Internal control, cash and receivables

Internal control is a process designed by a company to establish the reliability of the accounting records and financial statements in accordance with generally accepted accounting principles (GAAP) and to ensure that the company’s assets are protected. Management must assess its needs for internal controls, establish its responsibility for them, and engage auditors of them, if required.

Buying and selling, the principal transactions of merchandising businesses involve assets – cash, account receivable, and merchandise inventory – that are vulnerable to theft and embezzlement. Cash and inventory can be fairly easy to steal. The potential for embezzlement exist because the large number of transactions that are usually involved in merchandising businesses makes monitoring the accounting records difficult. If that company does not take steps to protect its assets, it can suffer high losses of both cash and inventory. Management’s responsibility is to establish an environment, accounting systems, and internal control procedures that will protect the company’s assets.

Management is responsible for establishing a satisfactory system of internal controls. Such a system includes all the policies and procedures needed to ensure the reliability of financial reporting, compliance with laws and regulations, and the effectiveness and efficiency of operations. In other words, management must safeguard the firm’s assets, ensure that reliability of its accounting records, and see that its employees comply with all legal requirements and operate the firms to the best advantage of its owners.

Components of Internal Control:

1. Control environment is created by management’s overall attitude, awareness, and actions. For example, the manager of retail store should train employees to follow prescribed procedures for handling cash sales, credit card sales, and returns and refunds.

2. Risk assessment involves identifying areas in which risks of loss of assets or inaccuracies in accounting records are high so that adequate controls can be implemented. Among the greater risks in retail store are that employees may steal cash and customers may steal goods.

3. Information and communication pertains to the accounting system established by management – to the way the system gathers and treats information about the company’s transactions and to how it communicates individual responsibilities within the system. Employees must understand exactly what their functions are.

4. Control activities are the policies and procedures management puts in place to see that its directives are carried out.

5. Monitoring involves management’s regular assessment of the quality of internal control, including periodic review of compliance with all policies and procedures.

No system of internal controls without weakness. As long as people perform control procedures, an internal control system will be vulnerable to human error. Errors can arise from misunderstandings, mistakes in judgment, carelessness, distraction, or fatigue.

The management of cash and accounts and notes receivable is critical to maintaining adequate liquidity. These assets are important components of the operating cycle, which also includes inventories and accounts payable. In dealing with cash and receivables, management must address five key issues: managing cash needs, setting credit policies, evaluating the level of accounts receivable, financing receivables, and making ethical estimates of credit losses.

On the balance sheet, cash usually consist of currency and coins on hand checks and money orders from customers, and deposits in checking and savings accounts. Cash is the most liquid of all assets and the most readily available to pay debts. Cash may include compensating balance – is a minimum amount that a bank requires a company to keep in its bank account as part of a credit-granting arrangement. Such arrangement restricts cash; in effect, it increases the interest on the loan and reduces a companies that have compensating balances to disclose the amounts involved.

Like cash, accounts receivable and notes receivable are the major types of short-term financial assets. Both kinds of receivables result from extending credit to individual customers or to other companies.

An effective system of internal control has five interrelated components:

1.Control environment: is created by management’soverall attitude, awareness, and actions. It encompasses a company’s ethics,philosophy and operating style, organizational structure, method of assigningauthority and responsibility, and personnel policies and practices.

2. Risk assessment: involves identifying areas in which risks of loss of assets or inaccuracies in accounting records are high so that adequate controls can be implemented

3.Information and communication: pertains to the accounting system established by management—to the way thesystem gathers and treats information about the company’s transaction sand to how it communicates individual responsibilities within the system.Employees must understand exactly what their functions are.

4.Control activities: are the policies and procedures management puts in place to see that its directives are carried out. (Control activi-ties are discussed in more detail below.) 5.Monitoring: involves management’s regular assessment of the quality of internal control, including periodic review of compliance with all policies and procedures. Large companies often have a staff of internal audi-tors who review the company’s system of internal control to determine if it is working properly and if procedures are being followed. In smaller businesses,owners and managers conduct these reviews.

Control activities are a very important way of implementing internal control.

Control activities include the following:1. Authorization: means the approval of certain transaction sand activities. 2.Recording transactions: To establish accountability for assets, all transactionsshould be recorded.

3.Documents and records: must be properly recorded-using prenumbered invoices and other documents is a way of ensuring that all transactions are recorded.4.Physical controls: are controls that limit access to assets.5.Periodic independent verification: Example-are periodic counts of physical inventory and reconciliations of monthly bank statements.6.Separation of duties: means that no one person should authorize transactions, handle assets, or keep records of assets. For ex,in a well-managed electronics store, each employee oversees only a single part of a transaction7.Sound personnel practices:

include adequate supervision, rotation of key people among different jobs,insistence that employees take vacations, and bonding of personnel whohandle cash or inventory.Bonding is the process of carefully checking an employee’s background and insuring the company against theft by that person.

CASH On the balance sheet,cash usually consists of currency and coins on hand, check sand money orders from customers, and deposits in checking and savings accounts.Cash is the most liquid of all assets and the most readily available to pay debts. It is central to the operating cycle because all operating transactions eventually use or generate cash.Cash may include a compensating balance, an amount that is not entirely free to be spent. A compensating balance is a minimum amount that a bank requires a company to keep in its bank account as part of a credit-granting arrangement. If these investments have a term of 90 days or less when they are purchased, they are called cash equivalents because the funds revert to cash so quickly they are treated as cash on the balance sheet. Cash control – through Bank reconciliation, imprest systems (petty cash, checks), banking services ‘(ATM, ecommerce systems.)

