Your text defines internal control as an organizational plan to:
Safeguard company assets
Encourage employees to follow laws, regulations, and company policy
Promote operational efficiency
Ensure accurate, reliable accounting records
Over the history of business management, there have been countless frauds perpetrated in corporations that have resulted in millions of dollars of losses--to the corporations themselves, to stockholders, to customers, and members of the general public. Several high profile cases in recent years gave rise to a piece of legislation enacted by the United States Congress--the Sarbanes-Oxley Act.
The Sarbanes-Oxley Act included several provisions:
1. Public companies (corporations) are now required to issue an internal control report; additionally, an auditor is required to evaluate a corporation's internal control.
2. A new organization, the Public Company Accounting Oversight Board, oversees the work that auditors perform.
3. Accounting firms are not allowed to audit a corporation while at the same time providing consulting services to that corporation.
4. Executives who violate Sarbanes-Oxley rules are subject to severe penalties.
There are five components to a good Internal Control program:
1. Control Environment--executives must set a good example for employees.
2. Risk Assessment--A company must take the initiative in evaluating its risks.
3. Control Procedures--These are described separately below, and constitute the bulk of the internal control effort.
4. Monitoring of Controls--Internal auditors continually monitor the safeguarding of assets, and external auditors monitor the accuracy and reliability of accounting reports.
5. Information System--Because of the importance of information in a business, the input, processing and output of information must be continuously analyzed.
Internal control can never be perfect. We cannot achieve 100% control over fraud, theft, or inefficiency. There are two items that prevent 100% success with internal control procedures:
1. Human beings make mistakes, due to inattention, stress, exhaustion, and other factors;
2. We can only invest so much money, attention and effort into internal control. If we want 100% assurance of internal control success, it would cost too much. For example, hiring a police officer to patrol a candy store would ensure a high degree of control, but would probably cost more than it would save.
The actual details of how a good internal control program is created are based on the following procedures.
1. Hire competent reliable and ethical people.
2. Assign responsibilities in a clear manner and get employees to comply.
3. Separation of Duties (also called segregation of duties)--the basic idea is that if one person is allowed access to assets and access to accounting records, the company is inviting disaster. Your text mentions two aspects of separation of duties: a. separate operations from accounting; and b. separate custody of assets from accounting.
4. Audit--virtually all corporations are subject to an annual external audit, in which an independent auditor examines the documents, organization, and individual transactions, to determine if the company has performed accounting functions fairly. Frequent internal audits (by a company's employee) can determine of employees are following the law, performing efficiently, and obeying company policy.
5. Documentation--Virtually every transaction in a business will involve a document of some sort. A purchase will involve a purchase order, a sale will generate an invoice, payroll data will support the fact that employees performed work, and canceled checks prove that expenses were paid. All of these documents can be used to support the resulting financial statements--and it is vital to organize them appropriately. Increasingly, the concept of a "document" implies a computer-generated record, which can complicate the auditor's task of determining document validity.
6. Electronic Devices--cash registers, computers, and other devices are subject to internal controls. Additionally, computer security is vital to the survival of the company. Virus protection, firewalls, and data encryption are necessary costs in protecting electronic data.
7. Other Controls--use of a safe for checks and cash, alarm systems, security cameras, employee bonding, job rotation and mandatory employee vacations fall into this category.
One of the fundamental objectives of an outside auditor is to judge the effectiveness of Internal Control in an organization. If the Internal Control is ineffective or lacking, the auditor may choose not to render a "clean opinion" regarding the company's financial statements. At the opposite end of the continuum, if Internal Control is so stringent as to impair company efficiency, it may not be worth the effort or resources expended. Thus, the cost of Internal Control should not exceed its expected benefit.
Your textbook recommends a high degree of control over cash receipts and cash payments. As you might expect, cash is the most valuable asset, because any other asset can be acquired using cash. Therefore, the cash account is the one that requires the most vigilance. Two basic ideas are that all cash receipts should be deposited in the bank daily, so that employees and customers have no opportunity to steal them; and all cash payments should be made by check. The use of a checking account puts responsibility for safeguarding cash in the hands of a third party--the bank. And, as cash comes in and goes out, a record is created by the bank that can be reviewed--on paper or online.
It probably has occurred to you that, of all the assets owned by a company, the most important asset is cash. Cash has no memory, nor do you need to have it registered to you to allow you to use it. If an unscrupulous individual is able to get possession of cash, they can spend it illegally, and in many cases, will not get caught. For all of these reasons, a company should maintain only a small portion of its cash on the premises, and trust a bank to hold the bulk of its cash. Additionally, if the bank is holding the company's money, a record is kept of the deposit as well as the later withdrawal.
Most people keep their spending money in a checking account. By writing checks for expenditures, an individual or company will have proof that an employee or vendor was paid. However, periodically, the checking account must be reconciled--to ascertain that all checks were cashed properly, and that deposits were recorded by the bank in a timely manner.
Most adults these days have a checking account, and the text discussion probably confirms what you already know from experience.
An accountant performs a bank reconciliation in order to verify the correct amount of cash in the account. You might think that the bank statement is a reliable indicator of the bank balance--and it is, except for timing differences that happen between the time a check or deposit has been made, and the time at which it appears on the bank statement.
For example, if you deposited $1,000 in your checking account on January 10, and wrote check 101 for $20.00 on January 12, you would probably see the correct bank balance on the bank statement of January 31--the bank balance would be $980.00, and would match your calculation of the balance.
