Financial Accounting

Eleventh Edition
Global Edition

Chapter 5
Internal Control,
Cash, and
Receivables

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Course Overview
Details of common asset accounts:
➢Cash: Bank Reconciliation (This Lecture)
➢Receivables: Impairment & notes interests (This Lecture)
➢Inventory (Lecture 6)
➢Property, plant and equipment (Lecture 7)
Details of common liability accounts (Lecture 8)
Details of equity (Lecture 9)
Details of Statement of Cash Flow (Lecture 10)

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Learning Objectives
5.1 Understand the role of internal controls and
corporate governance (brief coverage, not in exam)
5.2 Apply internal controls over cash receipts and cash
payments
5.3 Prepare and use a bank reconciliation
5.4 Account for receivables and its potential
impairment
5.5 Evaluate a company’s ability to collect receivables

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Learning Objective 5.1
Understand the role of internal controls and corporate
governance

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Role of Internal Controls (1 of 3)
• Fraud
– Intentional misrepresentation of facts
– For the purpose of persuading another party to act
in a certain way
– Causes injury or damage to other parties

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Role of Internal Controls (2 of 3)
Common Types of Business Fraud
• Misappropriation of assets
– Committed by employees
– Theft of money or inventory
– Bribery and kickback schemes
– Overstate expense reimbursements
• Fraudulent financial reporting
– Committed by managers
– False and misleading journal entries
– Deceive investors and creditors
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Role of Internal Controls (3 of 3)
Internal Control
• Primary way to prevent, detect, and correct fraud

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Internal Control Procedures (1 of 5)
• Separation of Duties
1. Asset handling
2. Record keeping
3. Transaction approval

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Internal Control Procedures (2 of 5)
• Limited Access
– Only persons with custodial responsibilities are
authorized
– Lock-box system
– Physical access controls
– Password and encryption
• Proper Approvals

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Internal Control Procedures (3 of 5)
• Information Technology
Rely less on manual procedures and more on
information technology (automation).
– Improved accuracy and speed
– Examples:
▪ Vending or ticketing machine
▪ Electronic sensors (e.g. Amazon Go)

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Internal Control Procedures (4 of 5)
• Comparison and Compliance Monitoring
– Operating and cash budgets (benchmark)
– Exception reporting (deviation from benchmark)
– Audit
• Adequate Records
– Details of business transactions
– Hard copy documents or electronic
– Pre-numbered documents

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Internal Control Procedures (5 of 5)
The Limitations of Internal Control—Costs and
Benefits
• Ways to circumvent internal controls:
‒ Collusion: two or more people working together
‒ Management override
‒ Human limitations: fatigue and negligence
Additional controls: mandatory vacation or job rotation
Benefits of internal controls should always outweigh the
costs

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Learning Objective 5.2
Apply internal controls over cash receipts and cash
payments

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Apply Internal Controls Over Cash
Receipts and Cash Payments (1 of 4)
Cash requires specific internal controls because it is
easy to steal and to convert to other forms of wealth.

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Apply Internal Controls Over Cash
Receipts and Cash Payments (2 of 4)
Cash Receipts Over the Counter
• Point-of-sale terminals (automation, adequate records)
– Provide control over cash receipts
– Record sale, cost of item sold, and reduction to inventory
– Effective inventory control
• Customer issued a receipt as proof of purchase
• Sales associate turns in cash drawer at end of shift
– Combined with other cash and deposited
• Accounting department reconciles sales per terminal to cash in drawer
(separation of duties)

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Exhibit 5-6 Cash Receipts by Mail

Separation of duties; adequate records; limited access

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Apply Internal Controls Over Cash
Receipts and Cash Payments (3 of 4)
Internal Control over Cash Payments
• Companies make most payments by check (cheque).
This in an important internal control because it:
‒ Provides record of payment
‒ Must be signed by authorized official
‒ Is supported by evidence

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Apply Internal Controls Over Cash
Receipts and Cash Payments (4 of 4)
Controls over Purchase and Payment
• Split the following duties
– Purchasing goods
– Receiving goods
– Preparing check for payment
– Approval of payment

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Exhibit 5-7 Cash Payments by Check

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Exhibit 5-8 Payment Packet

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Learning Objective 5.3
Prepare and use a bank reconciliation

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Prepare and Use a Bank
Reconciliation (1 of 3)
• Documents used to control a bank account
include:
– Signature card
– Deposit ticket
– Check
– Bank Statement
– Bank Reconciliation

