Internal Control, Managing Cash, and Making Ethical Judgments

Chapter 7

 Questions

1. Safeguarding assets is the most fundamental internal control feature because the entity must safeguard its assets if it is to survive. Accurate and reliable accounting records, operational efficiency, and adherence to company policies are important, but they are not as critical as safeguarding assets.

2. Seven features of an effective system of internal control are (1) competent, reliable, and ethical personnel, (2) assignment of responsibilities, (3) proper authorization, (4) separation of duties, (5) internal and external audits, (6) documents and records, and (7) electronic devices and computer controls.

3. Four key elements of separation of duties are (1) separation of operations from accounting, (2) separation of the custody of assets from accounting, (3) separation of the authorization of transactions from the custody of related assets, and (4) separation of duties within the accounting function.

4. Internal control systems are not usually designed to be foolproof and perfect because of cost constraints. The benefits of the system should exceed its cost.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 247 5. The bank account acts as a control device because banks have established practices for safeguarding cash. Also, banks provide depositors with detailed records of cash transactions. Banks use the signature card to verify signatures on documents and thus protect the bank and the depositor against forgery. The deposit ticket serves as a receipt for a deposit made in a bank account. The deposit ticket describes the details of the deposit. The bank statement provides a record of each transaction that affected the account during the period.

6. a Deposit in transit b Outstanding check c Bank collection d NSF check d Customer check returned d Bank service charge because of unauthorized d Cost of printed checks signature a Bank error that decreased d Book error that increased bank balance balance of Cash account

7. A bank reconciliation explains the difference between the book and bank balances of the depositor’s cash in the bank account. It ensures that all cash transactions have been accounted for and that the bank and book records of cash are correct.

8. This company would likely report all the amounts as a single figure —Cash—because each amount is cash or liquid enough to be considered cash. An analogy is the reporting of one amount for Accounts Receivable even though the entity may have many individual customer accounts in its accounts receivable subsidiary ledger.

9. A cash register controls cash receipts. It is a security device because the machine records the amount of each transaction entered through it. Periodic comparisons of cash on hand against the record inside the machine discourage theft.

248 Accounting 5/e Solutions Manual 10. A mailroom employee should open incoming mail and compare the amount of cash to the accompanying remittance advice. If no remittance advice is enclosed, the employee should prepare one. The employee should also enter each cash receipt amount on a control tape and present the tape to a responsible official, such as the controller, for verification. Actual cash receipts should be given to the cashier, who combines them with the cash received over the counter and prepares the bank deposit.

The remittance advices are forwarded to the accounting department. Their information is entered in the cash receipts journal and posted to customers’ accounts in the accounts receivable ledger. In the final step, the controller compares the three records of the day’s cash receipts: (1) control tape total from the mailroom; (2) bank deposit amount from the cashier; and (3) debit to Cash from the accounting department.

11. The invoice, the receiving report, the purchase order, and the purchase request make up the payment packet. Three accounting department procedures use the payment packet to ensure that each payment is appropriate, as follows:

a. The invoice is compared to a copy of the purchase order and purchase request to ensure that the business pays cash only for the goods ordered. A purchasing agent prepares the purchase order and mails it to the supplier as the first step in the purchase transaction. b. The invoice is compared to the receiving report to ensure that cash is paid only for the goods actually received. The receiving department prepares the receiving report when the goods arrive. c. The mathematical accuracy of the invoice is proved.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 249 12. The Petty Cash account keeps its prescribed balance at all times. This balance does not always equal the amount of cash in the fund. The two amounts are equal immediately after the fund has been opened or replenished. At other times, when payments have been made from the fund, the balance in the account exceeds the amount of cash in the Petty Cash fund.

13. A budget helps a company manage its cash by providing a plan for the receipt and payment of cash during a future period. During the period covered by the budget, owners and managers compare actual figures to budgeted amounts. Differences between actual and budget amounts lead managers to take needed action.

14. Accountants should generally adhere to a higher standard of ethical conduct than other members of society because accountants agree to abide by a code of professional conduct. The work of professionals is difficult to judge, so the American Institute of Certified Public Accountants and the Institute of Management Accountants require a high standard of conduct as a condition of membership.

250 Accounting 5/e Solutions Manual  Daily Exercises

(5 min.) DE 7-1

Treasurer – chief finance officer responsible for cash management

Controller – chief accounting officer responsible for all aspects of accounting

Separating the controller’s duties (accounting) from the treasurer’s duties (cash management) keeps either person from stealing cash and making accounting entries to cover the theft.

(5 min) DE 7-2

Safeguarding assets is most important because all organizations need assets to survive.

(5-10 min.) DE 7-3

Separation of duties is essential for safeguarding assets. The person who has custody of an asset should not also account for the asset. With both duties, the person can steal the asset and hide the theft by making a false entry in the accounting records.

Note: Student responses may vary.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 251 (5-10 min.) DE 7-4

The internal auditors examine various segments of the business to ensure that employees follow company policies. Internal auditors report to the company’s audit committee.

The internal auditors do not report to the treasurer because the treasurer is responsible for cash management. If the treasurer is not managing cash effectively, then higher-level personnel, such as the audit committee, need to know about it. If the internal auditors were to report directly to the treasurer, the treasurer may not correct his or her behavior or improve performance.

Note: Student responses may vary.

(5 min.) DE 7-5

Differences:

1. External auditors are entirely independent of the business. Internal auditors are employees of the business.

2. External audits are designed to determine whether the company’s financial statements are prepared in accordance with generally accepted accounting principles. Internal audits are designed to ensure that employees follow company policies and that operations run efficiently.

Similarities:

1. Both types of auditors are independent of the operations they examine.

2. Both types of auditors suggest improvements that help the business run more efficiently.

252 Accounting 5/e Solutions Manual (5 min.) DE 7-6

Merrill Lynch could have:

1. Kept all accounting duties away from the cashier. This would have kept the cashier from covering her theft with entries in the accounting records.