However, what if you deposited the $1,000 in your checking account on January 12, and then wrote the $20.00 check on January 30? Because the check would likely not arrive at the bank until about February 2 or 3, the bank statement would probably report your balance as $1,000. You would have to use the evidence in your checkbook to correct the bank's balance. In fact you would take the balance shown on the bank statement and subtract the outstanding check of $20.00, to reach the correct balance of $980.00. For a busy company, there may be 5, 10 or 20 checks outstanding when the bank statement comes in, so in order to reach the correct balance, these outstanding checks must be subtracted from the bank statement balance.
You could also imagine a situation in which you send a deposit to the bank of $500, perhaps received from your customer, but deposited it on January 30. You would have evidence that the deposit was made, but it won't show up on the bank statement of January 31. A deposit made by you but not recorded yet by the bank is called a deposit in transit, and must be added to the bank balance on the statement.
Writing a check or making a deposit to your account are actions that you take, that either lower or raise the balance in your account. But sometimes, the bank takes actions that will affect your bank balance. What if the bank charges a fee of $.25 each time a check written by you is received by the bank? You will not be aware of this charge until you receive the bank statement. Similarly, the bank may pay you interest, in which case you will find out about it when you receive your bank statement.
An accountant must perform a bank reconciliation at least once per month, usually at the time the bank statement is received. If there is a high degree of deposit or check activity, the reconciliation can be done more often. Note that we think of a bank statement as a "piece of paper," but, increasingly, depositors are using the online view of their account--meaning that a bank reconciliation could be done more frequently than once per month.
A good example of a bank reconciliation appears in your text. You could model a bank reconciliation as follows:
A bank reconciliation starts with comparing the Balance Per Bank (the final figure on the bank statement) with the Balance Per Books. The Balance Per Books is the depositor's record of how much cash is in the account. A good question to ask is: "why doesn't the Balance per Books match the Balance Per Bank?" The problem is that there is a time lag between when the depositor takes an action, and when the bank records that action.
An example of this time lag-- the depositor started the account with a deposit of $1000 on April 1. The first check was written on April 10 for $300. On April 10, the bank still shows a balance of $1,000, because the check has not reached the bank yet. However, the depositor knows that the current balance is really $700.
If you look at the model of the bank reconciliation shown above, you will note that one side of the reconciliation involves taking the Balance Per Bank, and then adding in deposits that have been sent to the bank, but which have not been recorded by the bank as yet. Similarly, any checks that the depositor has written must be subtracted from the bank balance to reach the correct balance.
On the other side, sometimes the bank takes an action that the depositor is unaware of. For example, the bank collects a note on behalf of our company. We must account for the increase in cash, the earning of revenue, and any charges that the bank may have levied against our account. Additionally, the collection of the note will require a credit to Notes Receivable. These types of transactions have already been included in the bank statement--but since the depositor is unaware of their occurrence, a correction must be made to the ledger balance for cash.
Special note: for any additions or subtractions to balance per books, a journal entry must be made. Here are some typical examples:
|Feb 3||Accounts Receivable--Wilson||357.00|
In the journal entries above, we are processing the transactions indicated by the January 31 bank statement. The bank reconciliation was done on February 3 and reflected the following events.
a. The bank statement showed that $4.00 of interest had been earned on our bank account.
b. A customer--Wilson, had paid cash to us on account in the amount of $357. However, Wilson didn't have sufficient cash in his account, and the check was returned to us. Because Wilson still owes us $357, we re-establish his account receivable.
c. The third transaction on February 3 indicates that our customer paid off a note receivable. We loaned $1,000 for one year to a customer at 6%. The maturity date was January 31. Instead of paying us directly, the customer deposited the $1,000 plus $60 of interest to our account at the bank. The bank reported this receipt of cash on the bank statement of January 31.
Although internal control principles would dictate that all cash disbursements be paid by check, there are times when payment by cash is expedient. For example, if postage stamps are required, a company might choose to purchase them by cash, rather than by writing a check. Additionally, the check-writing process may be warranted in situations in which approvals and oversight are desirable, but inefficient for the purchase of small items like office supplies. For purchases using cash, it is customary to create a petty cash system.
Suppose Stark Company creates a petty cash fund of $100 by cashing a $100 check and placing the bills in a small locked box. A petty cash custodian, Betty, is appointed to manage the petty cash box. During January, three expenditures are made from the box: postage was purchased for $35.00; office supplies were purchased for $22, and pizzas were purchased for an office party in the amount of $30. On January 31, the petty cash fund was replenished (restored to the original $100).
When dispensing cash from the petty cash fund, a voucher is filled out. A voucher is a numbered document with a space to write the amount spent and a description of the purchase. Note that when the first expenditure was made for postage, cash was taken from the box in the amount of $35. A voucher (number 101 perhaps) would be filled out for $35 and placed into the box. At that point, the box would contain $65 cash plus a $35 voucher. The main control feature of the fund is that the sum of the remaining cash plus the vouchers ($65 + $35) must add up to the petty cash total, in this case, $100.
The Petty Cash ("small cash") fund allows good internal control over small cash purchases. Here are the entries that would be made in this example:
Establishing the Petty Cash Fund
|Jan 5||Petty Cash||100|
|Petty cash fund of $100 created.|
Making Disbursements from Petty Cash--remove cash from box; make purchases; return vouchers to box.
Replenishing Petty Cash.
|Jan 31||Postage Expense||35.00|
Note that after the three expenditures, the petty cash in the box will end up at $13.00. At the time of replenishment, the three vouchers get recorded, and a credit of $87 is made to cash. A check is cashed for $87, and the bills will be placed into the petty cash box. The cash total in the box would now be $100.
The chapter concludes with a discussion of reporting cash on the balance sheet.