Chapter 6: Cash and Internal Control

6-16Financial accounting solutions manual

chapter 6 Cash and internal control6-17

CHAPTER 6Cash and Internal ControlOVERVIEW OF EXERCISES, PROBLEMS, AND CASES

Estimated

Time in

Learning OutcomesExercisesMinutesLevel

1.Identify and describe the various forms of cash reported110Easy

on a balance sheet.5*15Mod

2.Show that you understand various techniques that 210Easy

companies use to control cash.5*15Mod

3.Explain the importance of internal control to a business and the

significance of the Sarbanes-Oxley Act of 2002.

4.Describe the basic internal control procedures.320Mod

415Mod

5.Describe the various documents used in recording purchases

and their role in controlling cash disbursements.*Exercise, problem, or case covers two or more learning outcomes

Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

ProblemsEstimated

andTime in

Learning OutcomesAlternatesMinutesLevel

1.Identify and describe the various forms of cash reported4*20Mod

on a balance sheet.

2.Show that you understand various techniques that125Mod

companies use to control cash.4*20Mod

3.Explain the importance of internal control to a business and the

significance of the Sarbanes-Oxley Act of 2002.5*20Mod

4.Describe the basic internal control procedures.220Mod

5*20Mod

5.Describe the various documents used in recording purchases

and their role in controlling cash disbursements 325Diff*Exercise, problem, or case covers two or more learning outcomes

Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

Estimated

Time in

Learning OutcomesCasesMinutesLevel

1.Identify and describe the various forms of cash reported120Mod

on a balance sheet.330Mod

2.Show that you understand various techniques that

companies use to control cash.

3.Explain the importance of internal control to a business and the 225Mod

significance of the Sarbanes-Oxley Act of 2002.4*30Mod

4.Describe the basic internal control procedures.4*30Mod

5.Describe the various documents used in recording purchases

and their role in controlling cash disbursements

*Exercise, problem, or case covers two or more learning outcomes

Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)questions

1.A cash equivalent is an investment that is readily convertible to a known amount of cash and has an original maturity to the investor of three months or less. It is included with cash on the balance sheet because the risk of a material loss on it is small. Unlike other types of investments, such as those in stocks and bonds of other companies, the company holding a cash equivalent knows exactly how much cash will be received when it matures.

2.A cash equivalent is convertible to a known amount of cash. Therefore, the purchase of a cash equivalent is not considered a significant investing activity to be reported on the statement of cash flows. Cash equivalents are included with cash on the balance sheet, and thus the company is merely trading one cash item for another when it writes a check and uses the proceeds to invest in a cash equivalent.

3.The friend is correct in the observation that all receipts should be deposited intact for control purposes. However, no company should have a policy to maximize the balance in checking accounts. Other than a nominal interest rate paid, cash is a non-earning asset, and a minimal amount should be maintained in checking accounts to pay bills as they are due. Excess cash can be much more productive if it is invested in other assets, such as debt and equity securities, inventories, and plant and equipment.

4.The meaning of a debit or a credit depends on which company is concerned. To the bank, a companys checking account is a liability. Therefore, when a bank deducts a service charge from a companys account, it is reducing its liability to the company. A liability is decreased with a debit. Thus, banks refer to charges to a companys account as debit memoranda.

5.When the balance per the bank statement and the balance per the books are reconciled to the correct balance, a service charge is deducted from the balance on the books. However, if it is added to the balance per the bank, it is because the company is reconciling the balance on the bank statement to the balance on the books. The bank has deducted the charge from the balance it shows. Because the company has not yet deducted this amount, a reconciliation of the bank balance to the book balance requires that the charge be added back.

6.The Sarbanes-Oxley Act was passed in the wake of a number of high-profile cases involving questionable accounting practices. Congress decided that action by the federal government was needed to protect the interests of various parties that rely on corporate financial statements in making decisions.

7.A board of directors normally is composed of a combination of key officers of the corporation, such as the president, and outsiders. The outsiders usually have been or are presently key officers themselves of other corporations.

8.This misuse of corporate assets could have been prevented by having a procedure in place for segregation of duties. A single employee should not be allowed to order merchandise, receive it, and initiate payment for it.

9.There are a number of limitations on the efficiency of internal control. First, a system of internal control is not cost free. For example, the segregation of duties may require a larger staff than would otherwise be necessary. An internal audit staff may be too costly for a small company. Second, no system of internal control can prevent collusion by two or more employees. Third, the lack of support from upper management may weaken an otherwise strong commitment to a system of internal control. Finally, the element of human error can never be eliminated in any operation, regardless of how big or small.

