Fundamental Financial Accounting Concepts Fourth Edition by Edmonds, McNair, Milam, Olds

1
Fundamental Financial Accounting ConceptsFourth
EditionbyEdmonds, McNair, Milam, Olds

• PowerPoint presentation by
• J. Lawrence Bergin

2
Chapter 6

• Internal Control
• and
• Accounting
• for Cash

3
What Is Internal Control?

• The policies and procedures by which management
  protects the assets and assures the accuracy and
  reliability of the accounting records.

4
Goals of an internal control system

• Resources of the business are safeguarded
• Policies of management are followed
• Designed to prevent errors and fraud

5
Elements of Internal Control

• Separation of duties
• Quality of employees
• Bonded employees
• Periods of absence
• Procedures manual
• Clear lines of authority responsibility
• Prenumbered documents
• Physical control over assets
• Performance evaluations

6
Separation of duties

• Whenever possible, the functions of
  authorization, recording and custody should be
  exercised by separate individuals.
• This minimizes the likelihood of errors and
  embezzlement.

7
Quality of employees

• Hire and keep employees that are
• Competent
• Honest
• Trained to do a variety of tasks.

8
Bonded Employees

• A Fidelity Bond is insurance coverage to protect
  the employer if an employee is dishonest
  (embezzles).

9
Periods of Absence

• Require vacations and rotate employees.
• Illegal activities are often uncovered when
  someone else performs the offenders duties for a
  few days.

10
Procedures Manual

• Provide Procedures Manuals detailing the correct
  procedures for processing transactions.
• These procedures should be designed to promote
  accuracy and internal control.

11
Clear lines of authority responsibility

• Make sure employees understand the extent of
  their authority and responsibilities.
• Define and communicate the appropriate chain of
  command.

Organization Chart
12
Prenumbered documents

• Reduces the likelihood of unauthorized
  transactions.
• Reduces the likelihood of embezzlements.
• Be sure to account for the sequence of documents
  periodically

13
Physical control over assets

• Safeguard all assets--cash, equipment, inventory,
  etc.
• Be sure to keep all records and supporting
  documents in a fireproof safe.

14
Performance Evaluations
Good job!

• Independent verification of performance.
• Includes such things as an external audit by an
  independent CPA (Certified Public Accountant),
  the internal audit function, count of inventory,
  etc.

15
Internal Control in Computer Systems

• Basic internal controls apply to both manual and
  computerized systems.
• Some controls are specific to computerized
  systems.
• Tests of reasonableness
• Audit around the computer
• Proper documentation and system (both program and
  data) backup are essential.
• Significant technical expertise may be needed.

16
Controlling CASH

• Cash has universal appeal and ownership is
  difficult to prove.
• Both cash receipts and cash payments should be
  recorded immediately when received and made.
  (Deposit daily, intact.)
• Checks should be prenumbered and kept secure.

17
Accounting for CashReconciling the Bank
Statement

• An important part of internal control
• Need for calculating a true cash balance
• Two sections to be reconciled
• balance per bank
• balance per books
• If there are any mistakes or transactions that
  have not been recorded in the companys books,
  adjusting journal entries will be needed.

18
An example of a reconciliation

• A review of the bank statement dated April 30 and
  the cash ledger
• account balance on that date revealed
• a. April 30 balance according to the bank
  statement 8,750.
• b. April 30 balance according to our cash
  T-account 6,900.
• Our comparison of the books and bank statement
  revealed the following inconsistencies
• c. Checks 150 for 800 and 156 for 580 have
  not cleared yet.
• d. The bank statement showed a 30 service
  charge for the month.
• e. A 400 deposit made at 8PM, April 30 is not
  on the bank statement.
• f. The bank returned a customers NSF check for
  100 that was
• part of our April 29th deposit.
• g. With the bank statement was a credit memo
  telling us that the
• bank was successful in collecting a 900
  note and 100 interest
• for us (total collected 1,000).

19
Balance per bank section of reconciliation

• Balance per bank
• Plus
• Less
• True Cash Balance

20
Balance per books section of reconciliation

• Balance per books (ledger)
• Plus
• Less
• True Cash Balance

21
An example of a reconciliation

• A review of the bank statement dated April 30 and
  the cash ledger
• account balance on that date revealed
• a. April 30 balance according to the bank
  statement 8,750.

22
Balance per bank section of reconciliation

• Balance per bank 8,750
• Plus
• Less
• True Cash Balance

23
An example of a reconciliation

• A review of the bank statement dated April 30 and
  the cash ledger
• account balance on that date revealed
• a. April 30 balance according to the bank
  statement 8,750.
• b. April 30 balance according to our cash
  T-account 6,900.

