Fundamental

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

PowerPoint® presentation by
J. Lawrence Bergin
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Chapter 6

Internal Control
and
Accounting
for Cash

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What Is Internal Control?

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

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Goals of an internal control

system:
● Resources of the
business are
safeguarded
● Policies of management
are followed
● Designed to prevent
errors and fraud

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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

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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.

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

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

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Periods of Absence
Require vacations and
rotate employees.
– Illegal activities are often
uncovered when someone
else performs the
offender’s duties for a few
days.

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

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Clear lines of authority & responsibility

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

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

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Physical control over assets

● Safeguard all assets--

cash, equipment,
inventory, etc.
● Be sure to keep all
records and supporting
documents in a fireproof
safe.

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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.

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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.

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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.

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Accounting for Cash:

Reconciling 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
company’s books, adjusting journal
entries will be needed.

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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 customer’s 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).

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Balance per bank section of
reconciliation:
Balance per bank $
Plus:

Less:

“True” Cash Balance $

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Balance per books section of
reconciliation:
Balance per books (ledger) $
Plus:

Less:

“True” Cash Balance $

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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.

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Balance per bank section of
reconciliation:
Balance per bank $ 8,750
Plus:

Less:

“True” Cash Balance $

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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.

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Balance per books section of
reconciliation:
Balance per books (ledger) $ 6,900
Plus:

Less:

“True” Cash Balance $

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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.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

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Balance per bank section of
reconciliation:
Balance per bank $ 8,750
Plus:

Less: Outstanding Checks

#150 (800)
#156 (580)
“True” Cash Balance $

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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.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

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Balance per books section of
reconciliation:
Balance per books (ledger) $ 6,900
Plus:

Less:
Bank Service Charge Exp. (30)

“True” Cash Balance $

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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.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

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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 $

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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 customer’s NSF check for $100 that was part
of our April 29th deposit.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

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Balance per books section of
reconciliation:
Balance per books (ledger) $ 6,900
Plus:

Less:
Bank Service Charge Exp. (30)
Customer’s NSF check (100)
“True” Cash Balance $

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

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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 customer’s 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).

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

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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)
Customer’s NSF check (100)
“True” Cash Balance $

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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

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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

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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)
Customer’s NSF check (100)
“True” Cash Balance $ 7,770

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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.

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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.

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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
Customer’s NSF check put back

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Cash account after posting

April 30 balance
before reconciliation
Cash
Bal. 6900
1000 30
Cash

100
True 7770

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What about the “bank” side?

● If the bank has made an error,
we can’t 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 bank’s attention.

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Accounting for Cash:

Petty 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).

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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.

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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.

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Petty cash example:

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

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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

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Petty cash continued...

● When the fund gets low, let’s 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.

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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 today’s 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.

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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!

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Petty cash example...

(Assume use of Periodic Inventory system.)
Transportation In $ 10
Purchases 60 150
Advertising Expense 45
- 30
Cash short and over 5
120
Petty Cash $120
and
Petty Cash $120
Cash $120

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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.

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Current vs. noncurrent...

● Classified balance sheet

– separation of current and

noncurrent items

– enhances the usefulness

of the information

Here’s an example………..

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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

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Operating cycle
● the average time it takes a
business to convert cash
into inventory, inventory
into AR, and AR back into
cash.

Cash

Inventory

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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

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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

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The Current Ratio

●Used to evaluate a
company’s liquidity (a
company’s ability to
generate short term
cash flows)
Current Assets
Current Liabilities
Calculate the Current Ratio using the
Balance Sheet data on the following slide.

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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

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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 $4,000

Current Ratio = = = 2.22 to 1
Current Liabilities $1,800

You have $2.22 of current assets for each $1 of current liabilities.

Is that enough?
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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?

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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 retailer’s 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, ……..

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The Quick (Acid-Test) Ratio

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

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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 $1,000

Quick Ratio = = = .56 to 1
Current Liabilities $1,800

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).
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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
year’s (or base year’s) amount.

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Chapter 6:

Financial
Accounting

The End

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