2. Required employees to take vacations and rotated employees from job to job. These measures would have placed another person in the cashier’s job and probably would have brought the theft to light earlier.

3. Used an internal auditor. Darlyne Lopez would be less likely to steal and manipulate customer accounts if she knew her work would be audited.

Note: Only two measures are required.

(5 min.) DE 7-7

Bank Bank Accounting statement recon- records ciliatio n

Note: Student responses may vary.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 253 (5 min.) DE 7-8

1. A bank statement is the document the bank uses to report what it did with the depositor’s cash. The statement shows the bank account’s beginning and ending cash balances for the period and lists the month’s cash transactions conducted through the bank.

A bank reconciliation is a document prepared by the company (not by the bank) to ensure that all cash transactions have been accounted for and that the bank and book records of cash are correct.

2. A bank reconciliation is neither a journal, a ledger, an account, nor a financial statement. Instead, it is an accountant’s tool, separate from the company’s books, that explains all differences between the firm’s cash records and the bank statement figures.

3. The Books side

254 Accounting 5/e Solutions Manual (10 min.) DE 7-9

1. Deposit in transit: 3. Bank side of reconciliation

Date Amount Added on bank Jan. 31 $1,591.63 side of reconciliation

2. Outstanding checks:

Check No. Amount Subtracted on bank 337 $286.00 side of reconciliation 338 319.47 339 83.00 340 203.14 341 458.53

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 255 (10 min.) DE 7-10

Theraband Equipment Bank Reconciliation May 31, 20XX

BANK BOOKS Balance, May 31 $3,270 Balance, May 31 $2,280 Add: Add: Deposit in transit 200 Bank collection 300 3,470 Interest revenue 10 2,590 Less: Less: Outstanding checks (900) Service charge (20) Adjusted bank balance $2,570 Adjusted book balance $2,570

Amounts agree

256 Accounting 5/e Solutions Manual (5 min.) DE 7-11

May 31 Cash...... 300 Accounts Receivable—Kelly Brooks...... 300 Collection on account.

31 Cash...... 10 Interest Revenue...... 10 Interest earned on bank balance.

31 Miscellaneous Expense...... 20 Cash...... 20 Bank service charge.

(5 min.) DE 7-12

Someone with only accounting duties should prepare the bank reconciliation. The preparer should not have cash-handling duties because that person could steal cash and cover the theft by manipulating the bank reconciliation.

(5 min.) DE 7-13

It appears that the employee has stolen $980 (adjusted book balance, $3,280 adjusted bank balance, $2,300). The adjusted bank balance is the company’s true cash balance, and the company books show more cash on hand, so the books must be wrong.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 257 (5 min.) DE 7-14

A dishonest salesperson could steal cash from the cash register and alter the record of transactions.

Macy’s keeps this from happening by denying the salesperson access to the transaction record.

(5 min.) DE 7-15

Dupree will notice a gap in the sequence of sales receipts for the receipt Carter destroyed.

This knowledge will lead Dupree to investigate what happened to the missing sales receipt and what happened to the related cash.

258 Accounting 5/e Solutions Manual (5-10 min.) DE 7-16

The controller compares three records of the day’s cash receipts, as follows:

1. Control tape total from the mailroom This comparison establishes that cash receipts went into the bank. 2. Bank deposit amount from the cashier

This comparison establishes that 3. Debit to Cash from the accounting department customers received proper credit for their payments.

A lock-box system protects cash from theft by having customers send the amounts they owe directly to the bank, not to the company. This way company personnel never touch cash receipts from customers.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 259 (10 min.) DE 7-17

1. Two controls over cash resulting from payment by check:

 Each check acts as a source document.

 To be valid, the check must be signed by an authorized official, so each payment by check draws the attention of management.

2. A dishonest purchasing agent could:

 Purchase goods and have them delivered to his home or other location that he controls, or otherwise take the goods for personal use.

 Approve payment by the company for goods that he used for personal gain.

Companies avoid this internal control weakness by separating the following duties related to the purchase of, and payment for, goods:

 purchasing goods

 receiving goods

 approving and paying for goods

260 Accounting 5/e Solutions Manual (10 min.) DE 7-18

1. An imprest petty cash system maintains the Petty Cash account at the prescribed balance at all times. The account balance equals the sum of cash still in the fund plus petty cash tickets for payments that have been made from the fund.

The main control feature of an imprest system is that it clearly identifies the amount of cash for which the custodian is responsible.

2. Nov. 1 Petty Cash...... 400 Cash in Bank...... 400 To open the petty cash fund.

30 Travel Expense...... 80 Office Supplies...... 60 Delivery Expense...... 40 Cash in Bank...... 180 To replenish the petty cash fund.

3. Petty Cash Nov. 1 400

Petty Cash balance at all times...... $400

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 261 (10 min.) DE 7-19

1. Gap, Inc. Cash Budget Year Ended January 31, 20X2 Millions Cash balance, February 1, 20X1 $ 203 Estimated cash receipts—total 2,869 3,072 Estimated cash payments—total ($3,386  $349) (3,037) Cash available (needed) before new financing 35 Budgeted cash balance, January 31, 20X2 (200) Cash available for additional investments, or ______(New financing needed) $ (165)

2. Gap, Inc. Cash Budget Year Ended January 31, 20X2 Millions Cash balance, February 1, 20X1 $ 203 Estimated cash receipts—total 2,869 3,072 Estimated cash payments—total ($3,386  $206  $349) (2,831) Cash available (needed) before new financing 241 Budgeted cash balance, January 31, 20X2 (200) Cash available for additional investments $ 41

262 Accounting 5/e Solutions Manual (5-10 min.) DE 7-20

Florida Progreso Growers Cash Budget Year Ended January 31, 2002 Millions Cash balance, December 31, 2001 $ 6 Estimated cash receipts—total 147 153 Estimated cash payments—total (158) Cash available (needed) before new financing (5) Budgeted cash balance, December 31, 2002 (5) Cash available for additional investments, or ______(New financing needed) $ (10)

(5 min.) DE 7-21

Larson should report the errors to Kwan because Kwan is Larson’s supervisor, and Kwan is responsible for the errors. If Kwan fails to take action, then Larson should report the errors to the owner of the company. In any event, outsiders who are relying on BSI’s financial statements must be made aware of the need to correct the reported net income figure.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 263  Exercises

(10 min.) E 7-1

Toshima’s internal control weakness was a lack of separation of duties. The article states that “Takeda admitted to concealing the losses by falsifying Toshima’s books and records.” Obviously Mr. Takeda, a copper trader, also had access to the accounting records for his own trades.

