1-1

Internal Control and Cash

CHAPTER 7
Electronic Presentations in Microsoft® PowerPoint® to accompany
Fundamental Accounting Principles, 17ce
Prepared by
Regula Lewis

© 2022 McGraw Hill Ltd.

 1-2

Learning Objectives 1

1. Define, explain the purpose, and identify the principles of internal

control. (LO1)
2. Define cash and explain how it is reported. (L O2)
3. Apply internal control to cash. (LO3)
4. Explain and record petty cash fund transactions. (L O4)
5. Explain and identify banking activities and the control features they
provide. (LO5)
6. Prepare a bank reconciliation and journalize any resulting
adjustment(s). (LO6)
7. Calculate the quick ratio and explain its use as an indicator of a
company’s liquidity. (LO7)

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Vignette Video
Shopify: Canada’s Biggest Homegrown Tech Sector Success Story – “The
Entrepreneurship Company”
Shopify has grown into a publicly traded company with nearly $3 billion in
revenue in fiscal 2020. Over the first year of the pandemic Shopify
doubled in value as more and more businesses shifted their sales online.
Every 52 seconds, someone has the experience of getting their first sale.
Tobias refers to the ability to spread the amazing feeling of a first sale for
an entrepreneur as the company’s North Star.
• Video Link: Shopify President Harley Finkelstein on Entrepreneurship and E-commerce,
https://youtu.be/1YCBjO4KrJY
• Podcasts: The Tim Ferriss Show, #486: Harley Finkelstein—Tactics and Strategies from Shopify, the Future of
Retail, and More, 2 hr 14 min; Shopify: Tobias Lütke: How I Built This with Guy Raz, 1 hr 17 min.

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Critical Thinking Challenge

If a debit card is used instead of currency to purchase a $10 item, would
the journal entry for the buyer/seller be affected?
Explain.

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LO1: Internal Control System

All policies and procedures used to :

• Protect assets;
• Ensure reliable accounting;
• Promote efficient operations;
• Encourage adherence to company policies;
• Adhere to sustainability targets set by management;
• Collect accurate data relating to sustainability targets.

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IMPORTANT TIP

Remember the CAR principle.

Attributes of a strong control system can be broken into an easily
remembered acronym: CAR.
This stands for Custody, Authorization, and Recording of assets.
These three duties must always be performed by separate individuals to
strengthen the control environment and reduce the potential for errors
and reduce opportunities for fraud to take place.
A control weakness can be identified when two or more of these tasks are
performed by the same or related individuals.

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Principles of Internal Control

1. Establish a separation of duties.

2. Ensure transactions and activities are authorized.
3. Maintain records.
4. Insure assets and bond key employees.
5. Apply technological controls.
6. Perform internal and external audits.

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IMPORTANT TIP

Solving problems related to controls.

To ensure you provide a full analysis of a control issue it is helpful to
remember the acronym WIR.
First identify the weakness (could be due to a CAR issue), then explain the
implication of how the weak control will cause issues/errors, and provide
a recommendation to resolve the identified weakness.

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Three Drivers of Fraud 1

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Three Drivers of Fraud 2

PwC’s 2020 Global Economic Crime and Fraud Survey indicated the
top four types of fraud include:

1. Customer fraud
2. Cybercrime
3. Asset misappropriation
4. Bribery and corruption

According to the survey, fraud committed by customers, accounting

fraud, anti-trust, human resources fraud, and bribery and
corruption all saw significant increases over the previous year.

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Three Drivers of Fraud 3

Most Disruptive Fraud Events by Industry:

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Three Drivers of Fraud 4

Perpetrators of Fraud:

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Fraud Prevention Methods

1. Reduced processing Errors.

2. More Extensive Testing.
3. Limited Evidence of Processing.
4. Increased E-commerce.

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ETHICAL IMPACT
Warning Signs
There are clues to internal control violations. Warning signs from accounting include (1) an
increase in customer refunds (could be fake), (2) missing documents (could be used for fraud), (3)
differences between bank deposits and cash receipts (could be embezzled cash), (4) delayed
recording (could reflect fraudulent records), and (5) increase in customer or supplier complaints.
Warning signs from employees include (1) lifestyle changes (could be embezzlement), (2) too
close with suppliers (could signal fraudulent transactions), and (3) failure to leave job, even for
vacations (could conceal fraudulent activities).
Consider what you would do if you noticed over the past few months some unusual activities with
respect to your manager, the director of finance. She began to modify the control requirements,
bypassing previously established organizational requirements to eliminate redundancy and to
create efficiencies. She also recently informed you that she is going to take over all sign-offs, and
from now on everything is to go through her for approval. In addition, you overhear her talking to
a co-worker about her recent high-end sports car purchase and her new home overlooking Lake
Ontario. What concerns, if any, do you have? What would you do?

