MODULE 6 Part 1

Internal Control
of Cash
 INTRODUCTION
 Internal controls have become a key business function for every U.S. company since the accounting
scandals in the early 2000s.
EX: ENRON, an energy trader and supplier, collapsed in 2001, the biggest corporate
bankruptcy to ever hit the financial world (est. 20,000 employees)
WORLD COM, a GIANT telecommunication company, its collapse was considered to be the largest
accounting fraud, and the biggest bankruptcies of all time in 2002, since Enron. (85,000
employees)
TYCO, security solutions and fire protection, its collapsed in 2002 was due to theft and stocks fraud.
(24,000 to 69,000 employees-data of 2011)

 The Sarbanes-Oxley Act of 2002 was enacted to protect investors from fraudulent accounting & financial
activities and improve the accuracy and reliability of corporate disclosures.
 This has had a profound effect on corporate governance, by making managers responsible for financial
reporting and creating an audit trail. (a step-by-step record by which accounting, trade details, or other financial data can be
traced to their source to prove validity of accounting entry and financial data sources)
 Auditors, accountants and corporate officers become accountable for the new set of rules.
 Managers found guilty of not properly establishing and managing internal controls face serious criminal
penalties.
 Rationale
 Federal lawmakers enacted the Sarbanes-Oxley Act in large part due to corporate
scandals at the start of the 21st century which involves the three giant companies,
Enron, WorldCom and Tyco and also involved in the scandal was considered to be
one of the top accounting firm-Andersen Consulting, LLP which was immediately
dissolved as the accounting firm lost public trust and due to many lawsuits faced
by the company.
 The legislation sought to both improve the reliability of public companies'
financial reporting as well as restore investor confidence in the wake of high-
profile cases of corporate crime.
 The act was named for its sponsors: U.S. Sen. Paul Sarbanes (D-Md.), and U.S.
Rep. Michael Oxley, (R-Ohio). Former U.S. President George W. Bush, who
signed the act into law on July 30, 2002, called the act "the most far-reaching
reforms of American business practices since the time of Franklin Delano
Roosevelt."
 Learning Objectives
At the end of the module, students should be able to
 Define internal control and how it works;
 Identify the principles of internal control;
 Explain the application of internal control to Cash Receipts and Cash
Disbursement;
 Explain the reporting of cash;
 Discuss the basic principles of cash management;
 Prepare a bank reconciliation statement to reconcile balances recorded per
books and the balances per bank.
What Are Internal Controls?

 Are the mechanisms, rules, and procedures implemented by a

company to ensure the integrity of financial and accounting
information, promote accountability, and prevent fraud.
 Besides complying with laws and regulations and preventing
employees from stealing assets or committing fraud, internal
controls can help improve operational efficiency by improving the
accuracy and timeliness of financial reporting.
Internal controls are policies and procedures put in place to ensure the continued reliability
of accounting systems as this two factors Accuracy and Reliability are paramount in the
accounting world.
 Limitations of Internal Control
 a. Internal control is designed to provide reasonable assurance that assets are properly
safeguarded and that the accounting records are reliable (they are not fool-proof; a cost-
benefit relationship must be observed between controls and security)
➢ The concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not
exceed their expected benefit.

 b. The human element is important in internal control.

➢ A good system can become ineffective as a result of employee fatigue, carelessness, or indifference. Employees
may become tired and not bother to count inventory.

➢ Occasionally two or more employees may work together in order to get around prescribed controls.

c. The size of the business may impose limitations on internal control. In a small company, for example, it
may be difficult to apply the principles of segregation of duties and independent internal verification.
d. An important and inexpensive measure any business can take to reduce employee theft and fraud is to
conduct thorough background checks.
➢Two tips include:

Check to see whether job applicants actually graduated from the schools they list

Never use the telephone numbers for previous employers given on the reference sheet; always look them up
yourself.
 Limitations …
 Regardless of the policies and procedures established by an organization, only reasonable assurance
may be provided that internal controls are effective and financial information is correct.
 The effectiveness of internal controls is limited by human judgment.
 A business will often give high-level personnel the ability to override internal controls for operational
efficiency reasons, and internal controls can be circumvented through collusion.
Reasonable assurance is important because it gives directions on the valuations of the soundness and
dependability of the financial reports by auditors.
*Reasonable Assurance means there is a remote likelihood that material misstatements will not be
prevented or detected on a timely basis.

