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Chapter 7

Chapter 7 notes

Financial Accounting
Course Code
G.Quan Fun

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Chapter 7 Internal Control and Cash Notes
Internal Control
x internal control consists of all the related methods and measures adopted within a company to help it achieve reliable financial
reporting, effective and efficient operations, and compliance with relevant laws and regulations
x good internal control systems have the five primary components listed here:
o control environment—it is the responsibility of management to make it clear that the organization values integrity, and that
unethical activity will not be tolerated (often referred to as “setting the tone at the top”
o risk assessment—companies must identify and analyze the various factors that create risk for the business and determine
how to manage these risks
o control activitiesto reduce the occurrence of fraud, management must design policies and procedures to address the
specific risks faced by the company
o information and communicationthe system must capture and communicate all pertinent information both down and up the
organization and communicate it to appropriate external parties
o monitoring—internal control systems must be monitored periodically for their adequacy; significant deficiencies need to be
reported to management and/or the board of directors
Control Activities
x specific control activities that are used by a company will vary depending on management’s assessment of these risks
x this assessment is also heavily influenced by the size and nature of the company
x control activities that apply to most companies include the following: authorization of transaction and activities; segregation of
duties; documentation; physical controls; independent checks of performance; human resource controls
Authorization of Transactions and Activities
x an essential characteristic of internal control is the assignment or responsibility to specific employees
x this control activity is most effective when only one person is authorized to perform a specific task
x establishing responsibility is significantly easier when there is a system for proper authorization
x in addition, it is important that policies be established by the right individuals or departments
x the policies that are established also typically require written credit approval for sales transactions above a certain value
Segregation of Duties
x essential in a system of internal control because the responsibility for related activities should be assigned to different individuals
x when the same individual is responsible for related activities, the potential for errors and irregularities is increased
x in general, the following categories of activities should be separated from one another: authorization of transactions and
activities; recording of transactions; and custody of assets
x when the responsibilities for ordering, receiving, and paying are assigned to different individuals, risk of abuses is much lower
x related sales activities should also be assigned to different individuals
x in summary, segregation of duties means that responsibilities should be divided up so that one person cannot both commit a
fraud and cover it up
x in addition, the work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of
another employee as this helps ensure the accuracy of the accounting records
x documentation provide evidence that transactions and events have occurred
x procedures should be established for documents
x first, whenever possible, documents should be pre-numbered and all documents should be accounted for
x pre-numbering helps prevent a transaction from being recorded more than once or, conversely, from not being recorded at all
x second, documents that are source documents (the original receipts) for accounting entries should be promptly forwarded to the
accounting department to help ensure timely recording of the transaction
x this control contributes to the accuracy and reliability of the accounting records
Physical Controls
x it is essential to have controls that protect assets and records, or else they can be stolen, damaged, or lost
x physical controls include:
o safes, vaults, and safety deposit boxes for cash and business papers
o locked warehouses and storage cabinets for inventories and records
o computer facilities with password or biometric access
o alarms to prevent break-ins
o television monitors and garment sensors to deter theft
o time clocks for recording time worked
Independent Checks of Performance
x independent review is necessary because employees can forget or intentionally fail to follow internal controls, or they might
become careless if there is no one to observe and evaluate their performance
x independent internal reviews are especially useful in comparing accounting records with existing assets to ensure that nothing
has been stolen; three measures are recommended:
1. the review should be done periodically on a surprise basis
2. the review should be done by an employee who is independent of the personnel responsible for the information
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3. discrepancies and exceptions should be reported to a management level that can take appropriate corrective action
x internal auditors : company employees who evaluate the effectiveness of the companys system of internal control
x while it is management’s responsibility to establish and maintain systems of internal control, management relies on internal
auditors to assist with this responsibility
x external auditors : auditors who are independent of the organization; they examine internal control and report on whether or not
the financial statements are reported fairly in accordance with generally accepted accounting principles
x as part of governance process of company, independent audit committee of the board of directors is responsible for reviewing the
companys internal control systems to ensure that they are adequate to result in fair, complete, and accurate financial reporting
Human Resource Controls
x other control measures can include the following:
1. Conduct thorough background checks. Many believe that the most important and inexpensive measure any company can
take to reduce employee theft and fraud is for the human resources department to conduct thorough background checks.
2. Bonding of employees who handle cash. Bonding means having insurance protection against theft of assets by dishonest
employees. This is often referred to asfidelity insurance. Fidelity insurance contributes to the safeguarding of cash in two
ways. First, the insurance company carefully screens all individuals before adding them to the policy and may reject risky
applicants. Second, bonded employees know that the insurance company will vigorously prosecute all offenders. Common
fidelity insurance claims arise from employee dishonesty, embezzlement, forgery, robbery, safe burglary, computer fraud,
wire transfer fraud, counterfeiting, and other criminal acts.
3. Rotating employees’ duties and requiring employees to take vacations. These measures are designed to deter employees
from attempting any thefts, since they will not be able to permanently conceal their improper actions. It is important for
employers to require employees to take vacations, for personal health and wellness reasons as well as for internal control
reasons. Many employee thefts have been discovered when the employee was on vacation or assigned to a new position.
Limitations of Internal Control
x no matter how well it is designed and operated, a company’s system of internal control can only provide reasonable assurance
that assets are properly safeguarded and that the accounting records are reliable
x reasonable assurance is based on belief that costs of establishing control activities should not be more than their expected benefit
x the human element is an important factor in every system of internal control as a good system can become ineffective as a result
of lack of training, employee fatigue, carelessness, or indifference
x occasionally, two or more individuals may work together to get around prescribed control procedures, which can significantly
lessen the effectiveness of internal control because it eliminates the protection expected from segregating the employees’ duties
x the size of the business may impose limitations on internal control
x in small company, it may be difficult to apply segregation of duties and independent internal verification because of employees
Cash Controls
x cash : resources that consist of coins, currency, cheques, money orders, and bank credit card slips that are acceptable at face
value on deposit in a bank or similar institution
x cash does not include post-dated cheques, stale-dated cheques, or returned cheques
Control Activities over Cash Receipts
x generally, internal control over cash receipts is more effective when cash receipts are deposited intact into the bank account on a
daily basis or are made by electronic funds transfer
x electronic funds transfer (EFT) : the system of transferring money electronically from one bank account directly to another
without any paper money changing hands
x EFTs normally result in better internal control since no cash or cheques are handled by company employees, though, this does
not mean that the opportunities for fraud are eliminated
Control Activities over Cash Payments
x control activities over cash payments are more effective when payments are made by cheque or by EFT, rather than in cash
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