07 Internal Control and Cash PDF

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Self Study guide to basics of accounting with examples...

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7. Internal Control and Cash

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7. Internal Control and Cash The reference for this topic is chapter 8 of your text. In the previous topic the concept of control was introduced. In this topic this concept will be explored further by looking at the following: 7.1 The Internal Control System. 7.2 Characteristics of an Effective System of Internal Control. 7.3 Application of Internal Controls a. b. c. d. e. f. g.

Bank Reconciliations Cash Receipts Cash Disbursements Inventory Petty Cash Voucher System Electronic Funds Transfer

7.4 Self-test questions i. Matching ii. Multiple choice iii. Completion statements iv. Exercises Self-test solutions i. Matching ii. Multiple choice iii. Completion statements iv. Exercises 7.5 Problems and solutions. 7.6 Spreadsheet examples

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7.1 The internal control system Internal control is the system of methods and procedures put in place by management to:    

safeguard the assets of the business; ensure accurate and reliable accounting records; promote operational efficiency; encourage adherence to company records.

Two types of controls make up internal control: 1.

Administrative Controls whose purpose is to eliminate waste by promoting operational efficiency. These controls include the plan of the organisation and methods and procedures designed to promote efficiency.

2.

Accounting Controls, whose purpose is to safeguard assets, authorise transactions and ensure accuracy of the financial records.

In Australia the need to maintain an adequate system of internal control is required by the common law (see Pacific Acceptance v Forsyth [1970] WN (NSW) 29; Simonius Vischer & Co v Holt & Thompson [1979] NSW LR 322; and, AWA Ltd v Daniels t/a Deloitte Hoskins & Sells & Ors [1992] 10 ACLR 933), the Corporations Law and the professional accounting and auditing standards of the Institute of Chartered Accountants in Australia and CPA, Australia.

7.2 Characteristics of an effective system of internal control The essential characteristics of an effective system of internal control are listed below. 1.

Competent and Reliable Personnel This is achieved by employing qualified employees at appropriate salaries. Ensuring that employees continue their training by adequate supervision, rotation of duties and courses also leads to competent staff. Rotation also helps promote reliability.

2.

Assignment of Responsibilities All procedures and duties of significance should be clearly defined and assigned to individuals who bear the responsibility for carrying them out.

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This is achieved by the use of an organisation chart and duty statement for each position in the organisation. 3.

Proper Authorisation Having laid down the procedures of the firm and the duties of each position, deviations from these require proper authorisation. Those positions that are authorised to permit deviations should be clearly identified in the procedures manual of the firm and set out in the duty statement for the position.

4.

Separation of Duties To minimise the opportunity for fraud and promote accuracy of accounting records, some responsibilities should not be carried out by the same person. The duties/responsibilities that should be separated include: operations from accounting; custody of assets from accounting for the same assets; authorisation of transactions from custody of related assets; various phases of accounting function (e.g. responsibility for the cash receipts journal and cash payments journal).

5.

Internal Audit The examination of the accounting system and procedures to ensure the internal controls are adequate and operating.

6.

Documents and Records The use of well-designed records and documents enhance efficiency. Fraud and theft can be discouraged by the use of prenumbered documents, e.g. cash receipts.

While the above characteristics enhance internal control and promote its objectives, it must be noted that most internal control objectives can be overcome (egg by collusion). Total control by a tight system may itself be undesirable because of its cost and complexity.

7.3 Application of internal controls Cash (which for accounting purposes includes paper money, coins, cheques, money orders and money kept in bank accounts) is the most tempting asset for theft and internal controls for it are usually the tightest. For this reason cash is an appropriate item to consider when looking at the application of internal control. The use of a bank account is part of internal control because: (i) it separates the physical possession of cash and responsibility for it, and (ii) banks have established procedures for safeguarding assets. These procedures include the 4

use of documents such as signature cards, deposit slips, cheques and bank statements to control the account. 1.

