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					Accounting 201
Chapter Seven Lecture Notes

Internal Controls, Cash and Cash Management

Internal Controls

Internal Controls are the methods and measures an entity employs to safeguard its assets and enhance the
accuracy and reliability of its accounting records.

Principles of internal control:

Establishment of responsibility – responsibility for specific tasks is assigned to specific individuals, and as
much as possible only one person is made responsible for performance of a specific task, such as making
bank deposits.

Segregation of duties – responsibility for accounting for an activity is separated from the physical custody
of the asset. In particular, the responsibility of handling cash should be separated from the responsibility of
accounting for cash.

Documentation procedures – transactions should be fully documented in order to be able to trace what
transpired at a later time. Forms should be prenumbered and controlled to ensure that they are used
properly and that all forms have been accounted for.

Independent internal verification – This involves the review and reconciliation of data. It includes
balance sheet account reconciliation and income statement analysis of percentage changes.

Physical, mechanical, and electronic controls. These include physical barriers (walls and counters),
physical controls (serial numbers), mechanical barriers (locks and safes), and electronic controls
(passwords and limitation of access or utilization).

Limitations of internal controls
          The costs of establishing controls should not exceed their expected benefits
          Controls should be put in place with the idea to “prevent someone from being tempted” as
             opposed to “no one can be trusted”. Excessive controls will destroy morale and are ultimately

Cash Controls

The same controls discussed above can be tailored to control cash.

Cash Receipt Controls:

Establishment of responsibility – only designated and trained cashiers handle cash. Try to limit access to a
specific cash register to one specific individual (per shift).

Segregation of duties – Different individuals receive cash (cashiers), record cash receipts (accounting
technicians), and make bank deposits (other accounting technicians).

Documentation procedures – Use electronic cash registers which have a journal tape, prepare daily cash
accountability forms, use detailed deposit slips, maintain detailed backup of each day’s cash receipts..

Independent internal verification – Supervisors balance out cashiers, accountants review daily cash
accountability forms, accountants reconcile cash accounts..
Physical, mechanical, and electronic controls. Use cash registers with Z out capabilities and internal
journal registers, store cash in safes.

Other controls – bond personnel who handle large amounts of cash, deposit cash daily.

Additional Check Controls:

Customer Account Credits and Statements. A risk with checks is that an accounting technician will divert
checks to a personal account. Controls to prevent against this include customer statements and supervisor
approval of all customer account credits. Statements should include all account activity including all
invoices, payments, and credits. The idea is that a customer would complain if they received a statement
showing a balance owed after they have paid. Supervisors should approve all customer credits to prevent
against diversion of a check which is covered up by issuing a customer account credit.

Cash Disbursement Controls:

Establishment of responsibility – only designated personnel sign checks.

Segregation of duties – Different individuals account for disbursements and sign checks. I.E., the A/P
Technician should never sign checks.

Documentation procedures – Use purchase orders, vendor invoices, and receiving reports as substantiation
for payment. Use pre-numbered checks and account for them in sequence.

Independent internal verification – Accountants reconcile bank accounts.

Physical, mechanical, and electronic controls. Automated accounting systems really help, physically
control blank check stock and signature dies.

Other controls – only pay off of invoices, not statements (to prevent against duplicate payments) and mark
invoices paid (to prevent against duplicate payments).

Electronic Funds Transfer (EFT) – commonly used to remit payroll taxes or remit payments. Wire
transfers can be Fed Funds (same day) or Automated Clearing House (ACH) next day. When you make
payment by one of these methods, you need internal controls described above as well as s system to endure
the transaction is recorded in the accounting system

Petty Cash Fund

            There is a difference between change fund and petty cash fund, do not intermingle the two.
            Transactions are accounted for when the fund is replenished.
            Accumulated transactions for an unreplenished fund are an adjustment item at cycle end
            Petty cash funds need to be physically counted on occasion to ensure the unspent amount of
             the fund is still present
            One individual serves as custodian who can not make purchases with the fund and who is
             personally responsible for it.
            Ensure physical security of the fund (a locked drawer or safe).
            Ensure reimbursements from the fund have adequate documentation and ensure that advances
             from the fund are documented with a receipt.

