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due that are paid later, such as for rent or utilities, this type of business is operating
almost entirely on a cash basis.
As organizations grow larger, their direct use of cash usually decreases. The
larger version of the above-mentioned retail store may make many of its sales
through the use of store-issued and bank credit cards. Although otherwise treated
as cash sales, these charges are receivables due per the larger store's accounting
records.
In larger organizations, virtually all business transactions are based on
recorded receivables and payables, rather than through the actual handling of
cash. What the larger organization considers to be cash is represented by
transaction balances in their various financial accounts. Only very special
legitimate business—such as a bank accepting retail customer cash deposits, or a
state government lottery authority—deals in substantial amounts of cash.
However, most businesses have only limited cash processes to handle the
relatively small amounts of cash needed for normal business purposes, such as
petty cash funds where small amounts of cash are maintained at various locations
to cover various small cash payments.
Cash, of course, is essential to pay for expenses such as the payroll and other
business costs (such as taxes). A publicly held corporation needs cash to pay for
dividends on its stock, and banks and lending agencies will require certain levels
of cash balances. Because cash in the bank has such a strong relationship with
other transaction cycles such as receivables or payables, an internal auditor
should have a good understanding of cash- related internal controls and processes.
(a) ACCOUNTING CONTROLS
A discussion of cash processes starts most logically with an identification of where
and why cash is handled in particular organization situations. Often, this
identification may lead to questions of whether a cash process is necessary or if it
might be handled differently. For example, is it really necessary that a salesperson
accept cash from customers or that some account collections are in cash? While
cash might be best in terms of accelerating and maximizing collections, different
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procedures can often eliminate the handling of cash and the risk of its improper
diversion. Any activities involving cash should be critically appraised to
determine if control compromises are justified because of other operational
considerations.
Internal audit should develop an understanding of the type and nature of the
organization's cash accounts that often require special control considerations. As
a matter of clarification, this cash is usually not maintained in the form of
currency but as an account recording cash transactions. For many organizations,
cash is maintained in five basic account types, as follows.
1. General Cash Account. This is the central bank account through which most
receipts from sales and collections pass, as well as disbursements for
purchases and expenses. Even though an organization may have a variety of
specialized cash accounts, all deposits and disbursements would normally be
made through this central, general account, with cash notification transactions
directed to other systems.
2. Branch Cash Accounts. Organizations with multiple locations will typically
have separate accounts at each of their outside locations. These accounts will
have the same attributes as the general account but will serve local or branch
operations.
3. Imprest Payroll Accounts. Payroll represents the major cash expense
for many organizations. Aside from a minimal balance maintained in this
account, at the start of each payroll period the organization would
prepare a check from its general account to transfer the total amount of
the payroll to the imprest payroll account. This improves controls and
reduces the time necessary to reconcile payroll account balances.
4. Imprest Petty Cash Funds. These are normally not bank accounts but
fixed amounts of cash placed under the control of various persons in the
organization for special cash transactions. For example, an
administrative assistant may retain a small amount of cash to dispense
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for such things as rolls and coffee for meetings. Petty cash funds are often
relatively small, and the person in charge replenishes them by submitting
receipts to cover the cash amounts disbursed.
5. Savings Accounts. Organizations typically place certain funds not
needed for day- to-day operations in longer-term cash or cash equivalent
accounts. These accounts earn interest but tie up the deposited money for
limited amounts of time. For example, an organization can place monies
in United States Treasury Bills that have a 90- day maturity and earn
interest over that period, or they can buy what is called commercial
paper, which pays interest based upon periods as short as overnight.
These deposits are considered to be the same as cash because they can be
easily sold with no market risk.
Cash for various purposes is usually maintained in accounts under one of
the above five general categories. Cash passes through these accounts
through the process of cash receipts, intermediary cash handling, and
custody activities, and leaves through the process of cash disbursements.
Internal audit should have a good understanding of the controls associated
with each of these general cash-handling areas.
(i) Receiving of Cash. Cash receipts may be in the form of checks mailed as
payments from billings, receipts from cash sales, or various types of bank
transfers. This cash is captured and deposited early in the cash receipts
processing cycle, and thereatter moves internally toward centralized cash
controls normally exercised by the organization. A key point to consider here
is that cash always has a time value. Customer checks as payments of bills
should always be deposited as soon as possible. Even if they are not deposited
in interest-bearing accounts, organizations may have agreed to maintain
certain average daily levels of balances and should deposit cash in those
accounts as soon as practicable.
Cash represents a major control risk to an organization. It can be
improperly diverted, and once diverted it is often difficult to trace because
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the cash itself is not separately identifiable. Thus, an organization must
establish strong controls over its overall cash processes, focusing both on
organization outsiders, to be sure that the cash received is what should be
received, and on insiders, to be sure that cash received is not improperly
diverted. The sooner controls can be established over cash received, the
better. Some form of receipt, such as a serially numbered document with one
copy to the outside party or the entry of the transaction on a cash register
with a serially numbered ticket of some kind, should be issued for the cash
received.
Ideally, any receipt of the cash should be linked to the relief of a previously
existing account, such as the collection of an accounts receivable with a debit to
cash and a credit to the requisite receivables account. Another illustration would
be the sale of merchandise controlled on an item-by-item inventory basis, where
the organization must account for its inventory or cash
Controls should be instituted to insure collection for any services
provided. This might mean giving the customer a cash sales slip, without
which the customer could not receive a service. It might mean physical
protection over merchandise or restricted entry to areas where these services
are rendered, as in the case of a theater. Appropriate internal controls over
cash require a segregation of duties, and this segregation-of-duties control
applies to all types of cash receipt controls.
