Chapter 7

Internal Control and Cash

Study Objectives

v Identify the principles of internal control.

v Explain the applications of internal control to cash receipts.

v Explain the applications of internal control to cash disbursements.

v Prepare a bank reconciliation.

v Explain the reporting of cash.

v Discuss the basic principles of cash management.

v Identify the primary elements of a cash budget.

Chapter Outline

Study Objective 1 - Identify the Principles of Internal Control

Internal control consists of all of the related methods and measures adopted within a business to:
Safeguard assets from employee theft, robbery, and unauthorized use; and
Enhance the accuracy and reliability of its accounting records by reducing the risk of errors
(unintentional mistakes) and irregularities (intentional mistakes and misrepresentations) in the
accounting process.

¨ To safeguard assets and enhance the accuracy and reliability of its accounting records, a company follows
internal control principles. The following six internal control principles apply to most companies:

¨ Establishment of Responsibility
An essential characteristic of internal control is the assignment of responsibility to specific individuals.
Control is most effective when only one person is responsible for a given task.
Establishing responsibility includes the authorization and approval of transactions.

¨ Segregation of Duties
Segregation of duties is indispensable in a system of internal control.
The rationale for segregation of duties is that the work of one employee should, without a duplication
of effort, provide a reliable basis for evaluating the work of another employee.
 There are two common applications of this principle:
1. The responsibility for related activities should be assigned to different individuals.
2. The responsibility for record keeping for an asset should be separate from the physical custody of
an asset.
Related Activities - When one individual is responsible for all of the related activities, the potential
for errors and irregularities is increased.
· Related purchasing activities should be assigned to different individuals. Related purchasing
activities include ordering merchandise, receiving goods, and paying (or authorizing payment) for
merchandise.
· Related sales activities also should be assigned to different individuals. Related sales activities
include making a sale, shipping (or delivering) the goods to the customer, and billing the customer.
Record Keeping Separate from Physical Custody - The custodian of the asset is not likely to convert
the assets to personal use if one employee maintains the record of the asset that should be on
hand and a different employee has physical custody of the asset.
¨ Documentation Procedures - Documents provide evidence that transactions and events have occurred.
§ Documents should be prenumbered and all documents should be accounted for.
§ Source documents for accounting entries should be promptly forwarded to the accounting department
to help ensure timely recording of the transaction and event.
Physical, Mechanical, and Electronic Controls – Physical controls relate primarily to the safeguarding of
assets. Mechanical and electronic controls safeguard assets and enhance the accuracy and reliability of the
accounting records. Use of physical, mechanical, and electronic controls is essential. Examples of these
controls include:
§ Safes, vaults, and safety deposit boxes for cash and business papers.
§ Locked warehouses and storage cabinets for inventory and records.
§ Computer facilities with pass key access or fingerprint or eyeball scans.
§ Alarms to prevent break-ins.
§ Television monitors and garment sensors to deter theft.
§ Time clocks for recording time worked.
Independent Internal Verification - Independent internal verification involves the review, comparison, and
reconciliation of data prepared by employees.
§ Verification should be made periodically or on a surprise basis.
§ Verification should be done by an employee independent of the personnel responsible for the
information.
§ Discrepancies and exceptions should be reported to a management level that can take appropriate
corrective action.
§ In large companies, independent internal verification is often assigned to internal auditors.
§ Internal auditors are employees of the company who evaluate on a continuous basis the effectiveness
of the company’s system of internal control.
§ They periodically review the activities of departments and individuals to determine whether prescribed
internal controls are being followed.
¨ Other Controls
§ Bonding of employees who handle cash.
§ Rotating employees' duties and requiring employees to take vacations.
¨ Limitations of Internal Control
§ Internal control is designed to provide reasonable assurance that assets are properly safeguarded and
that the accounting records are reliable.
§ The concept of reasonable assurance rests on the premise that the costs of establishing control
procedures should not exceed their expected benefit.
§ The human element is important in internal control.
§ A good system can become ineffective as a result of employee fatigue, carelessness, or indifference.
Employees may become tired and not bother to count inventory. Occasionally two or more employees
may work together in order to get around prescribed controls.
 § The size of the business may impose limitations on internal control. In a small company, for example,
it may be difficult to apply the principles of segregation of duties and independent internal verification.
§ An important and inexpensive measure any business can take to reduce employee theft and fraud is to
conduct thorough background checks. Two tips include:
1. Check to see whether job applicants actually graduated from the schools they list
2. Never use the telephone numbers for previous employers given on the reference sheet; always
look them up yourself.

