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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 inefficient. 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 vendor. 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 check. 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. Receivables 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 reconcile. 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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