Outside parties may be utilized as a further cash receipts control. A
customer can serve as a check on the action of the employee in a retail
environment, providing assurance that the employee rings up a cash receipt
on a point-of-sale register.
Cash receipts must always be separated from cash disbursements. In
smaller organizations, there is frequently pressure to use portions of the cash
received to cover current expenditures of one kind or another. This practice
should always be resisted. More effective controls and cleaner
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accountabilities will result when cash receipts and disbursements processes
are completely separated.
Cash receipts should always be channeled intact and promptly to
established central cash depositories. A day's receipts should be deposited
iptact as soon as possible after the cutoff for the day. If high volumes of cash
are received, consideration might be given to depositing the cash at several
times during the day. This is important for several reasons. First, any delay
results in a greater risk of theft or improper diversion. Second, checks might
be good upon receipt but not later. Third, it is important to be able to
identify a particular deposit with a given period of time. Finally, and most
important, undeposited cash is idle cash and is not contributing to the best
use of organization resources.
When the cash received is transferred to another organization unit, the
accountability of the transferor should be properly relieved and a new
accountability for the transferee clearly established. This is normally
accomplished by some type of a cash receipt or transfer record. Records by
which the accountabilities for cash are established and controlled should be
maintained by persons independent of the persons charged with the direct
accountability. Checks should be made periodically by an independent
person to verify that cash has been properly handled and accounted.
(ii) Cash Handling and Custody. Cash handling is interwoven to some extent
with both cash receiving and disbursements. Many of the handling and
custody issues here deal with cash as it resides in the five account types
described previously. When an organization has actual cash in its possession
at some point during its operations, there may be other control aspects that
can best be considered under the category of cash handling and custody.
Large amounts of cash retained by the organization create a risk of theft
by outsiders or even by employees, and physical safeguards over the cash
held within the organization should always be strong. In certain cases locked
cabinets may be adequate; in others, small safes are needed; in still others,
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elaborate vaults may be needed. These facilities, of course, must actually be
used. A safe is of little value if cash is often kept in an unlocked file and the
safe is used only on an exception basis.
Access to cash-storage facilities must be controlled through keys,
combination locks, and other physical protection mechanisms. If an
organization has a need to disburse a fairly large volume of cash or other
negotiable instruments during normal operations, a separate cashier function
should be established. During operational periods, the area used by such a
cashier needs to be adequately sealed off by cages or separately partitioned
portions of office quarters. Finally, when cash is transferred to or from a
banking facility, there must be suitable protection.
In past years, some organizations maintained large cashier facilities to
cash employee payroll or personal checks or even to pay employees in cash.
With the convenience of checking accounts and the ease with which pay can
be transferred to checking accounts and cash withdrawn through automatic
teller machines (ATMs), organizations today do not need to provide this level
of a cashier facility. A larger organization can arrange to directly deposit
employees' pay in their checking accounts and might even add an ATM,
supplied by a local bank, to allow employees to make cash withdrawals on
site. Travel advances can be handled in a similar manner. Employees can be
issued company credit cards and can use these cards both for charging their
expenses and for making cash withdrawals through an ATM. When these
types of procedures are established, the organization needs only to provide
very limited cashier facilities.
Since "cash" is a broad term that goes beyond physical cash on hand to
include all types of bank accounts and negotiable instruments, the earning
potential of that cash needs to be recognized, where practicable, through the
placement of funds in interest- bearing accounts or under other
arrangements where the time value of money will be realized. In some cases,
the maintenance of given bank balances may be the basis for credit lines or
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other services rendered by the banks involved, even though the given
account earns no interest. In other instances, funds can be placed in short-
term, interest-bearing commercial paper. The objective is to exploit these
potentials to the maximum extent possible.
(iii) Cash Disbursements. Once cash is received and available in its various
forms, it is ready for use for organization purposes such as the purchase of
operating facilities, the payment of expenses, and for other disbursements
such as paying dividends to investors. The general audit objective is that
cash disbursements should be for valid and proper purposes, that fair value
has been received, and that they are in the correct amounts.
Perhaps the most general control to always be considered here is that the
cash receipts and cash disbursement phases of the total cash process need to
be as separate as possible. Although the procedures to enforce this control
may vary, internal audit should always look for an appropriate separation of
responsibilities between cash receipts and disbursements.
In normal accounting operations, major expenditures are processed
through the creation of a payable that is then subsequently offset by the cash
disbursement. At the same time, the disbursement is normally reviewed in
terms of the validity of the underlying payable plus the propriety of the
timing of the liquidation of that payable. However, a number of situations
will arise when small cash expenditures must be made without delay and
when the amounts may be too small to justify the application of the formal
disbursement procedures. In these circumstances, cash may be advanced
using what is called a petty cash fund.
Normally, petty cash disbursements are best handled on an "imprest"
basis, as discussed earlier. Under this procedure, a designated fund amount
is established, cash payments are made from the fund as required, and then
reimbursements are made to the fund covering exactly the total amount of
expenditures, thus bringing the fund back to its original level. The size of the
fund should be large enough to sustain expenditures, with allowance for the
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time required to process the previously described reimbursements, but no
larger than necessary since the level of the fund can be changed from time to
time in light of experience and new conditions.
