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This book is licensed under a Creative Commons Attribution 3.0 License 8. Control of cash Learning objective After studying this chapter, you should be able to: • Describe the necessity for and features of internal control. • Define cash and list the objectives sought by management in handling a company's cash. • Identify procedures for controlling cash receipts and disbursements. • Prepare a bank reconciliation and make necessary journal entries based on that schedule. • Explain why a company uses a petty cash fund, describe its operations, and make the necessary journal entries. • Analyze and use the financial results-quick ratio. A career in forensic accounting This chapter emphasizes the importance of having effective internal controls in every business. Unfortunately, many smaller companies do not heed this advice. Failure to implement adequate internal controls can result in financial statement fraud (purposely misstated financial statements) or embezzlement (theft). This is when the services of a forensic accountant may be necessary. Forensic accounting is the application of accounting methodology to legal issues. It is frequently associated with the investigation of civil or criminal white-collar crime such as fraud, embezzlement, and general abuse of funds issues. Typical tools used in forensic accounting are bank records, personal financial statements, interviews, and credit reports. The forensic accountant's responsibility is to gather and analyze the evidence and deliver clear, accurate, and unbiased reports reflecting the results of the investigation. Forensic accounting is commonly performed by Certified Fraud Examiners (CFEs). CFEs have extensive training and possess special expertise in investigation and interview techniques specifically designed to detect or prevent fraud. A well-known agency performing forensic accounting in the United States is in the Federal Bureau of Investigation (FBI). You can learn more about the FBI from their homepage at www.fbi.gov. Click on employment in the 'About Us' section and then click on special agent employment to learn more about what it takes to be an FBI special agent. Did you know that the fastest track to becoming an FBI agent is with an accounting undergraduate degree? There are four entry programs for becoming an FBI special agent: accounting, law, language, and diversified. Law requires an undergraduate degree and a law degree, language requires an undergraduate degree and proficiency in a second language, and diversified requires three years of work experience beyond an undergraduate degree. The only entry program requiring only an undergraduate degree is one with an undergraduate accounting option. Why accounting? Because an ever-increasing portion of crimes investigated by the FBI are white-collar crimes where accounting knowledge is essential. Accounting Principles: A Business Perspective 354 A Global Text 8. Control of cash In a small corporation the president might make all the important decisions and will usually maintain a close watch over the affairs of the business. However, as the business grows and the need arises for additional employees, officers, and managers, the president begins to lose absolute control. Realizing that precautions are necessary to protect the company's interests, the company establishes an internal control structure at this point. The internal control structure of a company consists of "the policies and procedures established to provide reasonable assurance that specific entity objectives will be achieved".27 The three elements of an internal control structure are the control environment, the accounting system, and the control procedures. The control environment reflects the overall attitude, awareness, and actions of the board of directors, management, and stockholders. The accounting system consists of the methods and records that identify, assemble, analyze, classify, record, and report an entity's transactions to provide complete, accurate, and timely financial information. The control procedures of a company are additional policies and procedures that management establishes to provide reasonable assurance that the company achieves its specific objectives. These control procedures may pertain to proper authorization, segregation of duties, design and use of adequate documents and records, adequate safeguards over access to assets, and independent checks on performance. Internal control not only prevents theft and fraud but also serves many purposes: (1) Companies must implement policies requiring compliance with federal law; (2) personnel must perform their assigned duties to promote efficiency of operations; and (3) correct accounting records must supply accurate and reliable information in the accounting reports. This chapter discusses the internal control structure that a company establishes to protect its assets and promote the accuracy of its accounting records. You will learn how to establish internal control through control of cash receipts and cash disbursements, proper use of the bank checking account, preparation of the bank reconciliation, and protection of petty cash funds. The internal control structure is enhanced by hiring competent and trustworthy employees, a fact you will appreciate if you become a business owner. Internal control An effective internal control structure includes a company's plan of organization and all the procedures and actions it takes to: • Protect its assets against theft and waste. • Ensure compliance with company policies and federal law. • Evaluate the performance of all personnel to promote efficient operations. • Ensure accurate and reliable operating data and accounting reports. 