10.Two basic procedures are essential to good internal control over cash. First, all cash receipts should be deposited intact in a bank on a daily basis. That is, no disbursements should be made from any amounts received prior to their deposit in the bank. Second, all cash disbursements should be made by check. The use of serially numbered checks results in a clear record of all payments.

11.There may be a benefit in terms of good customer relations to positioning a cash register so that customers can read the display. However, it is equally important for control purposes. If the customer can read the display, the sales clerk is less likely to ring up a sale for less than the amount received and pocket the difference. This control feature is certainly not foolproof in preventing this from happening, but it will act as a deterrent.

12.An invoice rather than a purchase order is the basis for recording a purchase and a corresponding liability (accounts payable). From a legal viewpoint, the purchase order is merely an offer by the company to purchase and does not constitute by itself a legally binding contract. The receipt of an invoice from the supplier is evidence that this outside party has accepted the offer and agreed to sell the merchandise under a particular set of terms and conditions.

13.A receiving report is a document used by the receiving department to indicate the arrival of inventory from a supplier. In a computerized system, the same software program that generates the purchase order also generates a receiving report, showing the various items ordered, the terms of payment, the shipper, and other important information. On a blind receiving report, the columns for the quantities of each item are intentionally left blank. Rather than being allowed to just check off that the number ordered were all received, the clerk must count the number actually received.

14.A purchase invoice is compared with a purchase order to ensure that the goods were in fact ordered. The comparison of a receiving report with an invoice ensures that all goods that a company is being billed for were in fact received.

exercisesLO 1EXERCISE 6-1 CASH EQUIVALENTS

Cash equivalents at December 31, 2007:

Certificate of deposit, due March 30, 2008$150,000

Commercial paper, due February 28, 2008125,000

Deposit into a money market fund25,000

90-day Treasury bills

100,000

Cash equivalents$400,000

LO 2EXERCISE 6-2 ITEMS ON A BANK RECONCILIATION

1.DBank4.DBook7.NA

2.DBook5.ABook8.ABook

3.ABook6.ABank9.ABook

LO 4EXERCISE 6-3 INTERNAL CONTROL

1.Students answers to this question will vary. Among the possible guidelines the club should follow:

a.Prenumbered tickets

b.Segregation of duties for collecting cash, counting and recording cash, and depositing cash in a bank account

c.Payment by check of any expenses associated with the raffle

2.The president would like verification that all money is collected and recorded. It would be difficult, if not impossible, to be completely sure that this happens. For example, human errors in counting and handling the cash may result in not all of the cash being collected (such as errors in making change). Also, it is impossible to prevent collusion from occurring if two or more individuals work together to misdirect any of the cash.

LO 4EXERCISE 6-4 SEGREGATION OF DUTIES

Many possible combinations are possible. One appropriate way to segregate the duties would be as follows:

Employee

TaskMarySueJohn

Prepare invoicesX

Mail invoicesX

Pick up mail from post office

X

Open mail, separate checksX*X*

List checks on deposit slip in triplicateX

Post payment to customers account

X

Deposit checksX

Prepare monthly schedule of

accounts receivable

X

Reconcile bank statements

X*Two employees should be present to open mail and separate checks.

MULTI-CONCEPT exerciseLO 1,2EXERCISE 6-5 COMPOSITION OF CASH

1.Y7.N (Short-term investments: CD)

2.Y8.Y

3.Y9.N (Accounts receivable: Past due)

4.N (Office supplies)10.Y

5.N (Receivables from employees)11.Y

6.Y

problemsLO 2PROBLEM 6-1 BANK RECONCILIATION

1.

CALICO CORNERS

BANK RECONCILIATION

MAY 31, 2007

Balance per bank statement, May 31

$8,432.11

Add:Deposit-in-transit$1,250.00

Bank error: Deposit credited to

wrong account

123.45

1,373.45

Deduct:Outstanding checks:

#123$23.40

#127145.00

#128210.80

#130

67.32

(446.52)

Adjusted balance, May 31

$9,359.04Balance per books, May 31

$9,965.34

Add:Interest earned on bonds$465.00

Interest earned on account

54.60

519.60

Deduct:Bank service charges$50.00

NSF check166.00

Book error: Deposit of $101.10

recorded as $1,011.00

909.90

(1,125.90)

Adjusted balance, May 31

$9,359.04

2.The fallacy in the friends reasoning is that only the company, not the bank, can make errors. A bank reconciliation is needed to detect errors and omissions on both the books and the banks records.