24
Balance per books section of reconciliation

• Balance per books (ledger) 6,900
• Plus
• Less
• True Cash Balance

25
An example of a reconciliation

• A review of the bank statement dated April 30 and
  the cash ledger
• account balance on that date revealed
• a. April 30 balance according to the bank
  statement 8,750.
• b. April 30 balance according to our cash
  T-account 6,900.
• Our comparison of the books and bank statement
  revealed the following inconsistencies
• c. Checks 150 for 800 and 156 for 580 have
  not cleared yet.

26
Balance per bank section of reconciliation

• Balance per bank 8,750
• Plus
• Less Outstanding Checks
• 150 (800)
• 156 (580)
• True Cash Balance

27
An example of a reconciliation

• A review of the bank statement dated April 30 and
  the cash ledger
• account balance on that date revealed
• a. April 30 balance according to the bank
  statement 8,750.
• b. April 30 balance according to our cash
  T-account 6,900.
• Our comparison of the books and bank statement
  revealed the following inconsistencies
• c. Checks 150 for 800 and 156 for 580 have
  not cleared yet.
• d. The bank statement showed a 30 service
  charge for the month.

28
Balance per books section of reconciliation

• Balance per books (ledger) 6,900
• Plus
• Less
• Bank Service Charge Exp. (30)
• True Cash Balance

29
An example of a reconciliation

• A review of the bank statement dated April 30 and
  the cash ledger
• account balance on that date revealed
• a. April 30 balance according to the bank
  statement 8,750.
• b. April 30 balance according to our cash
  T-account 6,900.
• Our comparison of the books and bank statement
  revealed the following inconsistencies
• c. Checks 150 for 800 and 156 for 580 have
  not cleared yet.
• d. The bank statement showed a 30 service
  charge for the month.
• e. A 400 deposit made at 8PM, April 30 is not
  on the bank statement.

30
Balance per bank section of reconciliation

• Balance per bank 8,750
• Plus Deposit in Transit 400
• Less Outstanding Checks
• 150 (800)
• 156 (580)
• True Cash Balance

31
An example of a reconciliation

• A review of the bank statement dated April 30 and
  the cash ledger
• account balance on that date revealed
• a. April 30 balance according to the bank
  statement 8,750.
• b. April 30 balance according to our cash
  T-account 6,900.
• Our comparison of the books and bank statement
  revealed the following inconsistencies
• c. Checks 150 for 800 and 156 for 580 have
  not cleared yet.
• d. The bank statement showed a 30 service
  charge for the month.
• e. A 400 deposit made at 8PM, April 30 is not
  on the bank statement.
• f. The bank returned a customers NSF check for
  100 that was part
• of our April 29th deposit.

32
Balance per books section of reconciliation

• Balance per books (ledger) 6,900
• Plus
• Less
• Bank Service Charge Exp. (30)
• Customers NSF check (100)
• True Cash Balance

33
An example of a reconciliation

• A review of the bank statement dated April 30 and
  the cash ledger
• account balance on that date revealed
• a. April 30 balance according to the bank
  statement 8,750.
• b. April 30 balance according to our cash
  T-account 6,900.
• Our comparison of the books and bank statement
  revealed the following inconsistencies
• c. Checks 150 for 800 and 156 for 580 have
  not cleared yet.
• d. The bank statement showed a 30 service
  charge for the month.
• e. A 400 deposit made at 8PM, April 30 is not
  on the bank statement.
• f. The bank returned a customers NSF check for
  100 that was part
• of our April 29th deposit.
• g. With the bank statement was a credit memo
  telling us that the
• bank was successful in collecting a 900
  note and 100 interest
• for us (total collected 1,000).

34
Balance per books section of reconciliation

• Balance per books (ledger) 6,900
• Plus
• Note Receivable Collected 900
• Interest Revenue Collected 100
• Less
• Bank Service Charge Exp. (30)
• Customers NSF check (100)
• True Cash Balance

35
There is one true cash balance...

• Bank balance per statement is reconciled to the
  TRUE cash balance
• Book balance (general ledger balance) is
  reconciled to the TRUE cash balance

36
Balance per bank section of reconciliation

• Balance per bank 8,750
• Plus Deposit in Transit 400
• Less Outstanding Checks
• 150 (800)
• 156 (580)
• True Cash Balance 7,770

37
Balance per books section of reconciliation

• Balance per books (ledger) 6,900
• Plus
• Note Receivable Collected 900
• Interest Revenue Collected 100
• Less
• Bank Service Charge Exp. (30)
• Customers NSF check (100)
• True Cash Balance 7,770

38
Our accounting records

• Our goal is to have the correct CASH balance in
  the General Ledger. So, all adjustments noted on
  the books part of the reconciliation require an
  adjusting journal entry (and posting) in our
  journal and ledger.