Like cash, accounts receivable and notes receivable are major types of short-term financial assets. Both kinds of receivables result from extending credit to individual customers or to other companies. accounts receivable are the short-term financial assetsof a wholesaler or retailer that arise from sales on credit. This type of credit isoften called trade credit. Terms of trade credit usually range from 5 to 60 days,depending on industry practice. For some companies that sell to consumers,installment accounts receivable which allow the buyer to make a series of time payments.

Financing Receivables. 1. Companies can also raise funds by selling or transferring accounts receiv-able to another entity, called afactor The sale or transfer of accounts receivable, called factoring, can be done with or without recourse.With recourse means that the seller of the receivables is liable to the factor (i.e., the purchaser) if a receivable cannot be collected.Without recourse means that the factor bears any losses from unpaid accounts .2. Set up funds to promote credit sales. 3. Under securitization, a company groups its receivables in batches and sells them at a discount to companies and investors

4. is to sell promissory notes, held as notes receivable, to a financial lender, usually a bank. This practice is called discounting because the bank derives its profit by deducting the interest from the maturity value of the note.

The accounts of such BAD customers are called uncollectible accounts, or bad debts, and they are expenses of selling on credit. To match these expenses, or losses, to the revenues they help generate,they should be recognized at the time credit sales are made.

2 ways of recognition of LOSS on Acc Rec:Under the 1. allowance method, losses from bad debts are matched against the sales they help to produce. Allowance Credited, Uncollect Accounts Exp Debited. Allowance for Uncollectible Accounts appears on the balance sheet as a contra account that is deducted from accounts receivable.

2. Accounts Receivable Aging Method.The accounts receivable aging method asks the question, How much of the ending balance of accounts receivable will not be collected? With this method, the ending balance of Allowance for Uncollectible Accounts is determined directly through an analysis of accounts receivable. The difference between the amount deter-mined to be uncollectible and the actual balance of Allowance for Uncollectible Accounts is the expense for the period.

 

69. Current & long term Liab.

Ethical reporting of Liab requires that they be properly recognized, valued, classified, & disclosed. A liability should be recognized (recorded) at the time it is incurred. However, for accrued & estimated Liab, it is necessary to make adjusting entries at the end of an accounting period. Contracts representing future obligations are not recorded as Liab until they become current obligations.

Current Liab are valued at the actual or estimated amount of money necessary to satisfy the obligation or at the fair market value of the goods or services that must be delivered.

Current Liab are obligations expected to be satisfied within one year or the normal operating cycle, whichever is longer. They are normally paid out of current assets or with cash generated from operations. Long-term Liab are obligations due beyond one year or the normal operating cycle.Supplemental disclosure of some Liab may be required in the notes to the financial statements—for example, when a company has special credit arrangements that can influence potential investors’ decisions.

1. Definitely determinable Liab are obligations that can be measured exactly. They include accounts payable, bank loans & commercial paper, notes payable, accrued Liab, dividends payable, sales & excise taxes payable, current portions of long-term debt, payroll Liab, & unearned revenues.

2. Estimated Liab are definite obligations, but the amount of the obligations must be estimated at the balance sheet date because the exact figure will not be known until a future date. Examples of estimated Liab are corporate income taxes, property taxes, promotional costs, product warranties, & vacation pay.

Businesses are required to disclose contingent Liab & commitments in the notes to their financial statements.

a A contingent liability is a potential liability that may or may not become an actual liability. The uncertainty about its outcome is settled when a future event does or does not occur. Contingent Liab arise from things like pending lawsuits, tax disputes, & failure to follow government regulations. Two conditions must be met before a contingency is entered in the accounting records: the liability must be probable, & it can be reasonably estimated.

b. A commitment is a legal obligation that does not qualify for recognition as a liability. Leases & purchase agreements are the most common examples of commitments.

Payables turnover= COGS + - change in INV/ Av Acc Pay № of times the Comp pays Acc Pay during acc period

Days pay = 365 / Pay turnover How long it takes to pay

Long-term liabilities are obligations that are expected to be paid after one year and are often in the form of bonds or long-term notes.

Long-term debt must be paid at maturity and usually requires periodic payments of interest.

Debt financing is not always in a company’s best interest.It may entail the following:

Financial risk. A high level of debt exposes a company to financial risk. A company whose plans for earnings do not pan out, whose operations are subject to the ups and downs of the economy, or whose cash flow is weak may be unable to pay the principal amount of its debt at the maturity date or even to make periodic interest payments. Creditors can then force the company into bankruptcy

Negative financial leverage. Financial leverage can work against a company if the earnings from its investments do not exceed its interest payments

A bond is a security, usually long term, representing money that a corporation borrows from the investing public. 4 types:

o Secured bonds have specific assets of the issuer pledged as collateral for the bonds.

o Unsecured bonds are issued against the general credit of the borrower.

o Convertible bonds can be converted into common stock at the bondholder’s option.

o The conversion often gives bondholders an opportunity to benefit if the market price of the common stock increases substantially.

o For the issuer, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities that do not have a conversion option.

o Callable bonds are subject to retirement at a stated dollar amount prior to maturity at the option of the issuer.

· Registered bonds are issued in the names of the bondholders. pays interest by check on the interest payment date. Most bonds today are registered.

· Coupon bonds are not registered with the organization. Instead, they bear coupons stating the amount of interest due and the payment date. The bondholder removes the coupons from the bonds on the interest payment dates and presents them at a bank for collection