acct 201 - chapter 4

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    CHAPTER

    . as_hand Internal Controls

    AFTER STUDYING THIS CHAPTER YOU SHOULD E ABLE TO:L01 Understand the impact of accounting scandals and the passage of theSarbanes-Oxley Act.L 2 Identify the components responsibilities and limitations of internal control.L 3 Define cash and cash equivalents.L 4 Understand controls over cash receipts and cash disbursements.LOS Reconcile a bank statement.L 6 Account for petty cash.L 7 Identify the major inflows and outflows of cash.

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    INTERN L CONTROLS RE BOX OFFICE HITAccording to research conducted by the Association of Certified Fraud Examiners (ACFE,www.acfe.com, U.S. organizations lose an estimated $650 billion to employee fraud eachvear This occurs despite increased emphasis on antifraud controls and recent legislation tocombat fraud. While some employees steal office supplies, inventory, and equipment theasset most often targeted is cash. Cash fraud includes skimming cash receipts before theyare recorded, stealing cash that has already been recorded, and falsely disbursing cash through fraudulentbilling, expense reimbursement or payroll.This means companies that rely heavily on cash transactions are especially susceptible to employee

    fraud. For example, consider a company like Regal ntertainment Group (NYSE: R , one of thelargest motion picture exhibitors in the world. The company operates more than 6,000 screens and sellsnearlv 300 million tickets per year, generating revenues each year of about $2.5 billion. The companystates that Revenues are generated principally through admissions and concessions sales with proceedsreceived in cash at the point of sale. The primary way a company like RGC can minimize cash losses dueto employee fraud is to establish strong systems for internal control.Toward that end, RGC makes extensive use of its point-of-service information technology for the

    management of its theatres. The revenue streams generated by admissions and concessions are fullysupported by information systems to monitor cash flow and to detect fraud and inventory theft. Simplerapproaches to internal control include separation of duties. For example, one person sells tickets andanother collects the tickets. This prevents the ticket seller from stealing a moviegoer's cash and thenallowing admission without a ticket being produced by the ticket machine. At the end of the day, thenumber of tickets produced by the machine should exactly match the cash collected.

    We discuss much more about fraud and ways to prevent it in this chapter. You can practice your skillsmpreventing and detecting fraud at a movie theatre in Problem 4-lA at the end of the chapter.

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    /. ~ \ . . \ \ . . J v _n l 1 - CHAPTER 4 Cash and Internal Controlsc_6- . _ } , : # ~ f ) _ -Itosits and Cred its Withdraws and Deb its Daily Balance

    Date Amount Desc. Date No . Amount Desc. Date Amount3/5 $3 ,600 DEP 3/8 293 2,100 CHK 3/5 7,4003/9 3,000 NOTE 3/ 12 294 2,900 CHK 3/ 8 5,3003/22 1,980 DEP 3/ 15 400 EFT 3/9 8,3003/31 20 INT 3/22 750 NSF 3/ 12 5,400

    3/ 26 296 1,900 CHK 3/ 15 5,0003/ 28 200 DC 3/22 6,2303/31 50 sc 3/26 4,330

    3/28 4,130- - 8,600 8,300 3/31 4,100Desc DEP Customer depos it INT Interest earned SC Service chargesNOTE Note collected CHK Customer check NSF Nonsufficient fundsEFT Elec tronic funds transfe r DC Debit card

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    ILLUSTRATION 4-6Bank Reconciliat ion

    ILLUSTRATION 4-7Bank Statement

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    ILLUSTRATION 4 8ompany Records o f

    Cash Activities

    Timing differences

    CHAPTER 4 Cash and Internal Con t rols

    Let's compgre the bank statement with Starlight's o.wn records of cash activityover the same period, as shown in Illustration 4-8.

    STARLIGHT DRIVE-INCash Account RecordsMarch 1, 2010, to March 3 , 2 1

    Deposits ChecksDate3/53/223/31

    Desc.Sales receiptsSales receiptsSales receipts

    BeginningCash BalanceMarch 1, 2 1

    $3,800

    Amount Date No.$3,600 3/6 2931,980 3/11 2942,200 3/21 2953/24 2963/30 297$7,780Summary of Transactions

    Deposits Checks$7,780 $8,700

    Desc.SalariesRentUtilitiesInsuranceSupplies

    Amount$2,1002,6001,2001,900900$8,700

    EndingCash BalanceMarch 3 , 2010

    $2,880First Bank's ending balance of cash ($4,100) differs from Starlight's ending bal

    ance of cash ($2 ,880). To reconcile these balances, we need to identify 1) timingdifferences created by cash activity reported by either First Bank or Starlight butnot recorded by the other and (2) any errors.