LO 4PROBLEM 6-2 INTERNAL CONTROL PROCEDURES

1.List of procedures to follow:

a.Ring the sale on the cash register, and give every customer a receipt.

b.Accept the money, and count the proceeds before putting it into the drawer.

c.Make change, and count it as it is given to the customer.

d.When given bills of $5 or over, do not put them in the drawer slot until customer accepts change (this avoids customer claiming he or she gave a $10 bill, for example, when it was actually a $5 bill).

e.Never leave drawer open.

2.Procedures to follow at end of day to close out:

a.Count the coins and currency in the drawer.

b.Remove the cash register tape.

c.Reconcile the tape to the cash in the drawer, and investigate any differences.

d.Remit the tape and the cash to central office.

3.The primary concern in this operation is control over cash, because all sales are cash. This concern was addressed by using a cash register, having the lead person check the cash, and depositing it intact daily.

LO 5PROBLEM 6-3 THE DESIGN OF INTERNAL CONTROL DOCUMENTS

1.The old system of allowing each motel to buy supplies from local distributors offered very little internal control. For example, the corporate office had no control over the amount paid by each individual operation for its supplies. The new system will allow the company to buy in larger quantities, hopefully at better prices. Also, with the old system, there was no physical control over the supplies. Dishonest employees at a particular motel could steal supplies much more easily than under the new system.

2.The purchase requisition form should be in triplicate, with the original filled out by the requesting department and copies to the purchasing and accounting departments. The form should show

a.requesting department

b.date requested

c.preferred vendor

d.date needed

e.complete description of items requested

f.quantity of each item requested

g.blank for signature of person requesting

h.blank for signature of supervisor for approval

i.sequential numbering of the forms

The receiving report should be in duplicate, with the original filled out by the receiving department with a copy to the accounting department. It should show

a.purchase order number

b.vendor

c.carrier/shipper

d.credit terms

e.dates requested, ordered, and received

f.shipping instructions

g.items ordered and quantity of each ordered

h.quantities received of each item

i.blank for signature of person receiving

j.blank for approvals

MULTI-CONCEPT PROBLEMSLO 1,2PROBLEM 6-4 CASH AND LIQUID ASSETS ON THE BALANCE SHEET

In order of liquidity on the balance sheet:

1.Petty cash fund

2.Money market fund

3.Investment in stock

4.Accounts receivable

5.Certificates of deposit (six months)

6.Prepaid rent

The first two items would be included in cash on the balance sheet. All other items are not as liquid as cash and require either collection or sale to generate cash. Each of these items would normally be classified as current assets. Prepaid rent is considered current because the benefits will normally expire within one year. However, prepayments do not generate any cash for the business. It should be noted that the CD does not qualify as a cash equivalent because it has a maturity longer than three months.

LO 3,4PROBLEM 6-5 INTERNAL CONTROL

1.Morris Mart suffers from a lack of segregation of duties. Mary handles all tasks associated with collection of customer accounts.

2.Mary should not handle all aspects of accounts receivable, billing, and collection. Two different employees should mail invoices and record the amounts billed. Two employees should be present when the mail is opened. Another employee should be responsible for recording collections from customers. Finally, all employees should be required to take vacations, and there should be rotation of job duties among employees.

3.Someone should explain to Mary that she personally is not the problem but that a good system of internal control requires certain changes to be made. This could be explained to her not in the context of fraud but rather in the context of the necessity to verify and check the work performed by all employees.

alternate problemsLO 2PROBLEM 6-1A BANK RECONCILIATION

1.Amounts can be found by preparing a bank reconciliation:

KARENS CATERING

BANK RECONCILIATION

MARCH 31, 2007

Balance per bank statement, March 31

$6,506.10

Add: Deposit-in-transit

423.00

Deduct:Outstanding checks:

#112$42.92

#117307.00

#12010.58

#122

75.67$436.17

Bank error: check written for

$990; $909 charged against

account

81.00

(517.17)

Adjusted balance, March 31

$6,411.93

Balance per books, March 31

$?

Add:Customer check collected

$45.00

Interest earned on account

4.30

Customer check not recorded

1,250.001,299.30

Deduct:Collection fee

$4.50

Bank service charges

22.00

(26.50)

Adjusted balance, March 31

$6,411.93*

*Adjusted balance per the books must be the same amount as the adjusted balance per the bank.