Satisfactory evidence should always be obtained to support expenditures. If
such evidence is not directly available in the form of an invoice, cash register
receipt, or other documentation, a special receipt should be prepared and
signed, preferably by the recipient of the cash, but at least by the person
making the expenditure. These supporting documents should be canceled at
the time of reimbursement to prevent their reuse. Because petty cash
expenditure amounts are usually relatively small, there may be a temptation
to relax controls requiring adequate documentation. Documentation should
be reviewed at the time of reimbursement. Improper use, however, cannot
be detected except by an actual examination and count of the fund. Both of
these protective efforts need to be carried out by responsible management on
a continuing basis.
The cash-disbursement process highlights the desirability of breaking
down the various aspects of control activities and assigning them to different
individuals. Thus, one person might review the documentation for the
request, another prepare the check-process- ing voucher, and a third review
the propriety of the combined set of documents as well as review the output
from the automated accounts payable system. For larger disbursements or
those not covered by an automated accounts payable system, a fourth person
might provide the primary signature and another for secondary signatures
for larger checks. Each of these activities serves as a cross-check on another.
The organization should not overcontrol this process, however. Although
multiple persons may be involved for large disbursement requests, the
process should be reduced to a more cost-effective level for smaller
disbursements.
All checks issued should be made payable to the specific individual or
firm from which the products or services are obtained. The writing of checks
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to "cash" or to "bearer" should be strictly prohibited, since cash can then
more easily be used for unauthorized purposes.
(iv) Otner Aspects of Cash Process. A number of other matters pertaining to
effective control over cash cut across the receiving, handling, and
disbursement aspects of this process. These include the need to bond
employees handling the organization's cash, to protect critical documents
such as checks, and to independently reconcile all checking and other cash
acsounts.
Normal business prudence requires that all employees participating in
any part of the cash processes be bonded—a company-paid insurance policy
against employee malfeasance. The benefits derived are twofold. First, there
is the actual protection to the organization in the case of any defalcation or
other improper diversion of organization funds. Second, the knowledge of
the bonding may motivate the individual employee to exercise a higher
standard of care and integrity. To accomplish the latter, the bonding action
should be properly publicized. The organization should also have strong,
well- publicized procedures in place to obtain restitution or to force
prosecution of any employee involved with any improper diversion of cash.
For all cash processes, records should be kept up-to-date as a basis for
both efficient current reference and prompt periodic reporting. Delays in
carrying out various parts of the cash processes can generate greater
physical risk and at the same time restrict the efficient utilization of cash
resources.
Although the use of paper check forms is declining due to electronic
transfers and other automated payment processes, the proper control of any
checks or other special forms is always important in terms of physical
protection and efficient usage. The problem is complicated because modern
computer printers generate the entire check document, using laser printers,
from blank paper form. Control of these computer programs is also very
important.
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An important part of the overall cash-management process is the
independent reconciliation of all bank accounts. Reconciliations should be
made by persons or computer systems who are independent of the regular
cash-receiving and -disbursing operations. Bank statements and canceled
checks should be obtained or received directly from the depositories
to,insure that they have not been tampered with in any manner by any
intermediary. A bank will often provide reports that help complete this
process. For accounts with a smaller number of transactions, bank
reconciliations also provide the opportunity to review how receipts and
disbursements are handled and to identify unusual actions.
In earlier days of internal auditing, the independent reconciliation of
checking accounts was once a regular internal audit task. While both
internal or external auditors may want to perform this exercise as part of
their annual financial audit, internal audit functions today have generally
moved away from this as a regular process. Internal audit resources are too
valuable, and other persons in the accounting organization can usually
perform this function subject to periodic internal audit review.
(b) CASH PROCESS INTERNAL CONTROLS
Many of the cash-related internal controls discussed in this book are covered
in subsequent chapters involving the receipt and disbursement of cash. This
section considers cash as it applies to overall accounting operations.
Cash presents a far greater internal control risk to an organization than
nearly any other operation. An organization may manufacture, for example,
a product called a "widget" that has wide consumer appeal. It might be
possible for dishonest employees to steal these widgets and use them or sell
them for their own personal gain. However, the dishonest employee can only
steal so many widgets before an astute management can see that widgets are
missing from the warehouse. Without proper reconciliation procedures in
place, it can be much harder to detect if cash from those widget sales is
missing. This is because of the numerous transactions associated with this
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cash, including customer credits for returned goods, outstanding receivable
balances, and payments in transit.
Cash is a dynamic commodity with its transaction balances in flux at any
moment. For this reason, external auditors take strong steps at year-end to
determine that the cash balances stated in financial statement balance sheets
represent cash on hand, cash in transit, and cash in various general accounts.
The external auditor should also be concerned that this cash has been
properly classified and that any committed funds have been identified.
Management has, or should have, a strong interest in establishing
adequate internal controls over its cash processes, including the following:
•Periodic reconciliation of checking accounts to recorded cash balances.
This includes a review of cash deposits and checks issued, with an
accounting for checks in transit.
•Examination of canceled checks on a test basis for appropriate
signatures, endorsements, dates, and amounts.
•Controls over the handling of cash at all levels to ensure that controls
include a proper segregation of duties.
•Physical controls over significant documents such as checks.
• Periodic follow-ups on special cash items such as checks
outstanding and stop- payment notices
•
• Cash is such an important element in organization operations
that strong internal controls are essential. These controls should be
in place for all cash accounts and at all levels.