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Limitations of Internal Control

Human Error:
• Negligence.
• Fatigue.
• Misjudgment.
• Confusion.

Human Fraud:
• Intent to defeat internal controls for personal gain.

Costs versus Benefits:

The costs of internal control must not exceed their benefits.

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CHECKPOINT
1. Fundamental principles of internal control state that (choose the
correct statement):
a. Responsibility for a series of related transactions (such as placing
orders, receiving, and paying for merchandise) should be assigned
to one person.
b. Responsibility for all tasks should be shared by two or more
employees so that one serves as a check on the other.
c. Employees who handle cash and negotiable assets are bonded.

2. What are some impacts of computing technology on internal control?

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LO2: Cash

• Cash is the most important asset companies need to manage.

• It is not only the most liquid asset, but also the most fraudulently
misappropriated.
• Due to the high risk of theft, it is essential that companies implement
effective controls over cash handling, cheque processing, and electronic
payments.
• Good accounting systems support both goals by managing how much
cash is on hand and controlling who has access to it.

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Cash Defined 1

• The financial statement line item cash includes items such as currency,
coins, amounts on deposit in bank accounts, chequing accounts, and
most cash savings accounts.
• Cash also includes items that are acceptable for deposit in these
accounts, such as customers’ cheques, cashier’s cheques, certified
cheques, money orders, e-currency, and deposits made through
electronic funds transfer (EFT).
• Many companies invest idle cash in short-term investments called cash
equivalents to increase earnings. Because cash equivalents are similar to
cash, many companies combine them with cash as a single item on the
balance sheet. Amazon.com, Inc., for instance, reports the following on
its December 31, 2020, balance sheet:
Cash and cash equivalents $41,122 (Million)
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Liquidity

• Cash is the usual means of payment when paying for other assets,
services, or liabilities.
• Liquidity refers to how easily an asset can be converted into another
asset or used in paying for services or obligations.
• Cash and cash equivalents are called liquid assets because they are
converted easily into other assets or used in paying for services or
liabilities.
• A company must maintain a certain level of liquid assets so it has the
capacity to pay bills on time and can make cash purchases when
necessary.

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LO3: Control for Cash 1

• It is important that we apply principles of good internal control to cash.

• Cash is the most liquid of all assets and is easily hidden and transported.
• A good system of internal control for cash provides adequate
procedures for protecting both cash receipts and cash disbursements.
• Because cash is the most liquid of assets, specific controls need to be in
place over the handling (custody) of cash.

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Control for Cash 2

These procedures should meet three basic guidelines:

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Personal Finance Series

Read full segment in textbook and identify 2 key takeaways.

How to Best Manage Your Personal Spending Habits in a Digital Age.

In the age of social media, and Netflix and YouTube and Crave, companies are
customizing marketing campaigns to get you to buy their products. In order to
achieve and maintain financial security, you need to develop a skill set in
determining how to best spend your limited resources to meet your big-picture
goals and objectives. Your budget is your best control to prevent you from
spending money on insignificant items that will not have a lasting or meaningful
impact.

• Tools: Budget software: youneedabudget.com, www.mint.com

• Podcasts: More Money Podcast with Jessica Moorhouse: How to be an All-Star in Your Financial Literacy,
Courtney Stephen, Financial Educator and Professional Football Player, 52 min; More Money Podcast with
Jessica Moorhouse: How to Master Your Money, Sandy Yong, Author of The Money Master, 44 min.

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Control of Cash Receipts 1

• Internal control of cash receipts ensures that all cash received is

accurately recorded and deposited.
• Cash receipts arise from many transactions, including cash sales,
collections of customers’ accounts, receipts of interest and rent, bank
loans, sale of assets, and owners’ investments.
• Two important types of cash receipts: over-the-counter and mail.

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Control of Cash Receipts 2

Over-the-Counter Cash Receipts

• For purposes of internal control, over-the-counter cash sales should be
recorded on a cash register at the time of each sale for internal control.
• Many software programs facilitate point-of-sale cash register
transactions and enter them in accounting records.
• Less technology-dependent registers simply print a record of each
transaction on a paper tape or electronic file locked inside the register.

