Chapter 7 discusses the purposes and characteristics of an effective system of internal control. Basic characteristics of an effective system of internal control are listed, including competent, reliable, and ethical personnel; assignment of responsibilities; proper authorization; separation of duties; internal and external audits; documents and records; electronic devices and computer controls; and other controls. The need for internal controls for companies engaged in e-Commerce is explained. Several limitations of internal control are mentioned.

The bank account is introduced as a control device related to cash. The discussion of the bank account includes the documents used to control a bank account—the signature card, deposit ticket, checks, bank statement, and electronic funds transfers is discussed. The bank reconciliation is illustrated and described in detail. Reconciling items discussed include deposits in transit, outstanding checks, bank collections, EFT’s, service charges, interest revenue, NSF checks, and various errors. The adjusting entries required by the reconciliation are presented followed by a discussion of how owners and managers use the reconciliation. A mid-chapter summary problem allows students to prepare a reconciliation and the entries based on the reconciliation.

The chapter continues with an explanation of internal control over cash receipts and cash payments. The section covering cash receipts emphasizes over-the-counter receipts, receipts by mail, and the use of a Cash Short and Over account. The section covering controls over cash payments emphasizes purchasing controls, approval of purchases, and petty cash payments. The chapter concludes with discussions related to using a budget to manage cash, reporting cash, and ethics. Decision guidelines help establish a framework for making ethical judgments. A summary problem reviews internal control weaknesses and petty cash. An appendix to the chapter describes the voucher system for recording cash payments.

1. Define internal control

2. Identify the characteristics of an effective system of internal control

3. Prepare a bank reconciliation and the related journal entries
4. Apply internal controls to cash receipts
5. Apply internal controls to cash payments
6. Use a budget to manage cash
7. Make ethical judgements in business

1. Internal control is the organizational plan and all the related measures that an entity adopts to

1. Safeguard assets,
2. Encourage adherence to company policies,
3. Promote operational efficiency, and
4. Ensure accurate and reliable accounting records.

1. Management has primary responsibility for the financial statements. Exhibit 7-1 is an excerpt from the Responsibility for Consolidated Financial Statements of Lands’ End.

1. Competent, reliable, and ethical personnel—Attract top-quality employees, train them well, and supervise them.
2. Assignment of responsibilities—Each employee is assigned certain responsibilities (often defined in the organizational chart, as illustrated in Exhibit 7-2).
3. Proper authorization—An organization generally has a written set of rules that outlines approved procedures. Tasks that fall outside this set of procedures may be performed only if properly authorized.
4. Separation of duties—Dividing responsibilities for transactions limits the chances for fraud and promotes accuracy of the accounting records. Separation of duties may be divided into four parts:

1. Separation of operations from accounting—The entire accounting function should be completely separate from operating departments.
2. Separation of custody of assets from accounting—Accountants should not have access to assets, and those that have access to assets (such as the cashier) should not have access to the accounting records.
3. Separation of authorization of transactions from the custody of related assets—People who authorize transactions should not handle the related asset.
4. Separation of duties within the accounting function—Different people should perform the various phases of accounting to minimize errors and opportunities for fraud.

1. Internal and external audits—Internal and external auditors identify weaknesses in internal control.

1. Internal auditors are employees.
2. External auditors are employed by accounting firms that are hired by a business to examine the financial statements.

1. Documents and records—Business documents should be prenumbered to call attention to a missing document.
2. Electronic devices and computer controls—Accounting systems are relying on the computer to perform basic functions; and therefore, programmers become the focus for internal controls. Businesses use other electronic devices to help protect assets and control operations, such as inventory sensors.
3. Other controls—Businesses often use controls to protect assets such as fireproof vaults (to protect documents), burglar alarms (to protect property), point-of-sale terminals (to protect cash).

1. Fidelity bonds insure the company against theft by an employee.
2. Mandatory vacations and job rotation enhances morale and helps keep employees honest.

1. e-Commerce creates some new risks such as protection confidential information.

1. Internal control systems can be thwarted by collusion between two or more people working together to defraud the firm.
2. An overly complex internal control system may be inefficient.

1. Banks provide depositors with detailed records of cash transactions. These records include:

1. A signature card, to ensure that only an authorized person has access to the account.
2. Deposit tickets, to maintain a record of amounts deposited.
3. Checks, to maintain a record of monies withdrawn from the bank; includes the date of the check, the name of the payee, and the signature of the maker. (Exhibit 7-3 shows a check drawn on a bank.)
4. Bank statements, to show the monthly activity in an account. (Exhibit 7-4 is an example of a bank statement.)

1. The bank reconciliation explains the differences between the bank statement balance and the general ledger balance of cash. (Exhibit 7-5 illustrates the Cash account.)

1. Items recorded by the company but not yet recorded by the bank include:

1. Deposits in transit—Money that has been deposited by the company but not yet recorded by the bank.
2. Outstanding checks—Checks that have been issued by the company but not yet paid by the bank.

1. Items recorded by the bank but not yet recorded by the company include:

1. EFT—The bank statement may include EFT’s that the company has not yet recorded.
2. Service charges—Fees that the bank charges for certain services and are not known by the depositor until the bank statement is received.
3. Interest revenue earned on the checking account—The amount of interest earned may not be known until the bank statement is received.
4. Nonsufficient funds checks (NSF)—NSF checks received from customers and returned to the payee; they are sometimes included in the bank statement. Exhibit 7-6 illustrates what happens to NSF checks and good checks.
5. Checks collected, deposited, and returned to payee by the bank for reasons other than NSF—The bank may return checks because the account has closed, the check is too old, the signature is not authorized, the check has been altered, or the check form is improper.
6. Check printing charge—A fee that the bank charges for printing checks.

1. The following adjustments are made to the balance per bank. (Exhibit 7-7 is an example of a bank reconciliation.)

Balance per bank XX

Add: Deposits in transit XX

XX

Less: Outstanding checks (XX)

Adjusted bank balance XX

2. The following adjustments are made to the balance per books.

Balance per books XX

Add: EFT receipt XX

Bank collection XX

Interest revenue XX

XX

Less: Service charge XX

NSF XX

EFT payment XX

Check printing charge XX

Other bank charges XX XX

Adjusted book balance XX

3. Errors that are made by the bank are adjustments to the balance per bank. Errors that are made on the books are adjustments to the balance per books.
4. Adjusting journal entries are required for every adjustment to the book’s balance and are illustrated below: