BAT4M University/College Grade 12 Accounting Chapter 7 and 8 Notes Chapter 7 – Internal Controls and Cash Internal Control – The strategy that management develops and employs to accomplish accurate financial reporting, efficient operations, and adherence to rules and regulations – Responsibility of management – Principles of Internal Control: authorization, safeguarding assets and records, segregation of duties, independent verification, documentation procedures, other controls Establishment of Responsibilities – Make specific employees responsible for specific tasks – Most effective when only one person is responsible for a single task Segregation of Duties – Employees with similar jobs should be separated from each other to prevent collusion – Physical counting and theoretical counting should not be responsibilities of one person Documentation Procedures – Documentation should be used to support the transactions in regards to merchandise and cash – Signatures increase the reliability of documentation – Pre-numbering documents will improve efficiency Physical Controls – Mechanical/electronic controls to protect assets can be used – Vaults, warehouses, passwords, alarms, sensors, and time clocks are all measures of physical control Performance Reviews – Periodic/surprise reviews will maximize effectiveness – Reviews should be conducted by people with very little relations to the employee being reviewed – Exceptions should be reported to management to correct the situation Internal Reviews – Done by someone within the company – Internal auditors belong to the company and conduct evaluations of employees External Reviews – Done by someone outside the company – Person conducting evaluations must be completely independent from the company and are professional accountants Other Controls – Bonding employees to protect them in the case of theft with insurance – This insurance is referred to as fidelity insurance and covers against the theft of assets by dishonest employees – Rotating duties/forcing vacations will expose any changes in daily operations – Embezzlement is commonly found in banks when employees are on vacation/assigned to new positions Limitations of Internal Control – The cost of internal controls should not be greater than the expected benefit – Improper training, collusion, and a large business size can limit the abilities of internal control methods Cash Controls – Same internal controls are applied to cash to prevent theft – A special journal is often used by companies to make cash controls more efficient – Cash Receipts Journals are used to record all cash receipts – Special Journals are used depending on what type of transactions occur the most Debit/Credit Card Transactions – Debit card sales are considered cash transactions – Debit card transactions can be compared to a personal cheque transaction – Depending on the seller, debit card expenses may be paid by either the buyer or seller – Bank credit card sales are often considered cash transactions – Credit card expenses are often paid by the seller Electronic Receipts – EFT (electronic funds transfer) systems are used to transfer cash electronically – Debit and credit cards are forms of electronic payment methods – Pre-authorized payments are another example of electronic funds Cash Disbursements – Same control methods listed above should be used for cash disbursements – Companies requiring many cash disbursements often use a special journal called a cash payments journal – Electronic payments are also used but result in no cheque/source document Petty Cash – Used for small payments – To establish the fund: DR Petty Cash, CR Cash – Petty cash receipts should be used as source documents – Payments from the petty cash should not be recorded until the petty cash fund is refilled – To replenish the fund: DR Expenses, CR Cash Banks – Bank deposits increase the bank account – Cheques decrease the bank account – Clearing refers to when a cheque/deposit is accepted by the bank – Clearing often takes a few days – Bank statements show transactions and balances – Credits on the bank statement are actually debits to the company, and vice versa for debits on the bank statement. – The bank statement is shown from the bank’s perspective Memorandums – Debit memos are issued by the bank to signify any decreases in the company’s balance – Banks can charge a monthly bank service charge – NSF cheques are also notified to companies through a debit memo – NSF cheques occur when a deposit of a cheque does not clear because the customer does not have enough money to pay the cheque – Credit memos are issued to the bank to signify any increases in the company’s balance – Often used for interest earned, or EFT transactions Bank Reconciliations – Done to show the true balances of cash on the bank statement and in the general ledger – Bank balance may be off due to outstanding cheques (cheques not yet cleared), deposits in transit or error made by the bank – Balance in the ledger may be off due to NSF cheques, unrecorded debit/credit memos or ledger errors – When the correct balance is made, adjusting entries must be made in the journal Extra Vocabulary Cash: coins, currency, cheques, money orders, travelers’ cheques, and money on deposit in a bank Cash Equivalents: short-term, high liquidity investments – often combined with cash Bank Overdraft: withdrawals are more than the amount in the bank account Restricted Cash: cash reserved for a special use (e.g. deposits to purchase a large item) Compensating Balances: minimum balances kept by banks to support their loans Chapter 8 – Accounting for Receivables Accounts Receivable – A/R is recognized whenever services/sales are made on account – A subsidiary ledger is used to keep track of individual A/R’s while a single A/R account is used on the balance sheet to summarize the subsidiary ledger – Interest can be applied to A/R