Chapter 8 Internal Control Multimedia Slides by Gail

Chapter 8 Internal Control Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University

Learning Objectives 1. Define internal control, explain its basic components and limitations, and give examples of control activities. 2. Apply internal control activities to common merchandising transactions. 3. Demonstrate the control of cash by preparing a bank reconciliation. Copyright © Houghton Mifflin Company. All rights reserved. 2

Supplemental Objectives 4. Demonstrate the use of a simple imprest system. 5. Define voucher system and describe the components and operation of a voucher system. Copyright © Houghton Mifflin Company. All rights reserved. 3

Internal Control: Basic Components and Control Activities • Objective 1 – Define internal control, explain its basic components and limitations, and give examples of control activities Copyright © Houghton Mifflin Company. All rights reserved. 4

Internal Control … is all the policies and procedures management uses to ensure the reliability of financial reporting compliance with laws and regulations and the effectiveness and efficiency of operations Copyright © Houghton Mifflin Company. All rights reserved. 5

Management • Is responsible for establishing a satisfactory system of internal controls • Must safeguard the firm’s assets and have reliable accounting records • Ensure that employees comply with legal requirements and operate the company in the best way possible Copyright © Houghton Mifflin Company. All rights reserved. 6

Components of Internal Control • Management must establish five interrelated components of internal control 1. Control environment 2. Risk assessment 3. Information and communication 4. Control activities 5. Monitoring Copyright © Houghton Mifflin Company. All rights reserved. 7

The Control Environment • Is created by the overall attitude, awareness, and actions of management • Includes management’s – Integrity and ethics – Philosophy and operating style – Organizational structure – Method of assigning authority and responsibility – Personal policies and practices • Managers must ensure that employees are trained and informed Copyright © Houghton Mifflin Company. All rights reserved. 8

Risk Assessment … identifies areas where the risk is high for loss of assets or inaccuracies in the accounting records so that adequate controls can be implemented • For example, in retail stores the risk is high that – Employees will take cash – Customers will shoplift Copyright © Houghton Mifflin Company. All rights reserved. 9

Information and Communication … relates to the accounting systems established by management, which should identify assemble analyze classify record and report a company’s transactions Copyright © Houghton Mifflin Company. All rights reserved. 10

Control Activities … are the policies and procedures management puts in place to see that its directives are carried out • Safeguard a company’s assets • Ensure the reliability of accounting records Copyright © Houghton Mifflin Company. All rights reserved. 11

Monitoring … involves management’s regular assessment of the quality of internal control including periodic review of compliance with all policies and procedures • Larger companies hire internal auditors to review the company’s system of internal controls • Managers and owners should conduct these reviews for smaller companies Copyright © Houghton Mifflin Company. All rights reserved. 12

Control Activities • Are a principal way in which internal control is implemented in the accounting system • Safeguard a company’s assets and ensure the reliability of accounting records • Include – Authorization – Recording transactions – Documents and records – Physical controls – Periodic independent verification – Separation of duties – Sound personnel procedures Copyright © Houghton Mifflin Company. All rights reserved. 13

Control Activities (cont’d) • Authorization – All transactions and activities should be properly authorized by management • Recording transactions – All transactions should be recorded • Facilitates preparation of financial statements • Establishes accountability for assets • Documents and records – Documents should be adequately designed and used to ensure proper recording of transactions Copyright © Houghton Mifflin Company. All rights reserved. 14

Control Activities (cont’d) • Physical controls – Permit access to assets only with management’s authorization • Periodic independent verification – Records should be checked against assets by someone other than those responsible for those records and assets • Separation of duties – Functional responsibilities should be separated • Different individuals or departments should be responsible for custody of assets and the record keeping for those assets

Control Activities (cont’d) • Sound personnel procedures – Supervision – Rotation of key personnel among different jobs – Mandatory vacations – Bonding personnel who handle cash or inventories Bonding is the process of checking an employee’s background and insuring the company against theft by that person Copyright © Houghton Mifflin Company. All rights reserved. 16

Limitations of Internal Control • Human error – Misunderstandings – Mistakes in judgment – Carelessness – Distraction – Fatigue • Separation of duties can be defeated through collusion – Employees secretly agreeing to deceive the company Copyright © Houghton Mifflin Company. All rights reserved. 17

Limitations of Internal Control • Established procedures may become ineffective against employees’ errors or dishonesty • Controls may become ineffective due to conditions that have changed • Costs of internal control systems may exceed the benefits Copyright © Houghton Mifflin Company. All rights reserved. 18