Toshima could have avoided the losses by denying Takeda access to the accounting records. This would have prevented him from falsifying the records and probably would have brought the losses to light earlier. Also, Toshima could have kept the losses from growing so large by having a supervisor review Takeda’s work and trace his trades to the related accounting records to ensure that the records agreed with details of Takeda’s trades.

264 Accounting 5/e Solutions Manual (10 min.) E 7-2

Cash Receipts: a. Weak internal control. The accountant both handles cash and accounts for cash. b. Strong internal control. There is a good separation of duties. Different people handle cash and account for cash.

Equipment Purchases: a. Strong internal control. There is a good separation of duties. Supervisors request equipment, and the home office purchases the equipment. b. Weak internal control. Supervisors request, purchase, and pay for equipment, with little oversight by the home office.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 265 (10 min.) E 7-3 a. Weakness. The sales clerk should not have access to the control tape because he or she could steal cash and delete a cash receipt from the tape. b. Weakness. The vice-president should examine the payment packet to ensure that the payment is valid and for the correct amount. Note: He or she may have to do this on a sample basis if there is a large number of checks to sign. c. Weakness. The control environment will not be as effective as it would be if top management led in establishing internal controls. d. Weakness. The accounting department should not be allowed to order merchandise. An accountant could have goods sent to a location he or she controls, then approve payment for the goods. e. Strength. The computer operator cannot steal cash because he or she does not handle the cash of the business.

(10 min.) E 7-4

The missing internal control characteristic in each situation is: a. Other controls (not depositing cash frequently enough for adequate security). b. Separation of duties (same person ordering merchandise and approving payment). c. Separation of duties (same person selling tickets and taking tickets). d. Other controls (not pricing at odd amounts to require that change be made and force the sale to be entered on the cash register’s tape). e. Documents and records (no receiving report).

266 Accounting 5/e Solutions Manual (20 min.) E 7-5 a. Managers are more concerned about safeguarding assets because most businesses cannot operate without assets. At a minimum, the business needs cash to purchase goods for resale and to pay employee salaries and other bills. Managers must safeguard the company’s assets, or it will go out of business.

Auditors are more concerned about the quality of the accounting records for two reasons. The final product of the records is the set of financial statements on which the auditors express an opinion. To arrive at the opinion, the auditors must rely on accounting records. If the records are reliable, auditors do not have to examine every transaction and can thus reduce the cost of the audit. b. Separation of duties is important because it limits the chances for fraud (loss of assets) and also promotes the accuracy of accounting records. This allows managers to rely on the accounting records to produce information useful for operating the business. c. Cash is important because of its effect on a business. All transactions ultimately affect cash. Businesses purchase assets and must pay cash. They make sales and collect cash. All expenses ultimately require cash. Also, cash is susceptible to theft because it is the medium of exchange. Financial distress is usually accompanied by a shortage of cash. These factors combine to give cash more importance than its account balance would suggest. d. Having a check signer cancel supporting documents reduces the opportunity for fraud. Without this control procedure, a dishonest employee could resubmit the documents for payment a second time. The employee could change the payee’s address and have the check sent to an address that the employee controls. Or the employee could arrange to have the second payee split the second payment with the employee. Canceling the documents immediately upon payment makes it difficult to get approval for duplicate payment.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 267 (5 min.) E 7-6 a. 1 e. 3 b. 4 f. 2 c. 3 g. 1 d. 2

(10-20 min.) E 7-7

Bill Westphal Bank Reconciliation September 30, 20XX BANK: Balance, September 30 $ 441 Add: Deposit in transit 1,800 Less: Outstanding checks: Check No. 626 $ (75) 627 (275) (350) Adjusted bank balance $1,891

BOOKS: Balance, September 30 $1,921 Less: Correction of book error— Recorded $68 check as $58 $ (10) Cost of checks (8) Service charge (12 ) (30) Adjusted book balance $1,891

268 Accounting 5/e Solutions Manual (10-15 min.) E 7-8

Mario Bocelli Bank Reconciliation October 31, 20XX BANK: Balance, October 31 $2,750 Add: Deposit in transit 1,788 4,538 Less: Outstanding checks: (467) Adjusted bank balance $4,071

BOOKS: Balance, October 31 $4,027 Add: EFT collection—rent 400 4,427 Less: Service charge $ (12) NSF checks (74) Charge for printed checks (9) Correction of book error— Recorded $290 check as $29 (261) (356) Adjusted book balance $4,071

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 269 (10 min.) E 7-9

Journal POST. DATE ACCOUNTS AND EXPLANATIONS REF. DEBIT CREDIT Oct. 31 Cash 400 Rent Revenue 400 EFT collection of rent.

31 Miscellaneous Expense ($12 + $9) 21 Cash 21 Bank service charge and charge for printed checks.

31 Accounts Receivable 74 Cash 74 NSF checks returned by bank.

31 Salary Expense ($290  $29) 261 Cash 261 Correction of book error.

270 Accounting 5/e Solutions Manual (5-15 min.) E 7-10

The most likely way a person would manipulate a bank reconciliation to cover a theft is by understating the dollar amount of the outstanding checks. These are the most numerous items on the bank reconciliation and thus the place where a manipulation would be hardest to detect.