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(C) CASH-RELATED INTERNAL AUDIT CONSIDERATIONS
In the early years of auditing, a major emphasis of many reviews
was on the controls over cash. As the years went by, the sources of
actual cash in the modern organization were limited to petty cash
funds used for very small, miscellaneous purchases. With an overall
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objective to review controls over cash, internal auditors all too often
made the reconciliation of a relatively minor petty cash fund a
major component of their reviews. Even worse, they often reported
a small difference in the petty cash fund as if it were a major control
issue. At the same time, they may have ignored more significant
control issues.
The modern internal auditor should have moved away from this
overemphasis on the controls over a relatively minor petty cash
account while ignoring more significant control issues. Internal
audit should not ignore such areas as petty cash funds because they
are viewed as too minor, but should understand where cash plays a
significant role in organization operations and should review for
appropriate controls.
(i) Financial Audit Considerations. Most cash-related financial
audit procedures are performed by external auditors as part of
their year-end procedures. Internal auditors often become involved
with these external audit procedures in their support of external
auditors. They also may have a need to reconcile account balances
as part of reviews of smaller units or other special audits.
Internal audit should understand how to perform a bank
reconciliation. In many respects, this is similar to the process an
auditor would use to reconcile a personal checking account. Internal
audit starts with a statement from the bank for each account as well
as internal records indicating receipts and deposits. In addition to
the bank's account statement, external auditors at year-end request
an independent confirmation of an organization's accounts at a
given bank, revealing such matters as restrictions on withdrawals
due to compensating balance requirements, liabilities to the bank
related to the account, and other matters. An internal auditor might
also request such a confirmation when performing a financial audit
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of cash at a smaller, remote unit not part of the external auditor's
scope.
Figure 22.9 is an example of a bank reconciliation worksheet to
test a bank account balance. This reconciliation process was once a
very labor-intensive task requiring the physical handling and
summation of checks. Computer systems both at the bank and
within the auditor's organization have made this much easier;
however, internal audit should not rely just on the printed summary
reports when making the reconciliation but should also look for
unusual items on a test basis. Some of these items should be
physically examined 4
in detail.
Reconciliations of petty cash funds are very similar to the
process for checking accounts. However, internal audit should look
for an internally prepared record of cash disbursements, including
appropriate documentation, as well as a record of all deposits into
the fund.
(ii) Cash-Related Operational Audit Procedures. In any operation
involving the handling of cash, internal audit should concentrate on
whether cash is properly protected from theft, that it is promptly
moved to appropriate accounts, and that it is managed to
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Balance per Bank
1. Obtain balance per bank statement. $5,236,000
2.Add deposits in transit and bank errors that understate the balance. $ 42,126
—Subtotal ' $5,278,126
3.________________________________________________________________Deduct
outstanding checks and bank errors that overstate the balance. $136,016
4.Calculate corrected cash balance. $5,142,110
Balance per Books
5.Obtain balance per books and financial records. $5,309,461
6.Add deposits credited by the bank but not yet recorded.$137,140
7.Deduct book errors that understate the balance per books (e.g. a
check for $10 that was recorded as $100 on the books).______$261,630
—Subtotal $5,184,971
8.Deduct bank charges not yet recorded by depositor (e.g. bank service
charges and NSF checks). $ 27,361
9.Deduct book errors that overstate the balance per books (e.g. the
depositor writes a check for $100 but records it as $10).______$ 15,500
10. Con-ect cash balance. $5,142,110
best serve the organization. Controls for proper protection over cash
include such simple matters as keeping petty cash funds in locked,
secure facilities, transporting all cash deposits in armored carriers,
and discouraging any temptation through strong separation-of- duties
controls. For the operational auditor, cash may include check forms,
credit vouchers, negotiable securities, retail gift certificates, or any
documents that could be easily converted to cash through improper
procedures. Internal audit should look for appropriate controls to
prevent misappropriation in any cash-related documents.
Cash always has a time value, and idle cash does not draw bank
account interest or satisfy bank minimum-balance requirements.
Internal audit should always look for situations where improved
controls and procedures could move cash faster to appropriate bank-
ing accounts.
Figure 22.10 contains selected audit procedures for operational
reviews for controls over the protection and movement of cash. These
procedures cover cash or cash- equivalent functions used for
operations but not cash investments, as discussed in Chapter 30 on
financial management. Because actual cash processes may vary to a
great extent due to the nature of the organization, these operational
audit steps are very general. Internal audit should always develop an
understanding of the various sources where the organization receives
its cash and then concentrates on the controls over the more
significant. That is, there is often little need to do a formal cash count
of a petty cash fund unless that fund experiences a high volume of
transactions or there is some other perceived concern.
22-26 Ch. 22 Accounting Systems and Controls Figure 22.10 Cash-
Related Audit Procedures
22.10.1 Identify all repositories of cash or cash
equivalents located throughout the organization.
The surveys should include cashier functions,
cash value documents such as cash redeemable
documents, and securities.
22.10.2 On a surprise basis and accompanied by a
member of management, to act as a witness, visit
one or more repositories of cash and perform a
formal cash count; reconcile that count to formal
accounting records, investigating any differences.
22.10.3 Review all procedures regarding cash and
comment on the adequacy and attention to
controls, including separations of responsibility
throughout.
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22.10.4 Perform a walk-through inspection'of all
cash-handling areas, with an emphasis given to
security over the cash or cash equivalents.
22.10.5 Determine that procedures are in place to
record the receiving, depositing, or disbursement
of all cash transactions.
22.10.6 If terminals
are used for cash, determine that controls exist
over the sign in / sign out for those terminals and
that procedures require a periodic review of
terminal logs. t
22.10.7 Determine whether procedures require
supervisory or management personnel to review
and approval all journal entries, recording cash
transactions and balancing cash routines.