39
Journal entries.

• Only those journal entries (and postings) needed
  to correct our book balance are recorded.
• Every item on the book side of the reconciliation
  will require a journal entry.

40
Journal Entries to correct Books
Date Account Title
Debit Credit

Apr 30 Cash 1,000
Notes Receivable 900
Interest Revenue 100 Note and
inter. collected by bank 30 Bank
Service Charge Expense 30
Cash 30 Record Bank Service
Charge 30 Accounts Receivable
100 Cash 100 Customers NSF check
put back
41
Cash account after posting
April 30 balance before reconciliation
Cash Bal. 6900 1000 30 100 True
7770
Cash
42
What about the bank side?

• If the bank has made an error, we cant fix their
  books... but we will call them to let them know!

• There is a difference between a
• timing difference and an
• error. Only errors should be
• called to the banks attention.

.
43
Accounting for CashPetty Cash

• Needed for small payments that need to be paid in
  cash--postage, taxi fares, etc.
• Usually maintained on an imprest basis--that
  means that fund is replenished periodically.
• To start the fund, DEBIT Petty Cash and CREDIT
  Cash.
• As the fund is used, receipts are kept (and
  employees usually sign voucher).

44
Petty Cash continued...

• When the fund is replenished, two entries are
  needed
• DEBIT Each Expense incurred or Asset purchased,
  CREDIT Petty Cash.
• DEBIT Petty Cash, CREDIT Cash.

45
Cash Short and Over

• Sometimes the actual petty cash balance is not
  what the vouchers indicate it should be.
• A special account called CASH SHORT AND OVER is
  used to absorb the difference.
• It can be a Debit or Credit--i.e., a little
  expense (debit) or revenue (credit). At year end
  it will be closed out to retained earnings.

46
Petty cash example

• ABC Company decided to establish a petty cash
  fund of 150.
• What is the journal entry to establish the fund?

47
Petty cash example

• ABC Company decided to establish a petty cash
  fund of 150.
• What is the journal entry to establish the fund?
• Petty Cash 150
• Cash 150

48
Petty cash continued...

• When the fund gets low, lets say 30, the fund
  custodian counts the receipts in the box.
• How much should the receipts total?
• 120 (150 - 30 in box)
• The cash and the receipts should total 150 (the
  petty cash fund balance) at all times.

49
Petty cash example

• The receipts were for
• Taxi fare to go to supplier to pick up items that
  our customer has requested at our store, 10.
• C.O.D charge on merchandise delivered, 60.
• Paid 45 to run an advertisement in todays
  newspaper.
• What is the journal entry to replenish the fund?
• There are two parts
• A journal entry to record (Debit) the expenses
  and costs and (Credit) reduce the petty cash
  fund.
• A journal entry to record the cash reimbursement
  to the fund.

50
Petty cash example

• REMEMBER
• Always check for a Cash Short or Over when you
  replenish the Petty Cash fund!

The three receipts total 115. How much SHOULD
still be in the petty cash box? 150 fund - 115
receipts 35 But, there is only 30 in the box!
51
Petty cash example...

• (Assume use of Periodic Inventory system.)
• Transportation In 10
• Purchases 60
• Advertising Expense 45
• Cash short and over 5
• Petty Cash 120
• and
• Petty Cash 120
• Cash 120

150 - 30 120
52
Using Accounting Information

• Current versus non-current
• What is a current asset?
• one which will be converted into cash or consumed
  in one year or less (from the balance sheet date)
  or an operating cycle, whichever is longer.
• What is a current liability?
• one which will be paid, using current assets, in
  one year or less (from the balance sheet date) or
  an operating cycle, whichever is longer.

53
Current vs. noncurrent...

• Classified balance sheet
  
• separation of current and noncurrent items
• enhances the usefulness of the information

Heres an example..
54
Winona Co. Balance Sheet at Dec. 31
Assets Liabilities
and Owners Equity Current Assets Current
Liabilities Cash 100 Accounts
Payable 800 Marketable Securities
300 Notes Payable 700 Accounts
Receivable 600 Unearned Revenue
300 Office Supplies 40
Total Cur. Liab. 1,800 Inventory
2,900 Long-Term Liabilities Prepaid
Insurance 60 Mortgage Payable
2,800 Total Current Assets 4,000
Notes Payable 2,000
Tot.. Lg-Term Liab. 4,800 Property, Plant
and Equip Total Liabilities 6,000
Land 200 Equity
Building, net 3,000 Contributed Capital
1,000 Equipment, net 2,800
Retained Earnings 3,000 Total
Prop.,Plant, Equip. 6,000 Total Owners
Equity 4,000 Total Assets 10,000 Tot.
Liab. and Own. Eq. 10,000
55
Operating cycle