Example: Reconciliation

Honest Manipulated

Bal. per bank $500 $500

Less: Outstanding checks (200) ( 100) Understated

Adjusted bal. per bank $300 Amounts $400 Amounts disagree agree Adjusted bal. per books $400 $400

This theft could have been avoided by having someone besides the restaurant manager perform the bank reconciliation.

Note: Student responses probably will not include this numerical example.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 271 (10 min.) E 7-11

TO: Store Manager

There is a weakness in internal control over cash receipts from customers. The cash registers do not keep an internal record of sales. With no record of sales locked in the cash register, there is no way to determine how much cash should be in the cash drawer. This omission makes it easy for the cashier to steal cash and not get caught. To improve internal control over cash, the company should use cash registers that lock a record of each sale and a record of the total cash receipts for the day into the machine. The manager can prove the amount of cash in the cash drawer against this recorded amount.

(10 min.) E 7-12

Journal POST. DATE ACCOUNTS AND EXPLANATIONS REF. DEBIT CREDIT Apr. 1 Petty Cash 300 Cash 300

2 Cash 2,873 Sales Revenue 2,869 Cash Short and Over 4

10 Office Supplies 111 Delivery Expense 13 Entertainment Expense 37 Cash Short and Over 20 Cash 181

272 Accounting 5/e Solutions Manual (10-15 min.) E 7-13

Req. 1

Journal POST. DATE ACCOUNTS AND EXPLANATIONS REF. DEBIT CREDIT Petty Cash 500.00 Cash in Bank 500.00 To set up the petty cash fund.

Delivery Expense 22.19 Supplies Expense ($34.14 + $85.37) 119.51 Miscellaneous Expense ($2.85 + $13.78) 16.63 Postage Expense 52.80 Cash in Bank 211.13 To replenish the petty cash fund.

Req. 2

Prior to replenishment: Currency and coins totaling...... $288.87 Petty cash tickets totaling...... 211.13 Imprest total...... $500.00

Req. 3

After replenishment: Currency and coins totaling...... $500.00

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 273 (10-15 min.) E 7-14

Sprint Corporation Cash Budget Year Ended December 31, 20X4 Millions Cash balance, December 31, 20X3 $ 135 Estimated cash receipts: Collections from customers 11,813 Sale of assets 116 12,064 Estimated cash payments: Payments for cost of services and products $(6,166) Payments of operating expenses (2,744) Investment in equipment (1,826) Investment in cellular division (275) Payment of debt (597) Payments to owners (338) (11,946) Cash available (needed) before financing 118 Budgeted cash balance, December 31, 20X4 (137) (New financing needed) $ (19)

Sprint expects to need an additional $19 million to carry out its plans during 20X4.

274 Accounting 5/e Solutions Manual (15-20 min.) E 7-15

1. Determine the facts. Given in the text description.

2. Identify the ethical issues. You must decide whether it is ethical—good or bad, moral or immoral—for a member of the Congress to write these NSF checks on a regular basis.

3. Specify the alternatives. Deliberately write the NSF checks or not.

4. Identify the people involved. You, other House members, and the public at large can be affected. The public is affected mostly by the example set by deliberately writing NSF checks. The money used to pay the checks belongs to the other members of the U.S. House of Representatives.

5. Assess the possible consequences. If you write the NSF checks, you may anger your constituents back home because they may not enjoy this privilege and view the practice as dishonest. They may vote you out of office (this actually occurred). You may also be encouraging the public to be lax in their own thrift and money management. The effect on people’s spending and saving behavior could be negative and widespread. Finally, you would be borrowing from your colleagues with no interest or service charges.

6. Make the decision. It would be ethical and wise to avoid the practice. The high road is always best. Was it unethical for the legislators to write the NSF checks? Each person must decide for himself or herself. The class discussion should be lively.

It is interesting to contrast the House bank situation with private citizens’ writing NSF checks by prior arrangement with their bank and paying interest and other charges on the borrowed money. Because of the prior arrangement with the bank, this is simply another way to borrow money.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 275 Challenge Exercise

(30-40 min.) E 7-16

Req. 1

Continental Paper Company Cash Budget Year Ended December 31, 20X5 Millions Cash balance, December 31, 20X4 $ 340 Estimated cash receipts: Collections from customers $ 19,467 Investments by owners 516 Other cash receipts 111 20,094 20,434 Estimated cash payments: Purchases of inventory $(14,345) Payments of operating expenses (2,349) Purchase of property and equipment (1,518) Acquisition of other companies (1,168) Payment of long-term and short-term debt (950) Payments to owners (237) 20,567 Cash available (shortage) before financing (133) Budgeted cash balance, December 31, 20X5 (300) Cash available for additional investments, or (New financing needed) $ (433)

276 Accounting 5/e Solutions Manual (continued) E 7-16

Req. 2

Before Borrowing:

Total current assets $5,873 Current ratio = = = 1.21 Total current liabilities $4,863

Total liabilities $16,180 Debt ratio = = = 0.67 Total assets $23,977

After Borrowing:

$5,873 + $433 Current ratio = = 1.30 $4,863

$16,180 + $433 Debt ratio = = 0.68 $23,977 + $433

I would lend $433 million to Continental Paper because the loan would improve the current ratio and have virtually no effect on the debt ratio.

The budgeted amount of borrowing ($433 million) is low relative to Continental Paper’s current liabilities and total liabilities, so the company should have no trouble paying off the long-term debt.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 277  Problems

Group A

(15-20 min.) P 7-1A

TO: Company President

FROM: Consultant

RE: Separation of duties within the company limits chances for fraud

 Operations should be separated from accounting. Otherwise, operating personnel can manipulate the accounting records to make their performance look better than it really is. This can waste company assets.

 Custody of assets should be separated from accounting. Otherwise, an employee can steal an asset and cover the theft by making a false entry on the books.

 Authorization of transactions should be separated from custody of related assets. Otherwise, an employee could authorize the acquisition of an asset and have it sent to his home or some other location that he controls.

 Duties should be separated within the accounting department. Independent performance of accounting duties minimizes errors and reduces the opportunity for fraud.

