Internal Control and Cash

The Fraud Triangle

The Fraud Triangle is a model used to explain the factors that lead to fraudulent behavior in organizations. It consists of three elements: Motive, Opportunity, and Rationalization. Understanding these elements helps companies design controls to prevent fraud.

• Motive: The reason or pressure that drives someone to commit fraud (e.g., financial need).

• Opportunity: The situation that enables fraud to occur, often due to weak internal controls.

• Rationalization: The justification or reasoning that makes the act acceptable in the perpetrator's mind.

The Function of an Internal Control System

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

• Fraud: Prevents unauthorized use or theft of company assets.

• Waste: Reduces unnecessary expenditures and resource misuse.

• Inefficiency: Promotes effective and efficient operations.

The Components of Internal Control System

An effective internal control system is built on several key components, often illustrated as a house structure. These components work together to create a strong control environment.

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

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

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

• Information System: Systems that support the identification, capture, and exchange of information.

• Monitoring: Ongoing or periodic assessments of the effectiveness of controls.

Internal Control Procedures

Internal control procedures are specific actions taken to achieve the objectives of internal controls. Examples include:

• Smart Hiring Practices: Conducting background checks, providing training, offering competitive salaries, and clarifying employee responsibilities.

• Separation of Duties: Dividing responsibilities for asset handling, record keeping, and transaction approval among different employees.

• Adequate Records: Maintaining detailed records of business transactions, using hard copy or electronic documents, and employing prenumbered documents.

• Information Technology: Utilizing electronic sensors, bar codes, and automated systems to improve accuracy and speed.

Cash Receipts by Mail

Companies implement controls over cash receipts by mail to prevent theft and ensure proper recording. The process involves several departments and steps:

• Mailroom opens mail and separates checks from remittance advices.

• Treasurer prepares deposit ticket and sends checks to the bank.

• Accounting department records the total amount credited to cash.

• Controller oversees the process for accuracy.

Controls Over Payment by Check

To safeguard cash, companies split duties related to purchasing and payment:

• Purchasing goods

• Receiving goods

• Preparing check or EFT for payment

• Approval of payment

Payment Packet

A payment packet is a collection of documents used to authorize payment. It typically includes:

• Purchase Order

• Invoice

• Receiving Report

Petty Cash

Petty cash is used for minor expenses. It is managed through an imprest system, where the sum of the fund plus vouchers paid should equal the specified balance. Debit cards may also be used for small payments.

• Custodian prepares a petty cash voucher list.

• Petty cash is replenished as needed.

Limitations of Internal Control

Internal controls are not foolproof. Limitations include:

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

• Management Override: Executives bypassing controls.

• Human Limitations: Fatigue and negligence.

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

Bank Reconciliation

Bank reconciliation is the process of matching the company's cash records with the bank statement. Adjustments are made for items such as deposits in transit, outstanding checks, bank errors, and book errors.

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

• Book Side: Bank collections, electronic funds transfers, service charges, interest revenue, NSF checks, cost of printed checks, book errors.

Journalizing Transactions from the Bank Reconciliation

After reconciling, companies must journalize the necessary adjustments. Typical entries include recording bank service charges, interest revenue, and correcting errors.

Reporting Cash on the Balance Sheet

Cash equivalents are highly liquid investments with maturities of three months or less. Companies disclose these in the footnotes of their financial statements.

• Examples: Treasury bills, money market funds.

Receivables and Revenue

Revenue Recognition under GAAP

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

• Contracts (written or oral) create enforceable rights or 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

Example: Revenue Recognition for Apple Inc.

When Apple delivers 30,000 iPhones to AT&T Wireless for $100 each, the following entries are made:

• Accounts Receivable: $3,000,000

• Sales Revenue: $3,000,000

• Cost of Goods Sold: $1,800,000

• Inventory: $1,800,000

Shipping Terms

Shipping terms affect when revenue is recognized:

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

• FOB Destination: Ownership changes hands and revenue is recognized when goods are delivered to the customer.

