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due that are paid later, such as for rent or utilities, this type of business is operating almost entirely

on a cash basis. As organizations grow larger, their direct use of cash usually decreases. The larger version of the above-mentioned retail store may make many of its sales through the use of store-issued and bank credit cards. Although otherwise treated as cash sales, these charges are receivables due per the larger store's accounting
V

records. In larger organizations, virtually all business transactions are based on recorded receivables and payables, rather than through the actual handling of cash. What the larger organization considers to be cash is represented by transaction balances in their various financial accounts. Only very special legitimate businesssuch as a bank accepting retail customer cash deposits, or a state government lottery authoritydeals in substantial amounts of cash. However, most businesses have only limited cash processes to handle the relatively small amounts of cash needed for normal business purposes, such as petty cash funds where small amounts of cash are maintained at various locations to cover various small cash payments. Cash, of course, is essential to pay for expenses such as the payroll and other business costs (such as taxes). A publicly held corporation needs cash to pay for dividends on its stock, and banks and lending agencies will require certain levels of cash balances. Because cash in the bank has such a strong relationship with other transaction cycles such as receivables or payables, an internal auditor should have a good understanding of cash- related internal controls and processes. (a) ACCOUNTING CONTROLS A discussion of cash processes starts most logically with an identification of where and why cash is handled in particular organization situations. Often, this identification may lead to questions of whether a cash process is necessary or if it might be handled differently. For example, is it really necessary that a salesperson accept cash from customers or that some account collections are in cash? While cash might be best in terms of accelerating and maximizing collections, different

procedures can often eliminate the handling of cash and the risk of its improper diversion. Any activities involving cash should be critically appraised to determine if control compromises are justified because of other operational considerations. Internal audit should develop an understanding of the type and nature of the organization's cash accounts that often require special control considerations. As
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a matter of clarification, this cash is usually not maintained in the form of currency but as an account recording cash transactions. For many organizations, cash is maintained in five basic account types, as follows.
1.

General Cash Account. This is the central bank account through which most receipts from sales and collections
pass, as well as disbursements for purchases and expenses. Even though an organization may have a variety of specialized cash accounts, all deposits and disbursements would normally be made through this central, general account, with cash notification transactions directed to other systems.

2.

Branch Cash Accounts. Organizations with multiple locations will typically have separate accounts at each of
their outside locations. These accounts will have the same attributes as the general account but will serve local or branch operations.

3. Imprest Payroll Accounts. Payroll represents the major cash expense for many organizations. Aside from a minimal balance maintained in this account, at the start of each payroll period the organization would prepare a check from its general account to transfer the total amount of the payroll to the imprest payroll account. This improves controls and reduces the time necessary to reconcile payroll account balances. 4. Imprest Petty Cash Funds. These are normally not bank accounts but fixed amounts of cash placed under the control of various persons in the organization for special cash transactions. For example, an administrative assistant may retain a small amount of cash to dispense for such things as rolls and coffee for meetings. Petty cash funds are often relatively small, and the person in

charge replenishes them by submitting receipts to cover the cash amounts disbursed. 5. Savings Accounts. Organizations typically place certain funds not needed for day- to-day operations in longer-term cash or cash equivalent accounts. These
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accounts earn interest but tie up the deposited money for limited amounts of time. For example, an organization can place monies in United States Treasury Bills that have a 90- day maturity and earn interest over that period, or they can buy what is called commercial paper, which pays interest based upon periods as short as overnight. These deposits are considered to be the same as cash because they can be easily sold with no market risk.

Cash for various purposes is usually maintained in accounts under one of the above five general categories. Cash passes through these accounts through the process of cash receipts, intermediary cash handling, and custody activities, and leaves through the process of cash disbursements. Internal audit should have a good understanding of the controls associated with each of these general cash-handling areas. (i) Receiving of Cash. Cash receipts may be in the form of checks mailed as
payments from billings, receipts from cash sales, or various types of bank transfers. This cash is captured and deposited early in the cash receipts processing cycle, and thereatter moves internally toward centralized cash controls normally exercised by the organization. A key point to consider here is that cash always has a time value. Customer checks as payments of bills should always be deposited as soon as possible. Even if they are not deposited in interest-bearing accounts,

organizations may have agreed to maintain certain average daily levels of balances and should deposit cash in those accounts as soon as practicable.

Cash represents a major control risk to an organization. It can be improperly diverted, and once diverted it is often difficult to trace because the cash itself is not separately identifiable. Thus, an organization must
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establish strong controls over its overall cash processes, focusing both on organization outsiders, to be sure that the cash received is what should be received, and on insiders, to be sure that cash received is not improperly diverted. The sooner controls can be established over cash received, the better. Some form of receipt, such as a serially numbered document with one copy to the outside party or the entry of the transaction on a cash register with a serially numbered ticket of some kind, should be issued for the cash received. Ideally, any receipt of the cash should be linked to the relief of a previously existing account, such as the collection of an accounts receivable with a debit to cash and a credit to the requisite receivables account. Another illustration would be the sale of merchandise controlled on an item-by-item inventory basis, where the organization must account for its inventory or cash Controls should be instituted to insure collection for any services provided. This might mean giving the customer a cash sales slip, without which the customer could not receive a service. It might mean physical protection over merchandise or restricted entry to areas where these services are rendered, as in the case of a theater. Appropriate internal controls over cash require a segregation of duties, and this segregation-of-duties control applies to all types of cash receipt controls. Outside parties may be utilized as a further cash receipts control. A customer can serve as a check on the action of the employee in a retail

