Chapter+8+Notes+-+Internal+Control


 * __SO 1 - SO 2__**
 * Homework: SS1, SS2, SS3; BE8-2**
 * Highlights:**

Internal control consists of an organization's policies and procedures that attempt to (i) maximize the use of resources to reduce inefficiencies and waste (ii) detect and prevent accounting errors (honest mistakes) and irregularities (intentional misrepresentations or fraud) (iii) protect company assets from theft and unauthorized usage and finally (iv) maintain control systems to ensure accuracy and reliability of accounting documents.

In order to achieve the aforementioned objectives, specific **internal control principles** must be followed, including:

a. **authorization of transactions and activities, and establishment of responsibility**: transactions and activities must be authorized and performed by the appropriate individuals or departments - tasks should be delineated to individual employees so that blame may easily and properly be assigned in the event of irregularities

b. **segregation of duties**: the work of one employee should allow for the reliable assessment of the work of another employee while simultaneously avoiding duplication of tasks - firstly, related activities should always be assigned to separate individuals -> related activities most commonly arise in terms of purchases (ordering, receiving, paying) and sales (selling, shipping, billing) of goods - secondly, accountability for an asset and physical control over that same asset should never be assigned to a single individual, e.g., maintaining records of cash or inventory vs. physically maintaining cash or inventory

c. **documentation procedures**: properly-prepared source documents (e.g., invoices, cheques, shipping slips, cash register tapes, etc.) provide good evidence of business transactions and events - documents must be comprehensive (i.e., containing names of parties, dates, price, terms, etc.) and signed by the appropriate employee - all documents should be prenumbered to avoid duplication and loss - source documents should be promptly forwarded to accounting department for entry

d. **safeguarding assets and accounting records, and use of physical, mechanical and electronic controls**: physical controls (such as safety deposit boxes, secure warehouses and storage rooms and password-protected computer databases) and mechanical/electronic controls such as security alarms, surveillance cameras and retail anti-theft sensors are useful in maintaining access to and use of assets and accounting records - specific computer applications have been designed to limit errors, fraud and unauthorized usage and include passwords, personal questions, checks and balances, tamper-proof programs, etc.

e. **independent verification:** most internal control systems include independent internal or external verification of performance and records involving review and reconciliation of data - to maximize effectiveness of verification systems, verification should be performed periodically (or on surprise basis) by someone independent of employee under review and discrepancies should be immediately reported to senior management - internal verification allows comparison between accounting records and company assets, e.g., cash and cash register tape, cash balance per books vs cash balance per bank statement - in larger companies, internal auditors are employed to continuously evaluate effectiveness of company's internal control systems - in smaller companies who cannot afford internal auditors, segregation of duties is used to ensure internal control is maintained - external auditors are third-party accountants hired to report on accuracy and honesty of company's financial statements as well as to examine effectiveness of company's internal control procedures

f. **other controls including bonding of employees, rotating employees' duties, requiring staff to take vacations, daily deposits and stamping invoices**: employees who handle cash should be bonded (added to company's insurance policy) so as to insure against misappropriation (theft) of assets - employees should be rotated throughout different departments within company on regular basis and given regular vacation time so as to minimize opportunities to misappropriate assets


 * Limitations of effective internal control**: monetary and non-monetary costs of enforcing effective internal control procedures should never exceed expected monetary and non-monetary benefits; human factors may limit effective administration of internal control procedures (laziness, recklessness, indifference); employees may conspire/collude to avoid detection of internal control systems; size of business (large or small) may frustrate internal control efforts.


 * Cash controls** (or controls over cash receipts and cash payments/disbursements) are the most important set of internal control procedures within an organization given the importance and desirability of cash.


 * Cash,** as you will read in more detail below, includes **currency, deposits, cheques, money orders/bank drafts, credit cards, debit cards, and various forms of electronic transfers (online banking, pre-authorized payments, direct deposits, Interac e-Transfer, Interac Online, third-party money transfer agents such as PayPal, etc.)**


 * NSF (not sufficient funds) cheques** and **post-dated (payable in the future only) cheques** are not considered cash but rather receivables.


 * __SO 3 - SO 4: Internal control over cash receipts and cash payments/disbursements__**
 * Homework: SS4, SS5, SS6; BE8-3, BE8-4; E8-2, E8-3**
 * Highlights:**


 * (i) C****ash receipts** originate from a variety of sources: cash sales, receipts from debtor customers, receipts of rent, dividends and interest, owner investments, bank loans, and extraordinary sales of capital assets.