22.10.8 Determine that persons involved with
depositing and recording cash receipts are
covered by insurance and fidelity bonds in
appropriate amounts.
22.10.9 Review the adequacy of security controls
over cash functions, both monetary and cash
equivalents. On a selected basis, review security
procedures in detail, noting any potential
vulnerabilities.
22.10.10 Assess overall procedures in place for the
conservation of cash throughout the organizaiion,
including:
• Use of cash discounts for early payments
• Cash concentration accounts
• Effective use of EDI and electronic fund transfers
• The use of zero-balance accounts for such matters as
payroll
• The issuance of employee credit cards for travel rather
than cash advances
(iii) Cash-Related Computer Audit Procedures. The typical
organization does not have many strictly cash-oriented
control systems. Cash-related transactions flow through
many processes, but internal audit is typically interested in
the other transactions related to that cash. That is, an
internal auditor might review controls over a sales system I
and would develop computer-assisted audit techniques
(CAATs) to measure various sales- related parameters.
Internal audit would have less occasion to develop CAATs
just for the cash side of that process
Banking or financial institutions deal with cash as their
primary product and have a large number of cash-related
processes such as checking accounts, home mortgages, and
other loans outstanding. These are supported by extensive
computer systems that internal audit should consider for
potential controls reviews and that lend themselves to
numerous types of CAATs. Specialized financial
professional organizations such as the Bank Admin-
istration Institute3 publish audit guides and other
materials for the computer audit-related reviews of
financial institution-related systems.
In a nonftnancial institution, internal audit can sometimes
develop very effective CAATs covering the organization's cash-
management procedures. For example, a sales organization with
remote branch offices may have instructed those locations to remit
all cash collected to a sweep type of account for processing in a
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central location. Those same branch organizations may not have
appropriate control disciplines to process these remittances on a
timely basis. Internal audit could possibly develop a CAAT to review
reported daily sales figures and match them with reported deposits to
determine if cash deposit rules are being followed. As another test,
internal audit could develop a CAAT to calculate the average cash
balances at these branch units. The results might reveal that
management was not taking proper stewardship control over their
cash management.
(Iv) Cash Process Sample Audit Report Findings
A: Excessive Cash Balances in Cashier Accounts. We did a count of
cash under the responsibility of the home office cashier that is used
for employee travel advances, expense reimbursements, and
miscellaneous expenses. We also reviewed average daily disburse-
ments from this account over a period of six months. With the
exception of two instances where there was significant employee
international travel, we found that the cashier total cash balance was
always greater than daily disbursements by a factor of about ten.
This large cashier cash balance ties up resources that might be
deposited in organization accounts.
Recommendation. The average daily balance of cash under the
control of the home office cashier should be reduced by about 80%.
This amount should be reevaluated periodically based on
organization activities and other needs. To allow for the occasional
circumstances when a large travel advance is needed, arrangements
should be made with the local bank to secure travelers checks on a
one-day notice.
B: Inactive Checking Accounts. The ABC and XYZ facilities were
both closed about one year ago. However, the local bank accounts for
each of these facilities remain open. Management advised us that the
accounts are open because certain refund checks issued before
closure have never cleared. Although the balances in each of these
accounts is at a minimum level, the open accounts expose the
organization to potential fraudulent transactions.
Recommendation. A detailed reconciliation should be performed
to identify the number and nature of the outstanding checks issued
from each of these accounts. Remaining balances should be reduced
to the level of these outstanding checks. Consideration should be
given to contacting some of these check payee parties, informing
them that the accounts will be closed. In any event, the checking
accounts should be closed within six months.
22-4 RECEIVABLES PROCESSES
Receivables processes cover any action that generates claims of
amounts due against individuals or other organizations. These claims
are usually against parties outside the
organization but at times can also involve employees and officers. The
claims are brought into existence to allow the organization to recognize
them as a future liability to be resolved later. They can be considered an
intermediary phase pending their ultimate collection in the form of cash or
other types of consideration. Although these claims can originate in a
variety of ways, the major category has to do with the sale of products or
services rendered by the organization. This section first deals with this
sales-related category and then later touches on other receivable types.
The receivable processes that relate primarily to sales have a number of
important relationships. There is a need for policies covering the extent to
which credit is first granted and then subsequently administered. Who
should be extended credit? In what amounts? How aggressive should the
organization be ih pressing for subsequent collection? A second type of
consideration concerns customer satisfaction and continuing customer
goodwill. The organization should be interested in how customers react to
the modes of credit authorization, billing, and collection. The organization
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is also interested in learning about how the customers are reacting to
organization products and policies in a broader sense. Finally, there is the
specific interest of the organization in the efficiency of its various receivable
activities and the effectiveness of its controls.
The modern organization faces many potential risks related to its
receivables processes. If credit is granted without proper policies or
customer screening, the organization may be either limiting its sales
through too tight credit practices or booking sales that may be eventually
uncollectible. Once a receivable is booked, the organization should handle
billings in a prompt and accurate manner. Cash payments against
receivables need to be properly recorded and deposited. Finally, the
organization needs to establish policies to collect on late or overdue
receivable accounts.
Accounts receivable are often covered by external auditors who send
out independent confirmation letters asking customers with receivable
balances to acknowledge the existence of those recorded receivables. This is
an important step in a financial statement audit. However, there are a large
number of additional and related receivables-related operational and
accounting review areas that should be a key part of the internal auditor's
activities.
