Internal Control and Cash

The Fraud Triangle

The Fraud Triangle explains the three elements necessary for fraud to occur in an organization: motive, opportunity, and rationalization. Understanding these elements helps organizations design controls to prevent fraud.

• Motive: The need or pressure to commit fraud (e.g., financial problems).

• Opportunity: The ability to commit fraud, often due to weak internal controls.

• Rationalization: The justification for fraudulent behavior (e.g., 'I deserve this').

The Function of an Internal Control System

Internal controls are processes and procedures implemented by a company to safeguard assets, ensure reliable financial reporting, and promote operational efficiency. They act as barriers against fraud, waste, and inefficiency.

• Fraud: Intentional misrepresentation for personal gain.

• Waste: Inefficient use of resources.

• Inefficiency: Failure to maximize productivity or minimize costs.

The Components of Internal Control

Internal control systems are structured around several key components, often visualized as parts of a house:

• Control Environment: The overall attitude, awareness, and actions of management regarding internal controls.

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

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

• Information System: Methods and records established to record, process, summarize, and report transactions.

• Monitoring: Ongoing evaluations to ensure controls are operating as intended.

Internal Control Procedures

• Smart Hiring Practices: Background checks, training, supervision, competitive salaries, and clear responsibilities.

• Separation of Duties: Different individuals handle asset custody, record keeping, and transaction approval to reduce fraud risk.

• Adequate Records: Maintain detailed, prenumbered documents (hard copy or electronic) for all transactions.

• Information Technology: Use of electronic systems (e.g., bar codes, sensors) to improve accuracy and speed.

Cash Receipts and Payments Controls

Cash Receipts by Mail

Segregation of duties is essential in handling cash receipts by mail. The process typically involves the mailroom, accounting department, treasurer, and controller to ensure accuracy and prevent theft.

Controls Over Payment by Check

• Separate duties for purchasing, receiving goods, preparing checks/EFTs, and approving payments.

• Use of a payment packet (purchase order, invoice, receiving report) to authorize payments.

Petty Cash

• Used for minor expenses, maintained on an imprest system (fund + vouchers = specified balance).

• Custodian manages the fund and prepares vouchers for each payment.

• Debit cards may be used as an alternative.

Limitations of Internal Control

• Collusion: Two or more people working together to circumvent controls.

• Management Override: Executives bypassing controls.

• Human Limitations: Fatigue, negligence, or error.

• Cost-benefit analysis: Controls should not cost more than the benefits they provide.

Bank Reconciliation

Bank reconciliation ensures that the cash balance in the company's records matches the bank statement. Adjustments are made for timing differences and errors.

• Bank Side Adjustments: Deposits in transit, outstanding checks, bank errors.

• Book Side Adjustments: Bank collections, EFTs, service charges, interest, NSF checks, book errors.

Journalizing Transactions from the Bank Reconciliation

Reporting Cash on the Balance Sheet

• Cash Equivalents: Highly liquid investments with maturities of three months or less are classified as cash equivalents.

• Disclosure in financial statement footnotes is required.

Revenue Recognition and Receivables

GAAP for Proper Revenue Recognition

Revenue is recognized when earned, typically when goods are delivered or services performed. The amount recorded is the cash received or the fair market value of assets received.

• A contract (written or oral) creates enforceable rights and obligations.

• Five-step process for revenue recognition:

  1. Identify the contract(s)

  2. Identify the performance obligation(s)

  3. Determine the transaction price

  4. Allocate the transaction price to the performance obligations

  5. Recognize revenue when the entity satisfies the obligations

Shipping Terms

• FOB Shipping Point: Ownership and revenue recognized when goods leave the seller's dock.

• FOB Destination: Ownership and revenue recognized upon delivery to the customer.

Speeding Up Cash Flow from Sales

• Offer sales discounts for early payment (e.g., 2/10, n/30).

• Charge interest on overdue accounts.

• Emphasize credit card or bankcard sales.

• Improve credit and collection procedures.

Sales Returns, Allowances, and Discounts

• Sales Returns and Allowances: Customers may return unsatisfactory goods; companies estimate and record expected returns.

• Credit Memo: Document authorizing a credit to the customer's account.

• Sales Discounts: Incentives for early payment (e.g., 2/10, n/30).

Types of Receivables

• Accounts Receivable: Amounts owed by customers for goods/services sold on credit.

• Notes Receivable: Formal written promises to pay a certain amount at a future date.

• Receivables are current assets and sometimes called trade receivables.

Uncollectible Accounts and the Allowance Method

Companies rarely collect all receivables. The allowance method estimates uncollectible accounts based on past experience, matching expenses to the period in which related revenue is earned.

• Allowance for Uncollectible Accounts: Contra-asset account showing estimated uncollectibles.

• Two estimation methods:

  • Percent-of-Sales Method: Income statement approach; expense is a percent of revenue.

  • Aging-of-Receivables Method: Balance sheet approach; analyzes accounts by age.

Direct Write-Off Method

• Records expense only when a specific account is deemed uncollectible.

• Not GAAP-compliant; may overstate assets and mismatches expenses and revenues.

Receivables Ratios

• Quick (Acid-Test) Ratio: Measures liquidity; higher ratio means easier to pay current liabilities.

• Formula:

• Accounts Receivable Turnover: Indicates how many times receivables are collected per year.

• Days' Sales Outstanding (DSO): Average days to collect receivables.

Inventory and Cost of Goods Sold

Inventory Accounting

• Inventory on hand is an asset on the balance sheet.

• Cost of inventory sold is an expense (Cost of Goods Sold) on the income statement.

• Gross Profit: Sales revenue minus cost of goods sold.

Inventory Systems

• Perpetual System: Continuous record of inventory; used for all goods.

• Periodic System: Inventory counted periodically; used for inexpensive goods.

Inventory Costing Methods

• Specific-Identification: Tracks actual cost of each item.

• Average-Cost: Uses weighted average cost for all units.

• FIFO (First-In, First-Out): First costs in are first costs out to cost of goods sold.

• LIFO (Last-In, First-Out): Last costs in are first costs out to cost of goods sold.

Income Effects of Inventory Methods

The choice of inventory method affects cost of goods sold, gross profit, and taxes, especially when prices are changing.

• When costs are rising: FIFO yields lowest COGS and highest gross profit; LIFO yields highest COGS and lowest gross profit (and lower taxes).

• When costs are falling: Effects are reversed.

Tax Advantages of LIFO

• LIFO results in lower taxable income and lower taxes when costs are rising, increasing available cash.

• FIFO provides more up-to-date inventory costs on the balance sheet.

Lower-of-Cost-or-Market (LCM) Rule

• Inventory must be reported at the lower of its historical cost or market value (net realizable value).

• Ensures assets are not overstated on the balance sheet.

Inventory Turnover and Days Inventory Outstanding (DIO)

• Measures how quickly inventory is sold.

• Formula:

• Average inventory = (Beginning inventory + Ending inventory) / 2

• Days Inventory Outstanding (DIO):

GAAP Requirements for Inventory

• Disclosure: Financial statements must provide enough information for decision-making.

• Representational Faithfulness: Inventory methods and material transactions must be properly disclosed.

• Consistency: Use comparable methods from period to period.