Internal controls over **cash receipts** include:

a. **authorization of transactions and activities, and establishment of responsibility**: only designated personnel may handle cash receipts, e.g. cashiers, bookkeepers b. **segregation of duties**: different individuals should receive, record and hold cash c**. documentation procedures**: employ remittance slips/advices, cash register tapes and deposit slips d. **safeguarding assets and accounting records, and use of physical, mechanical and electronic controls**: store cash in secure locations; limit access to storage areas and use cash registers e. **independent verification:** supervisors should double count daily cash receipts; bookkeeper should compare daily receipts to daily deposits f. **other controls:** bonding/insurance of employees who handle cash; rotating employees' duties; requiring staff to take vacations; daily cash deposits; stamping all sales invoices "PAID"


 * (ii) Cash payments/disbursements** are used to pay expenses and liabilities, and to purchase assets. Cash payments/disbursements are usually made by means of non-cash methods (cheque, credit card, electronic transfer, etc.) and only after internal control procedures have been followed.

Internal controls over **cash payments/disbursements** include:

a. **authorization of transactions and activities, and establishment of responsibility**: only authorized personnel may sign cheques b. **segregation of duties**: different individuals should approve and issue payments; cheque signers should not record disbursements c**. documentation procedures**: account for all prenumbered cheques; each cheque must be accompanied by approved invoice d. **safeguarding assets and accounting records, and use of physical, mechanical and electronic controls**: store blank cheques in secure locations; print cheque amounts by machine in indelible ink e. **independent verification:** compare cheques to associated invoice; reconcile bank statements monthly f. **other controls:** stamping all purchase invoices "PAID"

Both **cash receipts** and **cash payments/disbursements** are considered **payment systems**.

**Cash** **receipts** refer to incoming payments while **cash payments/disbursements** refer to outgoing payments.

**Cash,** in this broad sense of the word, includes **currency, deposits, cheques, money orders/bank drafts, credit cards, debit cards, and various forms of electronic transfers (online banking, pre-authorized payments, direct deposits, Interac e-Transfer, Interac Online, third-party money transfer agents such as PayPal, etc.)**


 * Currency ** refers to paper bills and coins, which are the only form of payment required by law to be accepted by vendors in Canada ( ** legal tender ** ).

**Deposits** include any monies held in a chartered/licensed financial institution (i.e., bank, credit union, etc.) for the benefit of the depositor, e.g., savings accounts, chequing accounts, etc.

Once received, a ** cheque ** may either be cashed (immediately exchanged for currency) or deposited (transferred into one's bank account) by the ** payee ** (cheque recipient) at the payee's bank, unless it is determined to be an ** NSF (non-sufficient funds) cheque, ** in which case we say the cheque has "bounced." Accordingly a ** certified cheque, ** wherein the requisite funds are set aside by the ** payor's ** (cheque writer's) bank, is the preferred method when paying by cheque.

A ** money order ** or ** bank draft ** may be used by those who lack a chequing account and is similar to a cheque except for the fact that the payment represented by the money order is immediately set aside by the payor's bank, not unlike a certified cheque.


 * Credit card ** transactions involve the ** card holder ** (you), the ** vendor/merchant/retailer ** (e.g., The Gap) and ** card issuers ** such as American Express, chartered banks (Visa and MasterCard) and department stores (WalMart).


 * Debit cards **, allowing instant transfers of funds from purchaser to vendor, are made possible via ** point of sale terminals ** and the Interac network.

Finally, **electronic transfers** refer to credit card bill payments and payments to other designated payees via online banking, monthly mortgage installments and utility bill payments via pre-authorized payments, weekly paycheques via direct deposits, rent payments or other money transfers via Interac e-Transfer using the recipient's email address, and online purchase payments involving participating online retailers via Interac Online or third-party money transfer agents such as PayPal.


 * Cash receipts ** (cheques, money orders, credit card slips, debit card transfers, bills and coins) may be taken in via ** mail receipts ** from debtor customers or ** over-the-counter sales ** (cash register receipts).

Vendors/merchants/retailers that accept payment by way of ** debit ** and ** credit cards ** from customers must pay a small fee (approximately 12 cents per debit card transaction or 1.5% to 4% of the sale price per credit card transaction) to the issuers of those cards in recognition of the increased sales such options invariably promote:

........................................ ** Sales - cr - 100 **
 * Bank - dr - 98 **
 * Debit/Credit Card Expense - dr - 2 **
 * To record credit card sale with 2% merchant transaction fee **


 * __SO 5 - Accounting for cash payments using petty cash fund and Cash Short or Over account__ **
 * Homework: SS7; BE8-5; E8-5**
 * Highlights:** M any businesses use a ** Petty Cash fund ** (usually consisting of a locked box containing approximately $100 in small bills and coins) to pay for inexpensive items such as coffee, stamps and delivery charges.