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Prepare and Use a Bank
Reconciliation (2 of 3)
• Bank Reconciliation
‒ Explanation for the differences between the book
(company’s cash records) and bank balance
‒ Differences due to time lag in recording
transactions
‒ Bank Side reconciliation: some transactions gone
through the accounting system have not been
processed by the bank
‒ Book Side reconciliation: some transactions
skipped the accounting system and have been
processed by the bank
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Prepare and Use a Bank
Reconciliation (3 of 3)
Preparing the Bank Reconciliation
• Bank Side • Book Side
– Deposits in transit – Bank collections
– Outstanding checks – Electronic funds transfers
(payments) – Service charge
– Bank errors – Interest revenue
– Non-sufficient funds
(NSF) checks
– Cost of printed checks
– Book errors
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Exhibit 5-12 Bank Reconciliation (1 of 3)
Bank Reconciliation (At month end, your bank statement shows a
balance of $5,900 and your Cash ledger shows a balance of $3,340)
Bank side:
1. Deposit in transit, $1,600. (deposit made but not yet shown on bank
statement)
2. Bank error: the bank deducted $100 for a check written by another
company. Add $100 to the bank balance.
3. Outstanding checks (payment) – total of $1,340

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Exhibit 5-12 Bank Reconciliation (2 of 3)
Book side:
4. EFT receipt of your dividend revenue earned on an investment, $900
5. Bank collection of your account receivable, $2,100.
6. Interest revenue earned on your bank balance, $30.
(4 - 6: someone paid the bank directly without/before informing you)
7. Book error: you recorded check no. 333 for $510. the amount you
actually paid on account was $150. add $360 to your book balance.
8. Bank service charge, $20.
9. NSF check from a customer, $50.
10. EFT payment (autopay) of insurance expense, $400.

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Exhibit 5-12 Bank Reconciliation (3 of 3)
Bank Reconciliation

• Next, you must journalize the Book side of the reconciliation

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Journalizing Transactions from the
Bank Reconciliation

• All transactions are against Cash account

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Summary of Various Reconciling
Items
• Bank Balance—Always
‒ Add deposits in transit.
‒ Subtract outstanding checks.
‒ Add or subtract corrections of bank errors.
• Book Balance—Always
‒ Add bank collection, interest revenue, and EFT
receipts.
‒ Subtract service charges, NSF checks, and EFT
payments.
‒ Add or subtract corrections of book errors.
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Report Cash on the Balance Sheet (1 of 2)
• Cash and Cash Equivalents
– Time deposits
– Certificates of deposit
– High-grade government securities (close to
maturity)

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Report Cash on the Balance Sheet (2 of 2)
Most public companies will include a footnote to their
financial statements such as the following:

Cash equivalents
All highly liquid investment with maturities of three
months or less at the date of purchase are classified as
cash equivalents.

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In-class exercise (S5-6)
The Cash account of Randell Corp. reported a balance of
$2,500 at 31 Oct. Included were outstanding checks
totaling $600 and a 31 Oct deposit of $350 that did not
appear on the bank statement.
The bank statement, which came from Park Bank, listed a 31
Oct balance of $3,280. Included in the bank balance was a
30 Oct collection of $560 on account from a customer who
pays the bank directly. The bank statement also shows a $20
service charge, $30 of interest revenue that Randell
earned on its bank balance, and an NSF check for $40.
Prepare a bank reconciliation to determine how much cash
Randell actually has at 31 Oct.

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In-class exercise (S5-6)
Bank Reconciliation, 31 Oct
BANK BOOK
Balance, 31 Oct $3,280 Balance, 31 Oct $2,500
Add: Add:
Deposit in transit 350 Bank collection 560
3,630 Interest revenue 30
3,090
Less:
Less: Service charge (20)
Outstanding check (600) NSF check (40)
Adjusted bank
$3,030 Adjusted book balance $3,030
balance

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Learning Objective 5.4
Account for receivables and its potential impairment

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Account for Receivables and its
Potential Impairment (1 of 12)
Types of Receivables
• Third most liquid asset (after cash and short-term
investments)
• Monetary claims against others
• Acquired by:
– Selling goods and services (accounts receivable)
– Lending money (notes receivable)
*for normal businesses, we do not discuss banks/financial
institutions in this course

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Account for Receivables and its
Potential Impairment (2 of 12)
Journal entries to record receivables

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Account for Receivables and its
Potential Impairment (3 of 12)
Accounts Receivable
• Current assets
• Also called trade receivables
• Serves as a control account
– Summarizes total receivable form all customers
– Subsidiary ledger kept with separate account for each
customer