Discussion Q. Why is the separation of duties necessary to ensure sound internal control? What does this principle assume about the relationships of employees in a company and the possibility of two or more of them stealing from the company? A. Separation of duties is important to sound internal control because a person who combines the responsibilities of keeping records, operating a department, and managing assets would be able to misappropriate assets without detection The separation of duties assumes that two or more employees will not work together to overcome internal controls Copyright © Houghton Mifflin Company. All rights reserved. 19

Internal Control Over Merchandising Transactions • Objective 2 – Apply internal control activities to

Internal Control Over Merchandising Transactions Cash sales receipts Purchases Cash payments • Sound internal control activities are very important when assets are involved • Assets are particularly vulnerable when they enter or leave a business, as with merchandising transactions Copyright © Houghton Mifflin Company. All rights reserved. 21

Internal Control and Management Goals • Two key goals for the success of merchandising businesses 1. To prevent losses of cash or inventory as a result of theft or fraud 2. To provide accurate records of merchandising transactions and account balances Copyright © Houghton Mifflin Company. All rights reserved. 22

Internal Control and Management Goals (cont’d) • Three broader goals for management are 1. Keeping enough inventory on hand without overstocking 2. Keeping enough cash on hand to pay for purchases within the discount period 3. Keeping credit losses as low as possible by making credit sales only to customers who are likely to pay on time Copyright © Houghton Mifflin Company. All rights reserved. 23

The Cash Budget … projects future cash receipts and disbursements • Is one control used to meet broader management goals • Used to maintain adequate cash balances so that a company can – Take advantage of discounts on purchases – Prepare to borrow money when necessary – Pay bills when they are due Copyright © Houghton Mifflin Company. All rights reserved. 24

Separation of Duties … is a control procedure for safeguarding a company’s assets in which the responsibilities for custody of assets and record keeping for those assets are held by separate individuals or departments Copyright © Houghton Mifflin Company. All rights reserved. 25

Separation of Duties (cont’d) • Makes theft without detection extremely unlikely – Unless two or more employees conspire • Easier to accomplish in large businesses versus smaller ones – With smaller businesses, one person may have to carry out several duties Copyright © Houghton Mifflin Company. All rights reserved. 26

Internal Control over Cash • Varies based on the size and nature of the business • Most firms should use the following procedures 1. Separate the functions of • Authorization • Recordkeeping • Custodianship of cash 2. Limit the number of people who have access to cash Copyright © Houghton Mifflin Company. All rights reserved. 27

Internal Control over Cash (cont’d) 3. Designate specific people who are responsible for handling cash 4. Use bank facilities as much as possible • Keep the amount of cash on hand to a minimum 5. Bond all employees who have access to cash 6. Physically protect cash on hand by using • Cash registers • Cashiers’ cages • Safes Copyright © Houghton Mifflin Company. All rights reserved. 28

Internal Control over Cash (cont’d) 7. Have a person who does not handle cash make periodic independent verifications of cash on hand 8. Record all cash receipts promptly 9. Deposit all cash receipts promptly 10. Make payments by check rather than by currency 11. Have a person who does not authorize, handle, or record cash transactions reconcile the Cash account Copyright © Houghton Mifflin Company. All rights reserved. 29

Control of Cash Sales Receipts • Cash may be received – Over the counter – By mail – In currency – In the form of a check • Cash receipts should be recorded immediately upon receipt – Record by making an entry in a cash receipts journal – This establishes a written record of cash receipts • Should prevent errors and make theft more difficult Copyright © Houghton Mifflin Company. All rights reserved. 30

Control of Cash Received Through the Mail • Customers should be encouraged to pay by check or credit card – Cash payments are too vulnerable to theft by employees • Cash receipts should be handled by two or more employees Copyright © Houghton Mifflin Company. All rights reserved. 31

Control of Cash Received Through the Mail (cont’d) • Employee opening the mail should make a list in triplicate of the money received including – Each payer’s name – Purpose for which money was sent – Amount • Copy 1 – Goes with the cash to the cashier who deposits the money Copyright © Houghton Mifflin Company. All rights reserved. 32

Control of Cash Received Through the Mail (cont’d) • Copy 2 – Goes to the accounting department for recording • Copy 3 – Kept by the person who opens the mail • Errors can easily be caught because the amount deposited by the cashier must agree with the amount received and the amount recorded in the cash receipts journal Copyright © Houghton Mifflin Company. All rights reserved. 33

Control of Cash Received over the Counter • Two common tools – Cash registers – Prenumbered sales tickets • Ensure good internal control by separating responsibility for – Cash receipts – Cash deposits – Recordkeeping Copyright © Houghton Mifflin Company. All rights reserved. 34