Bank Reconciliation. This is a strong control procedure. The business’s own record of its cash holdings should be matched with the bank statement. Variances need to be explained (egg deposits in transit, outstanding cheques, bank collections, service charges, interest, other bank charges, etc.). Students should carefully read the techniques of preparing a Bank Reconciliation and the illustrative examples in their textbooks. It is essential that you understand the elements of a bank reconciliation and the journal entries necessary to correct any error in the cash account balance.

2.

Cash Receipts. Internal control over cash receipts should ensure that all cash received is recorded and deposited in the bank. The internal controls that ensure this are part of receipt controls and the division of duties. At the point of receipt the use of a cash register that displays the amounts entered, issues a receipt, and opens the cash drawer only when an amount is entered and records all transactions on a roll that is not accessible to the cashier - but accessible by accounting staff - is an example of effective internal control. The division of duties between the cashier’s physical possession of cash until it is deposited in the bank and the separate recording function of the totals shown on cash register rolls likewise strengthen internal control. Cash or cheques received in the mail likewise need to be subject to internal control processes at the point of receipt and by the division of duties. The mail room procedure should be that mail is opened when two employees are present and a record made of payments (cheques) received. The remittance advices should be sent to accounting for posting, cash and cheques sent to the cashier for deposit. A daily comparison should be made of mail room, cashier and accounting records of payments received.

3.

Cash Disbursements. The use of cheques to pay accounts promotes control over cash disbursements. Good internal control requires the need for two authorised signatories on each cheque and specifying in the duty statement of each signatory that they must sight supporting documentation (invoice, receiving report, purchase order).

4.

Inventories. Usually purchases of inventories or raw materials comprise a major cost of the business. To ensure control over amounts paid, if these purchases are made on the basis of a discount being offered if payment is 5

made within a specified time, then such purchases should be recorded at the amount calculated after all cash discounts are deducted. If payment is not made within the required time to take advantage of the discount, the discount lost will be recorded by a debit in the Purchase Discount Lost account. Control is exercised because the increase in disbursements of cash due to not making payment promptly is highlighted by the separate record of the discount lost. 5.

Petty Cash. Businesses incur minor expenses that would be uneconomic to pay for other than in cash. While the amount involved with each item is small their number over a period may be substantial so that control procedures are desirable to ensure proper application of funds. Control is achieved by: designating one employee responsible to administer the fund and have control of the cash; designating a second employee authority and responsibility to approve disbursements (optional); specify what costs may be met from the petty cash fund; keep a specific amount of cash in the fund (the float); support all fund disbursements with a petty cash ticket approved by the second employee; replenish the fund as necessary through normal cash disbursements. Once the fund is established, the balance for the petty cash account is constant. Disbursements are charged directly to the item concerned when the fund is replenished.

6.

Voucher System. Many businesses use a voucher system for recording cash payments. The voucher system is used in place of the purchases journal and the cash disbursements journal. A voucher system uses: (i) vouchers, (ii) a voucher register, (iii) an unpaid voucher file, (iv) a cheque register, and (v) a paid voucher file. Vouchers are prepared by the accounting department. They are matched with invoices from suppliers and receiving reports from the receiving department, checked for accuracy, and forwarded to a designated party for approval. Approved vouchers are recorded in the voucher register and placed in the unpaid voucher file. Cheques are prepared when vouchers are due. The cheques are recorded in the cheque register. Paid vouchers are cancelled to prevent duplicate payments, and are then filed in the paid voucher file.

7.

Electronic Funds Transfer. The loss of a document trail (also referred to as the audit trail) combined with on-line real time speed presents challenges to the design of an effective internal control system. Control procedures include restricted access to terminals (by the use of terminal locks, authorisation controls, and passwords), input logs and daily 6

dumping of input. This is a topic to which students will return to near the end of their degree when they study the auditing subject.

Examine the examples in chapter 8 of your text and the problems and solutions later in this topic.

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7.4 Self-test questions Using the information contained in the chapter and in this Study Guide, attempt the following questions:

i.