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Account for Receivables and its
Potential Impairment (4 of 12)

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Account for Receivables and its
Potential Impairment (5 of 12)
Internal Controls Over Cash Collections on Account
• Separation of duties – opening mail, recording receipt, and
making deposits
• Separate cash handling and recording duties
– Bookkeeper should not handle cash
• Bank as a lock-box system

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Account for Receivables and its
Potential Impairment (6 of 12)
Accounting for Uncollectible Receivables
• The Problem: sometimes receivables could not be
collected (e.g. client bankrupts), how to record the loss?
Standard Method: Allowance Method
• Estimate based on company’s past collection experiences
• Record Uncollectible-Account Expense (Bad Debt
Expense)
• Set up Allowance for Uncollectible Accounts
– Contra-account of receivables
– Shows the amount the business expects not to collect
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Account for Receivables and its
Potential Impairment (7 of 12)
Allowance for Uncollectible Accounts
• Contra-account of receivables
• Shows the amount the business expects not to collect
• A contra-account has two distinguishing characteristics:
– Always has a companion account
in this case, Accounts Receivable
– Normal balance is opposite that of the companion
account
Accounts Receivable: Debit normal balance
Allowance for Uncollectible Accounts: Credit normal
balance
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Account for Receivables and its
Potential Impairment (8 of 12)
Set up Allowance for Uncollectible Accounts

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Account for Receivables and its
Potential Impairment (9 of 12)
Record Uncollectible-Account Expense

The recognition of uncollectible-account expense has impact on

balance sheet / income statement

-291 0 -291 (Bad Debt Expense)

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Exhibit 5-15 Age of Accounts
Receivables
Estimating Uncollectible Accounts from past collection
experiences: shows the ending balance of allowance

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Account for Receivables and its
Potential Impairment (10 of 12)
Writing Off Uncollectible Accounts: At the beginning of the
year, the company had these accounts receivable (in
thousands):

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Account for Receivables and its
Potential Impairment (11 of 12)
Writing Off Uncollectible Accounts. On 31 Jan, the
company’s credit department determines that it can’t collect
from Toys Kingdom and Hamleys. The company then writes
off the receivables from these customers:

The write-off has no impact on balance sheet / income statement:

Accounts Receivable: -12 0 0

Allowance: +12

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Account for Receivables and its
Potential Impairment (12 of 12)
Writing Off Uncollectible Accounts

The write-off has no impact on balance sheet / income statement

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Direct Write-Off Method (1 of 2)
• Not accepted accounting practice to account for
uncollectible receivables for financial statement purpose
• Sometimes used for income tax purpose
• Records expense when specific customer’s account
proves to be uncollectible
– No allowance for uncollectible → may overstate assets
on the balance sheet
– Fails to recognize uncollectible accounts in the same
period in which the related revenue is earned

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Direct Write-Off Method (2 of 2)
The journal entry to write off uncollectible accounts using the
direct write-off method is the same as allowance method:

The write-off has impact on balance sheet & income statement

Accounts Receivable: -12 0 -12 (Bad Debt Expense)

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Allowance Method vs
Direct Write-Off Method
Allowance for Doubtful Receivables account is introduced to
match the bad debt expense to the revenue of the same
period.

Allowance Method Direct Write-Off Method

Bad Debt Expense Bad Debt Expense
Allowance for Doubtful Receivables Accounts Receivable

Allowance for Doubtful Receivables

Accounts Receivable

The balance sheet is the same after writing off, the timing of bad
debt expense appearing on the income statement may be different.

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Computing Cash Collections from
Customers
Receivables typically hold five items:

If you know all other items except for collections, you can
compute collections by solving for X.

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Account for Notes Receivable (1 of 5)
Creditor Party to whom money is owed; lender
Debtor Party that borrowed and owes money; maker, borrower
Interest Cost of borrowing money; stated as annual percentage rate
Maturity Date Date at which debtor must pay the note
Maturity Value The sum of principal and interest
Principal Amount of money borrowed by the debtor
Term Length of time from when the note was signed to when
payment must be made

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Exhibit 5-16 Promissory Note

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Accounting for Notes Receivable (2 of 5)
Consider the promissory note in Exhibit 5-16. After Lauren
Holland signs the note, Rabobank gives her $1,000 cash.
The bank makes the following entry to record the loan.

