1. finance
2. accounting and auditing

CHAPTER 7
Internal Control and Cash
Chapter Overview
Chapter 7 discusses the purposes and characteristics of an effective system of internal control. The text
describes four objectives that a company hopes to achieve with a good system of internal control. The
five components of internal control are identified, including monitoring of controls, information system,
control procedures, control environment, and risk assessment. Basic characteristics of an effective system
of internal control are listed, including competent, reliable, and ethical personnel; assignment of
responsibilities; separation of duties; internal and external audits; documents; electronic devices; and
other controls. The need for internal controls for companies engaged in e-commerce is explained. Several
limitations of internal control are mentioned. The chapter also discusses the Sarbanes-Oxley Act (SOX)
and its effect on corporate governance and the accounting profession.
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 are discussed. The bank reconciliation is illustrated and
described in detail. Various reconciling items discussed include deposits in transit, outstanding checks,
bank collections, EFTs, 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 and receipts by mail. The section
covering controls over cash payments emphasizes purchasing controls, approval of purchases, and petty
cash payments. The chapter concludes with discussions about reporting cash on the balance sheet and
ethics in accounting. Decision guidelines help establish a framework for making ethical judgments. A
summary problem reviews internal control weaknesses and petty cash.
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Chapter 7: Teaching Outline
1) Define internal control and its objectives.
a) Safeguard assets
b) Encourage employees to follow company policy
c) Promote operational efficiency
d) Ensure accurate, reliable accounting records
2) Discuss the Sarbanes-Oxley Act (SOX).
a) Effect on corporate governance
b) Effect on accounting profession
c) Exhibit 7-1 The Shield of Internal Control
3) Identify the components of internal control.
a) Monitoring of Controls
i) Internal Auditors
ii) External Auditors
b) Information System
c) Control Procedures
i)
Competent, Reliable, Ethical Personnel
ii) Assignment of Responsibilities
iii) Risk Assessment
iv) Separation of Duties
- Separate operations from accounting
- Separate custody of assets from accounting
v) Audits
vi) Documents
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vii) Electronic Devices
viii) Other Controls
d) Control Environment
i) Tone at the Top
e) Risk Assessment
4) Explain control concerns and procedures unique to e-commerce.
a) Stolen Account Numbers and Password
b) Computer Viruses and Trojans
c) Phishing Expeditions
d) Security Measures
5) Discuss the limitations of internal control.
a) Collusion
b) Costs Versus Benefits
6) Identify the bank account as a control device.
a) Signature Card
b) Deposit Ticket
c) Check
i) Exhibit 7-2 Check with Remittance Advice
d) Bank Statement
ii) Exhibit 7-3 Bank Statement
e) Electronic Funds Transfer (EFT)
7) Demonstrate the preparation of a bank reconciliation and the adjusting entries required.
a) Exhibit 7-4 Smart Touch’s Cash T-account
b) Exhibit 7-5 Bank Reconciliation
c) Exhibit 7-6 Adjusting Entries from Bank Reconciliation
d) Exhibit 7-7 Online Banking—Account History (like a Bank Statement)
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8) Discuss the internal controls over cash receipts and cash disbursements.
a) Exhibit 7-8 Cash Receipts over the Counter
b) Exhibit 7-9 Cash Receipts by Mail
c) Use of a lockbox for cash receipts
d) Exhibit 7-10 Cash Payments by Check
e) Exhibit 7-11 Payment Packet
f) Exhibit 7-12 Voucher
9) Explain the use of a petty cash fund.
a) Internal controls over fund
b) Journal entry to set up the imprest fund
c) Exhibit 7-13 Petty Cash Ticket
d) Replenishing the fund
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Chapter 7: Summary Handout for Students
1. Internal control is designed to do the following:
o
Safeguard assets.
o
Encourage employees to follow company policy.
o
Promote operational efficiency.
o
Ensure accurate, reliable accounting records.
2. The Sarbanes-Oxley Act (SOX) was passed by Congress to promote corporate governance and to
oversee the auditors of public companies.