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Control of Cash Receipts 3

Cash Over and Short

• Sometimes errors in making change are discovered when there is a
difference between the cash in a cash register and the record of the
amount of cash sales. This difference is reported in the Cash Over and
Short account.
• This income statement account, included under general and
administrative expenses, records the effects of cash overages and cash
shortages to profit from errors in making change and missing petty cash
receipts.

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Control of Cash Receipts 4

Cash Receipts by Mail

• Control of cash receipts that arrive through the mail starts with the
person who opens the mail.

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Control of Cash Disbursements

• Control of cash disbursements is especially important for companies.

• Most large thefts occur from payments of fictitious invoices.
• The three-way match is a good control for cash disbursements.
• The exact procedures used to achieve control over cash vary across
companies. They depend on factors such as company size, number of
employees, volume of cash transactions, and sources of cash.

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CHECKPOINT

3. Good internal control procedures for cash receipts imply that (choose
one):
a. All cash disbursements, other than those for very small amounts,
are made by cheque.
b. An accounting employee should count cash received from sales and
promptly deposit receipts.
c. Cash receipts by mail should be opened by an accounting employee
who is responsible for recording and depositing receipts.

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LO4: Petty Cash System Of Control

• A basic principle for controlling cash disbursements is that all payments

are made by cheque.
• An exception to this rule is made for petty cash disbursements. Petty
cash disbursements are the small amount payments required in most
companies for items such as postage, courier fees, repairs, and supplies.
• The purpose of setting up a petty cash fund is to prevent companies
from having to write cheques for small amounts.
• Once a business sets up a petty cash fund, the cash maintained in this
fund can be used to make small payments.

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Operating a Petty Cash Fund 1

• Establishing a petty cash fund requires estimating the total

amount of small payments likely to be made during a short
period such as a week or month.
• A cheque is then drawn by the company cashier’s office for an
amount slightly in excess of this estimate.

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Operating a Petty Cash Fund 2

Trendy messenger bag company, Demano, established a petty cash

fund on November 1, 2023, in the amount of $75. A $75 cheque
was drawn, cashed, and its proceeds turned over to Milani Taylor,
an office employee designated as the petty cashier or petty cash
custodian. The petty cashier is responsible for safekeeping of the
cash, for making payments from this fund, and for keeping accurate
records.
The entry to record the setting up of this petty cash fund is:

Nov. 1 Petty Cash 75

Cash 75

To establish a petty cash fund.

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Operating a Petty Cash Fund 3

This entry transfers $75 from the regular Cash account to the Petty
Cash account. After the petty cash fund is established, the Petty Cash
account is not debited or credited again unless the size of the total
fund is changed.
The petty cashier should keep petty cash in a locked box in a safe
place. As each disbursement is made, the person receiving payment
signs a petty cash receipt or petty cash ticket.

Exhibit 7.2
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Operating a Petty Cash Fund 4

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Exhibit 7.3
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 1-34

IMPORTANT TIP

Steps to Reimburse the Petty Cash:

1) Add up all the receipts.

2) Add up all the remaining cash in the petty cash fund.
3) Calculate cash over/short:
= Total of petty cash receipts –
Cash required to replenish fund to its original amount
4) Record the journal entry to record all receipts in the petty cash to the
appropriate expense account, record the cash over/short and account
for the reduction in cash (to replenish the fund to the original
amount).

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Operating a Petty Cash Fund 5

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Operating a Petty Cash Fund 6

Jim Gibbs had only $2.20 cash remaining in the fund at the end of
November. Therefore, the reimbursement cheque is for $72.80 (= $75.00 −
$2.20). Notice that Exhibit 7.3 shows total receipts for $71.30. The
difference between the total receipts and the reimbursement cheque
represents a cash shortage of $1.50 (= $71.30 − $72.80) due to an error.
The reimbursement cheque is recorded as follows:

Nov. 27 Office Maintenance Expenses 46.50

Merchandise Inventory 15.05
Delivery Expense 5.00
Office Supplies Expense 4.75
Cash Over and Short 1.50
Cash 72.80
To reimburse petty cash
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Operating a Petty Cash Fund 7

Increasing or Decreasing Petty Cash Fund

A decision to increase or decrease a petty cash fund is often made when
the fund is being reimbursed. To illustrate, let us assume that Demano
decides to increase the petty cash fund by $25, from $75 to $100, on
November 27 when it reimburses the fund. This is recorded as follows:

Nov. 27 Petty Cash 25.00

Office Maintenance Expenses 46.50
Merchandise Inventory 15.05
Delivery Expense 5.00
Office Supplies Expense 4.75
Cash Over and Short 1.50
Cash 97.80
To reimburse petty cash and increase it by $25.00
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CHECKPOINT
4. Why are some cash payments made from a petty cash fund?
5. Why should a petty cash fund be reimbursed at the end of an
accounting period?
6. What are three results of reimbursing the petty cash fund?