Conclusion: The balance on the books before any adjustments is the ? in the bank reconciliation and can be found by working backwards: $6,411.93 + $26.50 $1,299.30 = $5,139.13. The corrected balance to be reported on the balance sheet is the adjusted balance of $6,411.93.

2.Karen has an ethical responsibility to tell the bank about the error of $81.00 in item g. Even though reporting the error will result in a decrease in Karens bank balance, the error should be called to the attention of the bank.LO 4PROBLEM 6-2A INTERNAL CONTROL PROCEDURES

1.The bank and regulatory agency are concerned with these documents because without proper documentation the legal agreement could be invalid. For example, without a valid title, the bank has no recourse if the customer defaults on the loan. A valid insurance policy is necessary in case the motorist should have an accident. The regulatory agency is empowered by the government to protect the interests of the public.

2.Internal control procedures to ensure that the documents are obtained and safeguarded:

a.The accuracy and completeness of all information on the note, insurance policy, and title should be verified and reviewed.

b.The note and insurance policy should be reviewed periodically for expiration dates.

c.Each of the documents should be kept in locked compartments with limited access.LO 5PROBLEM 6-3A THE DESIGN OF INTERNAL CONTROL DOCUMENTS

1.Procedures to ensure that all royalties are paid to the actors:

a.All payments must be made by check.

b.All payments are subject to approval by a supervisor.

c.All payments should be cross-referenced to the actual sales of movies.

2.The shipping form should be in duplicate, with the original filled out by the shipping department and a copy to the accounting department. It should include

a.authorizations

b.dates ordered and shipped, and expected delivery date

c.customer name, address

d.customer contact person

e.description of titles to be shipped

f.quantity of each title to be shipped

ALTERNATE MULTI-CONCEPT PROBLEMSLO 1,2PROBLEM 6-4A CASH AND LIQUID ASSETS ON THE BALANCE SHEET

1.Cash in the checking account and the petty cash fund are cash. The three-month certificates of deposit and the money market fund are both cash equivalents.

2.Accounts receivable and marketable securities should be classified on the balance sheet as current assets and listed in the order of their liquidity (marketable securities are more liquid than accounts receivable).

3.

Increase

Cash and Cash Equivalents12/31/0712/31/06(Decrease)

Certificates of deposit$10,000$10,000$0

Petty cash fund1,2001,500(300)

Money market fund25,80028,000(2,200)

Cash in checking account

6,000

6,000

0

Totals$43,000$45,500$(2,500)

The company is not as liquid at the end of 2007 as it was at the end of 2006. Although the decrease in liquidity is not large, it is due to the decreases in the balances in the petty cash fund and the money market fund.

LO 3,4PROBLEM 6-5A INTERNAL CONTROL

1.There are two major problems with the proposed personnel arrangements. First, regardless of how ethical and honest the two individuals might be, from the viewpoint of appearances alone, it is not healthy to have two relatives working this closely together in a business. The potential for collusion is very high in this situation. Also, it is not fair for either party to have Barbara doing a performance review for her cousin.

2.Regardless of how effective a system of internal control, it can be easily circumvented by collusion, that is, two or more employees working together to perpetrate a fraud. The potential for this to develop can be lessened by not having one relative reporting to another. Also, Barbara should not do the performance evaluation for Cheryl.

3.The above should be explained to the two individuals. They personally are not the problem. Any two or more persons in this situation would face a conflict and weaken the companys system of internal control.

DECISION CASESREADING AND INTERPRETING FINANCIAL STATEMENTS

LO 1DECISION CASE 6-1 COMPARING TWO COMPANIES IN THE SAME INDUSTRY: FINISH LINE AND FOOT LOCKER

1.The balance in Cash and cash equivalents on Finish Lines balance sheet on February 25, 2006, is $47,488,000. The balance on February 26, 2005, was $55,991,000, resulting in a decrease in cash and cash equivalents of $8,503,000. The balance in Cash and cash equivalents on Foot Lockers balance sheet on January 28, 2006, was $289,000,000. The balance on January 29, 2005, was $225,000,000, resulting in an increase in cash and cash equivalents of $64,000,000. 2.The change in cash and cash equivalents appears on the statement of cash flows. Because this statement summarizes a companys cash flows that result from its operating, investing, and financing activities, the bottom of the statement reports the net increase or decrease in cash and cash equivalents for the period. 3.On page 32 of its 2006 annual report in Note 1, Finish Line indicates that its Cash and cash equivalents are primarily invested in tax-exempt instruments with high liquidity, less then 90 days when purchased. In Note 1 on page 31 of its 2005 annual report, Foot Locker explains that The Company considers all highly liquid investments with original maturities of three months or less including commercial paper and money market funds to be cash equivalents. The company also explains that amounts due from third-party credit card processors are included in cash equivalents. Although the types of investments the companies make differ, they both use the 90-day or three-month cutoff to determine whether an item is a cash equivalent.LO 3DECISION CASE 6-2 READING AND INTERPRETING IBMS REPORT OF MANAGEMENT

1.IBM relies on clear definitions of responsibility and delegation of authority as part of its internal control structure. Another key ingredient in its structure is an internal audit program.