environment, providing assurance that the employee rings up a cash receipt on a point-of-sale register. Cash receipts must always be separated from cash disbursements. In smaller organizations, there is frequently pressure to use portions of the cash received to cover current expenditures of one kind or another. This practice should always be resisted. More effective
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controls

and

cleaner

accountabilities will result when cash receipts and disbursements processes are completely separated. Cash receipts should always be channeled intact and promptly to established central cash depositories. A day's receipts should be deposited iptact as soon as possible after the cutoff for the day. If high volumes of cash are received, consideration might be given to depositing the cash at several times during the day. This is important for several reasons. First, any delay results in a greater risk of theft or improper diversion. Second, checks might be good upon receipt but not later. Third, it is important to be able to identify a particular deposit with a given period of time. Finally, and most important, undeposited cash is idle cash and is not contributing to the best use of organization resources. When the cash received is transferred to another organization unit, the accountability of the transferor should be properly relieved and a new accountability for the transferee clearly established. This is normally accomplished by some type of a cash receipt or transfer record. Records by which the accountabilities for cash are established and controlled should be maintained by persons independent of the persons charged with the direct accountability. Checks should be made periodically by an independent person to verify that cash has been properly handled and accounted. (ii) Cash Handling and Custody. Cash handling is interwoven to some extent
with both cash receiving and disbursements. Many of the handling and custody issues here deal with cash as it resides in the five account types described

previously. When an organization has actual cash in its possession at some point during its operations, there may be other control aspects that can best be considered under the category of cash handling and custody.

Large amounts of cash retained by the organization create a risk of theft by outsiders or even by employees, and physical safeguards over the cash
X

held within the organization should always be strong. In certain cases locked cabinets may be adequate; in others, small safes are needed; in still others, elaborate vaults may be needed. These facilities, of course, must actually be used. A safe is of little value if cash is often kept in an unlocked file and the safe is used only on an exception basis. Access to cash-storage facilities must be controlled through keys, combination locks, and other physical protection mechanisms. If an organization has a need to disburse a fairly large volume of cash or other negotiable instruments during normal operations, a separate cashier function should be established. During operational periods, the area used by such a cashier needs to be adequately sealed off by cages or separately partitioned portions of office quarters. Finally, when cash is transferred to or from a banking facility, there must be suitable protection. In past years, some organizations maintained large cashier facilities to cash employee payroll or personal checks or even to pay employees in cash. With the convenience of checking accounts and the ease with which pay can be transferred to checking accounts and cash withdrawn through automatic teller machines (ATMs), organizations today do not need to provide this level of a cashier facility. A larger organization can arrange to directly deposit employees' pay in their checking accounts and might even add an ATM, supplied by a local bank, to allow employees to make cash withdrawals on site. Travel advances can be handled in a similar manner. Employees can be issued company credit cards and can use these cards both for charging their expenses and for making cash withdrawals through an ATM. When these

types of procedures are established, the organization needs only to provide very limited cashier facilities. Since "cash" is a broad term that goes beyond physical cash on hand to include all types of bank accounts and negotiable instruments, the earning potential of that cash needs to be recognized, where practicable, through the placement of funds in interest- bearing accounts or under other
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arrangements where the time value of money will be realized. In some cases, the maintenance of given bank balances may be the basis for credit lines or other services rendered by the banks involved, even though the given account earns no interest. In other instances, funds can be placed in shortterm, interest-bearing commercial paper. The objective is to exploit these potentials to the maximum extent possible. (iii) Cash Disbursements. Once cash is received and available in its various
forms, it is ready for use for organization purposes such as the purchase of operating facilities, the payment of expenses, and for other disbursements such as paying dividends to investors. The general audit objective is that cash

disbursements should be for valid and proper purposes, that fair value has been received, and that they are in the correct amounts.

Perhaps the most general control to always be considered here is that the cash receipts and cash disbursement phases of the total cash process need to be as separate as possible. Although the procedures to enforce this control may vary, internal audit should always look for an appropriate separation of responsibilities between cash receipts and disbursements. In normal accounting operations, major expenditures are processed through the creation of a payable that is then subsequently offset by the cash disbursement. At the same time, the disbursement is normally reviewed in terms of the validity of the underlying payable plus the propriety of the timing of the liquidation of that payable. However, a number of situations

will arise when small cash expenditures must be made without delay and when the amounts may be too small to justify the application of the formal disbursement procedures. In these circumstances, cash may be advanced using what is called a petty cash fund. Normally, petty cash disbursements are best handled on an "imprest"
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basis, as discussed earlier. Under this procedure, a designated fund amount is established, cash payments are made from the fund as required, and then reimbursements are made to the fund covering exactly the total amount of expenditures, thus bringing the fund back to its original level. The size of the fund should be large enough to sustain expenditures, with allowance for the time required to process the previously described reimbursements, but no larger than necessary since the level of the fund can be changed from time to time in light of experience and new conditions. Satisfactory evidence should always be obtained to support expenditures. If such evidence is not directly available in the form of an invoice, cash register receipt, or other documentation, a special receipt should be prepared and signed, preferably by the recipient of the cash, but at least by the person making the expenditure. These supporting documents should be canceled at the time of reimbursement to prevent their reuse. Because petty cash expenditure amounts are usually relatively small, there may be a temptation to relax controls requiring adequate documentation. Documentation should be reviewed at the time of reimbursement. Improper use, however, cannot be detected except by an actual examination and count of the fund. Both of these protective efforts need to be carried out by responsible management on a continuing basis. The cash-disbursement process highlights the desirability of breaking down the various aspects of control activities and assigning them to different individuals. Thus, one person might review the documentation for the request, another prepare the check-process- ing voucher, and a third review

