Lecture #7: Internal Control and Accounting for Cash
Cash can be converted into other types of assets or used to buy services more easily than any other type of asset. So cash is the most liquid asset. Because of this high degree of liquidity, cash is the most likely object that is stolen. These internal control procedures apply to all assets owned by a business, but especially important with respect to cash.
In a small business, the owner can control the entire operation and personal supervision of the business.
F The manager of a small business can effectively control his business. As the business increases in size, he has more difficulty in controlling his business. Therefore, he has to rely on an internal control system. This internal control system encourages adherence to managerial policies.
1. Clearly Establish Responsibilities.
In order to have good internal control, you must have one person made responsible for each task. If something goes wrong, then you can determine whose fault it is.
2. Maintain Adequate Records.
To protect assets and assure that employees follow the correct procedures, good record-keeping is required. Reliable records are also a source of information that managers use to monitor the operation of a business.
3. Separate Record-Keeping and Custody Over Assets.
A fundamental principle of internal control requires that the person who is responsible for an asset should not maintain the accounting records for that asset.
4. Divide Responsibility for Related Transactions.
Responsibility for a series of related transactions should be divided between individuals, so the work of one person acts as a check on another person.
5. Use Mechanical Devices Whenever Practicable.
6. Perform Regular and Independent Reviews.
Even if an internal control system is well designed, there is a tendency for it to deteriorate over time. Changes in personnel and shortcuts in procedures can cause the internal control system to deteriorate.
To solve this problem, internal auditors who are not directly involved in the operations must review the control procedures and make changes to improve the system. Also independent CPAs can also advise the business about its internal control system.
Computers and Internal Control
Computers provide more rapid access to large quantities of information. As a result, management’s ability to monitor and control business operations is greatly improved.
1. Computers reduce processing errors.
After the data is correctly entered, the human tendency to make mechanical and mathematical errors is largely eliminated. Also the lack of human involvement in later processing may cause data entry errors to go undiscovered.
2. Computers allow more extensive testing of records.
The regular review and audit of records can include more extensive testing if a computerized system is used. Complete files can be reviewed and analyzed.
3. Computerized systems may limit evidence of processing steps.
Because many data processing steps are performed by the computer, you have less evidence in written form. Therefore internal control may depend more on reviews of the design and operation of the computer system.
4. Separation of duties must be maintained
Companies that use computers must have employees with special skills to program and operate the computers. These employees must be carefully controlled to avoid the risk of fraud. For instance, the person who designs and programs the system should not also serve as the operator.
Internal Control for Cash
F Checks leave paper trails, so you can use the bank’s statement to verify your own records.
1. Cash from cash sales.
2. Cash received through the mail.
3. Cash disbursements.
Most large embezzlements do not involve cash receipts. More often, they are accomplished through the payment of fictitious invoices. To control cash disbursements, all disbursements should be made by check. If another person has authority to sign the checks (other than the owner), this person should not have access to the accounting records. This prevents fraudulent disbursements that are concealed in the accounting records.
A large business has to rely on an internal control system called the voucher system. The procedures of this system are designed to tell the check-signer that the obligation for which the checks were written are proper obligations, properly incurred, and should be paid.
The Voucher System and Control
1. Purchase Requisition.
When the manager of a store needs merchandise to stock the shelves, he fills out a form called a purchase requisition. He sends this form to the Purchasing Dept. This department contacts the suppliers to order the merchandise. You do not allow the manager to contact the supplier directly. Otherwise, you will not have any control over the manager’s actions, such as how much merchandise is bought, which price, etc.
2. The Purchase Order.
When the purchasing dept. receives the manager’s request for merchandise, they use a form called a purchase order. This is sent to the suppliers, so the suppliers will send the merchandise to the store. The purchasing dept. prepares four copies of the purchase order.
Copy 1: The original copy is sent to the supplier of merchandise.
Copy 2: The second copy to the purchase order and the requisition form is sent to the accounting dept.
Copy 3: This copy is sent to the manager, who requested the merchandise, so he knows that the items were ordered.
Copy 4: The purchasing dept. keeps a copy for its own records.
The supplier prepares a document called an Invoice. This is equivalent of receiving a sales slip from a store. This invoice is an itemized statement of the goods that have been sold. The invoice comes along with the merchandise that is sent to the store.
4. Receiving Report.
Most large companies have a dept. that receives all merchandise or other purchased assets. As each shipment is received, counted, and checked, the receiving dept. prepares a receiving report. This report lists the quantity, description, and condition of the items received. The accounting dept. will receive a copy.
5. Invoice Approval.
When the merchandise arrives to the store, the accounting dept. will have copies of
The accountant verifies all the information on these four documents.
6. The Voucher.
When the accountant approves the invoice, he prepares a voucher. This is a business paper, which summarizes a transaction and certifies its correctness. The voucher is sent to the office, where the voucher is paid for. The accountant does not have access to the business’s money. As a result, there is little chance for fraud, unless all documents were stolen and signatures forged or there was collusion.
The Petty Cash Fund
In controlling cash disbursements, you need to require that all disbursements be made by check. There is one exception to this rule, which is petty cash disbursements. Every business must make many small payments for items such as postage, express charges, telegrams, and small items of supplies. These amounts are too small to use a check, because the check can be time consuming and expensive.
They have to establish a petty fund to make these small disbursements. To establish one, you have to estimate the total amount of small payments that is likely to be made in one month. This petty cash is given to a person in the office and placed in a safe. He is the person who pays for the small transactions.
For example, a company establishes a petty cash fund for $75. This money is given to Ned Fox, so he can pay for small purchases. They have to debit $75 to the petty cash account and credit $75 to the cash account. After the petty cash fund is established, the petty cash account is not debited or credited again unless the size of the fund is changed. During November, Ned Fox made several payments from the petty cash fund.
For each payment, Ted asks the person who receives the money to sign a receipt. When Ted runs out of money or it is the end of the month, Ted turns the receipts into the company’s cashier. The cashier gives Ted $71.30 to replenish the fund. These receipts must be stamped “paid” on them, so they can never be used again. Otherwise Ted could reuse the receipts and pocket the money. These receipts are turned into the accounting office, where the accountant records these transactions in the cash disbursements journal.
Cash Over and Short
Even though a cashier is careful in making change, customers are sometimes given too much change or are shortchanged. At the end of the day, if the cash register is over, then the journal entry:
At the end of the day, if the cash register has a shortage of money, then to record it:
Usually, customers are more likely to report being shortchanged than being given too much change. As a result, the Cash Over and Short account usually has a debit balance at the end of the accounting period.