3. Five Components of Internal Control:
o
Monitoring of Internal Controls
ƒ
Internal Auditors
ƒ
External Auditors
o
Information System
o
Control Procedures
ƒ
Competent, reliable, ethical personnel
ƒ
Assignment of responsibilities
ƒ
Separation of duties
¾ Separate operations from accounting
¾ Separate custody of assets from accounting
ƒ
Audits
ƒ
Documents
ƒ
Electronic devices
ƒ
Other controls
o
Control Environment
o
Risk Assessment
4. Concerns over internal controls for e-commerce include the following:
o
Stolen account numbers and passwords
o
Computer viruses and Trojans
o
Phishing expeditions
o
Security measures in place to address concerns over internal control include the following:
ƒ
Encryption
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ƒ
Firewalls
5. Limitations of internal control are as follows:
o
Collusion between two or more people to circumvent internal control
o
Examine the costs and benefits of internal controls
6. The bank account can be used as a control over cash.
o
Documents include the signature card, deposit tickets, checks, electronic funds transfer (EFT),
the bank statement, and the bank reconciliation.
o
Bank reconciliations reconcile the differences between the bank balance and the book balance:
ƒ
Bank side includes items not yet recorded by the bank or errors made by the bank (e.g.,
deposits in transit, outstanding checks)
ƒ
Book side includes items recorded by the bank but not yet recorded by the company
(e.g., collections made by the bank on behalf of the company, service charges, interest
revenue, NSF checks)
ƒ
Journal entries are required to record items on the book side of the reconciliation.
7. Internal controls over cash receipts and cash payments:
o
o
Cash receipts:
ƒ
Over the Counter—use of receipts
ƒ
By Mail—separation of duties
Cash payments:
ƒ
By check with proper authorizations
ƒ
Use of a voucher system—voucher, purchase order, receiving report, invoice, copy of
check
8. Use of an imprest petty cash fund for small cash payments.
9. Work sheets to print for in-class practice (bookmatch), as specified by your instructor.
10. Myaccountinglab.com homework algorithmic assignments:
o E7-17; E7-19; E7-23; E7-24; P7-25A; P7-26A; P7-28A
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Lecture Outline Tips: Key Topics
When beginning a discussion of internal control, ask students to provide examples of theft and abuse they
have witnessed. Many students will have work experience, especially in some type of retail setting, and
my understanding is that they are eager to provide real-world examples. These examples can then lead to
a discussion of the types of controls that may have prevented or detected the examples provided. By the
same token, ask students for examples of internal controls their employers have in place and match these
to the controls discussed in the textbook.
Point out that an internal control system may not be 100% effective. It may not prevent theft, abuse, and
errors, but hopefully can detect them very quickly so corrective action can be taken. Employees can
attempt to circumvent the system through collusion. A discussion of the costs versus the benefits of an
internal control system as well as the requirements for public companies under the Sarbanes-Oxley Act
can help students better understand the importance of a good internal control system.
A bank account is an asset for the company and a liability for the bank. Some students may have trouble
thinking about this from the bank’s perspective. It may be helpful to provide journal entries for the
company and the bank side by side for a deposit transaction to display the difference. By the same token,
the bank statement is from the bank’s perspective—the bank account is a liability to the bank and
increases with a credit and decreases with a debit.
When reconciling the bank statement, errors should be adjusted by the party that made them. A bank
error should be adjusted through the bank statement balance and a book error should be adjusted through
the book balance. The increase or decrease of the adjustment depends on whether too much or too little
was added or taken from the balance.
Journal entries are required for the book balance section ONLY. These transactions have been recorded
by the bank, but not the company. If journal entries are not posted, the ledger accounts will not be up to
date. The company will have a reconciled bank statement but out of date account balances.
The balance in petty cash does not change unless the original established amount is increased or
decreased. The replenishment entry credits “cash in bank,” not “petty cash.” Cash is taken from the
regular bank account and placed into the petty cash box. The petty cash account is not maintained on a
perpetual basis; it is adjusted periodically when it is replenished, similar to the periodic system for
inventory.