(a) TRANSACTION CYCLE
The processes or transactions relating to accounts receivables can be
grouped into three phases. The first phase has to do with the conditions
under which the receivable comes into existence, including both recording
the sale and determining that the customer has a proper credit history. The
second covers the administration of the receivables thus created, including
the processing of bills and statements as well as monitoring the overall
status . of all receivable accounts. The third phase consists of the means by
which the receivable is finally liquidated. This includes the collection of cash
to satisfy billings or the use of credit collection procedures for any overdue
billings. The objective for each is to understand the general range of
matters involved and to identify major control problems.
Automation and competitive business practices have changed the
manner in which receivables are created and processed for many
organizations. Electronic data interchange (EDI) procedures, discussed
from a purchasing perspective in Chapter 24. are an example. A customer
may make a purchase through an electronic transmission to the
organization's order-entry system. The order is electronically
acknowledged, shipped, and electronically billed. The customer may then
pay through an automated electronic funds transfer (EFT)
process. Using EDI, much of the traditional paper trail frequently used by
auditors and others disappears. The accounts receivables process and its
related controls change extensively using these newer technologies.
(i) Recording Sales and Generating Receivables. Since an account
receivable normally arises out of the sale of the orgarlization's products or
services, internal audit is concerned with establishing a direct link between
the actual sale and the recording of the receivable. The recorded receivable
must be backed up by the shipment of the product or the performance of
the service according to preestablished sales terms. These objectives are
likely to be satisfied when the creation of the receivable can be directly
linked with the recording of the sale and the relief of an inventory account
or with a record of the performance of the service. This process usually
involves three basic automated systems in the organization: sales order
entry, inventory or shipping systems, and accounts receivable. The latter
also links to key accounting systems including the general ledger.
Generating an account receivable creates the need for the organization
to extend the required credit to the customer to cover the sale. This credit
decision depends upon the general credit policy of the organization and
how it is applied to a particular customer in* the light of his or her credit
standing and past payment experience. When credit acceptability has been
25
determined, regular sales and billing procedures are initiated. As a part of
those procedures, an invoice is prepared and the account of the customer
charged.
A major control consideration applying to the generating of receivables
is an independent review and approval of the customer's credit. This
approval should be provided by an independent department or person
within the framework of established organization policy and should
consider appropriate credit-related information about the particular cus-
tomer's current credit balances, payment history, and the general credit
and financial standing. A credit approval by parties independent from the
sales department is important since that sales function is often more
interested in completing the sale rather than collecting on it in the future.
Prices and terms for the sale must be properly authorized. For billing
purposes, the applicable prices, discounts, and other tenns must be based
on established organization policy. Any special interpretations or deviations
must be approved by properly authorized individuals.
Cash discounts are usually part of standard billing terms, typically a
2% discount if the invoice is paid within 10 days with the net amount due if
paid in 30 days. A penalty will usually be assessed after 30 days. These
terms should be clearly stated on the invoice document using such terms as
"2%-Net."
For goods shipped, invoices need to be prepared for use in several
operational areas. One copy, generally with prices omitted, goes with the
shipment as a packing list. Another, properly priced, goes to the customer
as the official invoice. Others are used for the compilation of sales data and
for accounts receivable posting. Invoice shipment data will also impact
inventory and production records and may also form a basis for calculating
sales commissions.
Invoices were once mostly multicopy paper documents, and proper
serial number control and correct postings were critical controls. Where
paper-based systems are still in place, these controls continue to be
important.
(ii) Administration of Accounts Receivables. The administration phase of
the receivables process starts when the receivable is recorded and continues
until the receivable
is paid or otherwise liquidated. This accounts receivable record
must be tied to control accounts that support individual customer
and other categories of billings.
Newly generated charges, credits from cash collections, and
all other miscellaneous charges and credits should be posted on a
daily basis so that up-to-date information is always available to
serve the various operational needs of the organization. At the
same time, accuracy must be maintained through checks on the
agreement of detailed accounts with the established control. This
check is normally handled by the typical automated accounts
receivable system. Figure 22.11 is a flow chart showing the
components of an automated accounts receivable system. Such a
system could be implemented as part of a larger computer system
Figure 22.11 Accounts Receivable Process27
or could be resident on a desktop microcomputer. The controls
necessary for such an application were discussed in Chapter 17.
In addition to the accounts receivable information furnished
regularly through online retrieval screens or the like, there should
be periodic reports of current balances and an aging analysis. The
aging analysis shows the portions of the account balances that
have been unpaid for different time periods, including current,
one month overdue, two months overdue, three months overdue,
and so on. Figure 22.12 is an example of this type of aged i
receivables balance report. An analysis of this aging data is
important for the administration of the ongoing credit and
collection efforts. It will also allow the organization to adjust its
estimates of reserves for bad debts, as discussed below.
At the end of a month or accounting period, organizations
generally send statements summarizing all invoices issued during
that period. Even though payment terms require that individual
invoices be paid in advance of the period-end statement date, the
statement provides an account summary.
A basic control here is mailing statements directly to individual
customers with noopportunity for diversion or modification by others. This
makes it possible for the statements to serve as a reliable cross-check on the
accuracy of the individual accounts. It is also an important means of
disclosing any delayed reporting of collections.
Although regular organization sales activities provide the major
source of the accounts receivable, other organization activities and
developments may lead to some special types of receivables,
including:
•Advances to Employees. Sales of organization products or
services are normally included in the regular accounts
receivable. However, there may be advances of one kind or
another for travel, special business purposes, or possibly for
personal reasons. Advances for travel would normally be
booked in a travel accounting system. Many other special
employee advances are controlled through the payroll system
and are settled over future pay periods. Advances for personal
purposes would require the approval of properly authorized
managers.
