Lesson notes Lesson 12: Internal Controls and Business Ethics Learning objectives 1.Explain the fundamental principles of internal control. 2.Define, explain the purpose, and identify the principles of internal accounting control. 3.Apply internal control to cash. 4.Explain and record petty cash fund transactions. 5.Identify control features. 6.Prepare a bank reconciliation7.Explain the fundamental principles of internal control. Teaching hours Students major in accounting: 4 hours Others: 2 hours Teaching contents: Opening story China Aviation Oil (Singapore) Corp., an overseas arm of China's main jet-fuel supplier, revealed the end of 2004 that it has racked up about $550 million in trading-related losses. 2. Define internal control Internal control is the organizational plan and all the related measures that an entity adopts to Safeguard assets, Encourage adherence to company policies, Promote operational efficiency, and Ensure accurate and reliable accounting records. Management has primary responsibility for the financial statements. Exhibit 7-1 is an excerpt from the Responsibility for Consolidated Financial Statements of Lands’ End. ERM 3. Identify the characteristics of an effective system of internal control (1)Competent, reliable, and ethical personnel—Attract top-quality employees, train them well, and supervise them. (2)Assignment of responsibilities—Each employee is assigned certain responsibilities (often defined in the organizational chart). (3)Proper authorization—An organization generally has a written set of rules that outlines approved procedures. Tasks that fall outside this set of procedures may be performed only if properly authorized. (4)Separation of duties—Dividing responsibilities for transactions limits the chances for fraud and promotes accuracy of the accounting records. Separation of duties may be divided into four parts: Separation of operations from accounting—The entire accounting function should be completely separate from operating departments. Separation of custody of assets from accounting—Accountants should not have access to assets, and those that have access to assets (such as the cashier) should not have access to the accounting records. Separation of authorization of transactions from the custody of related assets—People who authorize transactions should not handle the related asset. Separation of duties within the accounting function—Different people should perform the various phases of accounting to minimize errors and opportunities for fraud. (5)Internal and external audits—Internal and external auditors identify weaknesses in internal control. Internal auditors are employees. External auditors are employed by accounting firms that are hired by a business to examine the financial statements. (6)Documents and records—Business documents should be prenumbered to call attention to a missing document. (7)Electronic devices and computer controls—Accounting systems are relying on the computer to perform basic functions; and therefore, programmers become the focus for internal controls. Businesses use other electronic devices to help protect assets and control operations, such as inventory sensors. (8)Other controls—Businesses often use controls to protect assets such as fireproof vaults (to protect documents), burglar alarms (to protect property), point-of-sale terminals (to protect cash). Fidelity bonds insure the company against theft by an employee. Mandatory vacations and job rotation enhances morale and helps keep employees honest. (9)e-Commerce creates some new risks such as protection confidential information. 1)Some pitfalls include: a.Stolen credit-card numbers that can be used by authorized people. b.Computer viruses (that reproduce themselves) and Trojan horses (that do not reproduce) are vicious programs that can destroy or alter data and/or infect word-procession files. c.Hackers can impersonate legitimate businesses on the web and solicit confidential data from unsuspecting people. 2)Two standard techniques are used to secure e-commerce data. a.Encryption rearranges text messages by some mathematical process so that the message cannot be read by anyone who does not know the process. b.Firewalls limit access to a local network by blocking intruders. (10)There are some limitations of internal control procedures. 1)Internal control systems can be thwarted by collusion between two or more people working together to defraud the firm. 2)An overly complex internal control system may be inefficient. (12)The bank account is a control device because banks have established practices for safeguarding cash. 1)Banks provide depositors with detailed records of cash transactions. These records include: a.A signature card, to ensure that only an authorized person has access to the account. b.Deposit tickets, to maintain a record of amounts deposited. c.Checks, to maintain a record of monies withdrawn from the bank; includes the date of the check, the name of the payee, and the signature of the maker. d.Bank statements, to show the monthly activity in an account. Canceled checks, checks that have cleared the bank, are usually included in the bank statement. Electronic funds transfer (EFT) are paperless transactions that transfer cash to or from a bank account. The bank statement lists EFT transactions. 