27 AICPA, Statement on Auditing Standards No. 55, "Consideration of the Internal Control Structure in a Financial Statement Audit" (New York, 1988), p. 4. The sixth and seventh editions of this text use the terminology (internal control structure) of the AICPA. Previous editions referred to the "internal control system." 355 This book is licensed under a Creative Commons Attribution 3.0 License As you study the basic procedures and actions of an effective internal control structure, remember that even small companies can benefit from using some internal control measures. Preventing theft and waste is only a part of internal control. In general terms, the purpose of internal control is to ensure the efficient operations of a business, thus enabling the business to effectively reach its goals. Since additional control procedures are necessary in a computer environment, a discussion of these controls concludes this section on internal control. An accounting perspective: Business insight When performing an audit, one of an outside auditor's first duties is to examine the internal control structure of the corporation. To understand the internal control structure, an auditor focuses mainly on management's attitude and awareness concerning controls and the accounting system's processing of transactions. To increase understanding, the auditor inspects documents in the accounting system, discusses external influences on the company with management, reads accounting manuals, and observes the happenings in the company. This understanding of the company's control environment helps the auditor to plan the audit and to determine the nature, timing, and extent of tests. Companies protect their assets by (1) segregating employee duties, (2) assigning specific duties to each employee, (3) rotating employee job assignments, and (4) using mechanical devices. Segregation of employee duties Segregation of duties requires that someone other than the employee responsible for safeguarding an asset must maintain the accounting records for that asset. Also, employees share responsibility for related transactions so that one employee's work serves as a check on the work of other employees. When a company segregates the duties of employees, it minimizes the probability of an employee being able to steal assets and cover up the theft. For example, an employee could not steal cash from a company and have the theft go undetected unless someone changes the cash records to cover the shortage. To change the records, the employee stealing the cash must also maintain the cash records or be in collusion with the employee who maintains the cash records. Assignment of specific duties to each employee When the responsibility for a particular work function is assigned to one employee, that employee is accountable for specific tasks. Should a problem occur, the company can quickly identify the responsible employee. When a company gives each employee specific duties, it can trace lost documents or determine how a particular transaction was recorded. Also, the employee responsible for a given task can provide information about that task. Being responsible for specific duties gives people a sense of pride and importance that usually makes them want to perform to the best of their ability. Accounting Principles: A Business Perspective 356 A Global Text 8. Control of cash Rotation of employee job assignments Some companies rotate job assignments to discourage employees from engaging in long-term schemes to steal from them. Employees realize that if they steal from the company, the next employees assigned to their positions may discover the theft. Frequently, companies have the policy that all employees must take an annual vacation. This policy also discourages theft because many dishonest schemes collapse when the employee does not attend to the scheme on a daily basis. Use of mechanical devices Companies use several mechanical devices to help protect their assets. Check protectors (machines that perforate the check amount into the check), cash registers, and time clocks make it difficult for employees to alter certain company documents and records. Internal control policies are effective only when employees follow them. To ensure that they carry out its internal control policies, a company must hire competent and trustworthy employees. Thus, the execution of effective internal control begins with the time and effort a company expends in hiring employees. Once the company hires the employees, it must train those employees and clearly communicate to them company policies, such as obtaining proper authorization before making a cash disbursement. Frequently, written job descriptions establish the responsibilities and duties of employees. The initial training of employees should include a clear explanation of their duties and how to perform them. In publicly held corporations, the company's internal control structure must satisfy the requirements of federal law. In December 1977, Congress enacted the Foreign Corrupt Practices Act (FCPA). This law requires a publicly held corporation to devise and maintain an effective internal control structure and to keep accurate accounting records. This law came about partly because company accounting records covered up bribes and kickbacks made to foreign governments or government officials. The FCPA made this specific type of bribery illegal. To evaluate how well employees are doing their jobs, many companies use an internal auditing staff. Internal auditing