• the average time it takes a business to convert
  cash into inventory, inventory into AR, and AR
  back into cash.
• Cash
• Inventory

56
Operating cycle

• the average time it takes a business to convert
  cash into inventory, inventory into AR, and AR
  back into cash.
• Cash
• AR
• Inventory

57
Operating cycle

• the average time it takes a business to convert
  cash into inventory, inventory into AR, and AR
  back into cash.
• Cash
• AR
• Inventory

58
The Current Ratio

• Used to evaluate a companys liquidity (a
  companys ability to generate short term cash
  flows)
• Current Assets
• Current Liabilities

Calculate the Current Ratio using the Balance
Sheet data on the following slide.
59
Winona Co. Balance Sheet at Dec. 31
Assets Liabilities
and Owners Equity Current Assets Current
Liabilities Cash 100 Accounts
Payable 800 Marketable Securities
300 Notes Payable 700 Accounts
Receivable 600 Unearned Revenue
300 Office Supplies 40
Total Cur. Liab. 1,800 Inventory
2,900 Long-Term Liabilities Prepaid
Insurance 60 Mortgage Payable
2,800 Total Current Assets 4,000
Notes Payable 2,000
Tot.. Lg-Term Liab. 4,800 Property, Plant
and Equip Total Liabilities 6,000
Land 200 Equity
Building, net 3,000 Contributed Capital
1,000 Equipment, net 2,800
Retained Earnings 3,000 Total
Prop.,Plant, Equip. 6,000 Total Owners
Equity 4,000 Total Assets 10,000 Tot.
Liab. and Own. Eq. 10,000
60
Winona Co. Balance Sheet at Dec. 31
Assets Liabilities
and Owners Equity Current Assets Current
Liabilities Cash 100 Accounts
Payable 800 Marketable Securities
300 Notes Payable 700 Accounts
Receivable 600 Unearned Revenue
300 Office Supplies 40
Total Cur. Liab. 1,800 Inventory
2,900 Prepaid Insurance 60
Total Current Assets 4,000

Current Assets Current Liabilities
4,000 1,800
Current Ratio


2.22 to 1
You have 2.22 of current assets for each 1 of
current liabilities.
Is that enough?
61
The Current Ratio

• Rough Rule of Thumb is 2 to 1, but varies by
  industry. (Many successful companies have a
  current ratio significantly less than 2.0.)

Ratios
Question What if the
Winona Company
is a toy retailer? Does the company have
adequate liquidity?
62
Winona Co. Balance Sheet at Dec. 31
Assets Liabilities
and Owners Equity Current Assets Current
Liabilities Cash 100 Accounts
Payable 800 Marketable Securities
300 Notes Payable 700 Accounts
Receivable 600 Unearned Revenue
300 Office Supplies 40
Total Cur. Liab. 1,800 Inventory
2,900 Prepaid Insurance 60
Total Current Assets 4,000

Most of a toy retailers sales come in the last
few months of the year because of Christmas. If
the company has a large amount of unsold
inventory at the end of the year, it will have a
hard time converting this inventory to cash to
pay bills.
So, ..
63
The Quick (Acid-Test) Ratio

• A STRICTER test of a companys liquidity.
• The numerator only includes cash, short term
  receivables and short-term investments (never
  includes inventory, supplies or prepaids).
• Quick Assets
• Current Liabilities

64
Dec. 31 Balance Sheet data
Assets Liabilities
and Owners Equity Current Assets Current
Liabilities Cash 100 Accounts
Payable 800 Marketable Securities
300 Notes Payable 700 Accounts
Receivable 600 Unearned Revenue
300 Office Supplies 40
Total Cur. Liab. 1,800 Inventory
2,900 Prepaid Insurance 60
Total Current Assets 4,000

Quick Assets Current Liabilities
1,000 1,800
Quick Ratio


.56 to 1
Winona has 0.56 of quick assets for each 1
of current liabilities.
Is that enough? Rule of Thumb is 1 to 1 (but
varies by industry).
65
Balance Sheet Analysis
The same techniques used in Ch. 5 to analyze the
Income Statement are used for the Balance Sheet.
Common-size Analysis Use the TOTAL
ASSETS amount as the 100 figure. So, ..
Express each Balance Sheet item as a of Total
Assets. Trend Analysis Same approach as used
on the income statement. 1. Calculate the
change for each bal. sheet item. 2. Express the
change as a of the previous years
(or base years) amount.


66
Chapter 6

Financial Accounting
The End