the propriety of the combined set of documents as well as review the output from the automated accounts payable system. For larger disbursements or those not covered by an automated accounts payable system, a fourth person might provide the primary signature and another for secondary signatures for larger checks. Each of these activities serves as a cross-check on another. The organization should not overcontrol this process, however. Although
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multiple persons may be involved for large disbursement requests, the process should be reduced to a more cost-effective level for smaller disbursements. All checks issued should be made payable to the specific individual or firm from which the products or services are obtained. The writing of checks to "cash" or to "bearer" should be strictly prohibited, since cash can then more easily be used for unauthorized purposes. (iv) Otner Aspects of Cash Process. A number of other matters pertaining to
effective control over cash cut across the receiving, handling, and disbursement aspects of this process. These include the need to bond employees handling the organization's cash, to protect critical documents such as checks, and to independently reconcile all checking and other cash acsounts.

Normal business prudence requires that all employees participating in any part of the cash processes be bondeda company-paid insurance policy against employee malfeasance. The benefits derived are twofold. First, there is the actual protection to the organization in the case of any defalcation or other improper diversion of organization funds. Second, the knowledge of the bonding may motivate the individual employee to exercise a higher standard of care and integrity. To accomplish the latter, the bonding action should be properly publicized. The organization should also have strong, well- publicized procedures in place to obtain restitution or to force prosecution of any employee involved with any improper diversion of cash.

For all cash processes, records should be kept up-to-date as a basis for both efficient current reference and prompt periodic reporting. Delays in carrying out various parts of the cash processes can generate greater physical risk and at the same time restrict the efficient utilization of cash resources. Although the use of paper check forms is declining due to electronic
XIV

transfers and other automated payment processes, the proper control of any checks or other special forms is always important in terms of physical protection and efficient usage. The problem is complicated because modern computer printers generate the entire check document, using laser printers, from blank paper form. Control of these computer programs is also very important. An important part of the overall cash-management process is the independent reconciliation of all bank accounts. Reconciliations should be made by persons or computer systems who are independent of the regular cash-receiving and -disbursing operations. Bank statements and canceled checks should be obtained or received directly from the depositories to,insure that they have not been tampered with in any manner by any intermediary. A bank will often provide reports that help complete this process. For accounts with a smaller number of transactions, bank reconciliations also provide the opportunity to review how receipts and disbursements are handled and to identify unusual actions. In earlier days of internal auditing, the independent reconciliation of checking accounts was once a regular internal audit task. While both internal or external auditors may want to perform this exercise as part of their annual financial audit, internal audit functions today have generally moved away from this as a regular process. Internal audit resources are too valuable, and other persons in the accounting organization can usually perform this function subject to periodic internal audit review.

(b) CASH PROCESS INTERNAL CONTROLS Many of the cash-related internal controls discussed in this book are covered in subsequent chapters involving the receipt and disbursement of cash. This section considers cash as it applies to overall accounting operations. Cash presents a far greater internal control risk to an organization than nearly any other operation. An organization may manufacture, for example,
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a product called a "widget" that has wide consumer appeal. It might be possible for dishonest employees to steal these widgets and use them or sell them for their own personal gain. However, the dishonest employee can only steal so many widgets before an astute management can see that widgets are missing from the warehouse. Without proper reconciliation procedures in place, it can be much harder to detect if cash from those widget sales is missing. This is because of the numerous transactions associated with this cash, including customer credits for returned goods, outstanding receivable balances, and payments in transit. Cash is a dynamic commodity with its transaction balances in flux at any moment. For this reason, external auditors take strong steps at year-end to determine that the cash balances stated in financial statement balance sheets represent cash on hand, cash in transit, and cash in various general accounts. The external auditor should also be concerned that this cash has been properly classified and that any committed funds have been identified. Management has, or should have, a strong interest in establishing adequate internal controls over its cash processes, including the following:
Periodic reconciliation of checking accounts to recorded cash balances.

This includes a review of cash deposits and checks issued, with an accounting for checks in transit.
Examination of canceled checks on a test basis for appropriate

signatures, endorsements, dates, and amounts.

Controls over the handling of cash at all levels to ensure that controls

include a proper segregation of duties.