consists of investigating and evaluating employees' compliance with the company's policies and procedures. Companies employ internal auditors to perform these audits. Trained in company policies and internal auditing duties, internal auditors periodically test the effectiveness of controls and procedures throughout the company. Internal auditors encourage operating efficiency throughout the company and are alert for breakdowns in the company's internal control structure. In addition, internal auditors make recommendations for the improvement of the company's internal control structure. All companies and nonprofit organizations can benefit from internal auditing. However, internal auditing is especially necessary in large organizations because the owners (stockholders) cannot be involved personally with all aspects of the business. Companies should maintain complete and accurate accounting records. The best method to ensure such accounting records is to hire and train competent and honest individuals. Periodically, supervisors evaluate an employee's performance to make sure the employee is following company policies. Inaccurate or inadequate accounting records serve as an invitation to theft by dishonest employees because theft can be concealed more easily. 357 This book is licensed under a Creative Commons Attribution 3.0 License One or more business documents support most accounting transactions. These source documents are an integral part of the internal control structure. For optimal control, source documents should be serially numbered. (Transaction documentation and related aspects of internal control are presented throughout the text.) PURCHASE REQUISITION No. 2 4 1 6 BRYAN WHOLESALE COMPANY From; Automotive Supplies Department Date: 2010 N o v e m b e r 2 0 To: Purchasing Department Suggested supplier: W i l k e s R a d i o C o m p a n y Please purchase the following items; Description Item Number Quantity Estimated Price Model No. 5868200 $50 per unit 24393 Reason for request: To be filled in by purchasing department: Customer order Dated ordered 2 0 1 0 N o v e m b e r 2 9 Baier Company Purchase order number N - M S Approved R . S . T. Exhibit 65: Purchase requisition Since source documents serve as documentation of business transactions, from time to time firms check the validity of these documents. For example, to review a purchase transaction, they check the documents used to record the transaction against the proper accounting records. When the accounting department records a purchase transaction, it should receive copies of the following four documents: • A purchase requisition (Exhibit 65) is a written request from an employee inside the company to the purchasing department to purchase certain items. • A purchase order (Exhibit 66) is a document sent from the purchasing department to a supplier requesting that merchandise or other items be shipped to the purchaser. • An invoice (Exhibit 67) is the statement sent by the supplier to the purchaser requesting payment for the merchandise shipped. • A receiving report is a document prepared by the receiving department showing the descriptions and quantities of all items received from a supplier in a particular shipment. A copy of the purchase order can serve as a receiving report if the quantity ordered is omitted. Then, because receiving department personnel do not know what quantity to expect, they will count the quantity received more accurately. These four documents together serve as authorization to pay for merchandise and should be checked against the accounting records. Without these documents, a company might fail to pay a legitimate invoice, pay fictitious invoices, or pay an invoice more than once. Companies can accomplish proper internal control only by periodically checking the source documents of business transactions with the accounting records of those transactions. In Exhibit 68 we show the flow of documents and goods in a merchandise transaction. Accounting Principles: A Business Perspective 358 A Global Text 8. Control of cash PURCHASE ORDER No. N-145 BRYAN WHOLESALE COMPANY 476 Mason Street Detroit, Michigan 48823 To: Wilkes Radio Company 2515 West Peachtree Street Date: 2010 November 21 Atlanta, Georgia 30303 Ship by: 2010 December 20 Ship to: Above address FOB terms requested: Destination Discount terms requested: 2/10, n/30 Please send the foil owing item; Price Total Description Item Number Quantity Per Unit Amount True-tone stereo Model No. 200 $50 $10,000 radios 5868-24393 Ordered by: J a n e K n i g h t Please include order number on all invoice and shipments. Exhibit 66: Purchase order Unfortunately, even though a company implements all of these features in its internal control structure, theft may still occur. If employees are dishonest, they can usually figure out a way to steal from a company, thus circumventing even the most effective internal control structure. Therefore, companies should carry adequate casualty insurance on assets. This insurance reimburses the company for loss of a nonmonetary asset such as specialized equipment. Companies should also have fidelity bonds on employees handling cash and other negotiable instruments. These bonds ensure that a company is reimbursed for losses due to theft of cash and other monetary assets. With both casualty insurance on assets and fidelity bonds on employees, a company can recover at least a portion of any loss that occurs. According to the Committee of Sponsoring Organizations of the Treadway Commission, there are five components of an internal control structure. When these components are linked to the organization's