    COMMON MISTAKE

    Notice that bank statements refer to an increase (or deposit) in the cash bal-ance as a credit and a decrease (or withdrawal) as a debit This terminologyis the opposite of that used in financial accounting, where debit refers to anincrease in cash and credit refers to a decrease in cash. The reason is thatthe financial accounting records are prepared from a company's perspective,while the bank statement is prepared from a bank's perspective. When a com -pany makes a deposit, the bank's liability to the company (a credit account)increases. When a company withdraws cash from its bank account, thebank's liability to the company decreases.

    RECONCILING THE BANK S CASH BALANCECash transactions recorded by a company, but not yet recorded by its bank, includedeposits outstanding and checks outstanding. Deposits outstanding are cashreceipts of the company that have not been added to the bank's record of the com-panys balance. Checks outstanding are checks the company has written that havenot been subtracted from the bank's record of the company's balance. Once thebank receives the deposits outstanding , the bank's records will increase. Similarly,once the bank receives the checks outstanding, the bank's records will decrease}Wealso need to check for and correct any bank errors.

    Comparing the deposits recorded by Starlight (Illustration 4-8) to those reportedon the bank statement (Illustration 4-7) reveals that the deposit of 2,200 onMarch 31 is not reflected in the bank's balance by the end of March. This is adeposit outstanding.

    Comparing the checks written by Starlight to those reported in the bank state-ment shows that the bank received checks 293, 294, and 296 by the end of March.

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    CHAPTER 4 Cash and Internal Controls

    This means checks 295 (for $1,200) and 297 (for $900) remain outstanding andare not reflected in the bank's balance. The reconciled bank balance is calculated onthe left side of Illustration 4-9.RECONCILING THE COMPANY S CASH BALANCEWhat are some examples of cash transactions recorded by the bank, but not yetrecorded by the company?/ These would include items such as interest earnedby the company, collections made by the bank on the company s behalf, servicecharges, and charges for NSF checks-checks drawn on nonsufficient funds orbad checks from customers\Jn addition, we adjust the company s balance for anycompany errors.

    Six cash transactions recorded by First Bank (Illustration 4-7) are not reportedin Starlight's cash records (Illustration 4-8) by the end of March:1 Note collected by First Bank on Starlight's behalf ($3,000), which includesinterest of $200.2 Interest earned by Starlight on its bank account ($20).

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    3 Electronic funds transfer related to the payment of advertising ($400). Timing differences4 NSF check ($750).5 Debit card purchase of office equipment by employee ($200).6 Service charge ($50).

    COMMON MISTAKEStudents sometimes mistake an NSF check as a bad check written y thecompany instead of to the company. When an NSF check occurs, the company must adjust its balance of cash downward to reverse the increase incash it recorded at the time it received the check from the customer, becausethe customer did not have enough funds to cover the check.

    In addition to the amounts related to timing differences, we need to address oneother reconciling item. Comparing Starlight's record of checks written to those inthe bank statement reveals an error by Starlight. Check 294 for rent was written Company errorfor $2,900, but Starlight's accountant recorded it incorrectly as $2,600. First Bankprocessed the check for the correct amount of $2,900. This means Starlight needsto reduce its cash balance by an additional $300 for rent expense. The reconciledcompany balance is calculated on the right side of Illustration 4-9.

    Bank s ash BalanceBefore reconciliatio nDeposits outstanding:

    3/31 = $2,200Checks outstanding:

    295 = $1,200297 = $ 900

    After reconciliation

    STARLIGHT DRIVE-INBank Reconciliation

    March 31 2010

    $4, 100+2,200

    - 2,100

    $4,200

    o ash BalanceBefore reconciliationNote received

    Interest earned from noteInterest earned from bankEFT for advertisingNSF checkDebit card for office equip.Service chargeCorrected rent expense error

    After reconciliation

    $2,880+ 2,800+ 200

    20- 400750200

    50300

    $4,200---------Reconciled---------....l

    ILLUSTRATION 4 9Reconciling the BankStatement

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    ILLUSTRATION 4-10Entries to Adjustthe Company's CashBalance

    *

    CH PTER 4 Cash and Internal Controls

    f the bank ~ e r e aware of all deposits made and all checks written by the company, the bank's balance for cash would be $4,iOO. Similarly, once the companyadjusts its balance for information revealed in the bank statement, its cash balanceis 4,200. The fact that the two balances match provides some indication that cashis not being mishandled by employees.( sa final step in th