Physical controls over significant documents such as checks. Periodic follow-ups on special cash items such as checks

outstanding and stop- payment notices


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Cash is such an important element in organization operations

that strong internal controls are essential. These controls should be in place for all cash accounts and at all levels. 4 (C) CASH-RELATED INTERNAL AUDIT CONSIDERATIONS In the early years of auditing, a major emphasis of many reviews was on the controls over cash. As the years went by, the sources of actual cash in the modern organization were limited to petty cash funds used for very small, miscellaneous purchases. With an overall objective to review controls over cash, internal auditors all too often made the reconciliation of a relatively minor petty cash fund a major component of their reviews. Even worse, they often reported a small difference in the petty cash fund as if it were a major control issue. At the same time, they may have ignored more significant control issues. The modern internal auditor should have moved away from this overemphasis on the controls over a relatively minor petty cash account while ignoring more significant control issues. Internal audit should not ignore such areas as petty cash funds because they are viewed as too minor, but should understand where cash plays a significant role in organization operations and should review for appropriate controls.

(i) Financial Audit Considerations. Most cash-related financial audit


procedures are performed by external auditors as part of their year-end procedures. Internal auditors often become involved with these external audit procedures in their support of external auditors. They also may
XVII

have a need to reconcile account balances as part of reviews of smaller units or other special audits.

Internal audit should understand how to perform a bank reconciliation. In many respects, this is similar to the process an auditor would use to reconcile a personal checking account. Internal audit starts with a statement from the bank for each account as well as internal records indicating receipts and deposits. In addition to the bank's account statement, external auditors at year-end request an independent confirmation of an organization's accounts at a given bank, revealing such matters as restrictions on withdrawals due to compensating balance requirements, liabilities to the bank related to the account, and other matters. An internal auditor might also request such a confirmation when performing a financial audit of cash at a smaller, remote unit not part of the external auditor's scope. Figure 22.9 is an example of a bank reconciliation worksheet to test a bank account balance. This reconciliation process was once a very labor-intensive task requiring the physical handling and summation of checks. Computer systems both at the bank and within the auditor's organization have made this much easier; however, internal audit should not rely just on the printed summary reports when making the reconciliation but should also look for

unusual items on a test basis. Some of these items should be physically examined in detail. Reconciliations of petty cash funds are very similar to the process for checking accounts. However, internal audit should look
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for an internally prepared record of cash disbursements, including appropriate documentation, as well as a record of all deposits into the fund. (ii) Cash-Related Operational Audit Procedures. In any operation
involving the handling of cash, internal audit should concentrate on whether cash is properly protected from theft, that it is promptly moved to appropriate accounts, and that it is managed to

Balance per Bank


1. Obtain 2. Add

balance per bank statement.

$5,236,000
42,126

deposits in transit and bank errors that understate the balance. $


$5,278,126

Subtotal '
3. Deduct

outstanding checks and bank errors that overstate the balance. $136,016
19

4. Calculate

corrected cash balance. Balance per Books

$5,142,110

5. Obtain 6. Add

balance per books and financial records.

$5,309,461

deposits credited by the bank but not yet recorded.$137,140 book errors that understate the balance per books (e.g. a

7. Deduct

check for $10 that was recorded as $100 on the books).______$261,630 Subtotal
8. Deduct $5,184,971

bank charges not yet recorded by depositor (e.g. bank service $ 27,361

charges and NSF checks).


9. Deduct

book errors that overstate the balance per books (e.g. the
15,500

depositor writes a check for $100 but records it as $10).______$ 10. Con-ect cash balance.

$5,142,110

best serve the organization. Controls for proper protection over cash include such simple matters as keeping petty cash funds in locked, secure facilities, transporting all cash deposits in armored carriers, and discouraging any temptation through strong separation-of- duties controls. For the operational auditor, cash may include check forms, credit vouchers, negotiable securities, retail gift certificates, or any documents that could be easily converted to cash through improper procedures. Internal audit should look for appropriate controls to prevent misappropriation in any cash-related documents.

Cash always has a time value, and idle cash does not draw bank account interest or satisfy bank minimum-balance requirements. Internal audit should always look for situations where improved controls and procedures could move cash faster to appropriate banking accounts. Figure 22.10 contains selected audit procedures for operational reviews for controls over the protection and movement of cash. These procedures cover cash or cash- equivalent functions used for operations but not cash investments, as discussed in Chapter 30 on financial management. Because actual cash processes may vary to a great extent due to the nature of the organization, these operational audit steps are very general. Internal audit should always develop an understanding of the various sources where the organization receives its cash and then concentrates on the controls over the more significant. That is, there is often little need to do a formal cash count of a petty cash fund unless that fund experiences a high volume of transactions or there is some other perceived concern. 22-26 Ch. 22 Accounting Systems and Controls Figure 22.10 CashRelated Audit Procedures 22.10.1 Identify

all

repositories

of

cash

or

cash

equivalents located throughout the organization. The surveys should include cashier functions, cash value documents such as cash redeemable documents, and securities.
22.10.2 On a surprise basis and accompanied by a

member of management, to act as a witness, visit one or more repositories of cash and perform a formal cash count; reconcile that count to formal accounting records, investigating any differences.

22.10.3 Review

all procedures regarding cash and

comment on the adequacy and attention to controls, including separations of responsibility throughout.
22.10.4 Perform a walk-through inspection'of all cash21

handling areas, with an emphasis given to security over the cash or cash equivalents.
22.10.5 Determine that procedures are in place to record

the receiving, depositing, or disbursement of all cash transactions.