Study Objective 2 - Explain the Applications of Internal Control to Cash Receipts

Cash receipts may result from cash sales; collections on account from customers; the receipt of interest, rents,
and dividends; investments by owners; bank loans; and proceeds from the sale of noncurrent assets.

¨ The following internal control principles explained earlier apply to cash receipts transactions as shown:
§ Establishment of responsibility - Only designated personnel (cashiers) are authorized to handle cash
receipts.
§ Segregation of duties - Different individuals receive cash, record cash receipts, and hold the cash.
§ Documentation procedures - Use remittance advice (mail receipts), cash register tapes, and deposit
slips.
§ Physical, mechanical, and electronic controls - Store cash in safes and bank vaults; limit access to
storage areas; use cash registers.
§ Independent internal verification - Supervisors count cash receipts daily; treasurer compares total
receipts to bank deposits daily.
§ Other controls - Bond personnel who handle cash; require vacations; deposit all cash in bank daily.

Study Objective 3 - Explain the Applications of Internal Control to Cash Disbursements

¨ Cash is disbursed to pay expenses and liabilities or to purchase assets.

¨ Internal control over cash disbursements is more effective when payments are made by check,
rather than by cash, except for incidental amounts that are paid out of petty cash.
¨ Cash payments are generally made only after specific control procedures have been followed.

¨ The paid check provides proof of payment.

¨ The principles of internal control apply to cash disbursements as follows:

§ Establishment of responsibility - Only designated personnel (treasurer) are authorized to sign
checks.
§ Segregation of duties - Different individuals approve and make payments; check signers do not
record disbursements.
§ Documentation procedures - Use prenumbered checks and account for them in sequence; each check
must have approved invoice.
§ Physical, mechanical, and electronic controls - Store blank checks in safes with limited access; print
check amounts by machine with indelible ink.
§ Independent internal verification - Compare checks to invoices; reconcile bank statement monthly.
§ Other controls - Stamp invoices PAID.

¨ Electronic Funds Transfer (EFT) System

§ A new approach developed to transfer funds among parties without the use of paper (deposit tickets,
checks, etc.). The approach, called electronic funds transfers (EFT), uses wire, telephone, telegraph,
or computer to transfer cash from one location to another.
¨ Petty Cash Fund - A cash fund used to pay relatively small amounts. Information on the operation of a
petty cash fund is provided in the Appendix to this chapter.
¨ Use of a Bank
Contributes significantly to good internal control over cash.
§ Minimizes the amount of cash that must be kept on hand.
§ Facilitates the control of cash because a double record is maintained of all bank transactions - one by
the business and one by the bank.
§ The asset account Cash maintained by the company is the “flip-side” of the bank’s liability account for
that company. It should be possible to reconcile these accounts—make them agree—at any time.
§ Bank statements - Each month the company receives a bank statement showing its bank transactions
and balances. For example, some transactions and balances shown include:
Checks paid and other debits that reduce the balance in the depositor's account.
Deposits and other credits that increase the balance in the depositor's account.
· The account balance after each day's transactions.

Study Objective 4 - Prepare a Bank Reconciliation

The bank and the company maintain independent records of the checking account. The two balances are
seldom the same because of:

¨ Time lags that prevent one of the parties from recording the transaction in the same period.
Days elapse between the time a check is written and dated and the date it is paid by the bank.
§ A day may pass between the time receipts are recorded by the company and the time they are recorded
by the bank.
§ A time lag may occur when the bank mails a debit or credit memo to the company.

¨ Errors by either party in recording transactions. The incidence of errors depends on the effectiveness of
internal controls maintained by the company and the bank.