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LO5: Banking Activities As Controls

• From the first moment a business is established, the ability to efficiently

make and receive payments forms the lifeblood of the business.
• Banks safeguard cash, provide detailed and independent records of cash
transactions, and are a source of cash financing.
• Key bank services, including bank accounts, bank deposits, and cheques.
Each of these services contributes to the control or safeguarding of
cash.

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Bank Account

• To control access to a bank account, all persons authorized to use a

bank account must sign a signature card.
• A signature card includes the signature of each person authorized to
sign cheques from the account. Bank employees use signature cards to
verify signatures on cheques.
• Many businesses require dual signatures on cheques to strengthen
control over cash payments.
• Many companies have more than one bank account for various reasons
such as a payroll account dedicated to issuing payments for wages to
employees or for special transactions.

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Bank Deposit 1

• Each bank deposit is supported by a deposit slip.

• Companies use deposit slips to list the items such as currency, coins, and
cheques included in the deposit along with each of their dollar
amounts.
• When the deposit is brought to the bank, the company is provided a
copy of the deposit slip or a deposit receipt as proof of the deposit.

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Bank Deposit 2

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Bank Cheque 1

• A cheque is a document signed by the depositor instructing the bank to

pay a specified amount of money to a designated recipient.
• A cheque involves three parties: a drawer (also referred to as payor or
remitter) who signs the cheque, a payee who is the recipient, and a
bank on which the cheque is drawn.
• Both cheques and deposit slips are imprinted with identification codes
in magnetic ink for computer processing.

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Bank Cheque 2

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Electronic Funds Transfer 1

• Electronic funds transfer (EFT) is the use of electronic communication to

transfer cash from one party to another.
• Companies are increasingly using EFT because of its convenience and
low cost.
• We see items such as payroll, rent, utilities, insurance, and interest
payments being handled by EFT.
• The bank statement lists cash withdrawals by EFT with cheques and
other deductions.
• Cash receipts by EFT are listed with deposits and other additions. A bank
statement is sometimes a depositor’s only notice of an EFT.

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Credit Card Transactions 1

• Many companies allow customers to use credit cards such as Visa,

MasterCard, or American Express to pay for purchases.
• The seller pays a fee for the services provided by the credit card
company. The fee covers costs incurred by the credit card company
including credit checks on credit card customers, cost of collections,
and, of course, a profit margin.
• Therefore, when the fee is deducted, the cash received by the retailer is
less than 100% of the sales value of the transaction.
• The fee charged by the credit card company can be calculated as a
percentage of sales or it may vary depending on the volume of sales.

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Credit Card Transactions 2

When a credit card is used, the retailer receives cash, net of the credit
card fee, immediately upon deposit of the credit card sales receipt at the
bank or when the credit card is processed electronically at the point of
sale. For instance, if TechCom has $100 of credit card sales with a 4% fee
and cash is received immediately, the entry is (assume cost of sales is
$40):
Aug. 15 Cash 96
Credit Card Expense 4
Sales 100
To record credit card sales less a 4% credit card expense.

15 Cost of Goods Sold 40

Merchandise Inventory 40
To record cost of sales.
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Debit Card Transactions 1

• The use of debit cards is common and popular with consumers.

• Payment for a purchase is electronically transferred from the customer’s
bank account to the vendor’s bank account immediately at the point of
sale.
• The customer authorizes the transaction by entering their personal
identification number (PIN).
• Normally, the bank charges the retailer a fee for this service.

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Debit Card Transactions 2

The entries are identical to a credit card sale. For example, assume a
customer purchases a $100 service on October 1 and pays using a debit
card. If the bank charges the retailer $0.40 per debit card transaction, the
entry is:
Oct. 1 Cash 99.60
Debit Card Expense 0.40
Service Revenue 100.00
To record a debit card transaction.

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Contactless Payments 1

• Contactless payment options include tap to pay technology for both

debit and credit cards as well as features such as Apple Pay, Google Pay,
Samsung Pay, Fitbit Pay, and other bank applications that enable
contactless payment.
• Banks such as RBC, Scotiabank, and TD Canada Trust issue Interac Flash
debit cards with built-in radio-frequency identification (RFID) technology
that allows customers to pay using contactless debit technology.
• Credit card companies such as Visa, Mastercard, and American Express
also utilize the same RFID contactless payment technology.
• The cards are embedded with an integrated circuit chip and antenna. By
holding a debit or credit card at the contactless reader, a purchase is
quickly and securely processed.