•Deposits with Outsiders. In many situations, deposits are
required in connection with the establishment of utility services
or for other reasons. These deposits may be of a temporary
nature or may be permanent as long as the service is being
utilized. The receivable record here is important so that the
deposit can be recovered when the original need no longer
exists. While these deposits would not be part of an accounts
receivable system, other records should be established to record
them.
•Claims. Relations with vendors, carriers, or outside service
groups can lead to claims for a variety of reasons. These become
a special type of receivable. Insurance claims are still another
source of special receivables. Effective control is
provided by recording of the claim as a receivable, rather than
recording the proceeds when received.
• Accruals of Income. A special type of receivable, in a very loose sense,
exists when earned income is accrued prior to being due and collectible.
The objective here is to recognize income in the periods it is actually
earned and thus provide a better evaluation of current operational
performance.
While the nature and scope of the transactions and activities that
generate these miscellaneous types of receivables can vary greatly, certain
29
minimal controls are necessary for all of them. First, policy and procedure
conditions under which the particular type of receivable is created should be
clearly defined. Safeguards should exist to make sure that the receivable is
recorded at the earliest possible time and in the proper amount. Second,
procedures must be established for the periodic review of all miscellaneous
receivables, which are frequently overlooked or not given adequate attention
in a regular operational review. Specific precautions must be taken to
combat such tendencies.
(iii) Dispositions of Receivables and Credit Collections. Accounts receivables
represent an asset claim against the particular parties involved, and these
claims should be relieved only in a properly authorized manner. The four
normal modes of accounts receivable account relief are cash collections,
return allowances, account adjustments, or bad debt write-offs.
The most usual settlement mode is cash collections from customers to
liquidate the previously generated receivables. At the time of recording the
cash collections, the organization must verify that any cash or other
discounts deducted are properly earned and recorded. The customer account
should be properly credited and adjusted if the discount was improper.
When products sold are returned for one reason or another, the result is
the reverse process of the original sale. While retailers often allow returns if
a customer indicates dissatisfaction, most manufacturers, industrial
distributors, and other organizations will have a requirement to determine
that the shipment was somehow not in compliance with terms or was in error
before returns are allowed. There should be a requirement that the actual
return is authorized. A second retum-related requirement is that the
products returned are actually received in proper condition. Finally, the
credit for the return must be in the proper amount. These three control
points—proper authorization, receipt of goods, and proper amounts—
provide the basis for establishing a sales return credit.
Adjustments and allowances are harder to control when a customer is
granted a special credit for volume purchases, for the promotional sale of
particular types of products, or to adjust for product deficiencies. Where an
allowance is pursuant to a specific arrangement, controls should be in place
to confirm compliance with the arrangement. In many cases, however, the
authenticity of the credit may be based on judgmental factors evaluated by
an executive who then approves the credit within the authorized limits.
There will always be customers who simply fail to pay. There may be
bankruptcy situations, disappearance of the debtor, or other causes that
leave no alternative but a write-off of the account as a bad debt. Provisions
should be made for such losses through the creation of reserves for doubtful
accounts. The actual bad debt write-off, properly authorized by a sufficiently
high-level organization manager, is then charged to that reserve account.
However, even after they are written off, these accounts written-off should
be given such further collection efforts as are practicable and reasonable.
(iv) Policy Aspects of Accounts Receivable. In addition to the
operational framework of the receivable process, several key policy areas
relating to the handling of receivables require consideration. First, the
economics of credit levels is a continuing policy question for many
organizations. Management must decide how liberal an organization should
be in extending credit. While it is clear that the tighter the credit granting,
the lower will be the ultimate bad debt losses, sales made pursuant to a more
liberal credit policy may be additional sales that otherwise would no: have
been made. Since these sales should yield extra profits, it may be in the
organization's interests to generate higher sales with less stringent credit
policies. It may be difficult to measure the incremental benefits accurately,
but it is important that the auditor recognize the several dimensions of the
problem when performing operational reviews in the accounts receivable
area.
A second related aspect of both the operation of the credit department
and the total receivable process is the impact that these activities have on
good customer relations. It is usually desirable to streamline procedures and
31
reduce the degree of personal contacts, but credit and receivable processes
unavoidably involve customer contacts. These contacts must be handled in a
way that minimizes customer irritation and builds positive goodwill. Real
effectiveness here is to combine internal efficiency with courteous and
reasonably cooperative customer relationships. Very often customer
dissatisfaction, due to a cause quite independent of the receivable process,
may surface through account receivable contacts. The problem can become
magnified if both parties are dealing with automated billing systems that
appear recalcitrant or difficult to understand. The receivable personnel must
channel problems to organization personnel who will solve them and work to
build greater customer goodwill.
Through a formal contract or a deferred payment, it may be the practice
of an organization to make sales for its products and services on a deferred
payment basis. In such cases, contracts are usually executed that specify the
timing of the payments. In some cases, notes receivable may be obtained.