Using Cash Registers • Amount of cash sale should be rung up at time of sale • Place register so customer can see amounts recorded • Each register should have a locked-in tape – Prints the day’s transactions • At day’s end, cashier counts cash in the register and turns it into the cashier’s office Copyright © Houghton Mifflin Company. All rights reserved. 35

Using Cash Registers • Another employee takes the tape out of the register and records the cash receipts for the day in the cash receipts journal • The amount of cash turned in and the amount recorded on the tape should agree – If not, any differences should be explained • Large retail chains may have each cash register tied into a computer that records each transaction as it occurs Copyright © Houghton Mifflin Company. All rights reserved. 36

Control of Purchases and Cash Disbursements • Pay cash only based on specific authorization backed by proof of validity and amount of claim • Separate purchasing and payment duties • Have at least two people document and verify every action Copyright © Houghton Mifflin Company. All rights reserved. 37

Internal Control for Purchasing and Paying for Goods and Services Copyright © Houghton Mifflin

Documents Used in an Internal Control Plan for Purchases and Cash Disbursements • Example of a typical sequence – Purchase requisition – Purchase order – Invoice – Receiving report – Check authorization – Check – Bank statement • Many variations of this sequence exist Copyright © Houghton Mifflin Company. All rights reserved. 39

Step 1: A formal request for a purchase is approved by the department head

Step 2: The purchasing department prepares a purchase order, which states quantity, description, price, terms, and other shipping instructions. The purchase order is sent to the vendor (seller) and a copy goes to the accounting department Copyright © Houghton Mifflin Company. All rights reserved. 41

Step 3: The vendor (seller) ships the items and mails an invoice separately to

Step 4: When the goods reach the receiving department, an employee fills out a receiving report, which is sent to the accounting department where it is compared with the invoice Copyright © Houghton Mifflin Company. All rights reserved. 43

Step 5: The accounting department completes a check authorization and attaches copies of the purchase order, invoice, and receiving report. These are sent to the treasurer. Copyright © Houghton Mifflin Company. All rights reserved. 44

Step 6: The treasurer examines the documents and issues a check, which is sent

Step 7: After the check is cashed by the vendor, it is canceled by the bank and returned with the company’s bank statement. If a check was filled out for the wrong amount or altered, it will show up on the bank reconciliation Copyright © Houghton Mifflin Company. All rights reserved. 46

Discussion Q. Name the documents needed for an internal control plan for purchases and cash disbursements – Purchase requisition – Purchase order – Invoice – Receiving report – Check authorization – Check with a remittance advice – Bank statement Copyright © Houghton Mifflin Company. All rights reserved. 47

Accounting For Discounts • Objective 3 – Demonstrate the control of cash by preparing

Bank Reconciliations … account for the difference between the balance appearing on the bank statement and the balance of the Cash account in a company’s records • Are a necessary step in internal control Copyright © Houghton Mifflin Company. All rights reserved. 49

Bank Reconciliations (cont’d) • Most common transactions shown in a company’s records but not entered in the bank records include – Outstanding checks • Checks the company has issued and recorded but do not yet appear on the bank statement – Deposits in transit • Deposits mailed or taken to the bank but not received in time to be recorded on the bank statement Copyright © Houghton Mifflin Company. All rights reserved. 50

Bank Reconciliations (cont’d) • Most common transactions that appear on the bank statement but not in a company’s records include – Service charges • Fees charged by the bank on checking accounts – NSF (nonsufficient funds) checks • Checks deposited by the company that are not paid when presented by the bank to the issuer’s bank • The bank charges the company’s account and returns the check to the company Copyright © Houghton Mifflin Company. All rights reserved. 51

Bank Reconciliations (cont’d) – Miscellaneous debits and credits • Fees charged by the bank for stopping payment on checks and printing checks • Amounts are reported to the company by a debit memorandum included with the monthly bank statement – Interest income • Banks commonly pay interest on certain accounts Copyright © Houghton Mifflin Company. All rights reserved. 52

Illustration of a Bank Reconciliation 1. A $276. 00 deposit was mailed to the

Illustration of a Bank Reconciliation 2. Five checks issued in October or earlier have

Illustration of a Bank Reconciliation 3. A deposit of October 6 was incorrectly recorded in the company’s books as $330. 00. The bank correctly recorded the deposit as $300. 00 Copyright © Houghton Mifflin Company. All rights reserved. 55

Illustration of a Bank Reconciliation 4. A credit memorandum was enclosed with the bank statement showing a note had been collected in the amount of $280. 00 along with interest of $20. 00. A debit memorandum was enclosed for the $5. 00 collection fee Copyright © Houghton Mifflin Company. All rights reserved. 56