22.10.6 If terminals are used for cash, determine that

controls exist over the sign in / sign out for those terminals and that procedures require a periodic review of terminal logs.
22.10.7 Determine

t procedures require

whether

supervisory or management personnel to review and approval all journal entries, recording cash transactions and balancing cash routines.
22.10.8 Determine that persons involved with depositing

and recording cash receipts are covered by insurance and fidelity bonds in appropriate amounts.
22.10.9 Review the adequacy of security controls over

cash

functions, in

both

monetary

and

cash

equivalents. On a selected basis, review security procedures detail, noting any potential vulnerabilities.

22.10.10

Assess overall procedures in place for the

conservation of cash throughout the organizaiion, including:


Use of cash discounts for early payments Cash concentration accounts Effective use of EDI and electronic fund transfers The use of zero-balance accounts for such matters as

payroll
The issuance of employee credit cards for travel rather than

cash advances (iii) Cash-Related Computer Audit Procedures. The typical


organization does not have many strictly cash-oriented control systems. Cash-related transactions flow through many processes, but internal audit is typically interested in the other transactions related to that cash. That is, an internal auditor might review controls I over a sales system

and would develop computer-assisted audit techniques (CAATs) to measure various sales- related parameters. Internal audit would have less occasion to develop CAATs just for the cash side of that process Banking or financial institutions deal with cash as their primary product and have a large number of cash-related processes such as checking accounts, home mortgages, and other loans outstanding. These are supported by extensive

computer systems that internal audit should consider for potential controls reviews and that lend themselves to numerous types of CAATs. Specialized financial professional organizations such as the Bank Administration Institute3 publish audit guides and other materials
23

for the computer audit-related reviews of financial institutionrelated systems.

In a nonftnancial institution, internal audit can sometimes develop very effective CAATs covering the organization's cashmanagement procedures. For example, a sales organization with remote branch offices may have instructed those locations to remit all cash collected to a sweep type of account for processing in a central location. Those same branch organizations may not have appropriate control disciplines to process these remittances on a timely basis. Internal audit could possibly develop a CAAT to review reported daily sales figures and match them with reported deposits to determine if cash deposit rules are being followed. As another test, internal audit could develop a CAAT to calculate the average cash balances at these branch units. The results might reveal that management was not taking proper stewardship control over their cash management. (Iv) Cash Process Sample Audit Report Findings A: Excessive Cash Balances in Cashier Accounts. We did a count of
cash under the responsibility of the home office cashier that is used for employee travel advances, expense reimbursements, and miscellaneous expenses. We also reviewed average daily disbursements from this account

over a period of six months. With the exception of two instances where there was significant employee international travel, we found that the cashier total cash balance was always greater than daily disbursements by a factor of about ten. This large cashier cash balance ties up resources that might be deposited in organization accounts.

Recommendation. The average daily balance of cash under the


control of the home office cashier should be reduced by about 80%. This amount should be reevaluated periodically based on organization activities and other needs. To allow for the occasional circumstances when a large travel advance is needed, arrangements should be made with the local bank to secure travelers checks on a one-day notice.

B: Inactive Checking Accounts. The ABC and XYZ facilities were both
closed about one year ago. However, the local bank accounts for each of these facilities remain open. Management advised us that the accounts are open because certain refund checks issued before closure have never cleared. Although the balances in each of these accounts is at a minimum level, the open accounts expose the organization to potential fraudulent transactions.

Recommendation. A detailed reconciliation should be performed to


identify the number and nature of the outstanding checks issued from each of these accounts. Remaining balances should be reduced to the level of these outstanding checks. Consideration should be given to contacting some

of these check payee parties, informing them that the accounts will be closed. In any event, the checking accounts should be closed within six months.

22-4 RECEIVABLES PROCESSES Receivables processes cover any action that generates claims of
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amounts due against individuals or other organizations. These claims are usually against parties outside the organization but at times can also involve employees and officers. The claims are brought into existence to allow the organization to recognize them as a future liability to be resolved later. They can be considered an intermediary phase pending their ultimate collection in the form of cash or other types of consideration. Although these claims can originate in a variety of ways, the major category has to do with the sale of products or services rendered by the organization. This section first deals with this sales-related category and then later touches on other receivable types. The receivable processes that relate primarily to sales have a number of important relationships. There is a need for policies covering the extent to which credit is first granted and then subsequently administered. Who should be extended credit? In what amounts? How aggressive should the organization be ih pressing for subsequent collection? A second type of consideration concerns customer satisfaction and continuing customer goodwill. The organization should be interested in how customers react to the modes of credit authorization, billing, and collection. The organization is also interested in learning about how the customers are reacting to organization products and policies in a broader sense. Finally, there is the specific interest of the organization in the efficiency of its various receivable activities and the effectiveness of its controls. The modern organization faces many potential risks related to its receivables processes. If credit is granted without proper policies or

