Chapter 4: Internal Control and Cash Flashcards
To control employee’s activities, management puts in place procedures that collectively are called the:
internal control system
Internal control systems include all the policies and procedures established by top management and the board to provide reasonable assurance that the company’s objectives are being met in what three areas?
- Effectiveness and efficiency of operations
- Reliability of financial reporting
- Compliance with applicable laws and regulations
What are the 5 components of internal control?
- Control Environment
- Risk Assessment
- Control Activities
- Information and Communication
- Monitoring Activities
Under _________, top management of publicly traded corporations have increased responsibility for a system of internal controls that ensures reliability of financial statements.
the Sarbanes-Oxley Act of 2002 (“SOX” for short)
What does Section 404 of the SOX Act require?
Requires management to produce an internal control report acknowledging that management is responsible for
- establishing and maintaining an adequate internal control system and procedures for financial reporting and
- assessing the effectiveness of these controls
What does Section 302 of the SOX Act require?
Requires the principal executive and financial officers to certify that they’re responsible for establishing and maintaining the system of internal control over financial reporting.
What is the foundation of internal control and the most important component?
The Control Environment
the collection of environmental factors that influence the effectiveness of control procedures
control environment
The control environment includes what three things?
- The philosophy and operating style of management
- The personnel policies and practices of the business
- The overall integrity, attitude, awareness, and actions of everyone in the business concerning the importance of control (commonly called tone at the top)
Overall integrity, attitude, awareness and actions of everyone in the business concerning the importance of control is commonly called the:
tone at the top
What is an important feature to recognize in regards to control environment?
That individual employees goals may differ from the goals of the business, leading to unethical acts
hotlines that allow employees to anonymously report unethical behavior
ethics hotlines
Risk assessment procedures (also called Enterprise Risk Management or ERM) are designed to identify, analyze and manage ________ risks and ________ _________ risks.
- strategic risks
- business process risks
possible external threats to the organizations success in accomplishing its objectives
strategic risks
Strategic risks are classified around Porter’s Five Forces, which are what? Or, strategic risks are classified around the PEST factors, which are what?
Porter’s Five Forces:
1. Competitors
2. Customers
3. Substitute Products/Services
4. Suppliers
5. Threat of New Competitors
PEST Factors:
- Macro political, economic, social, and technological factors
T or F: Competition is always considered to be an external risk for every type of company.
True
Arise out of an individual company’s internal processes– how the company allocates its resources to meet its objectives
business process risks
What are five common business processes?
- Materials Acquisition
- Production
- Logistics and distribution
- Branding and marketing
- Human Resources
Would this be a business process risk or strategic risk? Protecting your facilities (like sprinkler systems in case of a fire)
Business Process Risk
the policies and procedures top management establishes to help insure that objectives are met (some of the procedures the company will have in place)
Control Activities
Which component of internal control is most directly related to the accounting system and financial statements?
Control Activities
What are the 5 categories of Control Activities?
- Clearly Defined Authority and Responsibility
- Segregation of Duties
- Adequate Documents and Records
- Safeguards over Assets and Records
- Checks on Recorded Amounts
identifies who has authority to perform important duties and responsibility for performance of assigned tasks
Clearly Defined Authority and Responsibility
reduces the incidence of fraud because no one person prepares all the documents and records for one type of activity
Segregation of Duties
two or more employees engaging in a fraudulent scheme
collusion
What is the most important aspect of segregation of duties?
Separating the record-keeping responsibility from the physical control of the assets
underlying documentation must be thorough to allow evaluation of performance
adequate documents and records
the physical protection of assets through, for example, fireproof vaults, locked storage facilities, keycard access, etc.
safeguarding
pertains to the physical safety of assets/documents
safeguards over assets and records
recorded amounts should be checked by an independent person to determine the amounts are correct and that they correspond to properly authorized activities; requires independent verification, reconciliation of accounts, etc.
checks on recorded amounts
T or F: An internal control system will be unable to help a company achieve its objective unless adequate information is identified and gathered on a timely basis.
Which component of internal control does this relate to?
True ; information and communication
Timely reporting of returns and complaints made by dissatisfied customers allows management to respond before company reputation is damaged. This shows the importance of what component of internal control?
Information and communication
the process of tracking potential and actual problems in the internal control system; accomplished through normal supervising activities such as when a manager asks a subordinate how things are going
monitoring
Best practices of monitoring for larger organizations include an ______ _______ group that helps monitor the effectiveness of the internal control system.
internal audit
T or F: SOX Act Requires all publicly-traded corporations to have an internal audit function that reports to the audit committee of the board of directors. What component of internal control does this relate to?
True; Monitoring
the methods and records used to identify, measure, record, and communicate financial information about a business.
accounting system
When cash is received, the cash account is increased by a (debit/credit)
debit
When cash is paid out, the cash account is decreased by a (debit/credit)
credit
What is cash?
Something is cash if you can deposit it into a bank and readily use it to pay someone (ex: savings and checking accounts, checks, money orders, bills, travelers checks, coins)
Receipt of a check or currency is recorded by a (debit/credit) to cash.
debit
Issue of a check or payment of currency is recorded by a (debit/credit) to cash.
credit
Cash is reported on what two financial statements?
