CHAPTER 6

Cash and Internal Control

OVERVIEW OF EXERCISES, PROBLEMS, AND CASES
Learning Outcomes

Exercises

Estimated
Time in
Minutes

Level

1. Identify and describe the various forms of cash reported

on a balance sheet.

1
6*

10
15

Easy
Mod

2. Show that you understand various techniques that

companies use to control cash.

2
3
6*

10
10
15

Easy
Easy
Mod

4
5

20
15

Mod
Mod

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.
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)

6-1

6-2

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

Learning Outcomes

Problems
and
Alternates

Estimated
Time in
Minutes

Level

1. Identify and describe the various forms of cash reported

on a balance sheet.

4*

20

Mod

2. Show that you understand various techniques that

companies use to control cash.

1
4*

25
20

Mod
Mod

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

significance of the Sarbanes-Oxley Act of 2002.

5*

20

Mod

2
5*

20
20

Mod
Mod

25

Diff

4. Describe the basic internal control procedures.

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)

CHAPTER 6 CASH AND INTERNAL CONTROL

Learning Outcomes

1. Identify and describe the various forms of cash reported

on a balance sheet.

Cases

Estimated
Time in
Minutes

6-3

Level

1
3

20
30

Mod
Mod

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

significance of the Sarbanes-Oxley Act of 2002.

2
4*

25
30

Mod
Mod

4. Describe the basic internal control procedures.

4*

30

Mod

2. Show that you understand various techniques that

companies use to control cash.

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)

6-4

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

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 nonearning 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.

CHAPTER 6 CASH AND INTERNAL CONTROL

6-5

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.

6-6

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

EXERCISES
LO 1

EXERCISE 6-1 CASH EQUIVALENTS

Cash equivalents at December 31, 2007:

Certificates of deposit, due March 30, 2008
Commercial paper, due February 28, 2008
Deposit into a money market fund
90-day Treasury bills
Cash equivalents

LO 2

$150,000
125,000
25,000
100,000
$400,000

EXERCISE 6-2 ITEMS ON A BANK RECONCILIATION

1. DBank

4. DBook

7. NA

2. DBook

5. ABook

8. ABook

3. ABook

6. ABank

9. ABook

LO 2
2007
Jan. 2

EXERCISE 6-3 PETTY CASH FUND

Petty Cash Fund

Cash
To record establishment of petty cash fund.
Assets
+300.00
300.00

Jan. 31

Liabilities

300.00
300.00
+

Postage Expense
Delivery Expense
Entertainment Expense
Office Supplies Expense
Cash Over and Short
Cash
To record replenishment of petty cash fund:
$300.00 $74.10 = $225.90.
Assets
225.90

Liabilities

Owners Equity

76.00
45.30
65.40
36.00
3.20
225.90

Owners Equity
222.70
3.20

CHAPTER 6 CASH AND INTERNAL CONTROL

LO 4

6-7

EXERCISE 6-4 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 4

EXERCISE 6-5 SEGREGATION OF DUTIES

Many possible combinations are possible. One appropriate way to segregate the duties
would be as follows:
Employee
Task
Mary
Sue
John
Prepare invoices
X
Mail invoices
X
Pick up mail from post office
X
Open mail, separate checks
X*
X*
List checks on deposit slip in triplicate
X
Post payment to customers account
X
Deposit checks
X
Prepare monthly schedule of
accounts receivable
X
Reconcile bank statements
X
*Two employees should be present to open mail and separate checks.

6-8

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

MULTI-CONCEPT EXERCISE
LO 1,2

EXERCISE 6-6 COMPOSITION OF CASH

1. Y

7. N (Short-term investments: CD)

2. Y

8. Y

3. Y

9. N (Accounts receivable: Past Due)

4. N (Office supplies)

10. Y

5. N (Receivables from employees)

11. Y

6. Y

PROBLEMS
LO 2
1.

