Chapter 5
Internal Control,
Cash, and
Receivables
Learn about fraud and internal control
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Fraud
• Intentional misrepresentation of facts
• Causes injury or damage to another party
• Large problem that increases each year
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Types of Fraud
Misappropriation Fraudulent
of assets financial reporting
• Employees steal • Managers make
assets from false entries so
company company appears
• Cash more profitable
• Inventory • Deceives
• False expense investors and
reports creditors
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Fraud Triangle
Motive
Opportunity Rationalization
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Internal Control
• Primary way fraud and errors are:
▫ Prevented
▫ Detected or
▫ Corrected
• Management and Board of Directors implements a:
▫ Plan of organization
▫ System of procedures
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Objectives of Internal Control
Encourage Promote
Safeguard
employees to operational
assets
follow policy efficiency
Ensure Comply with
accurate, legal
reliable records requirements
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Sarbanes-Oxley Act (SOX)
• Federal law requiring public companies to have
system of internal controls
▫ Auditors examine controls and issue reports on
reliability
• Provisions:
▫ Require internal control report by companies
▫ Create Public Company Accounting Oversight
Board
▫ Limit non-audit services of auditing firms
▫ Penalize violators
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SCALP
• Smart hiring practices and segregation of duties
• Comparisons and compliance monitoring
• Adequate records
• Limited access
• Proper approvals
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Internal Control Procedures
• Smart Hiring Practices
• Separation of Duties
▫ Asset handling
▫ Record keeping
▫ Transaction approval
• Comparison and Compliance Monitoring
▫ Operating and cash budgets
▫ Audits
▫ Manual or computer checks
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Internal Control Procedures
• Adequate Records
▫ Hard copy or electronic
• Limited Access
▫ Assets by custodians
▫ Records by accounting department
• Proper Approvals
▫ The larger the transaction, the more specific
approval
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Information Technology (IT)
• Accounting systems rely on more than ever
before
• Examples:
▫ Inventory sensors
▫ Barcode scanning
• Basic attributes of internal control do not change
▫ Procedures to implement are different
• Use of computers can greatly improve speed and
accuracy
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Internal Controls for E-Commerce
• Pitfalls of e-commerce
▫ Stolen credit card numbers
▫ Computer viruses and Trojan Horses
▫ Phishing expeditions
• Security measures
▫ Encryption
▫ Firewalls
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Costs and Benefits of Internal
Control
• Ways good internal control can be circumvented
▫ Collusion
▫ Management override
▫ Fatigue & negligence
• The stricter the internal control, the more it
costs
▫ The benefits should outweigh the costs
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Applying internal controls to cash receipts and
cash payments
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Internal Control over Cash Receipts
• Cash is easy to steal
• All transactions ultimately affect cash
• Cash receipts should be deposited quickly
• Companies can receive cash
▫ Over the counter
▫ Through the mail
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Cash Receipts over the Counter
• Point-of-sale terminals provide control over cash receipts
▫ Also record sale, cost of item sold and reduction to
inventory
• Customer issued a receipt as proof of purchase
• Sales associate turns in cash drawer at end of shift
▫ Combined with other cash and deposited
• Accounting department reconciles sales per terminal to cash
in drawer
• “Depository bank accounts” prevents unauthorized access to
cash
▫ Also allow for more effective management of cash
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Cash Receipts by Mail
Mailroom
Remittance
Cheques
advices
Accounting
Treasurer
Department
Deposit Debit to
receipt Cash
Bank Controller
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Controls Over Payments by cheque
• Payment by cheque is an internal control
▫ Provides record of the payment
▫ Must be signed by an authorized official
▫ Should be supported by evidence payment
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Cash Payments by cheque 1
Purchase
Order
2
3
Company Inventory Company
Receiving A X
Report
2
Invoice
Check
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Internal Control for Purchasing
• Segregate the following duties:
▫ Purchasing goods
▫ Receiving goods
▫ Approving and paying for goods
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Payment Packet Receiving Report