customer screening, the organization may be either limiting its sales through too tight credit practices or booking sales that may be eventually uncollectible. Once a receivable is booked, the organization should handle billings in a prompt and accurate manner. Cash payments against receivables need to be properly recorded and deposited. Finally, the organization needs to establish policies to collect on late or overdue receivable accounts. Accounts receivable are often covered by external auditors who send out independent confirmation letters asking customers with receivable balances to acknowledge the existence of those recorded receivables. This is an important step in a financial statement audit. However, there are a large number of additional and related receivables-related operational and accounting review areas that should be a key part of the internal auditor's activities. (a) TRANSACTION CYCLE The processes or transactions relating to accounts receivables can be grouped into three phases. The first phase has to do with the conditions under which the receivable comes into existence, including both recording the sale and determining that the customer has a proper credit history. The second covers the administration of the receivables thus created, including the processing of bills and statements as well as monitoring the overall status . of all receivable accounts. The third phase consists of the means by which the receivable is finally liquidated. This includes the collection of cash to satisfy billings or the use of credit collection procedures for any overdue billings. The objective for each is to understand the general range of matters involved and to identify major control problems. Automation and competitive business practices have changed the manner in which receivables are created and processed for many organizations. Electronic data interchange (EDI) procedures, discussed from a purchasing perspective in Chapter 24. are an example.
A customer

may make a purchase through an electronic transmission to the organization's order-entry system. The order is electronically acknowledged, shipped, and electronically billed. The customer may then pay through an automated electronic funds transfer (EFT)
27

process. Using EDI, much of the traditional paper trail frequently used by auditors and others disappears. The accounts receivables process and its related controls change extensively using these newer technologies.
(i)

Recording Sales and Generating Receivables. Since an account receivable

normally arises out of the sale of the orgarlization's products or services, internal audit is concerned with establishing a direct link between the actual sale and the recording of the receivable. The recorded receivable must be backed up by the shipment of the product or the performance of the service according to preestablished sales terms. These objectives are likely to be satisfied when the creation of the receivable can be directly linked with the recording of the sale and the relief of an inventory account or with a record of the performance of the service. This process usually involves three basic automated systems in the organization: sales order entry, inventory or shipping systems, and accounts receivable. The latter also links to key accounting systems including the general ledger.

Generating an account receivable creates the need for the organization to extend the required credit to the customer to cover the sale. This credit decision depends upon the general credit policy of the organization and how it is applied to a particular customer in* the light of his or her credit

standing and past payment experience. When credit acceptability has been determined, regular sales and billing procedures are initiated. As a part of those procedures, an invoice is prepared and the account of the customer charged. A major control consideration applying to the generating of receivables is an independent review and approval of the customer's credit. This approval should be provided by an independent department or person within the framework of established organization policy and should consider appropriate credit-related information about the particular customer's current credit balances, payment history, and the general credit and financial standing. A credit approval by parties independent from the sales department is important since that sales function is often more interested in completing the sale rather than collecting on it in the future. Prices and terms for the sale must be properly authorized. For billing purposes, the applicable prices, discounts, and other tenns must be based on established organization policy. Any special interpretations or deviations must be approved by properly authorized individuals. Cash discounts are usually part of standard billing terms, typically a 2% discount if the invoice is paid within 10 days with the net amount due if paid in 30 days. A penalty will usually be assessed after 30 days. These terms should be clearly stated on the invoice document using such terms as "2%-Net." For goods shipped, invoices need to be prepared for use in several operational areas. One copy, generally with prices omitted, goes with the shipment as a packing list. Another, properly priced, goes to the customer as the official invoice. Others are used for the compilation of sales data and for accounts receivable posting. Invoice shipment data will also impact inventory and production records and may also form a basis for calculating sales commissions. Invoices were once mostly multicopy paper documents, and proper serial number control and correct postings were critical controls. Where

paper-based systems are still in place, these controls continue to be important.


(ii)

Administration of Accounts Receivables. The administration phase of the

receivables process starts when the receivable is recorded and continues until the receivable
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Figure 22.11 Accounts Receivable Process

is paid or otherwise liquidated. This accounts receivable record must be tied to control accounts that support individual customer and other categories of billings. Newly generated charges, credits from cash collections, and all other miscellaneous charges and credits should be posted on a daily basis so that up-to-date information is always available to serve the various operational needs of the organization. At the same time, accuracy must be maintained through checks on the agreement of detailed accounts with the established control. This check is normally handled by the typical automated accounts receivable system. Figure 22.11 is a flow chart showing the components of an automated accounts receivable system. Such a

system could be implemented as part of a larger computer system or could be resident on a desktop microcomputer. The controls necessary for such an application were discussed in Chapter 17. In addition to the accounts receivable information furnished regularly through online retrieval screens or the like, there should be periodic reports of current balances and an aging analysis. The aging analysis shows the portions of the account balances that have been unpaid for different time periods, including current, one month overdue, two months overdue, three months overdue, and so on. Figure 22.12 is an example of this type of aged i receivables balance report. An analysis of this aging data is important for the administration of the ongoing credit and collection efforts. It will also allow the organization to adjust its estimates of reserves for bad debts, as discussed below. At the end of a month or accounting period, organizations generally send statements summarizing all invoices issued during that period. Even though payment terms require that individual invoices be paid in advance of the period-end statement date, the statement provides an account summary. A basic control here is mailing statements directly to individual customers with noopportunity for diversion or modification by others. This makes it possible for the statements to serve as a reliable cross-check on the accuracy of the individual accounts. It is also an important means of disclosing any delayed reporting of collections. Although regular organization sales activities provide the major source of the accounts receivable, other organization activities and developments may lead to some special types of receivables, including:

Advances to Employees. Sales of organization products or services


are normally included in the regular accounts receivable. However, there may be advances of one kind or another for travel, special business purposes, or possibly for personal reasons. Advances for
31

travel would normally be booked in a travel accounting system. Many other special employee advances are controlled through the payroll system and are settled over future pay periods. Advances for personal purposes would require the approval of properly authorized managers.