Matching

You are required to match the numbered term with the letter of the most appropriate description. ____ 2. ____ 3. ____ 4. ____ 5. ____ 6. ____ 7. ____ 8. ____ 9. ____ 10. ____ 1.

Proper Authorisation Petty Cash Bank Statements Accounting Controls Outstanding Cheques Electronic Fund Transfer Cheque Receiving Report Voucher System Cheque Register

A.

Is a system that relies on electronic impulses to account for cash transactions.

B.

As goods arrive at a business, the receiving department checks them for any damage and lists the goods received on this report.

C.

The journal used in a voucher system in which all cheques issued are recorded.

D.

These have been issued by the business and have been recorded in its books but are as yet unpaid by the bank.

E.

Includes the methods and procedures that safeguard assets, authorise transactions, and ensure the accuracy of financial records.

F.

Small amounts of cash kept on hand to pay for minor expenses such as taxi fares.

G.

Consists of a written set of rules that outline approved procedures.

H.

Are sent monthly to show an account’s beginning and ending balance and the month’s transactions. 8

I.

The document that instructs the bank to pay a designated person or business a specific sum of money.

J.

Offers the business greater internal control by formalising the process of approving and recording invoices for payment.

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ii.

Multiple choice

For each of the following questions, identify the correct alternative. 1.

Common items that cause differences between the bank balance and the business’ own records of the bank balance do not include: A. B. C. D. E.

2.

The effective separation of duties that enhance internal control are separation of: A. B. C. D. E.

3.

Duties within the accounting function Operations from accounting Custody of assets from accounting Authorisation of transactions from custody of related assets All of the above

The bank reconciliation does not affect journals and ledgers. A. B. C. D. E.

4.

Outstanding cheques Service charges Interest paid on cheque account Bank charges None of the above

True False Only if the bank statement does not reveal transactions not yet recorded in the books of the business B and C A and C

A characteristic of effective internal control is not: A. B. C. D. E.

Assignment of responsibilities Internal and external audits Bank reconciliations Adequate documents and records None of the above

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5.

Internal control is the organisational plan and all related measures adopted by an entity to: A. B. C. D. E.

Safeguard assets Ensure accurate and reliable accounting records Promote operational efficiency Encourage adherence to company policy All of the above

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iii.

Completion statements

Complete each of the following statements with the most appropriate word or words. 1.

The unpaid voucher file acts as the accounts payable subsidiary ledger because

2.

An example of the separation of the authorisation of transactions from custody of related assets is

3.

Administrative controls include

4.

5.

Cash registers are a control because

Documents and records are important to internal control if

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iv.

Exercises

The following exercise is from Williams, J. F. Introduction to Accounting. CSU Wagga Wagga. 1.

The bank account of B. O’Rourke had a debit balance in the Cash at Bank Account of $600 on 1 January 20X1. The cash transactions for the month of January 20X1 were as follows: Extract from Cash Receipts Journal Date

Particulars

Bank $

20X1 2 Jan 4 8 11 15 17 21 23 29 31

Accounts Receivable Cash Sales Accounts Receivable Accounts Receivable Accounts Receivable Cash Sales Cash Sales Cash Sales Accounts Receivable Accounts Receivable

50 90 110 250 80 160 100 50 240 130 1,260

Extract from Cash Payments Journal Date

Chq No.

Particulars

Bank $

1 Jan 2 3 5 8 20 23 24 29 31

1051 1052 1053 1054 1055 1056 1057 1058 1059 1060

Accounts Receivable Rent Wages Accounts Payable Light and Power Wages Accounts Payable Advertising Accounts Payable Wages

165 80 95 300 50 95 230 40 130 95 1,280

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The bank statement for January was: B. O’Rourke Statement of Accounts with Bank of Australia Date