Auditors are incapable of achieving absolute assurance because of the various factors that limit and
hinder the auditing process.
 Who are Responsible for a Firm’s
Internal Control?
 Internal audits evaluate a company’s internal controls, including its corporate governance and
accounting processes.
 They ensure compliance with laws and regulations and accurate and timely financial reporting and
data collection, as well as helping to maintain operational efficiency by identifying problems and
correcting lapses before they are discovered in an external audit.
 The auditor’s opinion that accompanies financial statements is based on an audit of the procedures
and records used to produce them.
 As part of an audit, external auditors will test a company’s accounting processes and internal
controls and provide an opinion as to their effectiveness.
 The Sarbanes-Oxley Act of 2002, protect investors from the possibility of fraudulent accounting
activities by corporations, which mandated strict reforms to improve financial disclosures from
corporations.
 Principles of Internal Control
 No two systems of internal controls are identical, but many core philosophies regarding
financial integrity and accounting practices have become standard management practices.
While internal controls can be expensive, properly implemented internal controls can help
streamline operations and increase operational efficiency, in addition to preventing fraud.

The following seven (7) principles serve as control procedures once put in place:
1. Separation of Duties
Separation of duties involves splitting responsibility for bookkeeping, deposits, reporting and
auditing. The further duties are separated, the less chance any single employee has of committing
fraudulent acts.
Cash is generally received at cash registers or through the mail. The employee who receives
cash should be different from the employee who records cash receipts, and a third employee should
be responsible for making cash deposits at the bank. Having different employees perform these
tasks helps minimize the potential for theft.
 Principles …

2. Proper authorization/ Access Control

Only certain people should be authorized to handle cash or make cash transactions on behalf of the
company. In addition, all cash expenses should be authorized by responsible managers.

Controlling access to different parts of an accounting system via passwords, lockouts and electronic access
logs can keep unauthorized users out of the system while providing a way to audit the usage of the system
to identify the source of errors or discrepancies. Robust access tracking can also serve to deter attempts at
fraudulent access in the first place.
 Principles …

3. Adequate documents and records.

• Those who are responsible for safeguarding a company's cash assets must have confidence in the accuracy
and legitimacy of source documents that involve cash.
• Important documents such as checks, are prenumbered in sequential order to help managers ascertain the
disposition of each document. Blank checks, which can be used for forgery, are stored in locked, fireproof
files.
• This helps prevent transactions from being recorded twice or from not being recorded at all.
• In addition, documents should be forwarded to the accounting department soon after their creation so that
recordkeeping can be handled professionally and efficiently
• Allowing documents that describe cash transactions to go unrecorded for an unnecessarily long period of time
increases the likelihood that fraudulent or inaccurate records will pass undetected through the accounting
department.
.
 Principles …

 4. Approval Authority Requirements

Authorized signatories to certain documents must be clearly assigned so that accountability and
responsibility can be clearly established.
 Requiring specific managers to authorize certain types of transactions can add a layer of responsibility
to accounting records by proving that transactions have been checked, analyzed and approved by
appropriate authorities.
 Requiring approval for large payments and expenses can prevent unscrupulous employees from making
large fraudulent transactions with company funds, for example.
 Principles …

 5. Physical Audits of Assets

Physical audits include hand-counting cash and any physical assets tracked in the accounting system, such as
inventory, materials and tools as well checking titles to properties owned by the company.

Physical counting can reveal well-hidden discrepancies in account balances by bypassing electronic records altogether.
Counting cash in sales outlets can be done daily or even several times per day. Cash on hand must be physically secure.
Cash registers should contain only enough cash to handle customer transactions.
Larger projects, such as hand counting inventory, should be performed less frequently, perhaps on an annual or
quarterly basis.
.
 Principles …

 6. Standardized Financial Documentation

Standardizing documents used for financial transactions, such as invoices, internal materials requests, inventory
receipts and travel expense reports, can help to maintain consistency in record keeping over time.

 Using standard document formats can make it easier to review past records when searching for the source of a
discrepancy in the system. A lack of standardization can cause items to be overlooked or misinterpreted in such
a review.
.
 Principles …

 7. Independent checks on performance and Periodic Reconciliations in Accounting Systems

Surprise audit must be done for those handling sensitive positions most especially those who have access to cash
transactions like cashiers.
 These checks should be done periodically and may be done without fore-warning.
 Employees who handle cash or who record cash transactions must be prepared for independent checks on their
performance.
 Occasional accounting reconciliations can ensure that balances in your accounting system match up with
balances in accounts held by other entities, including banks, suppliers and credit customers.
 Differences between these types of complementary accounts can reveal errors or discrepancies in your own
accounts, or the errors may originate with the other entities.
 CLASSIFICATION
Preventive Control
Preventive control activities aim to deter errors or fraud from happening in the first place and
include thorough documentation and authorization practices. And the separation of duties
ensures that no single individual is in a position to authorize, record, and be in the custody of a
financial transaction and the resulting asset. Authorization of invoices and verification of
expenses are internal controls. In addition, preventative internal controls include limiting
physical access to equipment, inventory, cash, and other assets.