Deposits with Outsiders. In many situations, deposits are required in


connection with the establishment of utility services or for other reasons. These deposits may be of a temporary nature or may be permanent as long as the service is being utilized. The receivable record here is important so that the deposit can be recovered when the original need no longer exists. While these deposits would not be part of an accounts receivable system, other records should be established to record them.

Claims. Relations with vendors, carriers, or outside service groups


can lead to claims for a variety of reasons. These become a special type of receivable. Insurance claims are still another source of special receivables. Effective control is

provided by recording of the claim as a receivable, rather than recording the proceeds when received. Accruals of Income. A special type of receivable, in a very loose sense,
exists when earned income is accrued prior to being due and collectible. The objective here is to recognize income in the periods it is actually earned and thus provide a better evaluation of current operational performance.

While the nature and scope of the transactions and activities that generate these miscellaneous types of receivables can vary greatly, certain minimal controls are necessary for all of them. First, policy and procedure conditions under which the particular type of receivable is created should be clearly defined. Safeguards should exist to make sure that the receivable is recorded at the earliest possible time and in the proper amount. Second, procedures must be established for the periodic review of all miscellaneous receivables, which are frequently overlooked or not given adequate attention in a regular operational review. Specific precautions must be taken to combat such tendencies. (iii) Dispositions of Receivables and Credit Collections. Accounts receivables
represent an asset claim against the particular parties involved, and these claims should be relieved only in a properly authorized manner. The four normal modes of accounts receivable account relief are cash collections, return allowances, account adjustments, or bad debt write-offs.

The most usual settlement mode is cash collections from customers to liquidate the previously generated receivables. At the time of recording the cash collections, the organization must verify that any cash or other

discounts deducted are properly earned and recorded. The customer account should be properly credited and adjusted if the discount was improper. When products sold are returned for one reason or another, the result is the reverse process of the original sale. While retailers often allow returns if a customer indicates dissatisfaction, most manufacturers, industrial distributors, and other organizations will have a requirement to determine
33

that the shipment was somehow not in compliance with terms or was in error before returns are allowed. There should be a requirement that the actual return is authorized. A second retum-related requirement is that the products returned are actually received in proper condition. Finally, the credit for the return must be in the proper amount. These three control pointsproper authorization, receipt of goods, and proper amounts provide the basis for establishing a sales return credit. Adjustments and allowances are harder to control when a customer is granted a special credit for volume purchases, for the promotional sale of particular types of products, or to adjust for product deficiencies. Where an allowance is pursuant to a specific arrangement, controls should be in place to confirm compliance with the arrangement. In many cases, however, the authenticity of the credit may be based on judgmental factors evaluated by an executive who then approves the credit within the authorized limits. There will always be customers who simply fail to pay. There may be bankruptcy situations, disappearance of the debtor, or other causes that leave no alternative but a write-off of the account as a bad debt. Provisions should be made for such losses through the creation of reserves for doubtful accounts. The actual bad debt write-off, properly authorized by a sufficiently high-level organization manager, is then charged to that reserve account. However, even after they are written off, these accounts written-off should be given such further collection efforts as are practicable and reasonable.

(iv) Policy Aspects of Accounts Receivable. In addition to the operational


framework of the receivable process, several key policy areas relating to the handling of receivables require consideration. First, the economics of credit levels is a continuing policy question for many organizations. Management must decide how liberal an organization should be in extending credit. While it is clear that the tighter the credit granting, the lower will be the ultimate bad debt losses, sales made pursuant to a more liberal credit policy may be additional sales that otherwise would no: have been made. Since these sales should yield extra profits, it may be in the organization's interests to generate higher sales with less stringent credit policies. It may be difficult to measure the incremental benefits accurately, but it is important that the auditor recognize the several dimensions of the problem when performing operational reviews in the accounts receivable area.

A second related aspect of both the operation of the credit department and the total receivable process is the impact that these activities have on good customer relations. It is usually desirable to streamline procedures and reduce the degree of personal contacts, but credit and receivable processes unavoidably involve customer contacts. These contacts must be handled in a way that minimizes customer irritation and builds positive goodwill. Real effectiveness here is to combine internal efficiency with courteous and reasonably cooperative customer relationships. Very often customer dissatisfaction, due to a cause quite independent of the receivable process, may surface through account receivable contacts. The problem can become magnified if both parties are dealing with automated billing systems that appear recalcitrant or difficult to understand. The receivable personnel must channel problems to organization personnel who will solve them and work to build greater customer goodwill.