2)The bank reconciliation explains the differences between the bank statement balance and the general ledger balance of cash. (Exhibit 7-5 illustrates the Cash account.) a.Items recorded by the company but not yet recorded by the bank include: Deposits in transit—Money that has been deposited by the company but not yet recorded by the bank. Outstanding checks—Checks that have been issued by the company but not yet paid by the bank. b.Items recorded by the bank but not yet recorded by the company include: Bank collections—Money collected by the bank on behalf of its customers. Some companies use a lock-box system where customers make payments directly to the bank to reduce theft. EFT—The bank statement may include EFT’s that the company has not yet recorded. Service charges—Fees that the bank charges for certain services and are not known by the depositor until the bank statement is received. Interest revenue earned on the checking account—The amount of interest earned may not be known until the bank statement is received. Nonsufficient funds checks (NSF)—NSF checks received from customers and returned to the payee; they are sometimes included in the bank statement Checks collected, deposited, and returned to payee by the bank for reasons other than NSF—The bank may return checks because the account has closed, the check is too old, the signature is not authorized, the check has been altered, or the check form is improper. Check printing charge—A fee that the bank charges for printing checks. c.Errors may be made by either the bank or the company. 4. Prepare a bank reconciliation and the related journal entries (1)The following adjustments are made to the balance per bank. (Exhibit 7-7 is an example of a bank reconciliation.) Balance per bank XX Add: Deposits in transit XX XX Less: Outstanding checks (XX) Adjusted bank balance XX (2)The following adjustments are made to the balance per books. Balance per books XX Add: EFT receipt XX Bank collection XX Interest revenue XX XX Less: Service charge XX NSF XX EFT payment XX Check printing charge XX Other bank charges XX XX Adjusted book balance XX (3)Errors that are made by the bank are adjustments to the balance per bank. Errors that are made on the books are adjustments to the balance per books. (4)Adjusting journal entries are required for every adjustment to the book’s balance and are illustrated below: 1) Bank collection Cash XX Notes Receivable XX Interest Revenue XX 2) Interest revenue Cash XX Interest Revenue XX3) Service charge Miscellaneous Expense XX Cash XX 4) NSF check Account Receivable XX Cash XX 5) EFT—an EFT can be used for various transactions. The account, other than Cash, that is involved will depend on the situation. Receipt Payment Cash XX Various Accounts XX Various Accounts XX Cash XX 6) An adjusting entry for errors is made only when the error affects the book side of the reconciliation. (5)Owners and managers of small businesses do not have the luxury of separation of duties. The bank reconciliation can be used to help control cash. 5. Apply internal controls to cash receipts (1)Internal control over cash receipts ensures that all cash is deposited and that the accounting records are correct. (2)Point-of-sale terminals (cash registers) can provide control for cash receipts over the counter. 1)The register should be positioned so that the customer can see the amounts entered. 2)A receipt should be issued for each sale recorded by the register. 3)The cash drawer should open only when the clerk enters an amount so that all transactions will be recorded on the register tape. 4)The merchandise should be priced at “uneven” amounts to require that the clerk make change from the cash drawer. 5)The cashier should deposit the cash, with the register tape being sent to the accounting department. (3)A mailroom employee who compares the amount of the check with the remittance advice should handle cash received in the mail. 1)The remittance advices are forwarded to the accounting department and the checks are forwarded to the cashier. 2)The controller then compares the cash receipts with the control tape from the mailroom, the bank deposit slip from the cashier, and the debit to Cash from the accounting department. 3)Many companies use a lock-box system to separate cash duties and establish control over receipts. Customers send their checks directly to the bank. (4)A Cash Short and Over account is used to record shortages or overages in the daily cash sales. The balance of this account should be small. 6. Apply internal controls to cash payments (1)Internal control over cash payments is at least as important as controlling cash receipts. (2)Checks are an important control because a check acts as a source document and requires an authorized signature. (3)The purchasing process, requires the following steps. 