CHAPTER 7

internal control and cash

Summary of Questions by STUDY Objectives
and Bloom’s Taxonomy

Note: C = Comprehension E = Evaluation AN = Analysis AP = Application

Summary of Questions by level of difficulty (lod)

Note: E = Easy M = Medium H=Hard

CHAPTER STUDY OBJECTIVES

1. Explain the activities that help prevent fraud and achieve internal control. Fraud is an intentional dishonest act that results in a personal financial benefit by misappropriating (stealing) assets or misstating financial statements. The three factors that contribute to fraud (the fraud triangle) are opportunity, financial pressure, and rationalization. Internal control consists of all the related methods and measures that management implements in order to achieve reliable financial reporting, effective and efficient operations, and compliance with relevant laws and regulations. Control activities include establishment of responsibility, segregation of duties, documentation procedures, physical and IT controls, independent checks of performance, and human resource controls.

2. Apply control activities to cash receipts and cash payments. Internal controls over cash receipts include (a) designating only personnel such as cashiers to handle cash; (b) assigning the duties of receiving cash, recording cash, and maintaining custody of cash to different individuals; (c) using remittance advices for mail receipts, cash register tapes for over-the-counter receipts, and deposit slips for bank deposits; (d) using company safes and bank vaults to store cash with only authorized personnel having access, and using cash registers to issue over the-counter receipts; (e) depositing all cash intact daily; (f ) making independent daily counts of register receipts and daily comparisons of total receipts with total deposits; and (g) bonding personnel who handle cash. Debit and credit card transactions increase internal control but have related bank charges. Electronic funds transfer receipts also increase internal control over cash receipts.

Internal controls over cash disbursements include (a) authorizing only specified individuals such as the controller to sign cheques; (b) assigning the duties of approving items for payment, paying for the items, and recording the payment to different individuals; (c) using pre-numbered cheques and accounting for all cheques, with each cheque supported by an approved invoice; (d) storing blank cheques in a safe or vault, with access restricted to authorized personnel, and print cheque amounts electronically; (e) comparing each cheque to the approved invoice before issuing the cheque, and making monthly reconciliations of bank and book balances; and (f) after payment, stamping each approved invoice “Paid.”

3. Describe the control features of a bank account. A bank account contributes to good internal control by giving physical and IT controls for the storage of cash, reducing the amount of currency that must be kept on hand, and creating a double record of a depositor’s bank transactions.

4. Report cash on the balance sheet. Cash is usually listed first in the current assets section of the balance sheet. Cash may be reported together with highly liquid very short-term investments called cash equivalents. Cash that is restricted for a special purpose is reported separately as a current asset or a noncurrent asset, depending on when the cash is expected to be used.

Exercises

Exercise 1

Below are descriptions of internal control problems. In the space to the left of each item, enter the code letter of the one best internal control activity that is related to the problem described. Each code letter can be used more than once.

Control activities

A. Establishment of responsibility

B. Segregation of duties

C. Physical and IT controls

D. Documentation procedures

E. Independent checks of performances

F. Human resource controls

1. The same person opens incoming mail and posts to the accounts receivable subsidiary ledger.

2. Three people handle cash sales from the same cash register drawer.

3. A clothing store is experiencing a high level of inventory shortages because people try on clothing and walk out of the store without paying for the merchandise.

4. The person who is authorized to sign cheques approves purchase orders for payment.

5. Some cash payments are not recorded because cheques are not prenumbered.

6. Cash shortages are not discovered because there are no daily cash counts by supervisors.

7. The controller of the company has not taken a vacation for over 20 years.

Exercise 2

Andrea Portowski has worked for Dr. Lee Hum for several years. Andrea demonstrates a loyalty that is rare among employees. She hasn't taken a vacation in the last four years. One of Andrea's primary duties at the medical office is to open the mail and list the cheques received. She also takes cash from patients at the cashier window as patients leave. At times it is so hectic that Andrea doesn't bother with giving each patient a receipt for the cash paid on their accounts. She assures them she will see to it that they receive the proper credit. When the traffic is slow in the office, Andrea offers to help the bookkeeper post the payments to the patients' accounts receivable. She is always happy to receive Andrea’s help, because she is a very conscientious worker.

Instructions

Identify any internal control activities that may be violated in this medical office situation.

Exercise 3

The following situations are independent of each other:

1. A law firm has three partners and eight employees who provide legal services to clients, and two administrative staff. When a case is completed, an invoice is supposed to be issued by “whoever has time to do it”.

2. An accounting firm completes many personal tax returns in a very short period of time each April. In order to speed up the process of updating client personal data (address, contact information and so on), the firm has placed a computer terminal in the reception area and ask the clients to enter any relevant changes while waiting for their account manager to see them. The terminal is connected to the main server and a user-friendly screen has been developed to guide the client through the data entry process. The screen can access any client’s data simply by typing in the client’s surname.