Sales Returns and Allowances

Customers may return unsatisfactory or damaged goods. Companies estimate sales returns and allowances based on historical experience and record adjusting entries at period end.

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

Sales Discounts

Sales discounts are incentives for customers to pay early. For example, 2/10, n/30 means a 2% discount if paid within 10 days; otherwise, full payment is due in 30 days.

Types of Receivables

Receivables are monetary claims against others and are classified as current assets. They are acquired by selling goods and services (accounts receivable) or lending money (notes receivable).

Allowance for Uncollectible Accounts

Companies rarely collect all receivables. The allowance method estimates uncollectible accounts expense based on past experience. The allowance for uncollectible accounts is a contra account to accounts receivable.

• Shows the amount the business expects not to collect.

Estimating Uncollectibles: Percent-of-Sales and Aging-of-Receivables Methods

Two basic methods are used:

• Percent-of-Sales Method: Computes uncollectible-account expense as a percent of revenue (income statement approach).

• Aging-of-Receivables Method: Analyzes specific accounts based on how long they have been outstanding (balance sheet approach).

Writing Off Uncollectible Accounts

When a specific account is determined to be uncollectible, it is written off against the allowance for uncollectible accounts.

Direct Write-Off Method

This alternative method records expense when a specific customer's account proves to be uncollectible. It is less preferable and not in conformance with GAAP.

• No allowance for uncollectible accounts; may overstate assets.

• Fails to match expenses with related revenue.

Receivables Ratios

Key ratios for evaluating receivables:

• Quick (Acid-Test) Ratio: Measures liquidity.

• Accounts Receivable Turnover:

• Days' Sales Outstanding (DSO):

Inventory and Cost of Goods Sold

Inventory Accounting

Inventory is an asset on the balance sheet until sold, at which point its cost becomes an expense (cost of goods sold) on the income statement. Gross profit is the excess of sales revenue over cost of goods sold.

• Gross profit = Sales revenue - Cost of goods sold

Periodic vs. Perpetual Inventory Systems

• Perpetual Inventory System: Keeps a running record of all goods bought, sold, and on hand.

• Periodic Inventory System: Used for inexpensive goods; inventory counted at least once a year.

Inventory Costing Methods

Companies may use different methods to assign costs to inventory:

• Specific-Identification Method

• Average-Cost Method

• First-In, First-Out (FIFO) Method

• Last-In, First-Out (LIFO) Method

FIFO Method

FIFO assigns the first costs into inventory to cost of goods sold. The oldest costs are expensed first.

LIFO Method

LIFO assigns the last costs into inventory to cost of goods sold. The most recent costs are expensed first.

Income Effects of FIFO, LIFO, and Average-Cost Methods

The choice of inventory method affects cost of goods sold, gross profit, and tax liability. When costs are rising, LIFO results in lower taxable income and lower income taxes, increasing available cash.

Effects of Inventory Cost Trends

When inventory costs are decreasing:

• FIFO COGS is highest; gross profit is lowest.

• FIFO ending inventory is lowest.

• LIFO COGS is lowest; gross profit is highest.

• LIFO ending inventory is highest.

Tax Advantages of LIFO

When costs are rising, LIFO results in the lowest taxable income and lowest income taxes, increasing available cash. LIFO provides a more realistic net income figure, while FIFO provides more up-to-date inventory cost on the balance sheet.

LIFO Liquidation

LIFO liquidation occurs when a business draws down its inventory below previous levels, causing older, lower costs to be shifted into cost of goods sold.

GAAP Requirements for Inventory

U.S. GAAP requires proper disclosure, representational faithfulness, and consistency in inventory accounting. The lower-of-cost-or-market (LCM) rule requires inventory to be reported at the lower of historical cost or market value (net realizable value).

Inventory Turnover and Days Inventory Outstanding (DIO)

Inventory turnover measures how rapidly inventory is sold. Days inventory outstanding (DIO) indicates the average number of days inventory is held before sale.