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Contactless Payments 2

• The advantages of these apps? Convenience, for one: merchants can

serve customers more efficiently. The need for efficiency at the point of
sale is significant because of the huge volumes of transactions now
being handled electronically. In 2020, 89% of Canadians carried a credit
card and 34% of Canadians with a credit or debit card utilized
contactless payment technology.
• Security is another advantage. Security is a growing concern given the
increase in electronic payments and related increase in fraud. The new
Interac Flash card is reported to enhance protection against security
issues like skimming, counterfeiting, transaction replay types of fraud,
and electronic pickpocketing.

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 1-52

CHECKPOINT

7. What is a benefit to the retailer of accepting credit and debit cards?

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Bank Statements 1

Different banks use a variety of formats for their bank statements;

however, they all include the following information:
1. Beginning-of-month balance of the depositor’s account.
2. Cheques and other debits decreasing the account during the month.
3. Deposits and other credits increasing the account during the month.
4. End-of-month balance of the depositor’s account.

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Bank Statements 2

A summarizes
changes in the
account.

B lists paid
cheques in
date order
along with
other debits
(or decreases).

C lists deposits
and credits
(increases) to
the account.

D shows the
daily account
balances.
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 1-55

IMPORTANT TIP

Notice that deposits are called credits and cheques are called debits on
the bank statement.
This is because the bank statement reports information from the bank’s
point of view—that a depositor’s account is a liability on the bank’s
records since the money belongs to the depositor and not the bank.

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LO6: Bank Reconciliations

• A form of internal control over cash that explains the difference

between the balance of a chequing account according to the depositor’s
records and the balance reported on the bank statement.
• The purpose of a bank reconciliation is to reconcile the two balances
and explain or account for the differences in these two balances.

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Bank Balance Adjustments

1. ADD: Unrecorded deposits (also known as deposits in transit or

outstanding deposits).
• Deposits made and recorded by the depositor but not yet captured
on the bank statement.
2. DEDUCT: Outstanding cheques.
• Cheques written (or drawn) for outstanding payables and expenses,
resulting in a decrease in the company’s Cash account.
3. ADJUST FOR (+/-): Errors.
• Both banks and depositors can make errors.

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 1-58

IMPORTANT TIP

Adjustments to the Bank Balance

We only adjust the bank balance for items that have been recorded
correctly in the accounting records but by the date of the bank statement
had not yet been received by the bank or paid out of the bank account.
This includes outstanding cheques that have been written to
suppliers/employees but have not yet been drawn out of the bank
account. It also includes cash deposits in transit that were collected by the
business but were not yet received by the bank.

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Book Balance Adjustments 1

1. ADD (+): Interest earned and unrecorded cash receipts for

collections, and electronic transfers.
• Banks sometimes act as collection agents for their depositors
• When a bank collects an item, it adds it to the depositor’s account, less
any service fee.
• If an account earns interest, the bank statement includes a credit for
the amount earned during the past month.
2. DEDUCT (–): NSF cheques and for services.
A. Non-sufficient funds (NSF) cheques. A company deposits a customer’s
cheque that is uncollectible.
B. Services. Other possible bank charges to a depositor’s account
reported on a bank statement include the printing of new cheques and
a service charge for maintaining the account.
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Book Balance Adjustments 2

3. Adjust for (+/–): Errors.

• To find errors we use the same approach as described in the bank
errors section above.
• These kinds of errors might not be discovered until the depositor
prepares a bank reconciliation.

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 1-61

IMPORTANT TIP
We only adjust the book balance for items that showed up on the bank
statement and have not yet been recorded in the G/L, such as collections
of a note receivable, errors, interest earned, NSF cheques, bank service
charges, or cheque printing charges.

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 1-62

Comparison of Bank and Book Balance

Adjustments

Bank Balance Adjustments: Book Balance Adjustments:

Add deposits in transit. Add interest earned and

unrecorded cash receipts.
Subtract outstanding cheques. Subtract bank fees and NSF
cheques.
Add or subtract corrections of Add or subtract corrections of
bank errors. book errors.

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 1-63

IMPORTANT TIP
Understanding Bank Reconciliation Terminology—Bank Account vs. Cash
Account
The bank account refers to the actual account of cash held by the local
bank. This is also referred to as a chequing account, payroll account, etc.

