Why should the person who keeps the records of an asset not be the person responsible for its custody What are the limitations of internal control?

Recall that a bank reconciliation has two parts.

The "bank" part starts with the bank balance, makes adjustments for timing differences and errors, and arrives at an adjusted bank balance. Recall that the adjustments here are items that the bank doesn't know about yet. Also, recall that, except for bank errors (which must be individually analyzed), each of these items should be added or deducted based on what the bank will do when it processes the item.

Step 1—Identify the bank statement balance of the cash account (balance per bank). VideoBuster's bank balance is $2,050.

Step 2—Identify and list any unrecorded deposits and any bank errors understating the bank balance. Add them to the bank balance. VideoBuster's $145 deposit placed in the bank's night depository on October 31 is not recorded on its bank statement.

Step 3—Identify and list any outstanding checks and any bank errors overstating the bank balance. Deduct them from the bank balance. VideoBuster's comparison of canceled checks with its books shows two checks outstanding: No. 124 for $150 and No. 126 for $200.

Step 4—Compute the adjusted bank balance. The adjusted bank balance is $1,845.

No journal entries are required for the items reflected as adjustments to the cash balance per bank statement. These items are already recorded on the company's books.

The "book" part of the bank reconciliation starts with the book balance, makes adjustments for timing differences and errors, and arrives at an adjusted book balance. Again, think of the adjustments to the cash balance per books as the items that the company didn't know about until the bank statement was received. Except for book errors (which must be individually analyzed), each of these items should be added or deducted based on what the bank did when it processed the item.

Step 5—Identify the company's book balance of the cash account (balance per book). VideoBuster's book balance is $1,404.58.

Step 6—Identify and list any unrecorded credit memoranda from the bank, any interest earned, and errors understating the book balance. Add them to the book balance. VideoBuster's bank statement includes a credit memorandum showing the bank collected a note receivable for the company on October 23. The note's proceeds of $500 (minus a $15 collection fee) are credited to the company's account. VideoBuster's bank statement also shows a credit of $8.42 for interest earned on the average cash balance. There was no prior notification of this item, and it is not yet recorded.

Step 7—Identify and list any unrecorded debit memoranda from the bank, any service charges, and errors overstating the book balance. Deduct them from the book balance. Debits on VideoBuster's bank statement that are not yet recorded include (a) a $23 charge for check printing and (b) an NSF check for $20 plus a related $10 processing fee. (The NSF check is dated October 16 and was included in the book balance.)

Step 8—Compute the adjusted book balance. The adjusted book balance is $1,845.

Step 9—Verify that the two adjusted balances from steps 4 and 8 are equal.

What Are Internal Controls?

Internal controls are the mechanisms, rules, and procedures implemented by a company to ensure the integrity of financial and accounting information, promote accountability, and prevent fraud.

Besides complying with laws and regulations and preventing employees from stealing assets or committing fraud, internal controls can help improve operational efficiency by improving the accuracy and timeliness of financial reporting.

Key Takeaways

• Internal controls are the mechanisms, rules, and procedures implemented by a company to ensure the integrity of financial and accounting information, promote accountability and prevent fraud.
• Besides complying with laws and regulations, and preventing employees from stealing assets or committing fraud, internal controls can help improve operational efficiency by improving the accuracy and timeliness of financial reporting.
• Internal audits play a critical role in a company’s internal controls and corporate governance, now that the Sarbanes-Oxley Act of 2002 has made managers legally responsible for the accuracy of its financial statements.

Internal Controls

Understanding Internal Controls

Internal controls have become a key business function for every U.S. company since the accounting scandals in the early 2000s. In their wake, the Sarbanes-Oxley Act of 2002 was enacted to protect investors from fraudulent accounting activities and improve the accuracy and reliability of corporate disclosures. This has had a profound effect on corporate governance, by making managers responsible for financial reporting and creating an audit trail. Managers found guilty of not properly establishing and managing internal controls face serious criminal penalties.

