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Chapter 6 Lecture Notes

Internal Controls

Internal controls are the systems of policies and procedures that are designed to:
A. Protect assets against fraud and waste.
B. Provide for accurate accounting data.
C. Promote efficient operations.
D. Encourage adherence to management policies.
In other words these systems of procedures and methods not only control a companys
assets but they also monitor its operations.
Internal controls are extremely important when dealing with cash. Managing cash is a
very important part of any business.
Be sure to go over some of the simple internal control guidelines for managing Cash
Receipts and Cash Payments in the textbook.
One of the major internal control processes is that businesses should not have the same
employee doing multiple jobs. There should be checks and balances. For example: the
employee who posts the cash payments should not be the same one who goes to the bank
to make the deposits. Often this is difficult in small businesses and they are the ones that
you see a fair amount of embezzlement going on in.
Fraud is the intentional misrepresentation of the truth. In small businesses the most
common form of fraud is the theft of assets. These assets include cash, supplies,
inventory, and equipment.

Checking Accounts

Checking accounts are a method used for making cash payments.

When a business opens a checking account it will have to fill out a signature card with
the bank.
A Signature Card provides the bank with a copy of the official signatures of any
persons authorized to sign checks on that account. It validates the signatures and helps
to prevent forgeries.
Once the account is opened the business will receive a set of checks and deposit slips.
Deposit slips are used to summarize the coins, currency, and checks that are being
deposited into the business account.
Deposit slips for the business are in duplicate. The bank receives the original deposit slip
and the business receives the duplicate copy.
On the deposit slip the currency and coins should be listed separately. Each individual
check can be listed, indicating the amount and the bank number. A business can also list
the grand total amount of the checks along with an adding tape register listing all of the
check amounts. Either way is suitable to the bank.
The Check Clearing for the 21st Century Act of 2004 allows the banks to accept a twosided digital version of a check from a depositor. This is known as a Substitute Check.

The law also allows for Remote Deposits which means that anyone can use a computer
scanner to make an image of a check and deposit it online.
Automated Teller Machines (ATMs) allow banking transactions to be handled 42 hours
a day, 7 days a week at these machines.
Most banks do not allow businesses to withdraw funds at ATMs. Businesses can only
make deposits and transfers. This is primarily for internal control reasons.
Online Banking is used by most businesses for all of the primary functions. However
the business has to have extremely good internal control processes in place when using
online banking.
Electronic Funds Transfer (EFT) is used every day in the business environment. A
primary example is when the business needs to pay its payroll taxes to the IRS. Again
good internal control processes need to be in place.
Night Deposits are used by many businesses, especially those with large amounts of
cash or without a safe. The business drops off the daily deposit in the night box, and
picks up the receipt and deposit bag the next day from the bank.


The Check Endorsement is the transfer of the ownership of a check and guaranteeing
its payment.
Basically it is signing or, in the case of businesses, stamping the business name on the
back left hand side of the check. Most businesses have a rubber stamp to use.
There are three basic types of endorsements:
o Blank Endorsement the depositor signs the business name on the back of the
check. The check is payable to any bearer of the check (the person who has it in
their hand). Most businesses do not use this type of endorsement. Banks
generally will not cash checks made out to a business and signed by the owner
personally. This is the least secure type of endorsement.
o Full Endorsement the business stamps or writes on the back of the check Pay
to the Order of and the Name of the Business. This is much safer than simply a
signature as in the Blank Endorsement.
o Restrictive Endorsement This is the safest type of endorsement. The business
stamps on the back of the check that the check is For Deposit Only. Look at
the example in Figure 3.
For audit purposes and internal control processes, all cash and checks of a business
should be deposited into the accounts. The owners should then take funds out by writing
themselves a check.
Writing Checks

Checks are a written order signed by a drawer instructing a drawee to pay a specific sum
of money to the payee.
Drawer is the person who writes the check.

Drawee is the person who pays the check (the bank).

Payee is the person to whom the check is payable to.
A check is attached to the Check Stub. The check stub is important to a business. This
is where all the information is recorded about the transaction that has occurred. It is
where the bookkeeper obtains the necessary information to prepare the journal entries
(along with the invoices).
Go over the parts of the check in Figure 4.
At the bottom of the check is the Bank Routing Number which is a nine-digit number
used by the Federal Reserve Bank to identify the bank and account the check is drawn on.
Go over the parts of the Bank Routing Number and bottom of the check in Figure 5.
Positive Pay is a fraud prevention cash management program which requires companies
to provide the bank with a list of authorized checks written prior to the bank paying them.

Bank Statements

Bank Statements are received from the bank monthly by the business. They can be
accessed online or they can be received in paper format in the mail (or both).
Bank statements are prepared from the standpoint of the bank.
Debits and credits are different from what we understand and often confuse students.
The key is that the money in the bank account is a Liability (Accounts Payable) to
the Bank and has to be looked at from that stand point. Therefore, debits represent
decreases in the banks record of a businesss account, and credits represent increases.
Look at the terminology in this section of the textbook.
Look at recording deposits and withdrawals in this section of the textbook.