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 Adjusting Entry

Accounting for Notes Receivable (3 of 5)

Rabobank earns interest revenue during September to
December. At December 31, 20X6 (period end), the bank
accrues 9% interest revenue for four months:

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Accounting for Notes Receivable (4 of 5)
Rabobank reports these amounts in its financial statement at
December 31, 20X6 as follows:

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Accounting for Notes Receivable (5 of 5)
The bank collects the note on February 28, 20X7.

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How to Speed up Cash Flow from
Receivables (1 of 4)
• Strategies to shorten credit cycle and collect cash more
quickly:
– Sales discounts for early payment
(e.g. pay 2% less within 30 days)
– Charge interest after a certain time period
– Emphasize credit card or bankcard sales
– Selling (Factoring) Receivables

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How to Speed up Cash Flow from
Receivables (2 of 4)
Credit Card or Bankcard Sales. Fujitsu sells computers for
$2,000, and the customer pays with a VISA card. Fujitsu
records the sale as follows:

The company offload the receivables to the credit card

company and receive cash immediately. In return, the
company has to pay credit card fee.
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How to Speed up Cash Flow from
Receivables (3 of 4)
• Factoring (Selling) Receivables
– Sells receivables to another company, a factor
– Factor pays discounted price for receivable and then
tries to collect from the customer to earn revenue
– Benefits company with immediate receipt of cash
– Expensive and lose control over collection
– Used by companies without other means to obtain
short-term financing, usually those with
▪ Weak or insufficient credit history (start-ups)
▪ Significant amount of debt

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Show How to Speed up Cash Flow
from Receivables (4 of 4)
Factoring (Selling) Receivables. A company wishes to
speed up cash flow and therefore sells $100,000 of accounts
receivables, receiving cash of $95,000. The record is as
follows (note the high cost!):

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Learning Objective 5.5
Evaluate a company’s ability to collect receivables

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 Evaluate a Company’s Ability To
Collect Receivables
Receivable Turnover
Measures a company’s effectiveness in collecting
receivables

*Sales should be net credit sales, but it is usually not available from
financial statements
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In-class exercise (S5-11)
The company started the year with accounts receivable
of $31,000 and an allowance for uncollectible accounts
of $4,200. During the year, the service revenues on
account totaled $157,000, and cash collections on
account totaled $121,000. The company also wrote off
uncollectible accounts receivable of $3,200. At the year-
end date, the aging of accounts receivable indicated
that the company will not collect $1,850 of its accounts
receivable.
Journalize the transactions and calculate the net-
receivables at the year end.

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In-class exercise (S5-11)
(a) Accounts Receivable 157,000
Sales Revenue 157,000

(b) Cash 121,000

Accounts Receivable 121,000

(c) Allowance for Uncollectible Accounts 3,200

Accounts Receivable 3,200

(d) Uncollectible-Account Expense 850

Allowance for Uncollectible Accounts 850

Ending AR = 31,000 + 157,000 – 121,000 – 3,200 = 63,800

Ending Allowance = 1,850 = Opening Allowance – Write offs + Expense
Uncollectible-Account Expense = 1,850 + 3,200 – 4,200 = 850
net AR = 63,800 – 1,850 = 61,950

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Chapter Summary
• At the period end, the cash balances from the bank
statement and the accounting records need to be
reconciliated, the process is called “Bank Reconciliation”
• Differences between the two records are due to the timing
of some transactions around period end
• After bank reconciliation, the balance should be the same
on bank side and book side
! Get familiar with the structure and keywords to do it fast
and accurately

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Chapter Summary
• Some portion of account receivables are expected to be
uncollectable, it is called bad debt expense
• In Allowance Method, the amount uncollectible needs to be
estimated at the period end and to be recognized into
Allowance of Uncollectible Accounts (a contra-asset
account), usually by using the age of account receivables
• When the receivables are confirmed to be uncollectible, an
entry is needed to write-down the account receivables
• In Allowance Method, the write-down has no impact on
total assets, which is different from the Direct Write-down
Method
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Course Overview
Details of common asset accounts:
➢Cash: Bank Reconciliation ✓
➢Receivables: Impairment & notes interests ✓
➢Inventory (Next Lecture)
➢Property, plant and equipment (Lecture 7)
Details of common liability accounts (Lecture 8)
Details of equity (Lecture 9)
Details of Statement of Cash Flow (Lecture 10)

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Course Overview
Financial Statement Analysis:
•Current Ratio
•Receivable Turnover

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Homework Assignments
• E5-23A, E5-24A
• Due 22 Oct, 11:59pm
• Upload to Blackboard
• Late submission is not accepted

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