Debit $

1 Jan 2 3 4 6 8 10 11 15 16 17 20 21 23 23 28 29 31

Balance Deposit Cheque 1051 Deposit Cheque 1052 Deposit Cheque 1053 Deposit Deposit Cheque 1055 Deposit Bank Fee Deposit Cheque 1056 Deposit Cheque 1058 Deposit Cheque Book FID and FDT Direct Deposit Cheque Returned TDI

Credit $ 50

165 90 80 110 95 250 80 50 160 6 100 95 50 40 240 30 6 300 50 400

Balance $ 600 CR 650 CR 485 CR 575 CR 495 CR 605 CR 510 CR 760 CR 840 CR 790 CR 950 CR 944 CR 1,044 CR 949 CR 999 CR 959 CR 1,199 CR 1,169 CR 1,163 CR 1,463 CR 1,413 CR 1,813 CR

Key to abbreviations used: FID - State Duty on Credits FDT - Federal Government Tax on Debits TDI - Term Deposit Interest

Required a. b.

Prepare the Cash at Bank Ledger Account. Prepare a bank reconciliation statement as at January 31, 20X1. 14

2.

Jackson Enterprises is a small profitable business which does not have a strong system of internal control, in the belief that the cost of elaborate internal control procedures cannot be justified. Hence, Jackie Adams has been given the duties of handling all cash receipts, recording the cash receipts, and preparing the monthly bank reconciliation statement. The bank balance as per the bank statement was $25,600 (Cr) on 30 April 19X1. A check of the bank statement for the month of April with the cash journals revealed that the bank had collected $300 from an account receivable which had not been recorded in the journals, and the following cheques had not been presented. Cheque No

152 273 294 327 329 330

$298 325 380 286 340 248

In addition, the most recent deposit had not been recorded by the bank. The firm’s Cash at Bank account (before including any adjustments resulting from the information above) was $30,119 Debit. Of all the cash yet to be deposited, Adams has taken for her personal use all but $5,693, and this figure was reflected in the cash journal and the Cash at Bank account together with the amount misappropriated. She has prepared the following bank reconciliation statement at 30 April 20X1. Bank Reconciliation Statement as at 30 April 20X1 Balance as per bank statement Add: Deposit not credited Less: Unpresented cheques:

$25,600 Cr 5,693 31,293 No.

Balance as per Cash at Bank account

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327 329 330

$286 340 248 874 $30,419

Cr

Required a.

J Adams attempted to cover up the misappropriation of $1,003 in a number of ways. What were they?

b.

Prepare the bank reconciliation statement as it should appear.

c.

What basic principle(s) of internal control was violated in this case?

Source:

Hoggett, J., & Edwards, L. Financial Accounting in Australia (2nd ed.). John Wiley & Sons. Problem A7.6

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Self-test solutions i.

Matching 1 G; 2 F; 3 H; 4 E; 5 D; 6 A; 7 I; 8 B; 9 J; 10 C.

ii.

Multiple-choice 1. 2. 3. 4. 5.

iii.

E E C E E

Completion statements

1.

each voucher serves as an individual account payable.

2.

the same individual should not authorise the payment of a suppliers and also sign the cheque to pay the bill.

3.

the plan of organisation, the methods, and the procedures that help managers achieve operational efficiency and adherence to company policies.

4.

they ensure that customers only pay what the cashier enters into the register, produce a receipt, record transactions and safeguard cash.

5.

they are prenumbered so that a gap in the numbered sequence calls attention to a missing document.

iv.

Exercises

1.

a. Cash at Bank Dr 1/1 31/1 31/1

Balance Cash Receipts Jnl Cash Payments Jnl

Cr

1910 1,322

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Bal 600 DR 2,510 DR 1,188 DR

b. B. O’Rourke Bank Reconciliation Statement as at 31 January 20X1 $ Balance as per Bank Statement Add: Outstanding Deposits

1,813

CR

130 1,943

Less: Unpresented Cheques Cheque No 1054 1057 1059 1060 Balance as per Cash at Bank Account

$ 300 230 130 95

755 1,188

DR

2. Jackson Enterprises a.

Full receipts not deposited of $6,696 were rec...