Through a formal contract or a deferred payment, it may be the practice of an organization to make sales for its products and services on a deferred payment basis. In such cases, contracts are usually executed that specify the timing of the payments. In some cases, notes receivable may be obtained. These notes receivable are often an outgrowth of collection problems with regular accounts receivable, such as circumstances where a regular account
35

cannot be liquidated in accordance with its payment terms. In such a situation, the organization may wish to obtain what it regards as a more precise recognition of the receivable through the use of notes receivable. This also allows an organization to define the interest that can now be charged. In all these situations, circumstances under which any notes receivable come into existence need to be defined and properly authorized. Subsequently, there is the need for a regular monitoring of the collection of the notes on the dates specified, including the collection of such interest as has been agreed upon. Notes receivable also pose a problem of custody, since the notes exist as separate documents, and there is the possibility that since the use of notes receivable is an unusual type of transaction, regular and systematic attention will not be given to them. Specific notes receivable procedures are needed for periodic review and possible action. (b) INTERNAL CONTROLS The monies due an organization through its accounts receivable often represent a major asset to that organization. Accounts receivable must be turned into cash collections, and because much of this process is dependent upon the actions of outside parties, internal accounting controls are critical. A major internal control issue here is that the receivables recorded as due must be correct and collectible according to the terms of that receivable. The receivables must meet several general internal control objectives.

Overall Reasonableness. The recorded value of both the receivables and any
reserves must be consistent with actqal collection experiences. Trade discounts and allowances should also be consistent across all recorded receivables.

Accounts Receivable Evidence. The receivables must represent amounts


actually due to the organization. This can be verified by the auditor's direct confirmations or through the timely receipt of cash to pay off the receivables.

Valuation and Classification. The reteivables must be recorded as values


that are collectible. Receivables should also be properly classified as to whether they are expected to be collected in a normal span of time or are a potential bad debt. Appropriate reserves should be established for amounts estimated as uncollectibie.

Proper Receivables Cutoffs. Schedules need to be established to properly


record sales, sales returns, and allowances. This is tied to strong controls over the proper shipping and billing of goods. Of course, there should be a segregation of duties between the shipping and billing functions in an organization.

Accounts receivable represent a major internal control issue in an organization. They must be recorded in a prudent manner that reflects tiieir potential collectability. When the conditions surrounding those receivable accounts change, the receivable value must be adjusted through the establishment of a reserve account or through an actual write-off to reflect the anticipated collectability of that receivable.

(c) INTERNAL AUDIT PROCEDURES Internal auditors sometimes all but ignore their organization's accounts receivable processes, often because this is one area that almost always receives extensive attention from external auditors. The generally accepted audidng standards (GAAS) developed by the AICPA contain very general directions at most, suggesting areas that auditors should or may consider.
Specific procedures are usually not mentioned. However, GAAS requires that independent auditors must externally confirm their client's accounts receivable. This requirement dates back to a massive fraud of many years ago when a thenprominent organization claimed that a large number of fictitious accounts were valid and due to them. Had the auditors independently confirmed these accounts with the claimed customers, they would have found them to be invalid and would have encountered a massive fraud. Since then, independent public accountants have been required to confirm accounts receivable rather than rely upon the word of management. In addition to their confirmations activities, external auditors review the internal controls and other aspects of the organization's accounts receivable process.
37

Internal auditors also should have an interest in their organization's accounts receivable systems and procedures, and consider this a major risk area in their audit planning. This is an area where internal audit cannot easily separate financial, operational, and computer audit activities. Any review here may involve audit procedures in all three areas, and the following sections consider some of the separate internal audit activities in each area.

(i) Accounts Receivable Financial Audit Procedures. An internal auditor


should start any review of an accounts receivable process by developing an understanding of the organization's credit policies, its methods of billing customers, the types of customers that are part of the accounts receivable, the types of transactions that would be recorded, and the procedures used for collections. Each of these factors can have a major impact on how the accounts receivable process operates and on the expected level of controls.

A good first step in developing an understanding of the accounts receivable process might be to gather some statistics about the average size of billing transactions, the frequency of adjustments, and other indicators. Figure 22.13 is a questionnaire to help internal auditors gain this understanding. There are no right or wrong answers here. Rather, an internal auditor can use this information to identify potential problems with the accounts receivable process. For example, a relatively high percentage of overdue accounts may point to collection problems. A high number of adjustment transactions during any billing period may suggest incorrect billings. Internal audit may be able to gather this data through a discussion with accounts receivable management or reviews of key reports, or it might be possible to develop a computer-assisted procedure to survey the accounts receivable file to gather performance statistics. The major objective of any review of an accounts receivable process should be to determine that all sales are billed promptly and correctly. In addition, adequate controls should be in place to determine that any adjustments to accounts are made only with
1. 2.

What is the average days outstanding for your overall accounts receivable? How many accounts receivable open transactions are recorded in an

average month and how many are written off or otherwise adjusted?

3.

How many customer accounts have been set up on billing records ar.d

how often is the overall file reviewed or purged for inactive customers?
4.

How long do accounts remain open before they are written off and are

legal or other procedures used to encourage collection before write-off?


5.

What is the average size of the account written-off?


39

6.

How often are accounts adjusted, how long do they remain open prior to

any adjustment, and are statistics available to describe the reasons for adjustments?
7.

When credit policies suggest that credit should not be granted, how often

do other levels of management override (he decision and grant credit? What is the credit history of these doubtful credit accounts?
8.

Are cash discounts offered and what percentage of payments take

advantage of the cash discount offered?


9.

Are all recorded accounts receivable subject to normal billing temis or

are special, exception terms offered?


10.

Are any accounts receivable goods considered to be "on loan,"

on consignment, or under other special billing terms?


11.

Does the organization keep detailed records of all accounts

receivable adjustments, writeoffs, and other transactions?


12.

Are accounts receivable records reconciled to the general ledger

on a regular, periodic basis?

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