¨ Reconciliation procedure - In reconciling the bank account, it is customary to reconcile the balance per
books and balance per bank to their adjusted (correct or true) cash balances. To obtain maximum benefit
from a bank reconciliation, the reconciliation should be prepared by an employee who has no other
responsibilities related to cash.

The reconciliation schedule is divided into two sections - balance per bank and balance per books. The
following steps should reveal all the reconciling items causing the difference between the two balances:
Compare the individual deposits on the bank statement with the deposits in transit from the preceding bank
reconciliation and with the deposits per company records or copies of duplicate deposit slips. Deposits
recorded by the depositor that have not been recorded by the bank represent deposits in transit and are
added to the balance per bank.
§ Compare the paid checks shown on the bank statement or the paid checks returned with the bank
statement with (a) checks outstanding from the preceding bank reconciliation and (b) checks issued by
the company as recorded in the cash payments journal. Issued checks recorded by the company that
have not been paid by the bank represent outstanding checks that are deducted from the balance per
bank.
Note any errors discovered in the foregoing steps and list them in the appropriate section of the
reconciliation schedule. All errors made by the depositor are reconciling items in determining the
adjusted cash balance per books. In contrast, all errors made by the bank are reconciling items in
determining the adjusted cash balance per bank.
Trace bank memoranda to the depositor's records. Any unrecorded memoranda should be listed in the
appropriate section of the reconciliation schedule.
¨ Entries from Bank Reconciliation - Each reconciling item used in determining adjusted cash balance
per books should be recorded by the depositor. If these items are not journalized and posted, the Cash
account will not show the correct balance.

Study Objective 5 - Explain the Reporting of Cash

¨ Cash is recorded in both the balance sheet and the statement of cash flows. The balance sheet shows the
amount of cash available at a given point in time. The statement of cash flows shows the sources and uses
of cash during a period of time.
¨ Cash on hand, cash in banks, and petty cash are often combined and reported simply as Cash.

¨ Cash is the most liquid asset and listed first in the current assets section of the balance sheet.

¨ Some companies use the designation "Cash and cash equivalents" in reporting cash. Cash equivalents are
short-term, highly liquid investments that are both:
§ Readily convertible to known amounts of cash, and
§ So near their maturity that their market value is relatively insensitive to changes in interest rates.

¨ In case of a negative balance in the cash account, it should be reported among current liabilities.

¨ A company may have cash that is not available for general use but rather is restricted for a special
purpose. Cash restricted in use should be reported separately on the balance sheet as restricted cash. If the
restricted cash is expected to be used within the next year, the amount should be reported as a current
asset. When this is not the case the restricted funds should be reported as a noncurrent asset.

Study Objective 6 - Discuss the Basic Principles of Cash Management

¨ Management of cash is the responsibility of the company treasurer.

¨ A company can improve its chances of having adequate cash by following five basic principles of cash
management:

¨ Increase the speed of collection on receivables.

The more quickly customers pay the more quickly a company can use those funds.
Any attempt to force customers to pay earlier must be carefully weighted against the possibility of angering
or alienating customers.
One common way to encourage customers to pay more quickly is to offer cash discounts for early payment.

¨ Keep inventory levels low - Maintaining large inventories ties up large amounts of cash, as well as
warehouse space.
Increasingly, firms are using techniques to reduce the inventory on hand, thus conserving their cash.

¨ Delay payment of liabilities - A company should use the full payment period, but not “stretch” payment
past the point that could damage its credit rating.

¨ Plan the timing of major expenditures – In order to increase the likelihood of obtaining outside
financing, a company should carefully consider the timing of major expenditures in light of its operating
cycle. If at all possible, the expenditure should be made when the company normally has excess
cash—usually during the off-season.
¨ Invest idle cash.
Cash on hand earns nothing.
An important part of the treasurer’s job is to ensure that any excess cash is invested, even if it is only
overnight.
A liquid investment is one with a market in which someone is always willing to buy or sell the investment.
A risk-free investment means there is no concern that the party will default on its promise to pay its
principal and interest.