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ASSIGNMENT GRID
Assignment
Topic(s)
Learning
Objective(s)
Short Exercises
S7-1
Definition of internal control
1
S7-2
Sarbanes-Oxley Act
2
S7-3
Characteristics of internal control
3
S7-4
Pitfalls of e-commerce
4
S7-5
Bank account controls
5
S7-6
Preparing a bank reconciliation
6
S7-7
Recording transactions from a bank
reconciliation
6
S7-8
Control over cash receipts
7
S7-9
Control over cash receipts by mail
7
S7-10
Internal control over cash payments by check 8
S7-11
Petty cash
9
S7-12
Making an ethical judgment
10
Exercises
E7-13
E7-14
E7-15
E7-16
E7-17
E7-18
E7-19
E7-20
E7-21
E7-22
E7-23
E7-24
Sarbanes-Oxley Act; Identifying internal
control strengths and weaknesses
1, 2, 3
Identifying internal controls
3
E-commerce control procedures
4
Using a bank reconciliation as a control device 5
Classifying bank reconciliation items
6
Preparing a bank reconciliation
6
Preparing a bank reconciliation
6
Evaluating internal control over cash receipts 7
Evaluating internal control over cash payments 8
Accounting for petty cash
9
Control over petty cash
9
Evaluating the ethics of conduct by
government legislators
10
Problems (Group A)
P7-25A
Internal control, components, procedures,
and laws
1, 2, 3, 4
P7-26A
Correcting internal control weaknesses
3, 5, 7, 8
P7-27A
Preparing a bank reconciliation and journal
entries
6
P7-28A
Preparing a bank reconciliation and journal
entries
6
P7-29A
Identifying internal control weakness in
cash receipts
7
P7-30A
Accounting for petty cash transactions
9
P7-31A
Accounting for petty cash transactions
9
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Estimated
Time in
Minutes
Level
of
Difficulty
5
5
5–10
5
5–10
10
Easy
Easy
Easy
Easy
Easy
Easy
5
5
5–10
5
10
5
Easy
Easy
Easy
Easy
Easy
Easy
10–15
10
10–15
10
5
10–20
20–25
10
10
10–15
10
Easy
Easy
Easy
Easy
Easy
Easy
Easy
Easy
Easy
Easy
Easy
15–20
Medium
20–25
10–20
Easy
Easy
20–25
Medium
20
Medium
10–15
20–30
20–30
Easy
Easy
Medium
P7-32A
Making an ethical judgment
10
Problems (Group B)
P7-33B
Internal control, components, procedures,
and laws
1, 2, 3, 4
P7-34B
Correcting internal control weaknesses
3, 5, 7, 8
P7-35B
Preparing a bank reconciliation and journal
entries
6
P7-36B
Preparing a bank reconciliation and journal
entries
6
P7-37B
Identifying internal control weaknesses in
cash receipts
7
P7-38B
Accounting for petty cash transactions
9
P7-39B
Accounting for petty cash transactions
9
P7-40B
Making an ethical judgment
10
15–30
Medium
20–25
10–20
Easy
Easy
20–25
Medium
20
Medium
10–15
20–30
20–30
15–30
Easy
Easy
Medium
Medium
Continuing Exercise
E7-41
Accounting for petty cash transactions
9
10
Easy
Continuing Problem
P7-42
Preparing a bank reconciliation and journal
entries
6
20–25
Medium
Preparing a bank reconciliation and journalize
entries
6
20–25
Medium
20–30
15–30
20–30
Medium
Medium
Difficult
10–20
Medium
Practice Set
P7-43
Decision Cases
Case 1
Sarbanes-Oxley Act; Internal controls
1, 2
Case 2
Correcting an internal control weakness
3, 5, 8
Case 3
Using the bank reconciliation to detect a theft 5, 6
Ethical Issue
Financial Statement Case
Internal controls and cash
1
Team Project
End of Chapter Exercises and Problems Available in Alternate Accounting Software
Programs:
Excel Templates: P7-28A; P7-30A; P7-31A
QuickBooks: P7-28A; P7-30A; P7-31A
Peachtree: E7-22; P7-30A; P7-31A
General Ledger: E7-22; P7-30A; P7-31A
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Pre-Test Questions on MyAccountingLab: S7-4 (4); S7-5 (5); S7-6 (6); S7-8 (7); S7-10 (8);
S7-11 (9); S7-12 (10); E7-13 (1,2,3)
Post-Test Questions on MyAccountingLab: P7-33B (1, 2, 3, 4); P7-34B (3, 5, 7, 8); P7-36B (6)
Answer Key to Chapter 7 Quiz
1.
2.
3.
4.
5.
D
C
A
B
A
6.
7.
8.
9.
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A
B
B
A
Name
Date
Section
CHAPTER 7
TEN-MINUTE QUIZ
Circle the letter of the best response.
1.
Which of the following is not a purpose of internal control?
A.
To encourage employees to follow company policy
B.
To promote operational efficiency
C.
To ensure accurate, reliable accounting records
D
To ensure that management makes good decisions
The Data, Co., has asked you to assist in the preparation of a bank reconciliation at the end of July.
Answer questions 2–4 using the following code letters to indicate how the item described would be
reported on the bank reconciliation.
A.
Add to the bank statement balance
B.
Deduct from the bank statement balance
C.
Add to the book balance
D.
Deduct from the book balance
E.
Does not belong on the bank reconciliation
2.
Note and interest collected by the bank for the company, $500 (plus $25 interest).
3.
Deposit in transit, $400.