278 Accounting 5/e Solutions Manual (10-20 min.) P 7-2A

Requirement 1 Requirement 2 Requirement 3

Missing Internal Control Characteristic Possible Problem Solution a. Assignment of Lost sales due to Assign programmers responsibilities delay of product to product development. development only. Assign company accountants to redesign the accounting system. b. Separation of duties Theft of cash. Keep accounting and cash handling duties separate. c. Proper authorization Lost profits due to Authorize one high cost of materials employee to make and labor to complete purchases in owner’s jobs. absence. d. Other controls Theft of cash. Purchase fidelity (fidelity bonds for bonds on all cashiers. cashiers) e. Documents Theft of cash and Have receipts (prenumbered inefficiency. prenumbered. invoices)

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 279 (20-25 min.) P 7-3A

Req. 1

Veralux Interiors Bank Reconciliation March 31, 20X5 BANK: Balance, March 31, 20X5 $12,069 Add: Deposit of March 31 in transit 2,038 14,107 Less: Outstanding checks: Check No. 1420 $ (970) 1421 (200) 1422 (2,267) (3,437) Adjusted bank balance, March 31, 20X5 $10,670

BOOKS: Balance, March 31, 20X5 $ 9,941 Add: EFT collection of rent $ 625 Bank collection of note receivable, including interest of $122 1,000 1,625 11,566 Less: NSF check $ (441) EFT payment of insurance (340) Service charge (25) Book error—$4,216 check recorded as $4,126 (90) (896) Adjusted book balance, March 31, 20X5 $10,670

280 Accounting 5/e Solutions Manual (continued) P 7-3A

Req. 2

A bank account helps control cash by providing a place for safekeeping. The bank also provides a detailed list of Veralux’s cash transactions that Veralux managers can compare to the company’s own cash records and thereby correct any book errors quickly.

The bank reconciliation helps control cash by ensuring that the company accounts for all its cash transactions and that the bank and book records of cash are correct. In particular, the bank reconciliation establishes the balance of cash to report on the balance sheet.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 281 (20 min.) P 7-4A

Req. 1

Payne Stationers Bank Reconciliation May 31, 20XX BANK: Balance, May 31 $21,110.82 Add: Deposit of May 31 in transit $ 381.14 Correction of bank error— charged our account for the check of another company 410.00 791.14 21,901.96 Less: Outstanding checks ($403.00 + $74.25 + $36.60 + $161.38 + $229.05 + $48.91) (953.19) Adjusted bank balance, May 31 $20,948.77

BOOKS: Balance, May 31 $20,101.55 Add: EFT—collection on account $ 200.00 Bank collection of dividend revenue 899.14 Interest revenue on bank balance 16.86 1,116.00 21,217.55 Less: NSF check $ (67.50) Returned check due to unauthorized signature (195.03) Service charge (6.25) (268.78) Adjusted book balance, May 31 $20,948.77

282 Accounting 5/e Solutions Manual (continued) P 7-4A

Req. 2 (entries based on the reconciliation)

Journal POST. DATE ACCOUNTS AND EXPLANATIONS REF. DEBIT CREDIT May 31 Cash 200.00 Accounts Receivable—Jack Oates 200.00 Collection on account.

31 Cash 899.14 Dividend Revenue 899.14 Dividend revenue collected by bank.

31 Cash 16.86 Interest Revenue 16.86 Interest earned on bank balance.

31 Accounts Receivable—Sarah Batten 67.50 Accounts Receivable—Lena Masters 195.03 Cash 262.53 Customer checks returned by bank.

31 Miscellaneous Expense 6.25 Cash 6.25 Bank service charge.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 283 (10-15 min.) P 7-5A

TO: Company President

FROM: Concerned Employee

It is unwise to have the employee who opens the mail also grant sales allowances to customers. Suppose a customer pays an invoice in full. The mailroom employee can steal the customer check and grant a sales allowance to cover the theft. To correct this internal control weakness, deny the mailroom employee access to all accounting records. Also, appoint a separate employee to grant sales allowances to customers.

Notes: 1. Student responses may vary. 2. The mailroom employee obviously has access to the accounting records—to know that a customer has paid less than the full amount. 3. It may be necessary to explain to students that the mailroom employee must forge the company endorsement on stolen customer checks. This person must also open—and control—a bank account in the company’s name. Opening such an account may be quite easy.

284 Accounting 5/e Solutions Manual (20-30 min.) P 7-6A

Req. 1

An imprest fund is money set aside for a specific purpose. An imprest fund has the same balance at all times, which equals the sum of cash in the fund plus the total of the tickets that support payments from the fund. The internal control feature of an imprest fund is that it clearly identifies the amount of money for which the fund custodian is responsible.

Req. 2 (creation and replenishment of the petty cash fund)

Journal POST. DATE ACCOUNTS AND EXPLANATIONS REF. DEBIT CREDIT April 1 Petty Cash 400.00 Cash in Bank 400.00 To create the petty cash fund.

The custodian cashes the check and places $400 of currency and coin in the fund.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 285 (continued) P 7-6A

Journal POST. DATE ACCOUNTS AND EXPLANATIONS REF. DEBIT CREDIT April 30 Office Supplies Expense ($86.89 + $44.37) 131.26 Travel Expense 25.00 Delivery Expense 37.75 Entertainment Expense ($80.00 + $19.22) 99.22 Inventory 85.70 Cash Short and Over 3.71 Cash in Bank ($400.00  $17.36) 382.64 To replenish the petty cash fund.

The custodian totals the petty cash tickets ($378.93) and compares the total to the amount needed to bring the fund’s cash to the imprest balance of $400. The amount needed is $382.64, which is $3.71 more than the sum of the tickets. Assume this difference is considered immaterial. The custodian cashes the $382.64 check and places this amount of currency and coin in the fund, returning its cash balance to $400 ($17.36 + $382.64 = $400.00).