Detective control
Are backup procedures that are designed to catch items or events that have been missed by the
first line of defense.
Here, the most important activity is reconciliation, used to compare data sets, and corrective
action is taken upon material differences. Other detective controls include external audits from
accounting firms and internal audits of assets such as inventory.
CASH CONTROL
 Cash is a company's most liquid asset, which means it can easily be used to acquire other assets, buy services,
or satisfy obligations.
 Aside from being most liquid, portable, and desirable asset, a company must have adequate controls to prevent
theft or other misuses of cash. These control activities include segregation of duties, proper authorization,
adequate documents and records, physical controls, and independent checks on records.

 For financial reporting purposes, cash includes currency and coin on hand, money orders and checks made
payable to the company, and available balances in checking and savings accounts. Most companies report cash
and cash equivalents together.
 Cash equivalents are highly liquid, short‐term investments that usually mature within three months of their
purchase date. Examples of cash equivalents include Treasury bills, Money market funds, and Commercial
paper, which is short‐term corporate debt.
 CASH MANAGEMENT
 Cash management is the process of collecting and managing cash flows. Cash management
can be important for both individuals and companies.
 It is a key component of a company's financial stability.
 Banks are typically a primary financial service provider for the custody of cash assets.

MANAGING CASH RECEIPTS MANAGING CASH DISBURSEMENTS

Internal control procedures for the receipt of cash help Internal controls for cash disbursements are to ensure that cash
businesses prevent loss due to employee fraud and is disbursed only upon proper authorization of management, for valid
accounting errors: business purposes, and that all disbursements are properly recorded.
• Persons involve in accounting function should not have
access to cash.
• Company spends most of its cash by check, many of the internal
• Timely review and documentation.
controls for cash disbursements deal with checks and
• Implement lockbox system.
authorizations for cash payments.
• Collections today must be deposited intact the
• The basic principle of segregation of duties applies in
following day or the next banking day.
controlling cash disbursements.
• Adopt an electronic payment system
 Cash Management…

To safeguard the money of the business, part of internal control mechanism is

to account the business’s Cash account on imprest system.
Imprest System is an accounting system designed to track and document how
cash is being spent. The most common tool is through issuance of checks
whenever payments are to be made to payees. This system requires the setting
up of Petty Cash Fund for petty expenses.
Cash Receipts are deposited in the bank , maintaining both savings and
checking account where checks issued by the company will be cleared upon
presentation by the payee.

The bank maintains records of the depositor’s account which should

normally be equal to the depositors records of its Cash in Bank account.
Common Frauds involving Cash
❑ LAPPING SCHEME-A lapping scheme is a form of accounting fraud whereby stolen or
misappropriated cash is obscured by altering the accounts receivable.
The method involves taking a subsequent receivables payment from a transaction or
cash collection (for example, a sale) and using that to cover the theft. The receivable from the
second transaction is covered by money from the third transaction, and so on.
❑ CHEQUE KITING-is a form of check fraud, involving taking advantage of the float to
make use of non-existent funds in a checking account or other bank account. In this way,
instead of being used as a negotiable instrument, checks are misused as a form of
unauthorized credit.
❑ CASH SKIMMING-Consists of taking cash before it even enters the company’s
accounting system. It’s very hard to uncover because it requires finding evidence of
something that hasn’t been recorded yet
❑ CASH LARCENY- Is the theft of employers’ cash after it has been taken into accounts.
The only element that differentiates it from cash skimming is that cash larceny theft is the
amount that exists in the records while SKIMMING does not.
Best Practices
 1. Record cash receipts when received
 2. Keep funds secured
 3. Document all fund/ asset transfers
 4. Give receipts and ask for receipts for sale and purchase
transactions.
 5. Don’t share passwords.
 6. Each cashier should have own cash box.
 7. Supervisors verify cash deposits
 8. Supervisors approve all voided / refunded transactions.
 9. All payment transactions be made through checks.
 10. Set up petty cash fund for petty expenses.