The cash account is the company’s internal accounting record that

summarizes all internal accounting transactions in the company’s general
ledger. The total cash reported on the financial statements will be a
summary of all cash and cash equivalents held by the company.
The purpose of the bank reconciliation is to explain the difference
between the bank account and the corresponding G/L account balance.

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Illustrating the Steps in Compiling a Bank

Reconciliation 1

The first nine steps in compiling the bank reconciliation are highlighted as
follows:
① Obtain the bank statement and identify the bank balance of the cash account at October 31
(balance per bank) and enter it on the top left-hand side of the bank reconciliation. The bank
balance shown on the bank statement for MovieFlix is $2,050 (from Exhibit 7.6).
② Add any unrecorded deposits* and bank errors* to the bank balance on the bank
reconciliation that were recorded in the accounting records but not yet received into the
bank account. A $145 deposit was placed in the bank’s night depository on October 31 and is
not recorded on the bank statement (from Exhibit 7.7).
③ Subtract any outstanding cheques that have not yet been processed through the bank
account* and any bank errors that overstate the bank balance from the bank balance. * A
comparison of cheques that were processed through the bank account by cheque number
(referred to as cancelled cheques) with the company’s cash disbursements journal by cheque
number showed two cheques outstanding: #124 for $150 and #126 for $200 (from Exhibit
7.8).
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Illustrating the Steps in Compiling a Bank

Reconciliation 2

⑤ Identify the company’s balance of the cash account (book balance) and enter it on the
right-hand side of the bank reconciliation. Cash balance shown in the accounting records is
$1,404.58 (from Exhibit 7.9)
⑥ Add any unrecorded cash receipts identified on the bank statement, such as notes
receivable collected, interest earned, and errors understating the book balance. *
ⓐ Enclosed with the bank statement is a credit memo showing that the bank collected a note
receivable for the company on October 17. The note’s proceeds of $500 (minus a $15 collection
fee) were credited to the company’s account. This credit memo is not yet recorded by the
company (from Exhibit 7.6).
ⓑ The bank statement shows a credit of $8.42 for interest earned on the average cash balance
in the account. There was no prior notification of this item and it is not yet recorded on the
company’s books (from Exhibit 7.6).

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Illustrating the Steps in Compiling a Bank

Reconciliation 3

⑦ Subtract any unrecorded bank fees from the bank, such as monthly service charges, NSF
fees, and errors overstating the book balance* from the book balance on the bank
reconciliation.
Debits on the bank statement that are not recorded on the books include ⓐ a $23 charge for
cheques printed by the bank, and ⓑ an NSF cheque for $20 plus ⓒ a related $10 processing fee.
The NSF cheque is from a customer, Frank Heflin, and was originally included as part of the
October 3 deposit (from Exhibit 7.6).
⑧ Calculate the adjusted book balance, also called the corrected or reconciled balance. See
Exhibit 7.10.
⑨ Verify that the adjusted book balance = the adjusted bank balance from Steps 4 and 8. If so,
they are reconciled. If not, check for mathematical accuracy and missing data. See Exhibit 7.10.

*For simplicity, this example includes no errors and assumes that there were no
outstanding cheques or deposits on last month’s bank reconciliation. The End-of-
Chapter Demonstration Problem illustrates these additional complexities.
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 1-67

IMPORTANT TIP
Understanding Bank Reconciliation Terminology—Cancelled Cheques vs.
Outstanding Cheques.
The term cancelled cheques can be confusing. This term refers to cheques that have been
written by the company and have already processed through their bank account with the
bank. An example would be a cheque written to a supplier for inventory items and the
supplier deposited the cheque into the supplier’s bank account, resulting in a transfer of
money from the bank account. Cheques that show up on a bank statement as a withdrawal
of funds (referred to in banking terms as a debit) are all cancelled cheques, as the
payments have processed through the account.
Outstanding cheques have been written by the company and have not yet been processed
through the company’s bank account. Once they do process through the account they
become a cancelled cheque. Outstanding cheques show up on the company’s internal
accounting records in the cash disbursements journal when the cheque is written (internal
accounting record of the cash account is credited and the related inventory or expense
account—payroll, supplies, utilities—is debited), but because they have not yet been
deposited by the supplier/employee etc. the bank account does not show the adjustment.
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 1-68

Bank Statement

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EXHIBIT 7.6 © McGraw Hill Ltd. 7-68
 1-69

Bank Reconciliation 2

EXHIBIT 7.7 EXHIBIT 7.8

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Bank Reconciliation 3

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 1-71

Bank Reconciliation 4

• When the reconciliation is complete, the employee sends a copy

to the accounting department to record any needed journal
entries.