These notes receivable are often an outgrowth of collection problems with
regular accounts receivable, such as circumstances where a regular account
cannot be liquidated in accordance with its payment terms. In such a
situation, the organization may wish to obtain what it regards as a more
precise recognition of the receivable through the use of notes receivable. This
also allows an organization to define the interest that can now be charged. In
all these situations, circumstances under which any notes receivable come
into existence need to be defined and properly authorized. Subsequently,
there is the need for a regular monitoring of the collection of the notes on the
dates specified, including the collection of such interest as has been agreed
upon. Notes receivable also pose a problem of custody, since the notes exist
as separate documents, and there is the possibility that since the use of notes
receivable is an unusual type of transaction, regular and systematic attention
will not be given to them. Specific notes receivable procedures are needed for
periodic review and possible action.
(b) INTERNAL CONTROLS
The monies due an organization through its accounts receivable often
represent a major asset to that organization. Accounts receivable must be
turned into cash collections, and because much of this process is dependent
upon the actions of outside parties, internal accounting controls are critical.
A major internal control issue here is that the receivables recorded as due
must be correct and collectible according to the terms of that receivable. The
receivables must meet several general internal control objectives.
•Overall Reasonableness. The recorded value of both the receivables and
any reserves must be consistent with actqal collection experiences.
Trade discounts and allowances should also be consistent across all
recorded receivables.
• Accounts Receivable Evidence. The receivables must represent
amounts actually due to the organization. This can be verified by the
auditor's direct confirmations or through the timely receipt of cash to
pay off the receivables.
•Valuation and Classification. The reteivables must be recorded as values
that are collectible. Receivables should also be properly classified as to
whether they are expected to be collected in a normal span of time or
are a potential bad debt. Appropriate reserves should be established for
amounts estimated as uncollectibie.
• Proper Receivables Cutoffs. Schedules need to be established to
properly record sales, sales returns, and allowances. This is tied to
strong controls over the proper shipping and billing of goods. Of course,
there should be a segregation of duties between the shipping and billing
functions in an organization.
Accounts receivable represent a major internal control issue in an
organization. They must be recorded in a prudent manner that reflects tiieir
potential collectability. When the conditions surrounding those receivable
accounts change, the receivable value must be adjusted through the
33
establishment of a reserve account or through an actual write-off to reflect
the anticipated collectability of that receivable.
(c) INTERNAL AUDIT PROCEDURES
Internal auditors sometimes all but ignore their organization's accounts
receivable processes, often because this is one area that almost always
receives extensive attention from external auditors. The generally accepted
audidng standards (GAAS) developed by the AICPA contain very general
directions at most, suggesting areas that auditors should or may consider.
Specific procedures are usually not mentioned. However, GAAS requires
that independent auditors must externally confirm their client's accounts
receivable. This requirement dates back to a massive fraud of many years
ago when a then-prominent organization claimed that a large number of
fictitious accounts were valid and due to them. Had the auditors
independently confirmed these accounts with the claimed customers, they
would have found them to be invalid and would have encountered a massive
fraud. Since then, independent public accountants have been required to
confirm accounts receivable rather than rely upon the word of management.
In addition to their confirmations activities, external auditors review the
internal controls and other aspects of the organization's accounts receivable
process.
Internal auditors also should have an interest in their organization's
accounts receivable systems and procedures, and consider this a major risk
area in their audit planning. This is an area where internal audit cannot
easily separate financial, operational, and computer audit activities. Any
review here may involve audit procedures in all three areas, and the
following sections consider some of the separate internal audit activities in
each area.
(i) Accounts Receivable Financial Audit Procedures. An internal auditor
should start any review of an accounts receivable process by developing an
understanding of the organization's credit policies, its methods of billing
customers, the types of customers that are part of the accounts receivable,
the types of transactions that would be recorded, and the procedures used
for collections. Each of these factors can have a major impact on how the
accounts receivable process operates and on the expected level of controls.
A good first step in developing an understanding of the accounts
receivable process might be to gather some statistics about the average size
of billing transactions, the frequency of adjustments, and other indicators.
Figure 22.13 is a questionnaire to help internal auditors gain this
understanding. There are no right or wrong answers here. Rather, an
internal auditor can use this information to identify potential problems with
the accounts receivable process. For example, a relatively high percentage of
overdue accounts may point to collection problems. A high number of
adjustment transactions during any billing period may suggest incorrect
billings. Internal audit may be able to gather this data through a discussion
with accounts receivable management or reviews of key reports, or it might
be possible to develop a computer-assisted procedure to survey the accounts
receivable file to gather performance statistics.
The major objective of any review of an accounts receivable process
should be to determine that all sales are billed promptly and correctly. In
addition, adequate controls should be in place to determine that any
adjustments to accounts are made only with
1.What is the average days outstanding for your overall accounts receivable?
2.How many accounts receivable open transactions are recorded in an
average month and how many are written off or otherwise adjusted?
3.How many customer accounts have been set up on billing records ar.d
how often is the overall file reviewed or purged for inactive customers?
4.How long do accounts remain open before they are written off and are
legal or other procedures used to encourage collection before write-off?
5.What is the average size of the account written-off?
35
6.How often are accounts adjusted, how long do they remain open prior to
any adjustment, and are statistics available to describe the reasons for
adjustments?
7.When credit policies suggest that credit should not be granted, how often
do other levels of management override (he decision and grant credit?
What is the credit history of these doubtful credit accounts?
8.Are cash discounts offered and what percentage of payments take
advantage of the cash discount offered?
9.Are all recorded accounts receivable subject to normal billing temis or
are special, exception terms offered?
10. Are any accounts receivable goods considered to be "on loan,"
on consignment, or under other special billing terms?
11. Does the organization keep detailed records of all accounts
receivable adjustments, writeoffs, and other transactions?
12. Are accounts receivable records reconciled to the general ledger
on a regular, periodic basis?