1)Sales department prepares a purchase requisition. 2) The purchasing department locates the merchandise and prepares a purchase order. 3)The supplier fills the order, ships the goods, and mails an invoice to the purchaser. 4)When the goods arrive, a receiving report is prepared. 5)The accounting department combines all the documents, checks them for accuracy, and forwards this disbursement packet to the appropriate officer for approval and payment. 6)Before payment, the documents should be compared to ensure that the business pays cash only for the goods ordered and received. A voucher, a document that authorizes payment, is prepared. (4)Establishing a petty cash fund allows control over expenditures too small to pay by check. Introduction to the Current Situations (How Do Those Ethic Issues Stand Out in Modern Business World?) There is such an unprecedented sense of distrust in the business community today, on the part of the American public, perhaps it is best to ask why there was such a level of trust in the legal ethics of business during the boom period of the 1990s. Of course, the escalating profits investors were reaping may seem to be the main reasons for this misplaced trust and confidence, but there was also a sense that American business was comprehensible and amenable to the ordinary investor. The widespread allegations regarding insider trading and accounting fraud, as well as revelations that corporations such as Enron (and indeed, many of the poorly conceived internet bomb website creations) were in fact profitable and extant only on paper have created a sense that no one in the ordinary populace can either understand or trust business without specialized insider information and advice. Revelations of the abuse of executive perks at Tyco have also attracted the world’s focus on the issues of business and accounting ethics. Some quotes from the celebrities At this moment, America’s highest economic need is higher ethical standards --- standards enforced by strict laws and upheld by responsible business leaders. George W. Bush, Corporate Responsibility speech July 9,2002 There are two levers to set a man in motion, fear and self-interest. Napoleon B. What does PROFESSIONAL AND ACCOUNTING ETHICS mean to us? The boom of the 90's has changed the business environment in ways that will require a reshaping of corporate leadership. Financial scandals and out-of-hand executive compensation demonstrate not only a lapse of ethics and unprecedented greed, but also a disdain for the rule of law. Thus, the most pressing leadership issue for today is how to ensure that corporate officers behave in an ethical manner. Because investors and creditors place great reliance on financial statements in making their investment and credit decisions, it is imperative that the financial reporting process be truthful and dependable.? Accountants are expected to behave in an entirely ethical fashion, and this is generally the case.? To help insure integrity in the reporting process, the profession has adopted a code of ethics to which its licensed members must adhere.? In addition, checks and balances via the audit process, government oversight, and the ever vigilant "plaintiff's attorney" all serve a vital role in providing additional safeguards against the errant accountant.? If you are preparing to enter the accounting profession, you should do so with the intention of behaving with honor and integrity; if you are not planning to enter the profession, you will come to expect that the accountants who you hire and entrust with your most confidential financial information to act in a completely ethical way. Two key legal steps that must be taken to reestablish trust in the business community upon investors are limiting the ability of insiders to profit from insider trading tips and greater accountability in the accounting field. CEO focuses on boosting the corporation's daily share price or concentrates on building long-term corporate value. Current compensation practices encourage not only short-term behavior but also promote excessive risk-taking and aggressive accounting methods that overstate earnings to boost pay. Legislation is at least trying to tackle the accounting irregularities issues caused by unethical executives. President Bush signed into law the Sarbanes-Oxley Act of 2002 in July. Functions and Purposes of Accounting Ethics No matter how many regulations are imposed, unethical individuals and organizations will find new and innovative ways to circumvent them. Professional and accounting ethics can direct business people to abide by a code of conduct that facilitates, if not encourages, public confidence in their products and services. In the accounting field, professional organizations such as the AICPA, IMA, maintain and enforce a code of professional conduct for public accountants. They recognize the accounting profession's responsibility to provide