• For instance, entries are needed to record any adjustments made

to the balance per books to reflect items such as unrecorded debit
and credit memos and any company mistakes.

• Another copy goes to the cashier’s office. This is especially

important if the bank has made an error that needs correction.

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Recording Adjusting Entries Identified from

the Bank Reconciliation (Step 10) 1

• In the final step of preparing a bank reconciliation, we investigate

which journal entries need to be recorded to ensure the cash
account is correct at the end of the accounting period.

• The process of putting together a bank reconciliation helps to

locate errors by either the bank or the depositor.

• It also identifies unrecorded items that need recording on the

company’s books.

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Recording Adjusting Entries Identified from

the Bank Reconciliation (Step 10) 2

In MovieFlix’s reconciliation, the adjusted balance of $1,845.00 is the

correct balance as of October 31. But the company’s accounting
records show a $1,404.58 balance. We must prepare journal entries
to adjust the book balance to the correct balance. It is important to
remember that only the items reconciling the book balance side
require adjustment.
This means that the following four entries are required for MovieFlix:
1. Collection of Note
Oct. 31 Cash 485.00
Collection Expense 15.00
Notes Receivable 500.00
To record collection fee and proceeds of a note
collected by the bank.
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Recording Adjusting Entries Identified from

the Bank Reconciliation (Step 10) 3

2. Interest Earned
Interest earned is a type of income, and the entry recognizes both the
profit from interest income and the related increase in Cash.

The second entry records the interest income credited to MovieFlix’s

account by the bank:
31 Cash 8.42
Interest Income 8.42
To record interest earned on the average Cash
balance in the chequing account.

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Recording Adjusting Entries Identified from

the Bank Reconciliation (Step 10) 4

3. NSF Cheque
The third entry records the NSF cheque that is returned as
uncollectible. The $20 cheque was received from Heflin in payment of
his account and deposited. When the cheque cleared the banking
system, Heflin’s bank account was found to have insufficient funds to
cover the cheque. The bank charged $10 for handling the NSF cheque
and deducted $30 total from MovieFlix’s account. The company must
reverse the entry made when the cheque was received and also
record the $10 fee:
31 Accounts Receivable – Frank Heflin 30.00
Cash 30.00
To charge Frank Heflin’s account for his NSF
cheque and the bank’s fee.
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Recording Adjusting Entries Identified from

the Bank Reconciliation (Step 10) 5

4. Cheque Printing
The fourth entry debits Office Supplies Expense for the printing of
cheques:

31 Office Supplies Expense 23.00

Cash 23.00
Cheque printing charge.

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 1-77

IMPORTANT TIP

When recording journal entries identified from the bank

reconciliation, we only adjust for items that had been recorded as an
adjustment to the book balance.

For example: collection of a note by the bank, interest earned on the

bank account, cheque printing charges, or NSF fees.

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 1-78

Controls Related to Bank Reconciliations

The employee who prepares the bank reconciliation should not be

responsible for cash receipts, processing cheques, or maintaining cash
records. This employee needs to gather information from the bank
statement and from existing records.

Bank reconciliations should be reviewed on a monthly basis by an

independent party. As this account historically has a high risk of fraud,
it is important that the reviewer understand what they are reviewing
and red flags to look out for, such as photocopies of bank statements
in lieu of original statements, as these can be manipulated by a party
trying to cover up theft of cash.

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 1-79

CHECKPOINT

8. What is a bank statement?

9. What does it mean to reconcile a bank balance?
10. Why do we reconcile the bank statement balance of cash and the
depositor’s book balance of cash?
11. List items affecting the bank side of a reconciliation and indicate
if the items are added or subtracted.
12. List items affecting the book side of a reconciliation and indicate
if the items are added or subtracted.

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 1-80

LO7: Quick Ratio

The quick ratio, also called the acid-test ratio, differs from the current
ratio by excluding current assets that are less liquid, such as inventory and
prepaids.

EXHIBIT 7.11

*Quick assets are assets that can be readily converted to cash and include cash, short-
term investments, and receivables. Current asset accounts that are excluded from the
quick ratio would include any restricted cash balances and prepaid expenses.
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Current and Quick Ratios Compared

• The quick ratio is interpreted in a similar manner as the current ratio.