Illustration of a Bank Reconciliation 5. An NSF check was returned with the statement for $128. 14. The NSF check from Arthur Clubb was not reflected in the company’s books Copyright © Houghton Mifflin Company. All rights reserved. 57

Illustration of a Bank Reconciliation 6. A debit memorandum for the monthly $12. 50

Illustration of a Bank Reconciliation 7. Interest earned by the company on its average

Illustration of a Bank Reconciliation After all items have been listed on the reconciliation, total the columns. The adjusted bank balance should equal the adjusted book balance Copyright © Houghton Mifflin Company. All rights reserved. 60

Recording Transactions After Reconciliation • All items reported by the bank but not yet recorded by the company must be recorded in the general journal Copyright © Houghton Mifflin Company. All rights reserved. 61

Recording Transactions After Reconciliation (cont’d) Copyright © Houghton Mifflin Company. All rights reserved. 62

Discussion Q. Would a deposit in transit be included as an adjustment to the bank balance or book balance on a bank reconciliation? Would it be added to or subtracted from the balance? A. A deposit in transit would be added to the bank balance on a bank reconciliation. The deposit was recorded in the books before being sent to the bank and is therefore already reflected in the book balance. Copyright © Houghton Mifflin Company. All rights reserved. 63

Petty Cash Procedures • Supplemental Objective 4 – Demonstrate the use of a simple

Petty Cash Fund • Used for small disbursements that are impractical to pay by check – Postage stamps – Incoming postage – Shipping charges due – Other minor purchases • Pens, paper, etc. • The cash fund can be controlled by using an imprest system Copyright © Houghton Mifflin Company. All rights reserved. 65

Imprest System • A petty cash fund established for a fixed amount • Each payment from the fund is documented by a voucher • The fund is periodically reimbursed by the exact amount necessary to restore it to the original balance – Based on the vouchers Copyright © Houghton Mifflin Company. All rights reserved. 66

Establishing the Petty Cash Fund • Determine – Amount needed to cover small expenditures for a two- to four-week period – Employee who will administer the petty cash fund • Company issues a check for this amount, which is cashed • The money is placed in the petty cash box, drawer, or envelope Copyright © Houghton Mifflin Company. All rights reserved. 67

Discussion Q. What is an imprest petty cash system? A. An imprest patty cash system is a petty cash fund established for a fixed amount. Each payment from the fund is documented by a voucher. The fund is periodically reimbursed by the exact amount necessary to restore it to the original balance. This amount should equal the total amount of the vouchers Copyright © Houghton Mifflin Company. All rights reserved. 68

Voucher Systems • Supplemental Objective 5 – Define voucher system and described the components

Voucher System … is any system that gives documentary proof of and written authorization for business transactions • Consists of records and procedures for systematically gathering, recording, and paying expenditures Copyright © Houghton Mifflin Company. All rights reserved. 70

Voucher System • Internal control provided by separating duties and responsibilities in the following functions 1. Authorization of expenditures 2. Receipt of goods and services 3. Validation of liability • By examination of invoices from suppliers for correctness of prices, extensions (quantity x price), shipping costs, and credit terms 4. Payment of expenditure by check Copyright © Houghton Mifflin Company. All rights reserved. 71

Voucher System • Every liability must be recorded as soon as it is incurred by preparing a voucher – A voucher is a written authorization and checks are issued only for approved vouchers • No one person has the authority to both incur expenses and to issue checks • The written approval for each transaction leaves a trail of documentary evidence called an audit trail Copyright © Houghton Mifflin Company. All rights reserved. 72

Components of a Voucher System 1. Vouchers 2. Voucher checks 3. A voucher register 4. A check register • Most systems have these components, although there is more than one way to set up a voucher system Copyright © Houghton Mifflin Company. All rights reserved. 73

Vouchers … serve as the basis of an accounting entry • All vouchers are sequentially numbered • A separate voucher is attached to each bill as it comes in Copyright © Houghton Mifflin Company. All rights reserved. 74

Front of a Voucher Form Contains important information about the expenditure and the authorizing

Back of a Voucher Form Contains information about the accounts Copyright © Houghton Mifflin

Voucher Checks … tell the payee the reason the check was issued • The information is written either on the check itself or on a detachable stub • Regular checks can also be used efficiently Copyright © Houghton Mifflin Company. All rights reserved. 77

Voucher Register … …is a book of original entry in which vouchers are recorded after they have been approved • Takes the place of a purchases journal in companies that use special-purpose journals Copyright © Houghton Mifflin Company. All rights reserved. 78

