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Financial Accounting Unit 5: Cash and Internal Control

Cash is the asset most likely to be stolen, so companies protect it with internal controls and check it every month with a bank reconciliation. This unit covers control principles, petty cash and reconciliations.

Covers: Internal control and the fraud triangle, Control principles and limitations, Cash receipts and disbursements controls, Petty cash, Bank reconciliations, Reporting cash and cash equivalents

Study guide

Internal control is the set of policies and procedures a company uses to safeguard assets, produce reliable records, promote efficient operations and comply with laws. The widely used COSO framework lists five components: the control environment (the tone at the top), risk assessment, control activities, information and communication, and monitoring. The fraud triangle explains why employees commit fraud: an opportunity, a financial pressure, and a rationalization. Companies can rarely remove pressure or rationalization, so controls focus on reducing opportunity. After Enron and WorldCom, the Sarbanes-Oxley Act required public companies to document and test their controls, and Section 404 requires management to report on their effectiveness.

Common control activities include establishing responsibility (one person per cash drawer), segregation of duties (separating authorization, custody of assets and record keeping), documentation procedures (prenumbered invoices and checks), physical controls (safes, locks, cameras), independent internal verification (reconciliations and reviews by someone else) and human resource controls (bonding, background checks, rotating duties and required vacations). No system is perfect. Controls give reasonable assurance only, because they must cost less than the losses they prevent and because human error, management override and collusion between employees can defeat them. Even so, good controls make fraud harder to commit and quicker to detect.

For cash receipts, companies deposit all receipts intact and daily, use cash registers and prenumbered receipts, and have two people open mail and list checks. For disbursements, they pay by check or electronic transfer rather than cash, require approved invoices matched to purchase orders and receiving reports, use prenumbered checks, and keep check signing separate from approving and recording. Small payments are made from a petty cash fund. Establishing the fund debits Petty Cash and credits Cash. When the fund is replenished, the company debits the expense accounts shown on receipts, records any shortage or overage in Cash Short and Over, and credits Cash; Petty Cash itself changes only when the fund size changes.

A bank reconciliation explains the difference between the cash balance on the bank statement and the balance in the company's books, arriving at the same adjusted cash balance on both sides. On the bank side, add deposits in transit, subtract outstanding checks and correct bank errors. On the book side, add items the bank recorded that the company hasn't, such as collections of notes and interest earned; subtract bank service charges, NSF (not sufficient funds) checks returned and electronic payments; and correct the company's own recording errors. Only book-side items need journal entries. An NSF check is recorded by debiting Accounts Receivable and crediting Cash, because the customer still owes the money.

On the balance sheet, cash is usually combined with cash equivalents, which are highly liquid investments with original maturities of three months or less, such as Treasury bills and money market funds. Petty cash, cash in registers and checking balances are all included. Restricted cash, such as a fund required by a loan agreement or set aside to retire bonds, is reported separately and may be noncurrent. Certificates of deposit longer than three months are short-term investments, and postdated checks are receivables. Companies also manage cash actively: they forecast inflows and outflows with a cash budget, invest idle cash and arrange credit lines for shortfalls.

Key ideas

• Internal controls safeguard assets and make records reliable, mainly by reducing the opportunity for fraud.
• Segregation of duties separates authorization, custody of assets and record keeping.
• Controls provide reasonable, not absolute, assurance because of cost, error and collusion.
• Petty cash is replenished by debiting expenses and crediting Cash; the Petty Cash account rarely changes.
• A bank reconciliation brings bank and book balances to the same adjusted cash balance.
• Only book-side reconciling items require journal entries.
• Cash equivalents have original maturities of three months or less; restricted cash is reported separately.

Formulas and rules

Common mistakes

• Putting deposits in transit or outstanding checks on the book side.
• Making journal entries for bank-side items.
• Writing off an NSF check to expense instead of reinstating the receivable.
• Debiting Petty Cash when replenishing the fund instead of the expense accounts.
• Including long-term CDs or postdated checks in cash and cash equivalents.

Before the test, make sure you can

• Explain the fraud triangle and the purpose of internal control.
• Identify control principles, such as segregation of duties, in a described scenario.
• Spot a weakness in a company's cash procedures and suggest a fix.
• Record the establishment and replenishment of a petty cash fund, including cash short and over.
• Prepare a bank reconciliation and compute the adjusted cash balance.
• Journalize the entries required by a bank reconciliation.
• Solve for a missing reconciling item or unadjusted balance.
• Decide what is reported as cash, cash equivalents or restricted cash.

Words to know

Internal control

Policies and procedures that safeguard assets, ensure reliable records, promote efficiency and support compliance with laws.

COSO framework

A widely used internal control model with five components: control environment, risk assessment, control activities, information and communication, and monitoring.

Fraud triangle

The idea that fraud occurs when opportunity, financial pressure and rationalization are all present.

Segregation of duties

Assigning authorization, custody of assets and record keeping to different people.

Independent internal verification

Review, comparison and reconciliation of records by an employee who did not prepare them.

Physical controls

Mechanical and electronic safeguards such as safes, locks, alarms and limited access.

Bonding

Insuring the company against theft by employees who handle cash or valuable assets.

Petty cash fund

A small amount of cash kept on hand for minor payments and replenished periodically.

Cash Short and Over

An account that records differences between expected and actual cash; a shortage is a debit, an overage a credit.

Bank reconciliation

A schedule that explains differences between the bank statement balance and the book cash balance.

Deposit in transit

A deposit recorded by the company but not yet processed by the bank.

Outstanding check

A check written and recorded by the company that has not yet cleared the bank.

NSF check

A customer's check returned by the bank because the customer's account lacked sufficient funds.

Cash equivalents

Highly liquid investments with original maturities of three months or less, such as Treasury bills.

Restricted cash

Cash set aside for a specific purpose and not available for general use; reported separately.

Three-way match

Paying an invoice only when it agrees with an approved purchase order and a receiving report.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.