Financial Accounting:

Tools for Business Decision Making, 2nd Ed.

Kimmel, Weygandt, Kieso

Chapter 7

Chapter 7 Internal Control and Cash

After studying Chapter 7, you should be able to:
Identify the principles of internal control. Explain the application of internal control to cash receipts. Explain the application of internal control to cash disbursements. Prepare a bank reconciliation.

Chapter 7 Internal Control and Cash

After studying Chapter 7, you should be able to:
Explain the reporting of cash. Discuss the basic principles of cash management. Identify the primary elements of a cash budget. Identify and interpret measures that evaluate the adequacy of cash.

Internal Control consists of...

all the related methods and measures adopted within a business to:
safeguard its assets; enhance accuracy and reliability of accounting of its accounting records.

Illustration 7-1

Establishment of Responsibility
Control is most effective when only one person is responsible for a given task.

Segregation of Duties
Responsibility for related activities should be assigned to different individuals Responsibility for keeping records for an asset should be separate from the physical custody of the asset

Accountability for Assets

Documentation
Provide evidence that transactions and events occurred:
Shipping documents Sales invoices

Documentation Procedures
Documents should be pre-numbered All documents should be accounted for Sources documents should be promptly forwarded to accounting department

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Illustration 7-3

Physical, Mechanical and Electronic Controls

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Independent Internal Verification

Involves review, comparison, and reconciliation of data prepared by employees
Verification should be made periodically or on surprise basis Verification should be done by employee who is independent of the personnel responsible for the information Discrepancies and exceptions should be reported to management 12

Independent Internal Verification

Illustration 7-4

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Other Controls
Bonding of employees who handle cash Rotating employees duties and requiring employees to take vacations
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Limitations of Internal Controls

Cost/Benefit - cost of establishing procedure should not exceed expected benefit Human element - fatigue, carelessness, indifference Collusion - two or more individuals who work together to get around controls Size of business
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Cash consists of...

coins currency checks money orders money on hand deposits in bank
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Cash is the most desirable asset...

because it is readily convertible into any other asset.

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Internal Control

Illustration 297 Page 7-5 in book

Over Cash Receipts

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Illustration 7-6

Internal Control Over Cash Disbursements

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Electronic Funds Transfer (EFT)

An approach to transfer funds among parties without paper (deposit tickets, checks, etc.) EFT uses wire, telephone,telegraph or computer to transfer from one location to another

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Petty Cash Fund

is a cash fund used to pay relatively small amounts

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Use of a Bank...
is good internal control. minimizes the amount of cash that must be kept on hand. provides a double record of all bank transactions
one by the business one by the bank

helps a company safeguard its cash by using a bank as a depository and clearinghouse for checks received and written.
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Bank Statement a copy of the banks records sent to the customer for periodic review. Bank Statement shows check & other debits deposits & other credits daily cash balance

Illustration7-7

Apri l 30, 2001

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Company Balance and Bank Balance of Cash Usually Differ Because...

Time lags that prevent one of the parties from recording the transaction in the same period. Days pass between the time a check is written and dated and 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.
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Reconciliation Procedure
reconcile balance per books and balance per bank to their adjusted or correct balances the reconciliation should be prepared by an employee who has no other responsibilities pertaining to cash

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Terms
Deposits in transit - deposits recorded by the depositor that have not been recorded by the bank. Outstanding Checks - checks issued and recorded by the company that have not been paid by the bank. NSF Check - a check that is not paid by the bank because of insufficient funds in the customers bank account. Adjusted balance - same as true cash balance, 26 correct cash balance

Bank Reconciliation Procedures $ Per Bank Statement -outstanding checks +deposits +/- bank errors correct cash amount

Illustration 7-8

$ Per Books -NSF Checks -check printing or other service charge +notes collected by bank correct cash amount

W.A. Laird Company

Bank Reconciliation April 30, 2001 Cash balance per bank statement Add: Deposits in transit Less: Outstanding checks No. 453 No. 457 No. 460 Adjusted cash balance per bank Cash balance per books Add: Collection of N/R for $ 1000 plus interest earned $50, less collection fee $ 15 Error on recording check No. 443

Illustration 7-9

15,907.45 2,201.40 18,108.85 3,000.00 1,401.30 1,502.70

5,904.00 12,204.85 11,589.45

1,035.00 36.00

1,071.00 12,660.45

Less: NSF check Bank service charge Adjusted cash balance per bank

425.60 30.00

455.60 12,204.85

For Cash To Show the Correct Balance

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

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W.A. Laird Company

Bank Reconciliation April 30, 2001 Cash balance per bank statement Add: Deposits in transit Less: Outstanding checks No. 453 No. 457 No. 460 Adjusted cash balance per bank Cash balance per books Add: Collection of N/R for $ 1000 plus interest earned $50, less collection fee $ 15 Error on recording check No. 443

Illustration 7-9

15,907.45 2,201.40 18,108.85 3,000.00 1,401.30 1,502.70

5,904.00 12,204.85 11,589.45

1,035.00 36.00

1,071.00 12,660.45

Less: NSF check Bank service charge Adjusted cash balance per bank

425.60 30.00

455.60 12,204.85

JOURNAL
Apr 30 Cash 1,035.00 Miscellaneous Expense 15.00 Notes Receivable 1,000.00 Interest Revenue 50.00 Apr 30 Cash 36.00 Accounts Payable 36.00 Apr 30 Accounts Receivable-Baron 425.60 Cash 425.60 Apr 30 Miscellaneous Expense 30.00 Cash 30.00

Reporting 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.
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Cash Equivalents
Readily convertible to known amount of cash So near maturity that market value is relatively insensitive to changes in interest rates Examples:
Treasury bills Commercial paper Money Market Funds

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Restricted Cash...
Is cash that is not available for general use. Is set aside for special purpose. If not to be used within next year, report as noncurrent asset.

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Illustration 7-12

Operating Cycle of a Merchandising Companyis the average time it takes to go from cash to cash in producing revenues.

Illustration 7-13

Five Principles of Cash Management

Reporting Cash
Cash on hand, cash in banks, and petty cash are often combined and reported as cash. Cash is the most liquid asset and listed first in the current asset section of the balance sheet.

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Cash Budget
Cash is vital. Planning the company's cash needs is a key business activity. Cash budget shows the anticipated cash flows, over a 1 to 21-year period.
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Cash Budget
The cash budget contains : Cash receipts section; Cash disbursements section; Financing section.

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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 also shows anticipated receipts of interest and dividends, and proceeds from planned sales of investments, plant assets, and the company's capital stock 40

Cash Disbursements Section

shows expected payments for direct materials, direct labor, manufacturing overhead, and selling and administrative expenses. includes projected payments for income taxes, dividends, investments, and plant assets.
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Financing Section shows...

expected borrowings the repayment of the borrowings and interest

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Two Tools to Measure the Adequacy of Cash

cash to daily cash expenses ratio; free cash flow.

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Cash to Daily Cash Expenses Ratio

Computes the number of days of cash expenses that cash on hand can cover Average daily cash expenses can be approximated by subtracting depreciation (a noncash expense) from total expenses and dividing by 365 days

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Cash to Daily Cash Expenses Ratio

Illustration 7-16

Cash and cash equivalent Average daily cash expenses

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Free Cash Flow

Free cash flow is the amount of discretionary cash flow a company has for: purchasing additional investments reducing its debt adding to its liquidity
Illustration 7-17

Net cash provided by operations Less: Capital expenditures Cash Dividends Free Cash Flow $80,000 50,000

$250,000 130,000 $120,000

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