- Balance Sheet
- Statement of Cash Flows
any investment that is readily convertible into a known amount of cash (highly liquid) and has an original maturity of three months or less (ex: treasury bills, certificates of deposit, money market accounts, commercial paper, as long as they mature in three months or less)
cash equivalents
Why do companies bother to invest their cash in such short-term investments?
Short-term investments earn a greater rate of return than cash sitting in a bank account
What is the most vulnerable asset a company has? Why?
Cash; because it is liquid
Cash should be safeguarded where?
In vaults and banks
What two internal controls help cash control?
- Assigning (cash-handling) authority to collect, hold, and pay cash
- Assign record keeping activities to different people, with cash records being examined often by an objective party
Three important areas where the accounting system interacts with the internal control system to strengthen cash controls include:
- Bank reconciliations
- Cash over and short monitoring
- Petty cash management
The use of a ______ is one of the most important controls over cash
bank
Why do bank accounting records and company accounting records often disagree?
Due to timing differences
the process of reconciling any differences between a company’s accounting records and the bank’s accounting records.
bank reconciliation
What are the two purposes of a bank reconciliation?
- Serves a control function by identifying errors and providing an inspection of detailed records that deters theft
- It detects bank transactions, so the business can make the necessary entries in its records
shows the beginning and ending balance and the individual deposits and withdrawals recorded by the bank during the period (usually returned once a month); basically a copy of the bank’s accounting records showing each customer the increases and decreases in their balances
a bank statement
Debit or Credit the Account for Bank Accounting Records:
- Increase in Assets=
- Decrease in Assets=
- Increase in Liabilities =
- Decrease in Liabilities =
- Increase in Assets = credit
- Decrease in Assets = debit
- Increase in Liabilities = debit
- Decrease in Liabilities = credit
Debit or Credit the Account for Company Accounting Records:
- Increase in Assets =
- Decrease in Assets =
- Increase in Liabilities=
- Decrease in Liabilities =
- Increase in Assets = debit
- Decrease in Assets= credit
- Increase in Liabilities= credit
- Decrease in Liabilities= debit
Deposits and other events that increase your bank account balance are labeled “________” on the bank statement. Why?
Credits; because they increase the bank’s liability to you
Withdrawals and other events that decrease your bank account balance are labeled “_______” on the bank statement. Why?
Debits; because they decrease the bank’s liability to you
What are the three differences to resolve between the cash account balance and the bank statement balance?
- Transactions recorded by the business, but not yet recorded by the bank in time to appear on the current bank statement
2 Transactions recorded by the bank, but not yet recorded by the business - Errors in recording transactions on either set of records
What are two examples of transactions recorded by the business, but not yet recorded by the bank?
- Outstanding checks
- Deposits in transit
What are four examples of transactions recorded by the bank, but not yet recorded by the business?
- Service Charges
- Interest Earned
- Collection of a Receivable
- Debit and Credit Memorandums
a check that has been distributed by the company but does not appear on the bank statement because it has not cleared the bank; a check that has been issued and recorded by the business but that has not been “cashed” by the recipient of the check.
outstanding check
An outstanding check will cause a business to (increase/lower) its cash account balance.
lower
a deposit that has been made by the company but does not appear on the bank statement; an amount received and recorded by a company, but which has not been recorded by the bank in time to appear on the current bank statement
deposit in transit
A deposit in transit causes the bank account balance to be (larger/smaller) than the business’s cash account balance
smaller
fees charged by the bank for services provided (ex: annual maintenance, minimum balance, and foreign transaction fees)
service charge
Bank service charges unrecorded by the business at the end of the month cause the bank balance to be (smaller/larger) than the business’s cash account balance.
smaller
a check that has been returned to the depositor because funds in the issuer’s account are not sufficient to pay the check; a customer’s check that bounces because of lack of funds (a deduction on the bank statement)
Non-sufficient Funds Check (NSF Check)
NSF checks cause the bank balance to be (smaller/larger) than the cash account balance.
smaller
a deduction on the bank statement for items such as service charges
debit memorandum
an addition on the bank statement for items such as the collection of interest
credit memorandum
What are two examples of credit memos?
interest earned, collection of a receivable
Debit memos cause the bank account to be (smaller/larger) than the cash account balance
smaller
Credit memos cause the bank account to be (smaller/larger) than the cash account balance
larger
If an error is found on either the company or bank’s side for account balance, what are the two things needed to be done?
- Correct the error upon discovery
- Cause of error should be researched to take corrective action
To perform a bank reconciliation, what do you start with?
- Cash balance from the bank statement
- Cash balance from the company records
To perform a bank reconciliation, what four steps are used to adjust the bank and company cash balances to produce identical true cash balances?
Step 1: Compare the deposits on the bank statement to the deposits debited to the cash account.
Step 2: Compare the paid (cancelled) checks that are electronically returned with the bank statement to amounts credited to the cash account and the list of outstanding checks from prior months.