286 Accounting 5/e Solutions Manual (continued) P 7-6A

Req. 3

Journal POST. DATE ACCOUNTS AND EXPLANATIONS REF. DEBIT CREDIT May 1 Petty Cash 100.00 Cash in Bank 100.00 To increase the petty cash fund From $400 to $500.

The custodian cashes the check and places $100 in currency and coin in the fund.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 287 (10-15 min.) P 7-7A

Student Name Cash Budget 20X2 Cash balance, beginning ($300 + $200) $ 500 Estimated cash receipts: Earnings from summer job $3,600 Earnings from college cafeteria 1,500 Gifts 800 Scholarship 1,000 6,900 7,400 Estimated cash payments: Apartment rent ($150  12) $(1,800) Food (4,800) Gas and auto expenses ($50  12) (600) Entertainment ($100  12) (1,200) 8,400 Cash available (needed) before new financing (1,000) Budgeted cash balance, ending (300) Cash available, or (New financing needed) $(1,300)

288 Accounting 5/e Solutions Manual (10-15 min.) P 7-8A

Req. 1

Datek Enterprises Cash Budget 20X9 Millions Cash balance, beginning $ 792 Estimated cash receipts: Collections from customers ($8,089  1.07) $ 8,655 Interest revenue collected 24 Borrowings 160 Investments by owners 30 8,869 9,661 Estimated cash payments: Purchases of inventory ($5,597  1.05) $(5,877) Operating expenses paid (1,859) Purchases of plant assets (614) Long-term debt repayments (1) Payments to owners (183) (8,534) Cash available (needed) before additional financing 1,127 Budgeted cash balance, ending (400) Cash available for additional investments $ 727

Req. 2

Based on the above budget, Datek expects to have $727 million available for additional investments during 20X9.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 289 (15-30 min.) P 7-9A

1. Determine the facts. Clear from the description.

2. Identify the ethical issue. Reed’s ethical issue is whether to tell Cortez personnel about Peters & Sons’ possible bankruptcy.

3. Specify the alternatives. (1) Keep quiet and let nature take its course, or (2) Tell Cortez’s top managers of Peters’ possible bankruptcy.

4. Identify the people involved. Cortez Manufacturing, Peters & Sons, TriState Bank, and everyone connected to these organizations— owners, employees, creditors, depositors, and local communities.

5. Assess the possible consequences. Telling Cortez about Peters & Sons possible bankruptcy may help Cortez to avoid wasted effort on Peters & Sons. This may enable Cortez to seek more profitable ventures and aid Cortez’s recovery. In turn, this may help Cortez repay its loan to TriState.

Revealing this information to Cortez would probably harm Peters & Sons (others may learn also). It may interfere with Peters’ plans. After all, Peters is not bankrupt yet. If others learned that a TriState Bank officer was the source of this sensitive inside information, the bank’s reputation would suffer.

The owners, employees, creditors, depositors, and communities of these organizations would feel the effects of a bankruptcy or other disruption of Peters’, Cortez’s, or the bank's business.

290 Accounting 5/e Solutions Manual (continued) P 7-9A

6. Make the decision. Reed should keep quiet. It would be unwise and unethical for him to convey speculative inside information about one client to another client. Peters and Cortez should be free to conduct their affairs without interference caused by any revelations by Reed. Any gain to Cortez (and TriState Bank) from being able to protect themselves against Peters’ bankruptcy is more than offset by the potential damage to Peters’ viability and to the bank’s reputation.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 291  Problems

Group B

(15-20 min.) P 7-1B

TO: Mr. Matthews

FROM: Consultant

RE: Internal Control

Every business needs a system of internal controls. Internal control is the organizational plan and all the related measures adopted by an entity to (1) safeguard assets, (2) ensure accurate and reliable accounting records, (3) promote operational efficiency, and (4) encourage adherence to company policies.

A company with an effective system of internal control needs competent and reliable personnel. The business may have to increase employee pay in order to attract and retain high-quality employees.

It is necessary to assign responsibilities to employees so that everyone in the organization knows his or her duties. This avoids confusion and helps ensure that all jobs are performed.

The business needs a set of rules that outline approved procedures. Deviations from these procedures should require proper authorization to avoid errors.

Certain duties should be separated between two or more employees to limit the opportunity for fraud. For example, the custody of cash should be separated from the accounting for cash.

292 Accounting 5/e Solutions Manual (continued) P 7-1B

The business may need to have an audit by an independent CPA. Auditors can evaluate the system of internal control and suggest ways to improve efficiency. Auditors also gauge the reliability of accounting records, which provide the information for business decisions.

Documents and records are needed to keep track of sales and cash receipts, expenses, payments, and other transactions. These records will help manage the business better and save money.

Electronic and other controls can safeguard assets. For example, the company needs burglar alarms to protect buildings, and should store real estate contracts and property titles in fireproof vaults.

Note: Student responses may vary.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 293 (10-20 min.) P 7-2B

Requirement 1 Requirement 2 Requirement 3

Missing Internal Control Characteristic Possible Problem Solution a. Separation of duties Theft of cash. Separate accounting and cash-handling duties. b. Internal audit Lost profits and assets Reinstate the internal due to undetected audit department. inefficiency. c. Competent personnel Loss of revenue due Allow to low-quality work. paraprofessionals to do only the work for which they are qualified. d. Separation of duties Theft of diamonds— Separate purchasing, the purchasing agent approval, and check- could have diamonds signing duties. sent to a business he controls. e. Assignment of Lost revenue because Assign a single responsibility too many employees employee to manage are managing the the office when the office and neglecting owner is absent. their duties.