Use of A Bank

Specific insights in addition to common sense (i.e., things they already know):
Use 3-part checks. One copy of the remittance advice is kept in A/P along with the backup (vendor’s
invoice, etc.) for the check. The second copy of the remittance advice is sent along with the check to the

Pay invoices by vendor’s invoice number and list these individually on the remittance advice. This allows
the vendor’s A/R clerk to know how to apply the payment.

Keep copies or listings by check number and maker of all checks deposited in each deposit. This makes it
infinitely easier to reconcile individual customer’s accounts if they argue they we received and cashed their

Keep all banking information related to a single day in one place (we have often used manila envelopes).
This means a copy of all cash register tapes, credit card machine tapes, and check listings.

Total out your credit card draft capture machine daily. This makes credit card sales infinitely easier to
reconcile when reconciling a bank statement.

Reconciling A bank account

Use the following format:

Cash balance per bank statement                                 XXX
Add: deposits in transit                                        XXX
Less: Outstanding Checks                                       (XXX)
Equals: Adjusted Cash Balance Per Bank                          XXX

Cash Balance Per Books                                          XXX
Add: Interest received                                          XXX
     Errors                                                     XXX
Subtract: Bank charges                                         (XXX)
          NSF checks                                           (XXX)
          Credit card percentage fees                          (XXX)
          Errors                                               (XXX)

Adjusted cash balance per books                                 XXX

Errors include:
   Checks written for one amount and recorded for another
   Checks written but not recorded
   Checks or deposits recorded twice
   In an automated accounting system, outstanding checks voided with a backdated date into an
   accounting period where cash has already been reconciled. (You think the check is still outstanding).

If adjustment items are found which either add to or subtract from the cash balance per books, these items
are then recorded in the books with an adjusting journal entry. Note that it is not acceptable procedure to
carry adjustment items forward to the next period on a bank reconciliation statement to see if they clear.

Accounting For Cash

Cash items are often combined and reported on the balance sheet as “cash”. Some companies use the term
“Cash Equivalents”. Cash equivalents are highly liquid investments with maturities of three months or
less when purchased. Cash equivalents can include money market funds, certificates of deposit, and US
treasury bills and notes.

Types Of Receivables

Types of Receivables

Accounts Receivable are amounts owed by customers on account

Notes Receivable are formal instruments of credit (documents) that require the debtor to pay interest and
extend for 60-90 days or longer.

Other Receivables are non-trade receivables such as interest receivables, advances to employees, and tax
refunds receivable.

Accounts Receivable Journal Entries

To record a sale on credit

         Debit Accounts Receivable
                 Credit Sales

When finance charges are added to a past due account

         Debit Accounts Receivable
                 Credit Finance Charge Revenue or Interest Revenue

When payment is received from the customer

         Debit Cash
                 Credit Accounts Receivable

Valuing Accounts Receivable

Accounts Receivable are stated on the balance sheet at their net realizable value. At any one point in time,
some Accounts Receivable are on the books that will ultimately not be collected in the future. Accounts
receivable are recorded at historical cost, however. This means that we have to simultaneously state
Accounts Receivable on the balance sheet at both historical cost and net realizable value. When we have to
state an asset at both historical cost and at another value, we use a contra asset account. The contra asset
account we use to state Accounts Receivable at net realizable value is Allowance For Bad Debts.

Under GAAP, we are required to estimate the amount of current accounts receivable that will not be
collected and record an expense for these amounts entitled Bad Debts Expense. The offset to the recording
of this expense is the Allowance For Bad Debts account.

To record a journal entry for an estimate of bad debt expense:

         Debit Bad Debts Expense
                 Credit Allowance For Bad Debts

When an allowance account is used, debts that actually are written off are used by reducing accounts
receivable and the allowance account. To record a journal entry for writing off an actual uncollectible
account is:

         Debit Allowance For Doubtful Accounts
                  Credit Accounts Receivable
When a bad debt that has been written off is recovered, we record the following journal entries:

         Debit Accounts Receivable
                 Credit Allowance For Doubtful Accounts

         Debit Cash
                 Credit Accounts Receivable

We have to make an estimate of the amount of current Accounts Receivable that will ultimately be
uncollectible. But how do we do make this estimate? What do we use as our basis for estimating? GAAP
says that we can use one of two different methods – the Percentage of Sales Method or the Percentage of
Receivables method.