Invoice
Purchase Order
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Petty Cash
• Small fund to make minor purchases
• One employee is responsible for the accounting
▫ Custodian
• Set amount of cash
• Voucher prepared for each payment
• Sum of fund plus paid voucher should equal set
amount
▫ Imprest system
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Prepare and use a bank reconciliation
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Bank Account as Control Device
Signature Bank
Deposit ticket
card statement
Bank
Check
reconciliation
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Bank Account Documents
• Signature card
▫ Protects against forgery
• Deposit ticket
▫ Proof of transaction
• Cheque
▫ Maker – signs the cheque
▫ Payee – to whom the cheque is paid
▫ Bank – where funds are drawn
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The Bank Statement
• Reports:
▫ Cash receipts
▫ Cash payments
• Electronic Funds
Transfer (EFT)
▫ Make payments by
electronic
communication
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Bank Reconciliation
• Two records of a business’s cash
▫ The bank statement
▫ The Cash account in the general ledger
• Amounts are usually different
▫ Time lags in recording transactions
• Bank reconciliation explains differences
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Bank Reconciliation Items
Bank Side Book Side
• ADD • ADD
• Deposits in transit • Bank collections
• Certain bank errors • EFT receipts
• Interest revenue
• SUBTRACT • Certain book errors
• Outstanding cheques
• Certain bank errors • SUBTRACT
• EFT payments
• Service charges
• NSF cheques
• Certain book errors
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Summary of Reconciling Items
BANK BALANCE - ALWAYS BOOK BALANCE - ALWAYS
Add deposits in transit Add bank collections, interest
revenue and EFT receipts
Subtract outstanding cheques Subtract services charges, NSF
cheques, EFT payments
Add or subtract correction of bank Add or subtract correction of book
errors errors
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Journalizing Bank Reconciliation
Items
• All items on the book side of the bank
reconciliation require journal entries
• If the item is added to book side
▫ Debit Cash
• If the items is subtracted from the book side
▫ Credit Cash
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JOURNAL
Date Accounts and explanation Debit Credit
Cash
Dividend Revenue
Receipt of dividend revenue earned on
investment.
Cash
Accounts receivable
Account receivable collected by bank
Cash
Interest Revenue
Interest earned on bank balance.
Cash
Accounts Payable
Correction of cheque
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JOURNAL
Date Accounts and explanation Debit Credit
Bank service charges
Cash
Bank service charge.
Accounts Receivable
Cash
NSF cheque returned by bank.
Insurance Expense
Cash
Payment of monthly insurance.
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Online Banking
• allows you to pay bills and view your account
electronically
• can reconcile transactions at any time
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Exercise 5-39B
Bank: Books:
Balance, September 30 €545 Balance, September 30 €1,823
Add: Add:
Deposit in transit €1,790 EFT rent collection €325
Less:
Service charges (€18)
Less: NF cheques (€125)
Outstanding cheques (€609) Correction of error (€279)
€1,726 €1,726
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Budgeting
• Budget
▫ Financial plan to coordinate activities
• Cash budget
▫ Planning receipts and payments
• Steps:
▫ Start with beginning cash balance
▫ Add budgeted receipts and subtract budget
payments
▫ Equals expected cash balance
▫ Compare cash available to budgeted cash balance
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Expected Cash Balance
If expected cash is Invest
greater than excess
minimum needed
If expected cash is Consider
less than minimum borrowing
needed
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Cash Budget
Beginning cash balance
Budgeted cash receipts:
Collections from customers
Dividends from investments
Sale of store fixtures
Budgeted cash payments:
Purchases of inventory
Operating expenses
Expansion of store
Payment of long-term debt
Payment of dividends
Cash available (needed)
Budgeted cash balance, end of period
Cash available for investing or (new
financing needed)
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Reporting Cash on the Balance
Sheet
• All cash accounts combined into a single total
called “Cash and Cash Equivalent”
▫ Include liquid assets such as time deposits,
certificates of deposit, and high-grade government
yield
▫ Interest-bearing accounts with no withdrawal
penalty
• Reports liquid assets available for day-to-day
use
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Exercise 5-25A
Cole Communications
Cash Budget
Cash, December 31, 20X7 $86
Budgeted Cash Receipts:
Collections from customers $11,305
Sale of assets 118 $11,509
Budgeted Cash Payments:
Costs and services 6,167
Operating expenses 2,544
Purchase of equipment 1,826
Payment of long-term debt 603
Payment of dividends 347 $11,487
Cash available $22
Budgeted cash available $82
New financing needed $60
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Account for receivables and uncollectible
receivables
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Receivables
• Monetary claims against others
• Acquired mainly by:
▫ selling goods and services (accounts receivable)
▫ lending money (notes receivable)
• Two major types:
▫ accounts receivables
▫ notes receivables
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Accounts Receivable
• Amounts collectible from customers
• Balance in general ledger
▫ Control account: summarizes total amount due
from all customers
• Subsidiary ledger
▫ Separate account for each customer
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General Ledger Accounts Receivable Subsidiary Ledger
Customer A
$5,000
Accounts receivable
$9,000
Total Customer B
$9,000 $1,800
Customer C
$3,000
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Internal Control: Collections on
Account
• Separate cash-handling and cash accounting
duties
▫ Bookkeeper should not handle cash
Should record amounts from remittance advices
▫ Separate employee should open incoming mail
and make deposit
• Another option:
▫ Lockbox system
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Managing Risk of Not Collecting
Benefit of selling on credit Cost of selling on credit
• Customers that do not • Company cannot collect
have cash available can from some customers
buy on credit • This cost is called
• Sales and profits increase “Uncollectible account
expense” , “Doubtful-
account expense”, or
“Bad debt expense”
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Risks of Selling on Credit
Issues Plan of action
What are the benefits and costs of Benefit – increase in sales
extending credit to customers? Cost – risk of not collecting
Extend credit to only creditworthy Run a credit check on prospective
customers customers
Separate cash-handling and Design internal control system to
accounting duties to keep separate duties
employees from stealing cash from
customers
Pursue collection from customers Keep a close eye on customers.
to maximize cash flow Send additional statements to
slow-paying customers
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Accounting for Uncollectible
Receivables
Balance Sheet
December 31, 20X6
Equipment $XXX
Less: allowance for doubtful (XXX)
receivables
Net trade and other receivables XXX
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The Allowance Method
• Records collection losses based on company’s
collection experience
• Estimates Uncollectible-Accounts Expense
• Also sets up Allowance for Uncollectible
Accounts
Contra-account to Accounts Receivable
Shows amount of receivables expected not to be
collected.
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Net Realizable Value
Balance Sheet
Current assets:
Accounts receivable $10,000
Less: Allowance for uncollectible accounts (900)
Accounts receivable, net $9,100
Balance Sheet
Current assets:
Accounts receivable, less allowance of $900 $9,100
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Methods to Estimate Uncollectibles
Aging-of-receivables
• Focuses on proper valuation of accounts
receivable on the balance sheet
• Individual customer balances analyzed based
on time outstanding
• Aging schedule
• Allowance for Uncollectible Accounts adjusted
to equal amount from aging schedule
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Aging-of-Receivables
Age of Account
Not 1-30 31-60 Over 60 Total
yet days days days Balance
Customer due
Customer A $400 $400
Customer B 100 100 200
Customer C 300 200 600 100 1,200
All others … … … …
Totals 11,060 1,363 370 1,093 13,886
Est. percent uncollectible 1.0% 5.0% 12.5% 20.9%
Allowance balance should be: 111 68 46 219 444
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Aging-of-Receivables
JOURNAL
Date Accounts and explanation Debit Credit
Uncollectible accounts expense 151
Allowance for uncollectible accounts 151
Recorded uncollectible accounts expense
Allowance for Uncollectible Accounts
Balance before adjustment $293
$151 Adjustment needed
$444
Ending balance equals aging schedule
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Aging-of-Receivables
Accounts Receivables Allowance for Uncollectible Accounts
$13,886 $293
$151
$444
Net accounts receivables, $13,442
Uncollectible Account Expense
$151
$151
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Writing Off Uncollectible Accounts
JOURNAL
Date Accounts and explanation Debit Credit
Allowance for uncollectible accounts 12
Accounts Receivable 12
Write off customer account
Allowance for Uncollectible
Accounts Receivable Accounts
Bal. $100 $12 $12 $20 Bal.