Voucher Register (cont’d) • All expenditures are recorded in a voucher register – Only purchases of merchandise on credit are recorded in a single-column purchases journal • A Vouchers Payable column replaces the Accounts Payable column Copyright © Houghton Mifflin Company. All rights reserved. 79

Voucher Register Copyright © Houghton Mifflin Company. All rights reserved. 8– 80

Check Register … is the journal in which checks are listed as they are written • Replaces the cash payments journal – The incurrence of a liability is recorded in the voucher register – Its payment is recorded in the check register Copyright © Houghton Mifflin Company. All rights reserved. 81

Check Register Copyright © Houghton Mifflin Company. All rights reserved. 8– 82

Operation of a Voucher System • Five steps in the operation of a voucher system 1. Preparing the voucher 2. Recording the voucher 3. Paying the voucher 4. Posting the voucher and check registers 5. Summarizing unpaid vouchers Copyright © Houghton Mifflin Company. All rights reserved. 83

Preparing the Voucher • Prepare a voucher for each expenditure • Attach all documents to the voucher to submit it for approval – Purchase orders – Invoices – Receiving reports Copyright © Houghton Mifflin Company. All rights reserved. 84

Preparing the Voucher • If a separate account is used for payroll, a voucher is prepared to cover the total payroll – The check for the voucher is deposited in the payroll account – Individual payroll checks are drawn on the payroll account Copyright © Houghton Mifflin Company. All rights reserved. 85

Recording the Voucher • July All approved vouchers should be recorded in the voucher register 3 704 Belmont Products 7/13 205 1, 200 Vouchers that do not have appropriate approvals should be investigated immediately Copyright © Houghton Mifflin Company. All rights reserved. 86

Paying the Voucher • Vouchers are placed in an unpaid voucher file after being recorded – May be filed by due date and by vendor within due date so that checks can be written at the appropriate times • • Ensures that discounts for prompt payment can be taken After payment, vouchers are filed by voucher number Copyright © Houghton Mifflin Company. All rights reserved. 87

Paying the Voucher (cont’d) • A few days before the voucher is due – A check for the correct amount, accompanied by the voucher and supporting documents, is presented to the person authorized to sign the checks – Payment is entered in the check register 20 xx July 13 205 Belmont Products Copyright © Houghton Mifflin Company. All rights reserved. 704 1, 200 24 1, 176 88

Purchase Return or Allowance Applied to a Voucher • At the time the merchandise is returned or the allowance given 1. Record an entry on the general journal 2. Make a notation on the voucher in the voucher file Some companies cancel the original voucher and prepare a new one for the amount to be paid Copyright © Houghton Mifflin Company. All rights reserved. 89

Purchase Return or Allowance Applied to a Voucher (cont’d) • At the time of payment, only the net amount of the voucher should be paid and recorded in the check register – Net amount • Original amount less return or allowance and any applicable discount Copyright © Houghton Mifflin Company. All rights reserved. 90

Posting the Voucher and Check Registers • Very similar to posting the purchases journal and cash payments journal • Difference – The Vouchers Payable account is substituted for the Accounts Payable account Copyright © Houghton Mifflin Company. All rights reserved. 91

Summarizing Unpaid Vouchers • At the end of each accounting period, total the unpaid voucher file to prove the balance of the Vouchers Payable account – Because the sum of the unpaid vouchers should always equal the credit balance of the Vouchers Payable account, a subsidiary ledger is unnecessary Copyright © Houghton Mifflin Company. All rights reserved. 92

Schedule of Unpaid Vouchers Copyright © Houghton Mifflin Company. All rights reserved. 93

Reconciling the Voucher Register and Check Register Copyright © Houghton Mifflin Company. All rights

Vouchers Payable and the Balance Sheet • The account title Vouchers Payable may appear on a company's balance sheet • Preferred term is Accounts Payable, even when a voucher system is in place Copyright © Houghton Mifflin Company. All rights reserved. 97

Discussion Q. Is a voucher the same thing as a check? A. No. A voucher is a written authorization prepared for each expenditure when it becomes an obligation to pay. Checks are written only for approved vouchers. Copyright © Houghton Mifflin Company. All rights reserved. 98

Time for Review 1. Define internal control, explain its basic components and limitations, and give examples of control activities 2. Apply internal control activities to common merchandising transactions 3. Demonstrate the control of cash by preparing a bank reconciliation Copyright © Houghton Mifflin Company. All rights reserved. 99

And Finally … 4. Demonstrate the use of a simple imprest system 5. Define voucher system and describe the components and operation of a voucher system Copyright © Houghton Mifflin Company. All rights reserved. 100