294 Accounting 5/e Solutions Manual (20-25 min.) P 7-3B

Req. 1

Good Eats Café Bank Reconciliation April 30, 20X4 BANK: Balance, April 30, 20X4 $10,080 Add: Deposits in transit ($1,060 + $337) 1,397 11,477 Less: Outstanding checks: Check No. 3119 $ (632) 3120 (1,675) 3121 (100) 3122 (2,413) (4,820) Adjusted bank balance, April 30, 20X4 $ 6,657

BOOKS: Balance, April 30, 20X4 $ 5,565 Add: EFT collection of rent $ 326 Bank collection of note receivable, including interest of $185 1,368 Book error—$1,390 check recorded as $1,930 540 2,234 7,799 Less: EFT payment of insurance $ (219) Unauthorized signature check (903) Service charge (20) 1,142 Adjusted book balance, April 30, 20X4 $ 6,657

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 295 (continued) P 7-3B

Req. 2

A bank account helps control cash by providing a place for safekeeping. The bank also provides a detailed list of Good Eats’ cash transactions that Good Eats managers can compare to the company’s own cash records and thereby correct any book errors quickly.

296 Accounting 5/e Solutions Manual (20 min.) P 7-4B

Req. 1

Beeson Nursery Bank Reconciliation August 31, 20XX BANK: Balance, August 31 $5,116.22 Add: Deposit of August 31 in transit 316.15 5,432.37 Less: Outstanding checks ($46.10 + $141.00 + $578.05 + $11.87 + $609.51 + $8.88 + $101.63) $(1,497.04) Correction of bank error, which credited our account for the deposit of another company (300.00) (1,797.04) Adjusted bank balance, August 31 $3,635.33

BOOKS: Balance, August 31 $3,998.14 Add: Bank collection of note receivable including interest revenue of $179.36 $ 1,191.17 Interest revenue earned on bank balance 38.19 1,229.36 5,227.50 Less: Returned check due to unauthorized signature $ (395.00) NSF check (146.67) EFT (rent $750, insurance $290) (1,040.00) Service charge (10.50) (1,592.17) Adjusted book balance, August 31 $3,635.33

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 297 (continued) P 7-4B

Req. 2 (entries based on the reconciliation)

Journal POST. DATE ACCOUNTS AND EXPLANATIONS REF. DEBIT CREDIT Aug. 31 Cash 1,191.17 Note Receivable 1,011.81 Interest Revenue 179.36 Note receivable collected by bank.

31 Cash 38.19 Interest Revenue 38.19 Interest earned on bank balance.

31 Accounts Receivable—Lakeland Express 395.00 Accounts Receivable—Veracruz, Inc. 146.67 Cash 541.67 Customer checks returned by bank.

31 Rent Expense 750.00 Cash 750.00 Monthly rent.

31 Insurance Expense 290.00 Cash 290.00 Monthly insurance.

31 Miscellaneous Expense 10.50 Cash 10.50 Bank service charge.

298 Accounting 5/e Solutions Manual (10-15 min.) P 7-5B

TO: Company President

FROM: Concerned Employee

Notes: 1. Student response may vary. 2. The mailroom employee obviously has access to the accounting records—to know that a customer has paid less than the full amount. 3. It may be necessary to explain to students that the mailroom employee must forge the company endorsement on stolen customer checks. This person must also open—and control—a bank account in the company’s name. Opening such an account may be quite easy.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 299 (30-40 min.) P 7-6B

Req. 1

Req. 2

Journal POST. DATE ACCOUNTS AND EXPLANATIONS REF. DEBIT CREDIT June 1 Petty Cash 350.00 Cash in Bank 350.00 To create the petty cash fund.

The custodian cashes the check and places $350 of currency and coin in the fund.

300 Accounting 5/e Solutions Manual (continued) P 7-6B

Reqs. 2 and 3

Journal POST. DATE ACCOUNTS AND EXPLANATIONS REF. DEBIT CREDIT June 30 Postage Expense 18.40 Entertainment Expense ($13.19 + $50.00) 63.19 Office Supplies Expense ($20.82 + $27.13) 47.95 Travel Expense 169.00 Delivery Expense 6.30 Cash Short and Over 2.79 Cash in Bank ($350.00  $42.37) 307.63 To replenish the petty cash fund.

The custodian totals the petty cash tickets ($304.84) and compares the total to the amount needed to bring the fund’s cash to the imprest balance of $350. The amount needed is $307.63, which is $2.79 more than the sum of the tickets. Assume this difference is considered immaterial. The custodian cashes the $307.63 check and places this amount of currency and coin in the fund, returning its cash balance to $350 ($42.37 + $307.63 = $350.00).

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 301 (continued) P 7-6B

Req. 3

Journal POST. DATE ACCOUNTS AND EXPLANATIONS REF. DEBIT CREDIT July 1 Petty Cash 150.00 Cash in Bank 150.00 To increase the petty cash fund from $350 to $500.

The custodian cashes the check and places $150 in currency and coin in the fund.

302 Accounting 5/e Solutions Manual (10-15 min.) P 7-7B

Student Name Cash Budget 20X2 Cash balance, beginning ($500 + $100) $ 600 Estimated cash receipts: Earnings from summer job $3,000 Earnings from college cafeteria 2,000 Gifts 300 Scholarship 500 5,800 6,400 Estimated cash payments: Apartment rent ($175  12) $(2,100) Food (5,000) Gas and auto expenses ($50  12) (600) Entertainment ($125  12) (1,500) (9,200) Cash available (needed) before new financing (2,800) Budgeted cash balance, ending (500) Cash available, or (New financing needed) $(3,300)

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 303 (10-15 min.) P 7-8B

Req. 1

Toys.com Cash Budget 20X1 Millions Cash balance, beginning $ 203 Estimated cash receipts: Collections from customers ($9,414  1.09) $10,261 Interest revenue collected 17 Borrowings 292 Investments by owners 16 10,586 10,789 Estimated cash payments: Purchases of inventory ($6,750  1.08) $(7,290) Operating expenses paid (2,431) Purchases of plant assets (535) Long-term debt repayments (9) Payments to owners (200) (10,465) Cash available (needed) before new financing 324 Budgeted cash balance, ending (400) Cash available for additional investments, or (New financing needed) $ (76)

Req. 2

Based on the above budget, it looks like Toys.com will need to borrow an additional $76 million in order to achieve its goals for 20X1.