$88 $8
No impact on Income
Statement!
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Adjusting Ending Allowance for
Doubtful Receivables
JOURNAL
Date Accounts and explanation Debit Credit
Uncollectible for Doubtful receivables 22
Allowance for Doubtful receivables ($30 - $8) 22
Recorded bad debt expense for the year
Relationship between uncollectible-account expense, write-offs of receivables
and allowance for doubtful receivables account
Beginning – Receivables + Bad Debt = Ending
Allowance Write-offs Expense Allowance
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Direct Write-Off Method
• Waits until a specific account is uncollectible to
record the expense
• Inferior to Allowance method
▫ Receivables reported at full amount
Assets overstated on Balance Sheet
JOURNAL
Date Accounts and explanation Debit Credit
Uncollectible-account Expense
Accounts Receivable
Write off customer account
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Computing Cash Collections from
Customers
Accounts Receivable
Beginning balance $200 $100 Write-offs of
uncollectibles
Sales on credit $1,800 $1,500 ? Collections from
customers
Ending balance $400
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Notes Receivable
• More formal than accounts receivable
• Written promise to pay a sum at the maturity
date
▫ Plus interest
• Also called promissory notes
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Notes Receivable
• Can be current or long-term assets
• Terms:
Creditor Party to whom money is owed; Lender
Debtor Party that borrowed and owes money; Maker,
borrower
Interest Cost of borrowing money; stated as annual
percentage rate
Maturity date Date when debtor must pay note
Maturity value Sum of principal and interest
Principal Amount borrowed by debtor
Term Length of time from when note was signed to when
payment must be made
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Principal Date Interest
Starts
PROMISSORY NOTE
$1,000 August 31, 20X6
Amount Date
For value received, I promise to pay to the order of
RaboBank Payee (Creditor)
Amsterdam, Netherlands
Principal One thousand and no/100s-------------------------------- Dollars
Maturity Date
On February 28, 20X7
plus interest at the annual rate of 9 percent
Lauren Holland Maker
(Debtor)
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Accounting for Notes Receivable
JOURNAL
Date Accounts and explanation Debit Credit
20X6
Aug 31 Notes receivable – [Link] 1,000
Cash 1,000
Dec 31 Interest receivable ($1,000 x 0.09 x 4/12) 30
Accrued Interest revenue 30
2011
Feb 28 Cash 1,045
Notes receivable – [Link] 1,000
Interest receivable 30
Interest revenue ($1,000 x 0.09 x 2/12) 15
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Interest Computation
• Interest rates are always expressed as an annual
percent, unless stated otherwise
• The time element (4/12) is the fraction of the
year that the note has been in force during 2010.
• Often interest is computed based on days
▫ Denominator would be days/365
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Speeding Up Cash Flow
Credit cards
• Customers pay with credit cards
• Revenues increases, with a cost
• Credit card company takes 2-3% as a fee
Selling receivables
• Companies sell receivables to another business, called a
factor
• The factor pays a discounted price and then collects full
amount from customer
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Use two key ratios to evaluate a business
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Current Ratio
Total current assets
Total current liabilities
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Short Exercise 5-15
Acid-test ratio
$294,900
$99,000
= 2.98
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Days’ Sales in Receivables (Collection
Period)
Sales
Receivables
Turnover Average
Receivables
Receivables Turnover
Days’ sales in
receivables
365
(Beginning net receivables + Ending net receivables)/2
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Short Exercise 5-15
Days’ sales in receivable
$802,000
Receivables
Turnover $73,900
10.85
Days’ sales in
receivables $2,197.26
= 34 days
(Beginning net receivables + Ending net receivables)/2
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