6.2 Internal Controls and Bank Reconciliation

Internal Controls for Cash

• A company’s main responsibility is to safeguard their assets, especially cash.
• Cash is susceptible to improper diversion, theft, and mismanagement.
• Management faces two problems in accounting for cash transactions:
  • Establishing proper controls to prevent unauthorized transactions.
  • Providing information necessary to properly manage cash on hand.

Establishing Proper Controls

• Checks and Balances: Implement checks and balances.
  • Example: Require two signatures on checks to prevent unauthorized transactions.
• Rotation of Duties: Rotate duties among employees.
  • Involve several people in reviewing accounts receivables and cash management.
• Separation of Duties

Managing Cash

• Minimum Cash on Hand: Keep a minimum amount of cash on hand.
• Investment of Excess Cash: Invest excess cash to earn a higher rate of return for shareholders.

Safeguarding Cash

To safeguard cash and ensure accuracy, companies need effective internal controls that include:

• Separation of Duties: Among employees.
• Intact Cash Deposits: All cash receipts should be deposited intact.
  • Don't commingle cash use.
  • Example: Don't take money from the cash register for courier deliveries; use a petty cash account instead.
• Major Disbursements by Check or Electronic Funds Transfers: All major disbursements should be made by check or electronic funds transfers.
  • Checks should be in sequential order.
  • Transactions can be verified via bank statements.
• Month-End Bank Reconciliation: Prepare a month end bank reconciliation.

Bank Reconciliation

• A two-column bank reconciliation format is used to reconcile timing differences or errors.
• The goal is to determine the correct cash balance to report at month end.
• The first step is to prepare the mentioned two-column bank reconciliation.

Bank Reconciliation Items

• Need bank statement for the month end (e.g., March 31).
  • Includes itemized list of processed checks and deposits.
• Company's cash ledger on the same date.
  • The balance may differ from the bank statement.
• Reconciling items affect either the bank side or the book (company) side.

Items Affecting the Bank Side

• Deposit in Transit: A deposit recorded by the company but not yet processed by the bank.
  • Add to the bank balance when reconciling.
• Bank Errors: Errors made by the bank.
  • Example: Processing another company's transaction on your account.
• Outstanding Checks: Checks written and recorded by the company but not yet processed by the bank.
  • Deduct from the bank balance when reconciling.
    • Checks that have been written by our company, recorded on the company's internal accounting records, but they have yet to be processed by the bank.
• These adjustments lead to the true cash balance.

Items Affecting the Book Side

• Bank Credit: A note collected directly by the bank and deposited into the account.
  • Add to the book balance.
• Book Errors: Errors made by the company in recording transactions.
  • Example: Transposing numbers when recording a check amount.
• Insufficient Funds (NSF) Checks: Checks from customers returned by the bank due to insufficient funds.
  • Deduct from book balance.
• Bank Service Charges: Charges imposed by the bank.
  • Deduct from the book balance.
• Overdraft Charges: Charges for overdrawing the account.
  • Deduct from the book balance.
• These adjustments reconcile to the true cash balance.

Updating the Cash Ledger

• Update the cash ledger account for all timing differences.
• To increase the balance, debit cash.
• To decrease the balance, credit cash.

Interpreting a Bank Reconciliation

• Debit Memo: Means the bank reduced the balance in your cash account.
• Credit Memo: Means the bank increased the balance in your cash account.
• This is from the bank's perspective.
  • Example: If you deposit $1,000$ in the bank, the bank now owes you that money, so it's a liability to them. Reducing this liability (when you withdraw) is a debit, and increasing it (when you deposit) is a credit.

Example

• Sparky Company's books show a cash balance at the Arizona State Bank on July 31 of $9,070$.
• The bank statement covering the month of July shows an ending balance of $8,650$.
• Sparky should report on their balance sheet dated July 31.

Reconciling Items:

• Deposits in transit and outstanding checks.
  *In order to prepare a bank reconciliation for the month of July, you would have to have access to the June bank reconciliation.
• The bank collected a note of $1,000$ on Sparky's behalf.
• Bank fee for the month.
• Insufficient funds check.
• Error in recording check number 7322 (recorded as $310$ instead of $130$).

Supporting Schedules for Bank Reconciliation

Deposits in Transit

• Start with the deposits in transit from June.
• Add deposits per books in July.
• Subtract deposits per bank in July.
• The result is the deposits in transit as of July 31.

Outstanding Checks

• Start with the outstanding checks from June.
• Add checks written by the company in July.
• Subtract checks processed by the bank in July.
• The result is the outstanding checks as of July 31.

Sparky Company Example

• Balance per bank: $8,650$

• Add: Deposits in transit: $2,350$

• Less: Outstanding checks: $1,100$

• True cash balance: $9,900$

• Balance per books: $9,070$

• Add: Note collected by bank: $1,000$

• Add: Correction of book error:
  It was recorded as $310 instead of $130 so too much was subtracted so the difference must be added. $180$

• Less: Bank fee: $15$

• Less: Insufficient funds check: $335$

• True cash balance: $9,900$

Journal Entries to Update Cash Ledger:

• Debit Cash, Credit Note Receivable: $1,000$
• Debit Cash, Credit Account Payable: $180$
• Debit Bank Fee Expense, Credit Cash: $15$
• Debit Account Receivable, Credit Cash: $335$