Percentage of Sales method

The accountant estimates a percentage of the amount of credit sales that will ultimately be uncollectible.
When total credit sales are determined for the accounting period, the accountant multiplies the total amount
of credit sales to determine the amount to be recorded as bad debt expense. The problem with this method
is that the balance in the allowance account can grow to an unrealistic size or even gain a debit balance,
depending on how actual write-offs compare to the estimation percentage; there is no built in control.

Example and journal entry:

It is estimated that 1% of credit sales will ultimately become uncollectible. Credit sales for the period were
$500,000. The required estimation journal entry is, therefore:

         Debit Bad Debts Expense                                $5,000
                 Credit Allowance For Doubtful Accounts                  $5,000

Percentage of Receivables method

The accountant estimates a percentage of current accounts receivable that will ultimately become
uncollectible. The accountant prepares an Accounts Receivable Aging Schedule to help in this estimate.
The Accounts Receivable Aging Schedule divides accounts receivable into categories based on the number
of says past due a particular account is. These categories are called aging brackets. Common aging
brackets are current, 1-30 days past due, 31-60 days past due, 61-90 days past due, 91-120 days past due,
and 120+ days past due. The accountant makes an estimate of the percentage of the total amount of the
accounts receivable in each aging bracket that will ultimately become uncollectible. Usually the percentage
estimate increases as the aging brackets become increasingly past due. The accountant then multiplies the
amount of accounts receivable in each aging bracket by the bracket’s bad debt percentage, then adds up the
amounts to get a total estimate. In contrast to the Percentage of Sales Method, this amount is not directly
recorded as a bad debt expense. Instead, it is compared to the existing balance in the Allowance for Bad
Debts account and the difference is recorded as the Bad Debt Expense estimate.
Example and journal entry:

         An accounts receivable aging schedule contains the following information:

         Current                    $10,000
         1-30 days past due         $5,000
         31-60 days past due        $4,000
         61-90 days past due        $3,000
         91 – 120 days past due     $2,000
         Over 120 days past due     $1,000

         The amount of each aging bracket that is estimated to be uncollectible is:

         Current                    1%
         1-30 days past due         2%
         31-60 days past due        3%
         61-90 days past due        5%
         91 – 120 days past due     10%
         Over 120 days past due     50%

         The current balance in Allowance For Doubtful Accounts is $1,000

         The calculation of the estimate for Bad Debts Expense and journal entry are as follows:

         Current                    $10,000 x 1% = $100
         1-30 days past due         $5,000 x 2% = $100
         31-60 days past due        $4,000 x 3% = $120
         61-90 days past due        $3,000 x 5% = $150
         91 – 120 days past due     $2,000 x 10% = $200
         Over 120 days past due     $1,000 x 50% = $500 Total estimate = $1,170

         Adjustment therefore equals $1,170 - $1,000 = $170. Journal entry is:

         Debit Bad Debts Expense                               $170
                 Credit Allowance For Doubtful Accounts                 $170

Direct Write-Off Method

In this method, bad debt expense is recorded when an account is written off. As no estimate of future
uncollectible accounts is recorded as an expense during the present accounting cycle, the Direct Write-off
Method is not in accordance with GAAP. Example and journal entry are:

         An account of $100 is deemed uncollectible.

                  Debit Bad Debts Expense                               $100
                  Credit Accounts Receivable                                      $100

Sales of Accounts Receivable

Accounts receivable can be sold before they are collected from the customer. This is done in order to raise
cash when working capital is insufficient or liquidity is low. The term for a sale of accounts receivable is
called factoring. The purchaser of the receivables is called the factor and charges a percentage
commission of the amount of the receivables purchased.
Credit Card Sales

Visa and Mastercard – The amount is immediately added to the seller’s bank balance. The book shows the
service fee being deducted immediately, but many banks now deposit the full amount of the charge sale and
deduct all Visa/Mastercard fees once a month. Journal entry example:

         Deposit of charge sale proceeds:

         Debit Cash                           $xxx
                 Credit sales                         $xxx

         Month-end charge for fees

         Debit Credit Card fees               $xxx
                 Credit cash                          $xxx