operations, they can quickly respond to shifting conditions. The components are: • Control environment. The control environment is the basis for all other elements of the internal control structure. The control environment includes many factors such as ethical values, management's philosophy, the integrity of the employees of the corporation, and the guidance provided by management or the board of directors. • Risk assessment. After the entity sets objectives, the risks (such as theft and waste of assets) from external and internal sources must be assessed. Examining the risks associated with each objective allows management to develop the means to control these risks. • Control activities. To address the risks associated with each objective, management establishes control activities. These activities include procedures that employees must follow. Examples include procedures to protect the assets through segregation of employee duties and the other means we discussed earlier. • Information and communication. Information relevant to decision making must be collected and reported in a timely manner. The events that yield these data may come from internal or external sources. Communication throughout the entity is important to achieve management's goals. Employees must understand what is expected of them and how their responsibilities relate to the work of others. Communication with external parties such as suppliers and shareholders is also important. 359 This book is licensed under a Creative Commons Attribution 3.0 License • Monitoring. After the internal control structure is in place, the firm should monitor its effectiveness so that it can make changes before serious problems arise. In testing components of the internal control structure, companies base their thoroughness on the risk assigned to those components. Internal control is the general responsibility of all members in an organization. However, the following three groups have specific responsibilities regarding the internal control structure. INVOICE Invoice No. 1 5 7 4 Date: 2010 Dec. 15 WILXES RADIO COMPANY 2515 West Peachtree Street Atlanta, Georgia 30303 Customer's Orders No. N-14S Sold to: Bryan Wholesale Co. Address: 475 Mason Street Detroit, Michigan 4S823 Terms: 2/10, n/30, FOB destination Date shipped: 2010 D e c e m b e r 1 5 Shipped by: Description Nagel Trucking Co. Item Number Quantity Price Per Unit Total Amount Model No. 5868-24393 200 $50 $10,000 Total $10,000 Exhibit 67: Invoice Management holds ultimate responsibility for establishing and maintaining an effective internal control structure. Through leadership and example, management demonstrates ethical behavior and integrity within the company. The board of directors provides guidance to management. Because board members have a working knowledge of the functions of the company, they help shield the company from managers who try to override some control procedures for dishonest purposes. Often, an efficient board that has access to the company's internal auditors can discover such fraud. Auditors within the organization evaluate the effectiveness of the internal control structure and determine whether company policies and procedures are being followed. All employees are part of a communications network that enables an internal control structure to work effectively. Computerized financial records require the same internal control principles of separation of duties and control over access as a manual accounting system. The exact control steps depend on whether a company is using mainframe computers and minicomputers or microcomputers. Large corporations might use all three types of computers in their accounting environments. The size and complexity of mainframe computers and minicomputers require specially trained persons to keep these systems operating. While systems specialists operate the computer system itself, programmers develop the programs that direct the computer to perform specific tasks. In a mainframe or minicomputer environment, internal control should include the following: Accounting Principles: A Business Perspective 360 A Global Text 8. Control of cash • Control computer access by placing the computer in an easily secured room, and allow only persons authorized to operate the computer to enter the room. • Restrict the access of systems specialists (who operate the computer) to software programs and the access of programmers to the computer. This policy prevents the running of unauthorized, altered programs. • Require the use of passwords to access sensitive company data and confidential personal data. Change the passwords as necessary. Many smaller companies use microcomputers instead of a mainframe or a minicomputer. Also, large companies might supply certain employees with personal computers. The use of personal computers changes the control environment somewhat. Small companies generally do not employ systems specialists and programmers. Instead, these companies use off-the-shelf programs such as accounting, spreadsheet, database management, and word processing packages. The data created by use of these programs are valuable (e.g. the company's accounting records) and often sensitive. Thus, controls are also important. In a personal computer environment, the following controls can be useful: Exhibit 68: Flow of documents and goods in a merchandising transaction 361 This book is licensed under a Creative Commons Attribution 3.0 License • Require computer users to have tight control over storage of programs and data. Just as one person maintains custody over a certain set of records in a manual system, in a computer system