4.
Check No. 662 written for $730 was incorrectly recorded by the bank as $370.
5.
If a bank reconciliation includes an NSF check for $45, the journal entry to record this
reconciling item would include
A.
a credit to Cash.
B.
a debit to Cash.
C.
a credit to Accounts receivable.
D.
No entry is required.
6.
All of the following are procedures that should be followed for cash received by mail except:
A.
All incoming mail should be opened by a high-level, trusted employee.
B.
The debit to the Cash account should match the bank deposit.
C.
The controller should compare the day’s cash receipts to the bank deposit.
D.
The remittance advices are sent to the accounting department.
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7.
All of the following are internal controls over cash payments except:
A.
All payments should be made by check.
A.
Before payment is made, it should first be authorized by the treasurer.
C.
The invoice should be compared with a copy of the purchase order and receiving report.
D.
Small payments should be made from a petty cash fund.
8.
A petty cash fund has been established for $200. A count of the petty cash fund at the end of the
month reveals that there is $44 in the fund and petty cash tickets for the following amounts:
Postage expense
$ 75
Office supplies
42
Delivery expense
39
The journal entry to replenish the petty cash fund would be which of the following:
A.
B.
C.
Petty cash
Cash
Office supplies
Delivery expense
Postage expense
Cash
Cash
156
156
42
39
75
156
160
Petty cash
D.
Cash
160
44
Petty cash
9.
Decisions for ethical judgments should include all of the following steps except to
A.
determine the facts.
B.
assess the possible outcomes.
C.
identify the economic consequences.
D.
identify the ethical issues.
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44
Reference Document 7-1
SARBANES-OXLEY
Sarbanes-Oxley was important legislation with which students should be familiar. This document
provides supplemental information to assess the ramifications of inappropriate behavior.
Sarbanes-Oxley Act (SOX)
There have been serious consequences to the stakeholders as a result of the Enron (and other) corporate
financial misstatements.
•
•
•
•
The company’s outside auditor, Arthur Andersen closed its doors.
Executives lost their high paying positions.
Enron employees suffered serious financial consequences to their retirement accounts, largely
containing Enron stock.
Congress passed legislation increasing the penalties to management for misstating financial
results and financial condition.
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Reference Document 7-2
ETHICS
Since ethics is such a hot topic, we should have some more realistic situations to present to students so
that they can practice the ethical decision guidelines.
Ethical Decision Guidelines:
Let us use the guidelines on page 404 to respond to the following two situations.
I) A fellow student who you have become friendly with has asked you to help him cheat on the second
exam. He failed the first exam and needs to pass the class with at least a C so he can graduate next
semester. You like him, but as an “A” student, you are worried about getting caught.
1. Identify the ethical issue: Decide whether you should help your peer cheat.
2. Specify the alternatives: Either go along with what he wants or refuse.
3. Assess the possible outcomes:
• If I help him cheat and do not get caught, he will like me more because he will get a
better grade. Then I will be happy that he can graduate on time and it will be done.
• If I help him cheat and he gets a better grade, he may ask me to help him cheat again.
Each time I do this I am at risk of getting caught.
• If I refuse, he might be mad and not like me anymore. I might feel guilty if he does not
pass the course.
• We might get caught. We would both get zeroes for this exam and might even be
dismissed from the class or college. It would ruin my average, reputation, and the chance
of getting a recommendation from faculty. I would be embarrassed and mad at myself.
4. Make the decision:
What DO you do? It is a personal choice.
II) You work as a cashier at a liquor store. Your friend tells you that she will be shopping there and wants
you to “forget” to ring up the case of beer that she will have on the bottom of the cart.
1. Identify the ethical issue: Decide whether you should ring up the purchase or not.
2. Specify the alternatives: Either go along with what she wants or refuse.
3. Assess the possible outcomes:
• If I “forget” to ring up the beer and no one notices, she will like me.
• If I help her get away with this, she may ask me to do it again and again.
• If I refuse, she might be mad and not like me anymore. I will miss her.
• We might get caught. I could get fired from this job. I like the job and my co-workers
and I need the money for college.
• We might both be arrested. My family and I would be upset and embarrassed.
4. Make the decision:
What DO you do? It is a personal choice.
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Think About It
What if the student in situation (I) offered to pay you $100 for your help? Would that affect your answer
to step 4?
What if you needed the extra money to pay this month’s rent?
What if your child needed formula and diapers, and you did not have the money or a credit card? Would
that alter your decision?
Ask students to suggest other ethical dilemmas and go through the four step decision process together
with them.
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