Bank Statement Reconciliation

Businesses must reconcile their cash account and checking account balances with the
bank statement each month. That is it must bring the checkbook and bank balances into
Corrections and adjustments must be made which include journal entries.
Also a formal Bank Reconciliation Statement must be completed.
Terminology related to the bank statement and reconciliations are in the textbook. Be
sure to go over these.
The process of reconciling bank statements starts with the difference between the
balance of the businesss Cash account and the last balance on the bank statement. The
balance on the bank statement does not have all of the deposits and checks showing up
because they have not passed through or posted at the bank while they have in the
businesss Cash account.
There are basically four steps in reconciling the bank statement:
o Compare the Canceled Checks on the Bank Statement with the Cash Account.
o Compare the deposits in transit with the bank statement.

o Review the list of checks posted on the bank statements for any outstanding
checks not yet posted.
o Make entries for any bank memos.
A bank account is a separate record of cash: If all cash receipts are deposited in the bank
and all cash payments are made by check or transfer, a bank is maintaining a separate
record of cash for a business. Since Cash is the most active account, this verification is a
great benefit for the business.
The form of the bank reconciliation is shown on page 286 in the textbook. There is an
example in Figure 8. This is the formal Bank Reconciliation to go along with the
accounting records.
Some companies may use the blank form that accompanies the bank statement. There is
an example of this form in Figure 10.

Journal entries related to the bank reconciliation.

The adjusted balance, which represents the true balance of Cash, is determined by
reconciling the bank statement. The balance of the Cash account must be changed to
reflect the adjusted or true balance. Journal entries are required to change the balance of
any account.
Source of the journal entries: The data are always found in the Ledger Balance of Cash
section of the bank reconciliation. All the adds are debited to the Cash account. All the
deducts are credited to the Cash account.
Remember that the normal balance of the Cash account is a debit since it is an Asset
The journal entries to go along with the Bank Reconciliation example in Figure 8 are
listed in Figure 9.

Petty Cash

The Petty Cash Fund is a separate quantity of cash kept in the office of a business.
The purpose of the petty cash fund is to enable a business to make small immediate cash
payments in situations where it is not worthwhile to write checks. Example: to pay the
postal clerk for postage due, pay for a COD package, run to the grocery store to pick up
some coffee for the office coffee pot, etc.
Petty cash is not for the owners personal use, it is for business purposes only.
Anytime money is used out of petty cash there must be a receipt to replace the cash for
the purchase.
Only one individual in the business should be responsible for the petty cash funds. This is
for internal control purposes.

Establishing the Petty Cash Fund

The first decision that must be made by the business is the maximum payment for each
transaction out of petty cash, such as $20.

Next, decide on the total amount to be kept in the petty cash fund to handle small cash
transactions for a period of time, such as one month. This is generally based on the size
of the business. I have seen amounts ranging from $50 to $500.
Now do the journal entry to establish the Petty Cash Fund: Debit Petty Cash Fund and
credit Cash.
The Petty Cash Fund account is an Asset account and is listed under the Cash account.
You will not go back into the Petty Cash Fund account except for two reasons: to increase
or decrease the dollar amount of funds in the account.

Payments out of Petty Cash Funds

The person in charge of the fund issues a Petty Cash Voucher (Figure 11) for each
payment, showing who withdrew the cash, when, and for what purpose.
The vouchers are listed in the Petty Cash Payments Record (Figure 12) which is a list
of all the vouchers, indicating the amounts and accounts to be charged. Maintaining the
record is optional however you do need a list of all of the purchases/vouchers in some
A journal entry must be done at the end of the period to reimburse the Petty Cash Fund
for the total amount of the vouchers.
To make the journal entry Debit the accounts representing the things for which the money
was spent (Expenses), and credit Cash.
Do not debit or credit Petty Cash Fund unless the total amount of the fund is to be
changed. That is increasing or decreasing the original dollar amount of funds in petty

The Change Fund

The Change Fund is established to enable a business to handle daily cash transactions
where it is necessary to make change. In other words, it is the starting cash in the cash
drawer used to make change for customers during purchases in a business or at a bank.
The Change Fund is an Asset account and is listed under Cash and Petty Cash Fund.
The Change Fund is only debited once when it is established, after that you will not go
back to the account.

Establishing the Change Fund

Decide the total amount needed and the denominations required (dimes, quarters, dollar
bills, etc.).
Prepare the journal entry to establish the Change Fund: Debit Change Fund and credit

Maintaining the Change Fund Daily

At the end of each day you will total the amount of cash in the account and subtract the
beginning amount of the cash fund. This difference should equal the amount of the sales
cash receipts for the day.
The journal entry for the cash sales would be a Debit to the Cash account and Credit to
Income from Services or Sales.

Cash Short and Over

Do you think that the Petty Cash Receipts plus the cash in petty cash always equal to the
original funds put into Petty Cash? What about in the Change Fund? If not, what do you
do about it?
Whenever there is a shortage or overage of funds we use an account called Cash Short
and Over to keep up with the differences.
If there is a Shortage in Petty Cash or the Change Fund:
o The cash count after deducting Change Fund is less than the total shown on the
cash register tape.
o The journal entry will be a Debit to Cash, debit to Cash Short and Over, and credit
to the revenue account for the amount earned (shown on register tape).
If there is an Overage in Petty Cash or the Change Fund:
o The cash count after deducting Change Fund is more than the total shown on the
cash register tape.
o The journal entry will be a Debit to Cash, credit to Cash Short and Over, and
credit to the revenue account for the amount earned (shown on register tape).
Basically the business is using the Cash Short and Over account to balance of the debits
and credits in these entries for the period.
At the end of the period if there is a balance in Cash Short and Over it has to be
reclassified based on that balance. If there is a Credit Balance then it is an Overage and
is moved to Miscellaneous Income (Revenue). If it is a Debit balance then it is a
Shortage and it is moved to Miscellaneous Expense. This is done as an adjusting journal