Sarbanes-Oxley Act & Internal Controls

Sarbanes-Oxley Act

• US law enacted to foster public confidence and trust in companies' financial reporting.
• Enacted to prevent fraud, theft, and financial scandals such as Enron's bankruptcy.
• Requires companies to maintain effective internal control.

Internal Control Definition

• Procedures and processes used by a company to:
  • Safeguard its assets.
  • Process information accurately.
  • Ensure compliance with laws and regulations.

Objectives of Internal Control

• Ensure assets are safeguarded for business purposes.
• Ensure business information is accurate for management, investors, and creditors.
• Ensure employees and managers comply with laws and regulations like Sarbanes-Oxley.

Elements of Internal Control

Control Environment

• Overall attitude of management and employees about the importance of controls.
• Focuses on management philosophy, operating style, organizational structure, and personnel policies.

Risk Assessment

• Identifying and analyzing external risks and working to minimize them.

Control Procedures

• Competent personnel, rotating duties, and mandatory vacations.
• Separating responsibilities for related operations, custody of assets, and accounting.
• Proofs and security measures.

Monitoring

• Locating weaknesses and improving controls internally.

Information and Communication

• Management uses this to improve by listening to employees and other management team members.

Limitations to Internal Control

• Human element, as people will make mistakes.
• Cost-benefit considerations when implementing controls.

Cash Control: Electronic Funds Transfers (EFTs)

• Reasons to use EFTs:
  • Costs less than receiving cash payments.
  • Enhances internal controls because cash is received directly by the bank without employee interference.
  • Reduces late payments with automatic transfers.

Bank Accounts for Internal Control

• Banks provide an independent recording of cash transactions.
• Bank statement summarizes all checking account transactions each month.
• Company's checking account balance in bank records is a liability for the bank, resulting in a credit balance for the company.

Credit and Debit Memos

Credit Memo

• Represents an increase in cash.
  • Electronic Funds Transfers deposits.
  • Collection of notes receivables.
  • Collection of interest.
  • Loan proceeds.
  • Interest earned from the bank.

Debit Memo

• Represents a decrease in cash.
  • Payments made by EFT.
  • Service charges.
  • NSF (non-sufficient funds) checks.

Bank Reconciliation Definition

• Analysis of items and amounts that cause the cash balance reported in the bank statement to differ from the balance of the cash account in the company's ledger.

Bank Reconciliation Sections

• Bank Section: Adjustments to bank statement balance.
• Company Section: Adjustments to company ledger balance.
• Adjusted balances for both sections must be equal.

Bank Reconciliation: Bank Section Formula

• Cash balance according to the bank
  • Add: Deposits in transit (not recorded by the bank)
  • Deduct: Outstanding checks (not paid by the bank)
  • Equals: Adjusted balance

Bank Reconciliation: Company Section Formula

• Cash balance according to company ledger (or books)
  • Add: Credit memos not recorded (increases in cash)
    • Notes receivables collected by bank
    • Interest collected
  • Deduct: Debit memos not recorded (decreases in cash)
    • NSF checks
    • Bank service charges
  • Equals: Adjusted balance

Bank Reconciliation: Company Section Journal Entries

• Company records must be updated for any items in the company section of the bank reconciliation using journal entries.

Cash Balance Example

Company Section Cash Balance Calculation

• Start with cash balance per books: $5,400
• Add credit memos: Notes receivable and interest collected ($650)
• Deduct debit memos: Bank charge for check printing ($40) and NSF check ($140)
• Bank reconciliations adjust cash balances to reflect accurate company records.
• Bank side reconciliations do not include deposits in transit or outstanding checks.

Company Side Adjustments

• Focus on Cash balance per books.
• Credit memos increase the cash balance.
• Credit memos include notes receivable and interest collected by the bank.
• Debit memos decrease cash balance, including bank service charges and NSF checks.
• Adjustments modify the initial cash balance to arrive at the final adjusted balance.

Bank Reconciliation Statement Example

• Bank reconciliation statements reconcile bank and book balances.
• The bank statement for Company X indicates a balance of $7,735 on June 30.
• After posting June's journals, the cash account balance is $4,098.
• Cash sales of $742 were erroneously recorded as $724 in the cash journals.
• Deposits in transit not recorded by the bank total $425.
• Bank debit memo for service charges is $35.
• Bank credit memo for note collected is $2,475, including $75 interest.
• Bank debit memo for an NSF check is $256.
• Outstanding checks amount to $1,860.

Bank Reconciliation Process - Bank Section

• Starts with the cash balance according to the bank statement ($7,735).
• Deposits in transit ($425) are added to the bank balance.
• Outstanding checks ($1,860) are deducted from the bank balance.
• Adjusted balance is calculated as $7,735 + $425 - $1,860 = $6,300.

Bank Reconciliation Process - Company Section

• Starts with the cash balance according to the books ($4,098).
• Credit memos, such as notes collected by the bank ($2,475), are added.
• An error where cash sales of $742 were recorded as $724 requires an addition of $18.
• Debit memos, such as bank service charges ($35) and NSF checks ($256), are deducted.
• Adjusted balance for the company section is $4,098 + $2,475 + $18 - $35 - $256 = $6,300.
• The adjusted balances for the bank and company sections should be equal.

Journalizing the Company Section

• Adjustments made in the company section of the bank reconciliation must be journalized.
• Four entries are needed: note collected, error correction, bank service charge, and NSF check.
• All transactions are recorded on June 30.
• Notes receivable collection increases cash.
• Cash is debited for $2,475, and notes receivable is credited for $2,475.
• Error in recording cash sales increases cash.
• Cash is debited for $18, and sales are credited for $18.

Debit Memos

• NSF check requires reinstating accounts receivable.
• Accounts receivable is debited for $256, and cash is credited for $256.
• Bank service charge is recorded as an expense, increasing expenses.
• Bank service expense is debited for $35, and cash is credited for $35.
• Cash decreases for debit memos.