Internal Control and Cash

Internal Control

Purpose and Importance

Internal control systems are the policies and procedures adopted by a company to:

• Ensure reliable financial reporting

• Promote effective and efficient operations

• Ensure compliance with relevant laws and regulations

• Prevent and detect errors and fraud

Internal controls help prevent unintentional misstatements and intentional acts of fraud.

Components of Internal Control

Effective internal control systems have five primary components:

• Control Environment: The overall attitude, awareness, and actions of management and the board regarding the internal control system and its importance.

• Risk Assessment: Identifying and analyzing risks that may prevent the achievement of objectives.

• Control Activities: Policies and procedures that help ensure management directives are carried out.

• Information and Communication: Systems that support the identification, capture, and exchange of information in a form and time frame that enable people to carry out their responsibilities.

• Monitoring Activities: Ongoing or separate evaluations to ascertain whether each component of internal control is present and functioning.

Control Activities

Types of Control Activities

Control activities are the specific policies and procedures that help ensure management directives are carried out. They include:

• Assignment of Responsibility: Assigning specific tasks to specific employees to ensure accountability.

• Segregation of Duties: Dividing responsibility for related activities among different people to reduce the risk of error or inappropriate actions.

• Documentation: Maintaining evidence that transactions and events have occurred at specified times and amounts.

• Physical Controls: Safeguarding assets and enhancing the accuracy and reliability of accounting records (e.g., locks, safes, passwords).

• Review and Reconciliation: Independent checks of performance and records, such as bank reconciliations.

The specific control activities used depend on the risks faced and the size and nature of the company.

Assignment of Responsibilities

• Each employee is accountable for their assigned tasks (e.g., each cashier is responsible for their own cash drawer).

Segregation of Duties

• Authorization, recording, and custody of assets should be assigned to different individuals (e.g., no single employee should order, approve, receive, and authorize payment for purchases).

Documentation

• Transactions should be supported by documents (e.g., shipping documents for goods shipped).

Physical Controls

• Examples include computer passwords, building alarms, security cameras, safes, and vaults.

Review and Reconciliation

• Controls should be independently reviewed, both internally and externally (e.g., bank reconciliations).

Brief Exercise 7.2: Matching Control Activities

Limitations of Internal Control

• Internal controls provide reasonable assurance, not absolute assurance, that assets are safeguarded and records are reliable.

• Limitations include:

  • Cost/benefit considerations

  • Human error

  • Collusion among employees

  • Management override of controls

Fraud

Definition and Examples

• Fraud is an intentional act to misappropriate (steal) assets or to misstate financial information.

• Examples of fraudulent misstatements:

  • Recording expenses as assets

  • Overstating useful lives of assets

  • Recording revenues that do not exist

Fraud typically involves three elements: opportunity, pressure, and rationalization.

Cash Controls

Nature of Cash

• Cash is highly susceptible to theft.

• Cash includes coins, currency, cheques, money orders, and money on hand or in the bank.

• General rule: If the bank will accept it for deposit, it is considered cash.

Cash Receipts

Cash receipts can be received over-the-counter, by cheque, or by electronic funds transfer (EFT). Internal control is more effective when receipts are deposited daily or by EFT.

Cash Payments

Control activities over cash payments are more effective when payments are made by cheque or EFT rather than in cash.

Use of a Bank

• Using a bank safeguards cash by acting as a depository and clearinghouse for cheques received and written.

• Minimizes the amount of currency that must be kept on hand.

• Provides a second record of transactions (one by the business, one by the bank).

• These two records can be reconciled to ensure accuracy.

Understanding Debits and Credits

Bank Reconciliation

Purpose

• Bank reconciliation matches the balance per the company's bank account with the cash balance per the general ledger ("books").

• Both balances are reconciled to their adjusted (correct) cash balance.

• Adjusted cash balance = reconciled balance

Bank Reconciliation Procedures

Reconciling Items per Bank

1. Deposits in transit (+): Deposits recorded in the company's books but not yet on the bank statement.

2. Outstanding cheques (–): Cheques recorded in the company's books but not yet cleared by the bank.

3. Bank errors (+/–): Errors made by the bank in recording transactions.

Reconciling Items per Books

1. EFT collections, interest earned, and other deposits (+): For example, EFT collection from a customer not previously recorded.

2. EFT payments, service charges, interest charges, and other payments (–): For example, bank service charges.

3. Book errors (+/–): Errors made by the company in recording transactions.

Bank Reconciliation Journal Entries

• Each reconciling item in determining the adjusted balance per books must be journalized and posted.

• No entries are made on the bank side.

Bank Reconciliation Illustrated

Journal Entries for Bank Reconciliation

• To record electronic receipts on account:

  • Debit Cash, Credit Accounts Receivable

• To record NSF cheque:

  • Debit Accounts Receivable, Credit Cash

• To record bank service charges:

  • Debit Bank Charges Expense, Credit Cash

• To record book error:

  • Debit Accounts Receivable, Credit Cash

Reporting and Managing Cash

Reporting Cash

• Cash is reported in both the statement of financial position and the statement of cash flows.

• The statement of cash flows shows the receipts and payments of cash.

• Cash is the most liquid asset and is listed first in the current assets section of the statement of financial position.

Cash Equivalents

• Cash can be combined with cash equivalents—short-term, highly liquid investments subject to insignificant risk of changes in value.

• If cash is in a deficit or overdraft at year-end, it is reported as a current liability called bank indebtedness.

Managing Cash

Effective cash management ensures a company has sufficient cash to meet its needs. Basic principles include:

• Increase the speed of receivables collection

• Keep inventory levels low

• Monitor payment of liabilities

• Plan timing of major expenditures

• Invest idle cash

• Prepare a cash budget