Chapter 6 Notes (Part 1) COMM 320 PDF

COMM 320 Chapter Six Cash and Accounts Receivable (Part 1) Cash-to-Cash Cycle You will often hear management discussing ways to shorten an entity’s cash-to-cash cycle. This cycle is the time period between when a business pays cash to its suppliers for inventory and receives cash from...

COMM 320 Chapter Six Cash and Accounts Receivable (Part 1) Cash-to-Cash Cycle You will often hear management discussing ways to shorten an entity’s cash-to-cash cycle. This cycle is the time period between when a business pays cash to its suppliers for inventory and receives cash from its customers. The concept is used to determine the amount of cash needed to fund ongoing operations, and is a key factor in estimating financing requirements. Clearly the goal is to minimize this cycle. As one would expect the cash-to-cash cycles are dependent on the type of business under review. A fruit and vegetable store has a very short cash-to-cash cycle whereas a winery has a much longer cash-to-cash cycle. Internal controls Management is responsible for the preparation of timely, reliable and complete financial information. The Board of Directors is responsible for ensuring that processes are in place for maintaining the integrity of the company’s accounting system and the financial statement preparation and reporting. This is an important objective of internal controls. Other objectives include ensuring the efficient use of company assets and complying with laws and regulations. The larger the entity, the more important controls become – an owner cannot be overseeing all aspects of a large organization. © Scott M. Sinclair, FCPA, FCA 2022 1  COMM 320 Internal controls continued The main principles of effective internal control are: Ensuring adequate physical controls Assignment of Responsibilities Segregating incompatible duties Independent verification of transactions Documentation While these are relatively straight forward, it is helpful to think about the consequences of not implementing internal controls. For example, assume one person in the company has complete responsibility for the all aspects of a transaction (i.e., initiation, processing, accounting, payment, etc.). Such a situation provides that person with the opportunity to commit fraud. If a supervisor or manager never reviewed or verified the transactions, there is little likelihood of the fraud ever being discovered. While internal controls are necessary, they are not without the following limitations: they must be cost efficient they are carried out by humans and therefore subject to human error they can be overridden by management they can be circumvented by collusion – i.e., two or more employees working together they can be ineffective for transactions not contemplated when the systems were initially established – i.e., unusual or infrequent transactions and changing circumstances © Scott M. Sinclair, FCPA, FCA 2022 2  COMM 320 As we work through the remaining chapters, think about the importance of internal controls in each area of discussion. I will include further comments and examples as we work through each topic. CASH A company must generate sufficient cash to sustain itself and expend that cash to pay employees and suppliers. Ensuring that sufficient cash is on hand at all times requires careful monitoring. As cash is a valuable and liquid asset, management would be wise to ensure it is well protected. Segregation of duties is very important in the handling of, and accounting, for cash. Basic principles of internal control as applied to cash would include: daily depositing of all cash and cheques restricting access to cash approval of all invoices by management payment of all expenditures by cheque requiring two signatures on each cheque the verification of cash balances on an ongoing basis. Of particular interest is the verification of cash. An important internal control for cash is a periodic bank reconciliation. It is a comparison of the cash per the accounting records of the entity to those of the entity’s bank. Before commencing our discussion, it is important to understand that if the entity and the bank have each recorded all transactions simultaneously without error, then the two balances would always agree. Such circumstances seldom arise. Most differences arise from either timing differences or errors. Timing differences arise because there are lags between the time amounts are recorded in the accounting records and the date they are © Scott M. Sinclair, FCPA, FCA 2022 3  COMM 320 processed by the bank. For example, a cheque is prepared and recorded on December 29, 2022 and mailed to a supplier. The cheque may take 7-10 days to make its way to the bank – the bank will not process it until 2023 – the next fiscal year. Such differences are reasonable and require no adjustments. Timing differences may have to be investigated if they remain outstanding for a significant period. Errors can result from bank and/or entity mistakes such as incorrect recording of cheques and deposits, cashing or depositing of cheques that do not belong to the entity. The bank must amend its records for identified bank errors. The entity must amend its accounting records for entity errors and items not yet recorded. Let’s review the definitions of the important terms to help you better understand the process. Items that affect the balance per the bank Outstanding deposit – a deposit recorded by the entity but not yet processed by the bank. (Timing Difference) Outstanding cheque – a cheque written and recorded by the entity but not yet processed by the bank. (Timing Difference) Bank error – a misstatement which either increases or decreases the records of the bank– e.g., a cheque of another customer of the bank is charged to the entity’s bank account or a deposit made to the entity’s bank account which belongs to another customer of the bank. (Error) Please note that none of the above items will ever result in a journal entry on the company’s books. The bank must amend its records. © Scott M. Sinclair, FCPA, FCA 2022 4  COMM 320 Items that affect the Cash per the Entity’s Accounting Records Items recorded on the bank statement that have not been recorded on the entity’s records. Examples include deposits collected by the bank or electronic payments paid by the bank or bank interest or account charges. NSF cheques – customer cheques received by the entity and deposited to the bank are subsequently determined to be worthless as the customer has insufficient funds to cover the cheque. Entity errors – items which have been incorrectly handled by the entity – e.g., cheques written but not recorded, cheques written for amounts which differ from the entries made in the entity’s records. The entity will have to prepare journal entries to ensure the transactions have been properly reflected in its accounting records. Bank Reconciliation Template A bank reconciliation is a time-consuming and picky exercise. Entity accounting records must be matched to each entry on the monthly bank statement. The reconciliation should be done frequently and ideally prepared by an individual not responsible for preparing or recording banking activates. A commonly used format for completing and organizing the reconciliation is presented on the next page: © Scott M. Sinclair, FCPA, FCA 2022 5  COMM 320 Company Name Template for a Bank Reconciliation As at Date Balance per bank statement $ Add: 1) Deposits in transit 2) Bank errors that removed funds from the bank account in error Deduct: 1) Outstanding cheques 2) Bank errors which increased bank account in error Adjusted Bank Balance $ Balance per Accounting Records $ Add: 1) Deposits found on Bank statement but not yet recorded by entity 2) Entity accounting errors that mistakenly reduced Entity’s cash accounting records Less: 1) Payments found on Bank statement which have not yet been recorded on Entity’s accounting records 2) NSF cheques 3) Entity accounting errors which have mistakenly increased Entity’s cash accounting records Adjusted Accounting Records $ *The two adjusted balances must balance © Scott M. Sinclair, FCPA, FCA 2022 6  COMM 320 Journal entries arising from a bank reconciliation As previously noted, the only journal entries to be recorded by the entity arise from items found in reconciling the Accounting Records side of the reconciliation. For example: A deposit listed on the bank statement but not in the entity’s accounting records must be recorded: Dr Cash 125 Cr Rental revenue 125 This records revenue received by the bank directly from one of the company’s tenants. Identification of an NSF cheque Dr Accounts Receivable 250 Cr Cash 250 In this example, the customer gave the company a worthless cheque. As a result, the company must reinstate the receivable and reduce the cash balance on its accounting records. It is a good idea to review your bank statements on a monthly basis to identify any errors or unusual transactions. © Scott M. Sinclair, FCPA, FCA 2022 7