ethical guidelines to its members. The purpose of ethics in business is to direct business people to abide by a code of conduct that facilitates, if not encourages, public confidence in their products and services. In the accounting field, the AICPA maintains and enforces a code of professional conduct for public accountants. The Institute of Management Accountants (IMA) and the Institute of Internal Auditors (IIA) also maintain a code of ethics. Professional accounting organizations recognize the accounting profession's responsibility to provide ethical guidelines to its members. Can One Person Make A Difference? A Japanese proverb states: "The reputation of a thousand years may be determined by the conduct of one hour." The actions of just one person have even changed the course of a nation. Edward Everett Hale wrote: ? I am only one. But still I am one. I cannot do everything, But still I can do something; And because I cannot do everything I will not refuse to do the something that I can do. Summary of This Lesson Ethical issues have become an unprecedented topic of business community today. The most pressing leadership issue for today is how to ensure that corporate officers behave in an ethical manner. Professional and accounting ethics can direct business people to abide by a code of conduct that facilitates, if not encourages, public confidence in their products and services. Case for Open Discussion HOW DO YOU MEASURE SUCCESS? A popular story recounts a meeting that took place at the Edgewater Beach Hotel in Chicago in 1923. Attending this meeting were nine of the richest men in the world at that time: (1) Charles Schwab, President of the world's largest independent steel company; (2) Samuel Insull, President of the world's largest utility company; (3) Howard Hopson, President of the largest gas firm; (4) Arthur Cutten, the greatest wheat speculator; (5) Richard Whitney, President of the New York Stock Exchange; (6) Albert Fall, member of the President's Cabinet; (7) Leon Frazier, President of the Bank of International Settlements; (8) Jessie Livermore, the greatest speculator in the Stock Market; and (9) Ivar Kreuger, head of the company with the most widely distributed securities in the world. Twenty-five years later, (1) Charles Schwab had died in bankruptcy, having lived on borrowed money for five years before his death. (2) Samuel Insull had died virtually penniless after spending some time as a fugitive from justice. (3) Howard Hopson was insane. (4) Arthur Cutten died overseas, broke. (5) Richard Whitney had spent time in Sing-Sing. (6) Albert Fall was released from prison so he could die at home. (7) Leon Fraizer, (8) Jessie Livermore, and (9) Ivar Kreuger each died by suicide. Measured by wealth and power these men achieved success, at least temporarily. Making a lot of money may be an acceptable goal, but money most assuredly does not guarantee a truly successful life. Many people think of fame and fortune when they measure success. However, at some point in life, most people come to realize that inner peace and soul-deep satisfaction come not from fame and fortune, but having lived a life based on integrity and noble character. President Lincoln put it this way: “Honor is better than honors.” At a Congressional Hearing on ethics in July 2002, Truett Cathy, founder of Chik-Fil-A, quoted Proverbs 22:1: "A good name is more desirable than great riches; to be esteemed is better than silver or gold." In the final analysis, living an honorable life really is more satisfying than fame and fortune. How do you measure success? Suggested questions: What ethic lessons can you infer from this case story? How can an accountant give a well-balanced treatment to the ethic issues in his or her professional practices? What is the relationship(s) between the ethic quality and the professional ability and the actual performances of an accountant? 2)The entry to establish the fund is: Petty Cash XX Cash in Bank XX 3)A petty cash ticket whenever a disbursement is made from petty cash. No journal entry is made at this time. 4)When the fund is replenished, all petty cash payments are recorded in a summary entry such as the one illustrated below: Office Supplies XX Postage Expense XX Delivery Expense XX Cash Short and Over XX Cash in Bank XX 7. Make ethical judgements in business (1)Most large companies have a code of ethics designed to encourage employees to act ethically. (2)Accountants who are members of the AICPA must also abide by the AICPA Code of Professional Ethics. Accountants who are members of the IMA must also abide by the Standards of Ethical Conduct for Management Accountants. (3)The following framework, found in the Decision Guidelines, is a guide to making ethical decisions. 1)Determine the facts. 2)Identify the ethical issues. 3)Specify the alternatives. 4)Identify the people involved. 5)Assess the possible outcomes. 6)Make the decision. (4)External controls, such as IRS audits, loan agreements, U.S. laws, also encourage ethical behavior.