3. A warehouse operates 24 hours a day. Employees work either an eight or a twelve hour shift. Three managers each work an eight hour shift. Before leaving at the end of his or her shift, each manager makes a note on a clipboard of which employees were working during that shift. Once a week, someone from payroll gathers all of these notes to use in preparing the hourly employees’ pay cheques.

4. Marnie is the supervisor of accounting for a small business and has three junior accountants reporting to her. At the end of every day she reviews her assistants’ work and corrects any errors that she observes. She notices that one employee makes the same types of errors repeatedly and she hopes that she is catching and correcting all of the errors because otherwise the manager’s financial reports will not be reliable.

Instructions

For each weakness, describe what could go wrong as a result of the weakness described, state which type of internal control is required to correct the weakness, and describe a recommended control. You can use the following table to complete the exercise.

Example:

Exercise 4

The following internal control procedures are used by Brooks Company for cash receipts and disbursements:

1. Cashiers receive all over-the-counter receipts and place the cash into a single cash drawer.

2. When cash in the drawer exceeds $500, it is placed in an envelope marked “cash” and stored in a drawer in the supervisor’s office.

3. The company’s accountant makes daily bank deposits.

4. The clerk in the receiving department authorizes all payments for purchases.

5. Blank cheques are kept in the main office.

Instructions

For each of the above procedures, explain the weakness in internal control, identify the control policy or procedure violated and suggest a change in procedure that will result in better control.

Exercise 5

Pacific Used Books sells all of its products by “mail order.” Customers can select their purchases from an online catalogue. Once the books are selected, the customer sends an order in by e-mail, then prints out the e-mail and mails it in with a cheque. For individual customers, Pacific does not send out the order until the payment is received. For corporate customers like bookstores, Pacific will send out the order with an invoice before payment is received. Occasionally, “walk in” customers will come in to purchase specific books. These customers are expected to pay cash, and the receptionist prepares the invoices and takes the cash for the cash transactions.

The following procedures relate to the handling of cash payments from customers:

1. Pacific’s mail clerk opens all of the mail, which usually takes him the entire day. Orders from customers are placed in one file folder and the cheques received are placed in another file folder.

2. The cheques are delivered to the Accounts Receivable department at the end of the day, and placed in a filing cabinet by Joanie, the Accounts Receivable clerk. The file folder of orders is given to the shipping department.

3. The following morning Joanie prepares a bank deposit with all of the cheques received the previous day, and gives it to the receptionist to hold in her desk drawer.

4. At the end of the day, the receptionist adds any cash received from “walk in customers” to the deposit and then takes the deposit to the bank on her way to the bus stop.

5. From a photocopy of the bank deposit slip, Joanie prepares a list for the shipping department indicating which customer’s orders have been paid so that they know which orders are cleared for shipping. If the list includes payments from corporate customers, the shipping department ignores this information, assuming the orders have been sent previously.

6. Working from a photocopy of the bank deposit slip, Joanie enters the customer payments in the accounts receivable subledger, and records the cash received in the cash receipts journal.

7. At the end of the month, Joanie adds up all of the bank deposit slips, and reconciles this amount to the total cash receipts (per the cash receipts journal) for the month. There is very seldom a difference between the two amounts.

Instructions

a. For each procedure, explain one weakness in internal control.

b. For each procedure, identify the control activity that is violated.

c. For each weakness, recommend an improvement that will increase internal control over cash receipts.

Exercise 6

The following are internal control procedures over cash payments in place at Value Auto Parts.

1. Cheques are signed using an automated cheque signing machine. The machine is stored in a safe that requires two keys to open it. The Controller and Vice President Finance, each have custody of one of the keys.

2. Only original vendor invoices with unique invoice numbers are approved for payment. Faxes and photocopies are not acceptable, and if a vendor sends two invoices with the same number, they are returned and the vendor is asked to re-issue one of them with a different invoice number.

3. The Purchasing Manager is authorized to approve purchase orders, the Receiving Manager approves invoices after matching them to receiving reports, an Accounts Payable Assistant records the purchase invoices, the Accounts Payable Manager prepares cheques and the VP Finance signs them.

4. The computer system produces a log showing how many errors have been made and corrected by each Accounting Assistant in recording vendor invoices.

Instructions

For each internal control, identify which type of control is described, and describe a weakness that the control is designed to prevent or detect.

Exercise 7

Home Appliances allows customers to pay for merchandise with cash, debit cards, bank credit cards, or a Home Appliance Credit Card. The bank charges Home Appliances $1.00 for each debit card sale and a 4% fee for bank credit card sales. On September 25 a customer makes a $1,200 purchase from Home Appliances using her debit card.