Step 3: Look for items on the bank statement that have not been debited or credited to the cash account. (Debit and credit memos)
Step 4: If the true cash balances are still not equal, search for errors, like transpositions or addition and subtraction errors to the wrong cash balance.
Any deposits debited to the cash account but not on the bank statement are likely:
deposits in transit
Deposits in transit should be added to the (cash balance from the bank statement/ cash balance from company records).
cash balance from the bank statement
Any checks credited to the cash account but not on the bank statement are likely:
outstanding checks
Outstanding check amounts should be (added/subtracted) from the cash balance from the bank statement
subtracted
Bank debit memos should be (added/subtracted) from the cash balance from company records, while bank credit memos should be (added/subtracted) from the cash balance from company records.
Bank debits= subtracted
Bank credits = added
Debit and credit memos are subtracted/added from which cash balance?
Cash balance from company records
All errors made by the company should be added or subtracted from which cash balance?
Cash balance from company records
All errors made by the bank should be added/subtracted from which cash balance?
Cash balance from the bank statement
No adjustments are necessary for what two things in the accounting records because the accounting records have correctly recorded these amounts.
- Outstanding Checks
- Deposits in Transit
an account that records the discrepancies between deposited amounts of actual cash received and the total of the cash register tape
cash over and short
Another important control activity requires that cash receipts be deposited in a bank (yearly/ monthly/ daily). At the end of each ____, the amount of cash received during the ______is (credited/debited) to the cash account to which it has been deposited.
daily; day; day; debited
True or False: the amount of cash deposited should equal the total of cash register tapes.
True
If the amount of cash deposited doesn’t equal the total of cash register tapes (and differences will occasionally occur even when cash-handling procedures are carefully designed and executed), the discrepancy is recorded in an account called :
cash over and short
What is one common source of cash over and short?
errors in making change for cash sales
A cash shortage requires a (credit/debit) to cash over and short, while a cash overage requires a (credit/debit) to cash over and short.
Shortage= debit
Overage= credit
Cash over and short is usually treated as an _______ statement account and is reported as a port of other expenses or other revenues.
income
Cash controls are more effective when companies pay with a check for what 3 reasons?
- Only certain people have the authority to sign a check.
- Supporting documents are marked paid to avoid duplicate payment
- Checks are pre-numbered, which makes it easy to identify any missing checks
T or F: Issuing checks to pay small amounts is usually more costly than paying cash.
True
a fund used by companies to pay for small dollar amounts (such as stamps or a cake for an employee birthday party)
petty cash fund
The petty cash fund is overseen by a _______ _____ ________, who processes small dollar amounts directly from the fund and reimburses employees who have receipts for items the employees purchased. What does the custodian do at the end of the month?
- petty cash custodian
- custodian submits all receipts to the company.
After company personnel (other than the petty cash custodian) determine that the documents are authentic and that each transaction is supported by the appropriate documentation, what happens?
The custodian is given an amount to replenish the petty cash fund as needed. The company then records the amounts spent in the accounting records.
T or F: Replenishment of petty cash may also occur during the month if the amount of petty cash available gets too low.
True
the elapsed time between the purchase of goods for resale (or the purchase of materials to produce salable goods or services) and the collection of cash from customers (presumably a larger amount of cash than was invested in the goods sold)
operating cycle
True or False: The operating cycle is typically a year or more.
False; typically a year or less
T or F: The operating cycle can be as short as a few days (for perishable goods) or as long as many years for the production and sale of products such as timber and wine.
True
What are the three steps of the operating cycle?
- Purchase inventory and other assets
- Sell or use assets
- Collect from customers (financial resources gained)
At a high level, cash management principles entail the following three things:
- Delaying payments to suppliers, so a company can earn as much interest on their cash as possible.
- Speeding up collection from customers in order to invest their cash sooner or reduce the need for additional financing.
- Earning the greatest return on any excess cash.
What is the first stage of the operating cycle?
Buying Inventory
Why should companies keep inventory levels low?
Because money that is tied up in inventory sitting on the shelves is not earning any return. This decreases the need for cash.
What is the second stage of the operating cycle?
Paying for inventory
Why should companies delay payments as long as possible?
So more interest can be collected on the cash investments
What is the third stage of the operating cycle?
Selling Inventory
Selling inventory often produces _______.
receivables
Good cash management suggests (increasing/decreasing) the receivable collections. Why?
Increasing; to access faster cash collection
T or F: Businesses try to keep their bank cash balances to a maximum because most bank accounts earn relatively large amounts of interest.
False; minimum/relatively small
Short-term investments are purchased with temporary ______ _______.
cash surpluses
an agreement between the company and its bank in which the bank promises to lend the company funds up to a specified limit and at specified interest rates
line of credit
What are three examples of short-term investments?
- Treasury Bills
- Certificates of Deposit
- Short-Term Equity Holdings
T or F: short-term investments are usually liquidated.
True
T or F: Investing excess cash in short-term investments allows companies to have immediate access to cash to cover temporary short falls, while minimizing borrowing costs.
True