304 Accounting 5/e Solutions Manual (15-30 min.) P 7-9B

1. Determine the facts. Clear from the description.

2. Identify the ethical issues. Youngdale’s ethical issue is whether to use her knowledge of Baker’s plans and of Fletcher’s situation to either party’s advantage (or disadvantage). Should she help Baker buy the land at the lowest price? Should she help Fletcher sell the land at the highest price? Youngdale’s position presents her with a conflict of interest.

3. Specify the alternatives. There are several. Here are a few: (1) Let other members of the Baker board of directors know of Fletcher’s situation in the interest of helping Baker buy the land at a bargain price. (2) Disclose Fletcher’s situation to other board members and insist that Baker pay market price ($5 million) for the land. (3) Reveal nothing to the Baker board and take no part in the negotiation between the two parties. (4) Take a temporary leave of absence from the Baker board for unspecified “personal reasons.”

4. Identify the people involved. Youngdale, Baker Publishing, Fletcher, and Stateline Loan Associates.

5. Assess the possible consequences. Disclosing Fletcher’s weakened condition to the Baker board may help Baker buy the land at a low price, depending on the ethical bearing of other board members. This would help Baker and hurt Fletcher, relative to Fletcher’s ability to sell the land at market value of $5 million. Insisting that Baker offer market price for the land would seem fair to both parties, but that would betray the trust of Fletcher. And it may or may not sway the board to go along with a $5 million offer for the land.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 305 (continued) P 7-9B

Remaining silent would preserve Youngdale’s integrity. However, if either Baker or Fletcher ever learned of Youngdale’s relationship with the other party, they would wonder whether she used the information against them.

Taking a temporary leave of absence would preserve Youngdale’s integrity and remove her from the conflict of interest. It would also preserve her reputation for fairness and the reputation of Stateline Loan Associates for keeping customer information confidential.

6. Make the decision. The authors would take the leave of absence and hope other Baker board members do not probe her “personal reasons.” This way neither Baker nor Fletcher can accuse Youngdale of using privileged information to the advantage of the other party.

306 Accounting 5/e Solutions Manual  Decision Cases

(20-30 min.) Decision Case 1

Flexall Plastics Company Bank Reconciliation September 30, 20XX BANK: Balance, September 30 $14,124 Add: Deposit of September 30 in transit 3,794 17,918 Less: Outstanding checks ($116 + $150 + $353 + $190 + $206 + $145) (1,160) Adjusted bank balance, September 30 $16,758

BOOKS: Balance, September 30 $17,502 Add: Bank collection 200 17,702 Less: Service charge $ 8 NSF check 36 (44) Adjusted book balance, September 30 $17,658

Based on the above reconciliation, it appears the cashier has stolen $900, the difference between the adjusted book and bank amounts ($17,658  $16,758). He understated the total of outstanding checks by $900 to cover his theft.

Gilbreath should assign another employee with no cash-handling duties to prepare the bank reconciliation. The cashier should not perform this duty because, as this case demonstrates, a person who handles cash and also prepares the reconciliation can steal cash and manipulate the reconciliation to cover the theft. Perhaps Gilbreath should prepare the reconciliation herself.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 307 (15-30 min.) Decision Case 2 a. The main internal control weakness in this case is a lack of separation of duties. The foreman performs too many duties. 1. The foreman hires the workers. 2. The foreman has workers complete their employment documents. 3. The foreman fills out workers’ time sheets and transmits all documents to the home office. 4. The foreman passes out paychecks to workers. 5. The workers never go to the home office, so home-office personnel do not even know that all workers exist.

The foreman could steal from the company as follows: 1. The foreman could enter a fictitious worker into the payroll system and fill out time sheets for the fictitious employee. Then the foreman could pocket the pay check written to the employee. 2. The foreman could enter more time than actually worked by an employee and collude with the employee to split the extra pay received by the worker. 3. The foreman could pad his own hours to receive pay for time that he did not work. b. The following actions will correct the internal control weakness: 1. The home office could have workers come to the office for processing their employee documents. Then home office would at least know that all workers exist. 2. Use a time clock and have employees sign their own time sheets. 3. Have a home-office employee compare signatures on the workers’ time sheets to their signatures on file and, occasionally, to their endorsements on the backs of their paychecks. 4. Occasionally—or always—have a home-office employee go to the construction site to pass out paychecks. 5. Have a home-office employee go to the construction site occasionally to “take attendance” of workers on duty that day. Then match the names of workers on duty to the time sheets turned in at the end of the week.

308 Accounting 5/e Solutions Manual  Ethical Issue

Req. 1

Hudson’s lenders and the potential buyers of the Tulsa property can be harmed by this theft. Anyone who relies on Hudson’s financial statements can be harmed by the overstated amounts of cash. Hudson simply does not have as much cash as the balance sheet reports.

Req. 2

Accounting plays the critical role of providing information to persons who do business with Hudson. A common way for a business to represent itself to outsiders is through its financial statements. People commit their resources based on the information reported in these statements. To serve their intended purpose, financial statements must be complete and accurate.

Chapter 7 Internal Control, Managing Cash, and Making Ethical Judgments 309  Financial Statement Case

(15-20 min.)

Req. 1

Ernst & Young LLP in Minneapolis, Minnesota, signed the audit opinion on February 28, 2000, 30 days after Target’s fiscal year ended on January 29, 2000.

Req. 2

Target’s management—not the outside auditors—bears primary responsibility for the financial statements. Both the audit report and the report of management mention management’s responsibility for the statements.

Req. 3

Target’s internal controls must have been adequate. Otherwise, Ernst & Young would have referred to any serious control weakness in the audit report.

Req. 4

The auditors used “generally accepted auditing standards” in the examination of the Target statements. (That is the norm.) The Target statements were evaluated by reference to “generally accepted accounting principles.” (That, too, is the norm.)

Req. 5

Cash decreased by $35 million during the year—from $255 million to $220 million.

310 Accounting 5/e Solutions Manual  Team Project