PROBLEM 6-1 BANK RECONCILIATION

CALICO CORNERS
BANK RECONCILIATION
MAY 31, 2007

Balance per bank statement, May 31

Add: Deposit-in-transit
Bank error: deposit credited to
wrong account
Deduct: Outstanding checks:
#123
#127
#128
#130
Adjusted balance, May 31
Balance per books, May 31
Add: Interest earned on bonds
Interest earned on account
Deduct: Bank service charges
NSF check
Book error: Deposit of $101.10
recorded as $1,011.00
Adjusted balance, May 31

$ 8,432.11
$1,250.00
123.45
$

23.40
145.00
210.80
67.32

1,373.45

(446.52)
$ 9,359.04
$ 9,965.34

$ 465.00
54.60
$ 50.00
166.00
909.90

519.60

(1,125.90)
$ 9,359.04

CHAPTER 6 CASH AND INTERNAL CONTROL

6-9

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 4

PROBLEM 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.

6-10

LO 5

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 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

CHAPTER 6 CASH AND INTERNAL CONTROL

6-11

MULTI-CONCEPT PROBLEMS
LO 1,2

PROBLEM 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 3,4

PROBLEM 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.

6-12

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

A L T E R N AT E P R O B L E M S
LO 2

PROBLEM 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
Add: Deposit-in-transit
Deduct: Outstanding checks:
#112
#117
#120
#122
Bank error: check written for
$990; $909 charged against
account
Adjusted balance, March 31
Balance per books, March 31
Add: Customer check collected
Interest earned on account
Customer check not recorded
Deduct: Collection fee
Bank service charges
Adjusted balance, March 31

$6,506.10
423.00
$ 42.92
307.00
10.58
75.67

$ 436.17
81.00
45.00
4.30
1,250.00
$
4.50
22.00

(517.17)
$6,411.93
$
?

1,299.30
(26.50)
$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.

CHAPTER 6 CASH AND INTERNAL CONTROL

LO 4

6-13

PROBLEM 6-2A INTRNAL 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 5

PROBLEM 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

6-14

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

ALTERNATE MULTI-CONCEPT PROBLEMS

LO 1,2

PROBLEM 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.
Cash and Cash Equivalents
Certificates of deposit
Petty cash fund
Money market fund
Cash in checking account
Totals

12/31/07
$10,000
1,200
25,800
6,000
$43,000

12/31/06
$10,000
1,500
28,000
6,000
$45,500

Increase
(Decrease)
$
0
(300)
(2,200)
0
$ (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 3,4

PROBLEM 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.

CHAPTER 6 CASH AND INTERNAL CONTROL

6-15

D E C IS ION C AS E S
READING AND INTERPRETING FINANCIAL STATEMENTS

LO 1

DECISION CASE 6-1 READING LIFE TIME FITNESSS FINANCIAL STATEMENTS

1. The balance in Cash and cash equivalents on the companys December 31, 2004,
balance sheet is $10,211,000. The balance on December 31, 2003, was
$18,446,000; thus, cash and cash equivalents decreased during 2004 by
$8,235,000.
2. The decrease in cash and cash equivalents of $8,235,000 appears on the
companys statement of cash flows. The statement of cash flows summarizes a
companys operating, investing and financing activities for the year and the net
increase or decrease in these activities appears towards the bottom of the
statement.
3. According to Note 2 to the financial statements, the company includes all
unrestricted cash accounts and highly liquid debt instruments purchased with
original maturities of three months or less as cash and cash equivalents (page 36 of
the 2004 annual report).
LO 3

DECISION 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.
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.

6-16

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

MAKING FINANCIAL DECISIONS

LO 1

DECISION CASE 6-3 LIQUIDITY

TO:

The President of FNB of Verona Heights

FROM:

Joe Smith, Loan Officer

DATE:

X/X/XX

SUBJECT: Loan proposals

I 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 non-earning 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.

CHAPTER 6 CASH AND INTERNAL CONTROL

6-17

ETHICAL DECISION MAKING

LO 3,4

DECISION 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

According to the note on page 36 of the 2004 annual report, Life Time Fitnesss cash
and cash equivalents include all unrestricted cash accounts and highly liquid debt
instruments purchased with original maturities of three months or less.

REAL WORLD PRACTICE 6.2

There are a total of six members on Life Time Fitnesss Board of Directors. Five
members are outsiders and the other is part of Life Time Fitnesss management team
(the companys President and CEO).