairs).
The fund is replenished periodically or when it reaches a minimum amount.

Example

Establish a $500$ petty cash fund.
Petty Cash is debited only when the fund is established.
Petty Cash is credited only when the fund is decreased or eliminated.
At the end of August, there is $30$ of petty cash on hand and petty cash receipts for the items:
Office supplies $380$
Postage (debit Office Supplies) $22$
Store supplies $35$
Miscellaneous administrative expense $30$
Total $467$
The amount to replenish the petty cash fund doesn't equal the total of the petty cash receipts, the difference is recorded as Cash Short and Over.

Financial Statement Reporting of Cash (Learning Objective 7)

Cash is listed first in the “Current assets” section of the balance sheet.
Companies may invest excess cash in highly liquid investments called cash equivalents.

Compensating Balance

Banks may require minimum cash balances (compensating balances).
Compensating balance relates to the company's line of credit or outstanding loan with the bank, processing fees for a company’s checking and payroll accounts

Analysis for Decision Making: Days’ Cash on Hand (Learning Objective 8)

Days’ cash on hand measures how long a company could survive with declining revenue.
A higher number implies greater liquidity.
Formula:
$Days' Cash on Hand = \frac{Cash and Short-Term Investments}{Daily Cash Operating Expenses}$
Daily Cash Operating Expenses Formula:
$Daily Cash Operating Expenses = \frac{(Operating Expenses – Depreciation Expenses)}{365 Days}$

Example

Using the year 3 from the table
$Days' Cash on Hand = \frac{44,687+ 90,411}{(140,405-2,190)/365} = 356.7$