for overdue payments – Non-bank credit card sales are considered A/R because it can take longer for cash to arrive – Credit card expenses are often paid by the seller and is recorded as a DR to reduce the amount of A/R on a sale Valuing Accounts Receivable – Only the amount of collectable A/R is recorded in the balance sheet – This amount is called the net realizable value (NRV) – When A/R is written down, the account bad debts expense is used to reduce equity – An allowance method of accounting is used to estimate uncollectible accounts at the end of the accounting period – This matches expenses to revenue better because it accounts for any losses that will occur during the accounting period the revenue was earned – Allowance method is only used when bad debts expense has material – 3 important features: recording estimated uncollectibles, writing off the uncollectible account, and recovering any uncollectible account previously written off Recording Estimated Uncollectibles – DR Bad Debts Expense, CR Allowance for Doubtful Accounts – NRV of A/R = A/R – Allowance for doubtful accounts Determining Bad Debts Expense Percentage of Sales – Calculates BDE as a percentage of net sales on account – Based on past experience and company policies – Also called the income statement approach because it bases BDE on sales – two income statement accounts and does not factor in any balance sheet accounts Percentage of Receivables – Calculates BDE as a percentage of receivables that will be uncollectible – Uses an aging schedule to visualize the accumulation of BDE – The longer a receivable is past due, the less likely it is going to be collected – The percentage increases as time increases – When recording the BDE, it is debited for the amount of uncollectible calculated less any credit balance in the Allowance for Doubtful Accounts – The BDE is determined as the amount of uncollectible plus the balance in the Allowance for Doubtful Accounts if there is a debit balance in the Allowance for Doubtful Accounts. – Gives a better NRV of A/R than percentage of sales because it compares a balance sheet account to another balance sheet account – Often called the balance sheet approach Differences – Percentage of sales is better to match expenses and revenues – Percentage of receivables is better to evaluate an NRV for A/R – Percentage of sales compares BDE to Sales – Percentage of receivables compares A/R to Allowance for Doubtful Accounts – Regardless of method used, the entry is: DR BDE, CR Allowance for Doubtful Accounts Recording the Write-Off of an Uncollectible Account – Must be approved by management – DR Allowance for Doubtful Accounts, CR Accounts Receivable – Customer – Essentially permanently reduces A/R and removes the allowance for doubtful accounts initially used to signify the uncollectible Recovery of an Uncollectible Account – DR A/R – customer, CR Allowance for Doubtful Accounts – DR Cash, CR A/R – customer – Reverses previous write-off entry (exactly the opposite) – Journalize the collection of cash – Only affects balance sheet accounts Summary of the Allowance Method 1. Estimates of uncollectible accounts are calculated and journalized by DR Bad Debts Expense, and CR Allowance for Doubtful Accounts 2. Write-offs of uncollectibles are recorded by DR Allowance for Doubtful Accounts, and CR A/R 3. If any recoveries occur, reverse the write off entry by DR A/R, and CR Allowance for Doubtful Accounts then a normal collection of cash occurs Notes Receivables – Legal documents known as promissory notes are used to guarantee the payment of a given sum of money before or on a particular date. – Party making the payment is called the maker – Party receiving payment is called the payee – Notes receivables usually bear interest while A/R does not usually bear interest – Both N/R and A/R can be sold and must be recorded at their net realizable value – N/R is treated as an A/R but with interest – If settling an A/R with an N/R, the entry is: DR N/R – customer, CR A/R – customer – Interest rates determined in the N/R is an annual rate of interest – To make an adjusting entry for interest at the end of a month: DR Interest Receivable, CR Interest Revenue – When an N/R is paid in full, the following entry occurs: DR Cash, CR N/R – customer, CR Interest Revenue, CR Interest Receivable (if it exists) – If an N/R is not paid in full, the entry occurs: DR A/R – customer, CR N/R – customer, CR Interest Revenue, CR Interest Receivable – With a dishonored note, the payee still has a claim against the maker’s note and any receivable accrued – If the note is written off, Allowance for Bad Debts is debited instead of A/R and no interest revenue is credited, but the existing interest receivable is credited Ratios – Receivables Turnover Ratio = Net Credit Sales / Average Gross Accounts Receivable – Indicates how many times the company collects their receivables within a year – The higher the value, the more liquid the company is – Collection Period = Days in Year / Receivables Turnover – Indicates how many days on average it takes for a company to collect their receivables – Operating Cycle in Days = Days Sales in Inventory + Collection Period – cash Indicates how long it takes for a company to use their cash and convert it back into Accelerating Cash Receipts from Receivables – A/R can be used as collateral for a company to take a bank loan – Selling A/R is another option because companies will put the work of collecting A/R on another company – Factoring – selling to a factor – a finance company /bank that buys receivables from companies and collects them – will accelerate cash receipts – The company selling the receivables is responsible for any uncollected amounts by the factor – The transfer of receivables to investors is called securitization – Receivables à trust company converts to investments à investments are sold on the market