Three types of journal entries are used with this system:

(1) for ** establishing ** the fund

......... ** Bank - cr - 100 **
 * Petty Cash - dr - 100 **

(2) for ** replenishing ** the fund

...................................... ** Bank - cr - 96 **
 * Delivery Expense - dr - 30 **
 * Postage Expense - dr - 40 **
 * Miscellaneous Expense - dr - 26 **

(3) and occasionally for even ** increasing ** the fund

......................... ** Bank - cr - 50 **
 * Petty Cash - dr - 50 **

Petty Cash is an __asset__ account (and not an expense account) as it is only used __once__ when the fund is first created, unless the fund is subsequently increased (see above).

A __voucher__, usually attached to a __receipt__, is placed in the petty cash box each time funds are drawn to pay for small expenditures.

Accordingly, at any given time, the total of cash and vouchers in the box should equal the predetermined balance of the fund, e.g., $100.

Note that expenses (e.g., Delivery Expense) are only recorded when the petty cash fund is finally __replenished__.

Essentially the act of replenishment serves not one but rather two purposes: (1) to return the cash level inside the petty cash box to its predetermined balance (e.g., $100) and (2) to simultaneously allow for the recording of the vouchers/receipts inside the box as expenses of the business.

Any discrepancy between the total of cash and vouchers in the box and the predetermined fund balance is reconciled using the **Cash Short or Over** account in the journal entry to __replenish__ the petty cash fund.

A debit balance (shortage) in Cash Short or Over is treated as an expense while a credit balance (overage) is treated as revenue:

**Postage Expense - dr - 50** **Delivery Expense - dr - 45** ............................. **Bank - cr - 93** ............................. **Cash Short or Over - cr - 2**
 * To replenish petty cash with overage (assuming $7 remaining in petty cash fund prior to replenishment and receipts totalling $95) **


 * __SO 6 and SO 7 - Banking and b__**** __ank reconciliation statements__ **
 * Homework: SS8, SS9, SS10; E8-7, E8-9**
 * Highlights:** The use of a bank promotes good internal control over cash. Companies can protect cash by using banks as depositories and as clearing houses for cheques written and received. Use of banks minimizes the need for cash on hand. Banks act as secondary record of all banking transactions.

Daily bank deposits of cash, cheques and credit card slips are made to special low-cost business bank accounts known as ** current accounts, ** which pay no interest but offer free duplicate deposit slips (and sometimes prenumbered company cheques) and the return of all paid (cancelled) cheques to the account holder along with the monthly bank statement. Signature cards contain the signatures of all authorized representatives of the depositor

Regular bank deposits can only be made by authorized personnel and must be documented by stamped deposit slips prepared in duplicate.

A cheque is a written order by the maker/drawer of the cheque to its bank to make payment to the payee/recipient of said cheque upon presentation. Modern electronic fund transfers between parties to transactions reduce inefficiencies and the need for paper documentation like cheques.

Monthly bank statements are delivered by banks to their depositors indicating all credit inflows (receipts and deposits) and debit outflows (payments/disbursements) of funds within the bank account for the period. Bank statements also contain debit and credit memoranda (DM and CM) indicating actions carried out by the bank itself with respect to the account, e.g., bank service charges, NSF cheques, interest earned or paid, etc. Monthly bank statements should also be reconciled against the depositor's own records to account for any month-ending discrepancies.

Company bank accounts should be reconciled monthly via a ** Bank Reconciliation Statement **. In this way, a company’s actual bank account figure (balance per monthly bank statement) is compared to the company’s general ledger Bank account figure (balance per books) at the end of each month so that any discrepancies may be accounted for in terms of outstanding cheques, late deposits, bank service charges and interest payments, NSF cheques, note collections, interest earned and/or bookkeeping errors.


 * Click below for a comprehensive description and illustration of a monthly bank reconciliation statement with exercise: **




 * [|Details]
 * [[file:goldkindgrade11accounting/ch 10 bank reconciliation and exercise.doc|Download]]
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 * __SO 8 - Reporting cash__**
 * Homework: SS11; BE8-12**
 * Highlights:** Cash on hand, bank accounts and petty cash are typically reported as **Cash** - a current asset listed first on the balance sheet. Cash is often combined with **cash equivalents** into a single account. Cash equivalents refer to short-term investments with maturities of less than three months such as Treasury bills, money market funds and short-term notes receivable.

A **bank overdraft** occurs when a company issues a payment (cheque, e-transfer) for an amount greater than the current balance in its bank account. As long as the company has adequate **overdraft protection** with the bank, the full amount of the payment will be covered by the bank. In the meantime, this __credit__ balance in the company Bank account is reported as a current liability on the balance sheet.