Instructions

a. Prepare Home Appliances’ journal entry to record this transaction.

b. Assume instead the customer pays for her purchase using her MasterCard. Record the transaction.

c. Assume instead the customer uses her Home Appliances store credit card. Record the transaction.

Exercise 8

The following situations are independent of each other.

1. Jim’s Electronic Games is a very relaxed place to work. Unissued blank cheques are left in a box on the floor near the printer.

2. XL Products requires every cheque to be signed by the President and the VP Finance. Because the President travels a lot, he signs several blank cheques in advance of each trip so that his absences will not interfere with the operations of the Accounts Payable department.

3. Dubois Books is short staffed and the accounting department is very busy. As soon as the cheques are printed they are sent to the Executive office to be signed while the invoices that were paid are immediately filed so that the work will not get backlogged.

4. At Nora Sales, two accounting clerks share cheque disbursement duties. They can tell which invoices have been paid by whether they are located in the “unpaid” basket or in the vendor file.

Instructions

For each weakness, describe what could go wrong and make a recommendation to improve internal control.

Exercise 9

The following procedures are used by Kurtz Renovations in handling cash payments. The individuals involved in the cheque preparation and payment process are Howie, the Accounts Payable clerk, who reports to the Controller, and Jane, the Construction Manager.

1. When purchase invoices are received, Jane approves them for payment. After they are approved, Howie records the purchase invoices in the Accounts Payable subledger and then files them in an “unpaid invoices” file. Once or twice a week, Howie scans through the file and decides which invoices should be paid.

2. Howie prepares the cheques manually. He enters cheque numbers on the cheques which are not pre-numbered.

3. The unsigned cheques are put into Jane’s In Box to be signed.

4. Jane does not feel she needs to see the invoices again when she signs the cheques so only the cheques are given to her.

5. Jane is often out of the office on construction projects, but she tries to make sure that she signs the cheques within two or three days.

6. After she has signed the cheques, Jane returns them to Howie for mailing. After Howie has mailed the cheques, he files the paid invoices in the vendor invoice files.

Instructions

For each procedure, describe what could go wrong as a result of the weakness described, and recommend an internal control to correct the weakness.

Exercise 10

The following is information about Pelly Car Repair’s cash and related accounts at December 31, 2014:

1. Postdated cheques from customers total $5,500. The cheques are dated January 31, 2015.

2. The company has a savings account with a balance of $5,250 after all adjustments are recorded.

3. The company has guaranteed investment certificates totalling $10,000 due in 30 days.

4. The company maintains a cash float of $1,000 for use in the cash registers and which is stored in a locked safe overnight. On December 31, the sales manager borrowed $100 from the cash float, leaving an “IOU” note in the safe.

5. The chequing account is overdrawn, showing a negative balance of $12,400 after all adjustments.

Instructions

a. Calculate what amount of cash and cash equivalents will be reported on Pelly’s December 31, 2014 balance sheet.

b. For each of the items listed that is not included in cash on hand, indicate how the amount will be reported in Pelly’s December 31, 2014 financial statements.

Exercise 11

The following information is taken from the accounting records of Village Pet Shelter at December 31, 2014, the organization’s year end:

1. The organization owned $50,000 in guaranteed investment certificates due June 30, 2015.

2. The Bank of Montreal chequing account balance was $4,566 after all adjusting entries had been made.

3. The Bank of Montreal savings account balance was $35,600 before recording $150 in December interest revenue.

4. The Bank of Nova Scotia Chequing account balance, after all adjustments, is $80,700. The funds in this account were donated by a private foundation for the purpose of purchasing new shelter furnishings, which they plan to do in February, 2015.

Instructions

Prepare a partial balance sheet for Village Pet Shelter at December 31 showing how this information should be presented.

Exercise 12

The following information is taken from the accounting records of Joudrey Law Firm at December 31, 2014, the firm’s year end.

1. The firm has two chequing accounts:

- The general account has a balance of $67,000 after all adjustments and is used to pay for the firm’s operating expenses.

- The trust account has a balance of $450,000 and contains funds belonging to clients, which can only be used on behalf of the clients to whom the funds belong.

2. The firm has a savings account balance of $22,400 after recording $90 in December interest revenue.

3. On December 31, a client paid a $1,500 invoice in cash. The office manager did not have time to take the funds to the bank on December 31, so the money was locked in the firm’s safe.

4. The senior manager took $400 of the cash from the safe for personal use, and left an “IOU” note. He repaid the cash on January 3, 2015.

5. In the safe there are two post dated cheques from clients totalling $25,000. Both are dated February 28, 2015.

Instructions

Prepare a partial balance sheet for Joudrey Law Firm at December 31 showing how this information should be presented. Assume the firm has no accounts receivable other than those described in the above information.