• Recipe Unlimited’s current ratio at December 27, 2020 shows $0.65 of
current assets available to cover each $1.00 of current liability as it
comes due. As a stricter measure, the quick ratio tells us Recipe
Unlimited Corporation had $0.34 of quick assets to cover each $1.00 of
current obligations at the end of 2020. A quick ratio equal to or greater
than 1 is generally considered favourable (good). Recipe Unlimited has
improved its current ratio over the past two years compared to 2018.

Dec 27 2020 Dec 29 2019 Dec 30 2018

Current Ratio 0.65 0.66 0.44
Quick Ratio 0.34 0.37 0.33

EXHIBIT 7.12
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 1-82

CHECKPOINT

13. ABC Company had quick ratios of 1.4 and 1.6 for 2023 and 2024,
respectively. Is the change in the ratio favourable or unfavourable?

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 1-83

Critical Thinking Challenge

Refer to the Critical Thinking Challenge questions at the

beginning of the chapter.

Did your answers change after reading the chapter?

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 1-84

Summary 1

1. Define, explain the purpose, and identify the principles of internal

control.
An internal control system consists of the policies and procedures that
managers use to protect assets, ensure reliable accounting, promote
efficient operations, and encourage adherence to company policies. It is a
key part of systems design, analysis, and performance. It can prevent
avoidable losses and help managers both plan operations and monitor
company and human performance. Principles of good internal control
include establishing responsibilities to ensure custody, authorization, and
recording of assets are performed by separate individuals. Important
controls include maintaining adequate records, insuring assets and
bonding employees, dividing responsibilities for related transactions,
applying technological controls, and performing regular independent
reviews.
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Summary 2

2. Define cash and explain how it is reported.

Cash consists of cash on hand and demand deposits, including currency
and coins, and amounts on deposit in bank, chequing, and some savings
accounts. It also includes items that are acceptable for deposit in these
accounts. Cash equivalents or short-term investments are similar to cash;
therefore, most companies combine them with cash as a single item on
the balance sheet. Cash and cash equivalents are liquid assets because
they are converted easily into other assets or used in paying for services
or liabilities.

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Summary 3

3. Apply internal control to cash.

Internal control of cash receipts ensures that all cash received is properly
recorded and deposited. Cash receipts arise from cash sales, collections of
customers’ accounts, receipts of interest and rent, bank loans, sale of
assets, and owner investments. Good internal control for cash receipts by
mail includes at least two people being assigned to open the mail and
prepare a list with each sender’s name, amount of money received, and
explanation.

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Summary 4

4. Explain and record petty cash fund transactions.

To avoid writing cheques for small amounts, a company sets up one or
more petty cash funds to pay for items such as postage, courier fees,
repairs, and supplies. A petty cashier is responsible for safekeeping of the
cash, for making payments from this fund, and for keeping receipts and
records. A Petty Cash account is debited when the fund is established or
increased in size. The cashier presents all paid receipts to the company’s
cashier for reimbursement to restore petty cash to its full amount. Petty
cash disbursements are recorded whenever the fund is replenished with
debits to expense accounts reflecting receipts and a credit to cash.

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Summary 5

5. Explain and identify banking activities and the control features they
provide.
Banks offer several services—such as the bank account, the bank deposit,
and chequing—that promote the control or safeguarding of cash. A bank
account is set up by a bank and permits a customer to deposit money for
safeguarding and cheque withdrawals. A bank deposit is money added to
the account with a deposit slip as proof. A cheque is a document signed by
the depositor instructing the bank to pay a specified amount of money to
a designated recipient. Sales resulting from debit card and credit card
transactions are usually deposited into the bank account immediately, less
a fee. Electronic funds transfer (EFT) uses electronic communication to
transfer cash from one party to another, and it decreases certain risks.
Companies increasingly use it because of its convenience and low cost.
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Summary 6

6. Prepare a bank reconciliation and journalize any resulting

adjustment(s).
A bank reconciliation is prepared to prove the accuracy of the depositor’s
and the bank’s records. In completing a reconciliation, the bank statement
balance is adjusted for items such as outstanding cheques and unrecorded
deposits made on or before the bank statement date but not reflected on
the statement. The depositor’s Cash account balance also often requires
adjustment. These adjustments include items such as service charges,
bank collections for the depositor, and interest earned on the account
balance.

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 1-90

Summary 7

7. Calculate the quick ratio and explain its use as an indicator of a

company’s liquidity.
The quick ratio (also known as acid-test ratio) is calculated as quick assets
(cash, short-term investments, and receivables) divided by current
liabilities. It is an indicator of a company’s ability to pay its current
liabilities with its existing quick assets. A ratio equal to or greater than 1 is
often considered adequate.

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 1-91

End of Chapter

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