Study Objective 7 - Identify the Primary Elements of a Cash Budget

Cash is vital and planning the company's cash needs is a key business activity. The cash budget shows the
anticipated cash flows, over a one- to two-year period. The cash budget contains the following three sections:

¨ Cash receipts section—includes expected receipts from the company's principal source(s) of revenue,
such as cash sales and collections from customers on credit sales. This section also shows anticipated
receipts of interest and dividends, and proceeds from planned sales of investments, plant assets, and the
company's capital stock.

¨ Cash disbursements section—shows expected payments for direct materials, direct labor, manufacturing
overhead, and selling and administrative expenses. This section also includes projected payments for
income taxes, dividends, investments, and plant assets.

¨ Financing section—shows expected borrowings and the repayment of the borrowed funds and interest.

¨ Data in the cash budget must be prepared in sequence because the ending cash balance of one period
becomes the beginning cash balance for the next period.

¨ Data for preparing the cash budget are obtained from other budgets and from information provided by
management

¨ A cash budget contributes to more effective cash management.

Appendix – Operation of the Petty Cash Fund

Operation of a petty cash fund involves (1) establishing the fund, (2) making payments from the fund, and (3)
replenishing the fund.

¨ Establishing the petty cash fund:

Two essential steps in establishing a petty cash fund are (1) appointing a petty cash custodian who will be
responsible for the fund, and (2) determining the size of the fund.
Ordinarily, the amount is expected to cover anticipated disbursements for a three- to four-week period.
When a fund is established, a check payable to the petty cash custodian is issued for the stipulated amount.
For example, if Laird Company decides to establish a $100 fund on March 1, the entry in general journal
form is:
Mar. 1 Petty Cash 100.00
Cash 100.00
(To establish a petty cash fund)

The check is then cashed and the proceeds are placed in a locked petty cash box or drawer.

¨ Making payments from petty cash:

 The custodian of the petty cash fund has the authority to make payments from the fund that conform to
prescribed management policies.
The receipts are kept in the petty cash box until the fund is replenished.
As a result, the sum of the petty cash receipts and money in the fund should equal the established total at all
times.
No accounting entry is made to record a payment at the time it is taken from petty cash. Instead, the
account effects of each payment are recognized when the fund is replenished.

¨ Replenishing the petty cash fund:

When the money in the petty cash fund reaches a minimum level, the fund is replenished.
The request for reimbursement is initiated by the petty cash custodian.
The individual prepares a schedule (or summary) of the payments that have been made and sends the
schedule, supported by petty cash receipts and other documentation, to the treasurer’s office who then
approves the request and a check is prepared to restore the fund to its established amount.
At the same time, all supporting documentation is stamped “paid” so that it cannot be submitted again for
payment.
To illustrate, assume that on March 15, the petty cash custodian requests a check for $87. The fund
contains $13 cash and petty cash receipts for postage $44, supplies $38, and miscellaneous expenses
$5. The entry, in general journal form, to record the check is:

Mar. 15 Postage Expense 44

Supplies 38
Miscellaneous Expense 5
Cash 87
(To replenish petty cash fund)

Note that the Petty Cash account is not affected by the reimbursement.
Occasionally, in replenishing a petty cash fund it may be necessary to recognize a cash shortage or
overage.
To illustrate, assume in the preceding example that the custodian had only $12 in cash in the fund plus the
receipts. The request for reimbursement would therefore be for $88, and the following entry would be
made:

Mar. 15 Postage Expense 44

Supplies 38
Miscellaneous Expense 5
Cash Over and Short 1
Cash 88
(To replenish petty cash fund)

A petty cash fund should be replenished at the end of the accounting period, regardless of the cash in the
fund. Replenishment at this time is necessary in order to recognize the effects of the petty cash
payments on the financial statements.

Chapter 7 Review

ü Identify five principles of internal control.

ü List six internal controls over cash receipts.

ü List six internal controls over cash disbursements.

ü List the steps in preparing a bank reconciliation.

ü In which financial statement(s) is cash reported?

ü Discuss the five basic principles of cash management.

ü What are the primary elements of a cash budget and what types of items would one find in each of the
elements? Be specific in your answer.