Credit card sales are either made through a manual credit card machine with a carbon copy sales slip or,
now more commonly, through automated draft capture. If you use a manual credit card machine, all credit
card slips must be physically deposited at the bank to get the amount of the credit sales added to your bank
account. If you use automated draft capture, you use a “swipe” machine with a signature sales slip. The
automated draft capture machine automaticallly deposits the credit sales proceeds in your bank account, but
only after you “close out” the machine at the end of a day. If you forget to close out the automated draft
capture machine for a day (or a week), you don’t get any money and your bank statement is impossible to

A note on reconciling bank statements when you have credit card sales with automated draft capture. You
need to make sure you record your sales exactly as you process them with automatic draft capture. For
example, if you have a $100 credit sale today and a $200 credit sale tomorrow and you record them in your
cash account as $100 and $200, but you forget to “close out” your automated draft capture machine until
the end of day 2, you will get a deposit of $300 on your bank statement. Thus it can be difficult adding
together deposits to get them to match the way deposits are reported on your bank statement.

American Express, Discover, Carte Blanche, and Diner’s Club all take a few days (up to 2 weeks) to pay
the bank the amount of the credit sale to your bank account. Also, the amount paid to your account is net
of the fee, which can be 5% or more. Some companies record these sales as receivables until they have
reconciled the deposits in their bank account. An example and journal entry:

         A $100 Diner’s Club sale with a 5% fee

         Recording of charge sale proceeds:

         Debit Accounts Receivable                             $ 95
         Debit Credit Card Fees                                $ 5
                 Credit Sales                                           $100

         When payment hits your bank account

         Debit Cash                                            $95
                 Credit Accounts Receivable                             $95
Notes Receivable

A promissory note is a written promise to pay a specified amount of money at a specified time. They can
be used when (1) individuals or companies lend or borrow money, (2) when the amount of a credit
transaction exceeds normal credit limits, and (3) in settlement of accounts receivable.

The party making the promise to pay is called the maker, the party to whom payment is to be made is
called the payee.

The basic issues in accounting for notes receivable are recognizing notes receivable, valuing notes
receivable, and disposing of notes receivable.

Notes have maturity dates stated in terms of months or days. Months are computed in 1-month increments
regardless of the number of days in the month, and the note falls due on the exact day it was issued.. Days
are counted exactly, omitting the day the note was issued but including the day it matures. Examples:

         A 3-month note issued on January 31 matures April 30.

         A 31-day note issued January 31 matures on March 3 (assuming no leap year).

Interest rates on notes are stated in terms of an annual interest rate. The interest is usually computed on a
30/360 basis or a 365-day basis and will be stated on the face of the note.

Recognizing Notes Receivable

Notes Receivable are recognized at their face value. No interest revenue is accrued or recorded when the
note is received. The note is recorded as soon as the credit agreement has been entered into.

Valuing Notes Receivable

Notes Receivable are recorded at face value but are reported on the balance sheet at net realizable value.
This means that Notes Receivable have an associated Allowance For Doubtful Accounts contra asset
account, and, that an estimate for uncollectible accounts is written off to bad debt each period.

Disposing of Notes Receivable

A note that is collected at its maturity date along with all accrued interest is considered honored. The
journal entry for collection is as follows:

         Debit Cash
                 Credit Notes Receivable
                 Credit Interest Receivable
                 Credit Interest Revenue

A note which is not collected at its maturity date is considered dishonored. The amount of the note along
with any accrued interest receivable is transferred to accounts receivable.. The journal entry is as follows:

         Debit Accounts Receivable
                 Credit Notes Receivable
                 Credit Interest Receivable
                 Credit Interest Revenue
Financial Statement Presentation

Accounts receivable are presented on the balance sheet in the following format:

         Accounts Receivable                          $XXX
         Less: Allowance For Doubtful Accounts:         XX
         Net Receivables                               XXX

Financial analysts and managerial accountants who perform financial statement analysis compute a
financial ratio involving accounts receivable. It is a liquidity ratio called the Accounts Receivable
Turnover Ratio. It is equal to net credit sales divided by average net accounts receivable. The higher the
turnover ratio the more liquid the company’s receivables.

Exercises & Problems

Ex 7.9, 7.11, 7.17, P 7.1

Due Nov 4.

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