 * Restricted cash funds** - cash set aside for future expansion projects - should be reported separately from Cash and cash equivalents on the balance sheet. Another common example of a restricted cash fund is a **compensating balance** whereby borrowers of monies from financial institutions are required to maintain minimum bank balances in order to support outstanding loans.


 * __Review of specific internal control procedures from grade 11 notes__ **
 * Internal control ** refers to those elements of an accounting system that promote honesty, accuracy and efficiency among employees and management.

Proper internal control procedures protect company assets from theft and waste, ensure accurate accounting data, encourage efficiency and promote adherence to company policies.

Examples of such procedures include: multiple yet independent preparation of accounting records, divided control over physical assets and record keeping pertaining to such assets, daily deposits of cash receipts, deposit slips prepared in duplicate, cheques deposited featuring restrictive endorsement “For Deposit Only”, payment by cheque or debit/credit card or electronic transfer only, independent audits of accounting records, and clearly defined and segregated employee responsibilities.


 * Below you will find a comprehensive listing of proper internal control procedures with exercise: **

** INTERNAL CONTROL PROCEDURES ** An accounting system that ensures honesty, accuracy and efficiency amongst management and employees is considered to promote good internal control.

Internal control is the set of accounting procedures designed to protect the company’s assets from misappropriation and waste, to ensure accurate accounting data, and to encourage adherence to company policies.

The more workers a company employs, the more important a good system of internal control becomes.


 * __General Rules of Internal Control__ **

1. Wherever possible, __ two __ different employees should be responsible for preparing accounting records independently of one another, and hopefully, after comparison, their work should agree.

2. An employee who has physical control over the firm’s tangible assets should __ not __ also be responsible for recording transactions in relation to those same assets.

3. All company assets (e.g., cash, computers) should be stored in a safe place after hours.

4. __ Two __ authorized employees should always be present when negotiable instruments (e.g., cheques, promissory notes) or contracts are dealt with.

5. Only a __ few __ __ key __ employees should be authorized to approve transactions such as purchase orders and sales invoices.

6. Only an __ independent __ public accountant should carry out regular audits of the company’s books.

7. Employee responsibilities should be clearly defined and segregated so as to ensure accountability.


 * __Specific Internal Control Procedures for Cash__ **

8. An employee who handles cash should not also be responsible for keeping the records for cash. For example, the employee who opens the mail in order to organize the cheques received from debtor customers should not be the same employee who prepares the cash receipt daily summary.

9. All cash and cash receipts (cheques, credit card slips) should be deposited __ daily __ so as to minimize the amount of cash on hand.

10. Other than petty cash and cash refunds, all payments should be made by cheque or debit/credit card or electronic transfer of funds, and not by cash, so as to ensure that a paper trail (i.e., evidence) is generated.

11. Cheques received from debtor customers should immediately be restrictively endorsed “For Deposit Only” so as to reduce the risk of being cashed improperly.

12. Daily bank deposit slips should be prepared in duplicate and a stamped copy of the slip (i.e., stamped by the bank teller) should be retained by the company as evidence of the deposit.

13. The company’s Cash/Bank account (in the ledger) and bank account (as evidenced in the monthly bank statement) should be reconciled __ monthly __ via the preparation of a Bank Reconciliation Statement, so as to take account of the company’s outstanding cheques and late deposits, in addition to bank debit memos, customer NSF cheques and accounting errors.

** INTERNAL CONTROL EXERCISE ** The following scenarios describe the routine conduct of the management and staff at ** Goldkind & Hughes LLP, Chartered Professional Accountants **. For each of the following, indicate which rule of internal control is being violated.

1. The clerk responsible for the firm’s daily cash deposits routinely discards the duplicate deposit slip stamped by the teller.

2. Every night dozens of company laptops are left in plain view within the office.

3. Every June a CPA employed by Goldkind & Hughes prepares an audit of the company’s books.

4. At least eight individual office assistants have authority to order office supplies on behalf of the firm.

5. Purchases of office supplies by the firm are routinely made with cash.

6. Cheques received from the firm’s debtor customers are routinely cashed by Brian Goldkind, one of the firm’s founding partners.

7. The firm’s cash and cash receipts are typically deposited at the end of every week.

8. Every morning the mail receipts are opened and then recorded by the firm’s Senior Office Manager.

9. Each of the company’s three Junior Office Managers has been assigned responsibility for carrying out daily inspections of the firm’s client contact records.

10. A bank reconciliation statement is only prepared at the company’s fiscal year end every June.

11. The firm’s CFO recently executed (signed) a $1 million promissory note with the bank on behalf of the company.

12. Every Thursday a single accounting clerk oversees the preparation of the firm’s weekly payroll.

13. The employee in charge of allocating office supplies to the company’s various departments is also responsible for preparing receiving reports of those same items.