2.IBMs external auditor is PricewaterhouseCoopers LLP. In addition to auditing the companys financial statements, PricewaterhouseCoopers LLP also performs an audit of the assessment by management of the effectiveness of IBMs internal control over financial reporting. The firm follows the standards of the Public Company Accounting Oversight Board in conducting its audits.DECISION CASE 6-2 (Concluded)

3.IBMs Audit Committee is made up entirely of members of the board of directors who are independent from the company and not part of the companys management team. One of the key duties of the Audit Committee is to recommend to the board of directors the public accounting firm to be retained to perform the audit. In addition, the Audit Committee meets with the public accounting firm to review relevant matters. In addition, it meets with IBMs management and its internal auditors.

MAKING FINANCIAL DECISIONS

LO 1DECISION CASE 6-3 LIQUIDITY

TO:The President of FNB of Verona HeightsFROM:Joe Smith, Loan OfficerDATE:X/X/XXSUBJECT:Loan proposalsI have reviewed the loan proposals recently submitted by R Montague and J Capulet and would like to summarize for you my findings. Because of limited resources available for short-term loans, my recommendation is that we make a six-month $10 million loan to J Capulet only.

The total current asset positions of the two companies are identical. Each has $33 million in current assets. However, the composition of the current assets differs considerably between the two companies. On the surface, R Montague may appear to be stronger because it has twice the amount of cash on hand that J Capulet does. However, cash is essentially a nonearning asset, and I am skeptical as to why R Montague feels it necessary to maintain that much cash on hand, and consequently, why it feels as if it needs to borrow an additional $10 million.

The accounts receivable for J Capulet is significantly larger than that for R Montague. Assuming that the estimates of bad debts are reasonably reliable, R Montague has a bigger problem with uncollectibles than does J Capulet. R Montague has an allowance that is 1/15, or 6.67% of accounts receivable, while J Capulets percentage is only 1/23, or 4.35%.

In summary, I feel that J Capulet is a better candidate at the present time for a loan. I recommend that we make a six-month $10 million loan to J Capulet at the current market rate of interest. Please call if you need any further details in connection with these two loan requests.

ETHICAL DECISION MAKING

LO 3,4DECISION CASE 6-4 CASH RECEIPTS IN A BOOKSTORE

Memo to the store manager:

Thank you for the opportunity to spend a week at one of our stores and learn more about the bookstore business. During my training I received valuable experience that will benefit me as I begin working for the company. I am concerned, however, about one procedure related to the receipt of cash. The current system for handling cash shortages and overages is not effective from an internal control viewpoint.

A fundamental principle of internal control over cash is that all cash receipts should be deposited intact. I know that you can appreciate that the current system does not allow us to keep an accurate record of all receipts. For this reason, I recommend that we keep a daily record of all cash shortages and overages. Under the proposed system, we would record a debit for any shortages in cash and a credit when there is a cash overage at the end of the day. If these amounts are material, they should be investigated immediately. Under no circumstances should we keep a separate cash fund to make up the differences. Aside from the obvious concerns over physical custody of the cash, the present system of simply keeping a cash-over and -short envelope results in a lack of important information to us.

I am sure you share my concerns over this critical part of our business. Please call me if I can provide any further information to you.

REAL WORLD PRACTICE 6.1

On page 32 of its 2006 annual report in Note 1, Finish Line indicates that its Cash and cash equivalents are primarily invested in tax-exempt instruments with high liquidity, less then 90 days when purchased.REAL WORLD PRACTICE 6.2

The auditors report on internal control for Foot Locker was written by KPMG LLP. The report was addressed to Foot Lockers board of directors and shareholders. In the next to last paragraph of the report, KPMG indicates that it believes that managements assessment that it maintained effective internal control over financial reporting is fairly stated. KPMG also states that in its opinion Foot Locker did maintain effective internal control over financial reporting as of the balance sheet date.

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