one person maintains custody over certain information (such as the accounts receivable subsidiary ledger). Make backup copies that are retained in a different secured location. • Require passwords (kept secret) to gain entry into data files maintained on the hard disk. • In situations where a local area network (LAN) links the personal computers into one system, permit only certain computers and persons in the network to have access to some data files (the accounting records, for example). Computerized accounting systems do not lessen the need for internal control. In fact, access to a computer by an unauthorized person could result in significant theft in less time than with a manual system. Controlling cash Since cash is the most liquid of all assets, a business cannot survive and prosper if it does not have adequate control over its cash. In accounting, cash includes coins; currency; undeposited negotiable instruments such as checks, bank drafts, and money orders; amounts in checking and savings accounts; and demand certificates of deposit. A certificate of deposit (CD) is an interest-bearing deposit that can be withdrawn from a bank at will (demand CD) or at a fixed maturity date (time CD). Only demand CDs that may be withdrawn at any time without prior notice or penalty are included in cash. Cash does not include postage stamps, IOUs, time CDs, or notes receivable. In its general ledger, a company usually maintains two cash accounts—Cash and Petty Cash. On the company's balance sheet, it combines the balances of these two accounts into one amount reported as Cash. An accounting perspective: Business insight Users of financial data must look to see the real meaning behind the numbers. Reader's Digest publishes the world's most widely read magazine as well as various other books, home entertainment products, and special interest magazines. In Reader's Digest's annual report, for example, the company defines cash and cash equivalents in this footnote: The company considers all highly liquid debt instruments with original maturities of three months or less to be cash equivalents. Since many business transactions involve cash, it is a vital factor in the operation of a business. Of all the company's assets, cash is the most easily mishandled either through theft or carelessness. To control and manage its cash, a company should: • Account for all cash transactions accurately so that correct information is available regarding cash flows and balances. Accounting Principles: A Business Perspective 362 A Global Text 8. Control of cash • Make certain that enough cash is available to pay bills as they come due. • Avoid holding too much idle cash because excess cash could be invested to generate income, such as interest. • Prevent loss of cash due to theft or fraud. The need to control cash is clearly evident and has many aspects. Without the proper timing of cash flows and the protection of idle cash, a business cannot survive. This section discusses cash receipts and cash disbursements. Later in the chapter, we explain the importance of preparing a bank reconciliation for each bank checking account and controlling the petty cash fund. When a merchandising company sells its merchandise inventory, it may receive cash immediately or several days or weeks later. A clerk receives the cash immediately over the counter, records it, and places it in a cash register. The presence of the customer as the sale is rung up usually ensures that the cashier enters the correct amount of the sale in the cash register. At the end of each day, stores reconcile the cash in each cash register with the cash register tape or computer printout for that register. Payments received later are almost always in the form of checks. Stores prepare a record of the checks received as soon as they are received. Some merchandising companies receive all their cash receipts on a delayed basis as payments on accounts receivable. (See the cash receipts cycle for merchandise transactions in Exhibit 69.) Although businesses vary their specific procedures for controlling cash receipts, they usually observe the following principles: • Prepare a record of all cash receipts as soon as cash is received. Most thefts of cash occur before a record is made of the receipt. Once a record is made, it is easier to trace a theft. • Deposit all cash receipts intact as soon as feasible, preferably on the day they are received or on the next business day. Undeposited cash is more susceptible to misappropriation. • Arrange duties so that the employee who handles cash receipts does not record the receipts in the accounting records. This control feature follows the general principle of segregation of duties given earlier in the chapter, as does the next principle. • Arrange duties so that the employee who receives the cash does not disburse the cash. This control measure is possible in all but the smallest companies. Companies also need controls over cash disbursements. Since a company spends most of its cash by check, many of the internal controls for cash disbursements deal with checks and authorizations for cash payments. The basic principle of segregation of duties also applies in controlling cash disbursements. Following are some basic control procedures for cash disbursements: • Make all disbursements by check or from petty cash. Obtain proper approval for all disbursements and create a permanent record of each disbursement. Many retail stores make refunds for returned merchandise from the cash register. When this practice is followed, clerks should have refund tickets approved by a supervisor before refunding cash. 363