The auditor’s opinion that accompanies financial statements is based on an audit of the procedures and records used to produce them. As part of an audit, external auditors will test a company’s accounting processes and internal controls and provide an opinion as to their effectiveness.

Internal audits evaluate a company’s internal controls, including its corporate governance and accounting processes. They ensure compliance with laws and regulations and accurate and timely financial reporting and data collection, as well as helping to maintain operational efficiency by identifying problems and correcting lapses before they are discovered in an external audit. Internal audits play a critical role in a company’s operations and corporate governance, now that the Sarbanes-Oxley Act of 2002 has made managers legally responsible for the accuracy of its financial statements.

No two systems of internal controls are identical, but many core philosophies regarding financial integrity and accounting practices have become standard management practices. While internal controls can be expensive, properly implemented internal controls can help streamline operations and increase operational efficiency, in addition to preventing fraud.

Regardless of the policies and procedures established by an organization, only reasonable assurance may be provided that internal controls are effective and financial information is correct. The effectiveness of internal controls is limited by human judgment. A business will often give high-level personnel the ability to override internal controls for operational efficiency reasons, and internal controls can be circumvented through collusion.

The U.S. Congress passed the Sarbanes-Oxley Act of 2002 to protect investors from the possibility of fraudulent accounting activities by corporations, which mandated strict reforms to improve financial disclosures from corporations and prevent accounting fraud.

Preventative vs. Detective Controls

Internal controls are typically comprised of control activities such as authorization, documentation, reconciliation, security, and the separation of duties. And they are broadly divided into preventative and detective activities.

Preventive control activities aim to deter errors or fraud from happening in the first place and include thorough documentation and authorization practices. Separation of duties, a key part of this process, ensures that no single individual is in a position to authorize, record, and be in the custody of a financial transaction and the resulting asset. Authorization of invoices and verification of expenses are internal controls. In addition, preventative internal controls include limiting physical access to equipment, inventory, cash, and other assets.

Detective controls are backup procedures that are designed to catch items or events that have been missed by the first line of defense. Here, the most important activity is reconciliation, used to compare data sets, and corrective action is taken upon material differences. Other detective controls include external audits from accounting firms and internal audits of assets such as inventory.

Auditing techniques and control methods from England migrated to the United States during the Industrial Revolution. In the 20th century, auditors' reporting practices and testing methods were standardized.

Why Are Internal Controls Important?

Internal controls are the mechanisms, rules, and procedures implemented by a company to ensure the integrity of financial and accounting information, promote accountability, and prevent fraud. Besides complying with laws and regulations and preventing employees from stealing assets or committing fraud, internal controls can help improve operational efficiency by improving the accuracy and timeliness of financial reporting.

The Sarbanes-Oxley Act of 2002, enacted in the wake of the accounting scandals in the early 2000s, seeks to protect investors from fraudulent accounting activities and improve the accuracy and reliability of corporate disclosures.

What Are the Two Types of Internal Controls?

Internal controls are broadly divided into preventative and detective activities. Preventive control activities aim to deter errors or fraud from happening in the first place and include thorough documentation and authorization practices. Detective controls are backup procedures that are designed to catch items or events that have been missed by the first line of defense. 

What Are Some Preventive Internal Controls?

Separation of duties, a key part of the preventive internal control process, ensures that no single individual is in a position to authorize, record, and be in the custody of a financial transaction and the resulting asset. Authorization of invoices, verification of expenses, limiting physical access to equipment, inventory, cash, and other assets are examples of preventative internal controls.

What Are Detective Internal Controls?

Detective internal controls attempt to find problems within a company's processes once they have occurred. They may be employed in accordance with many different goals, such as quality control, fraud prevention, and legal compliance. Here, the most important activity is reconciliation, used to compare data sets, and corrective action is taken if there are material differences. Other detective controls include external audits from accounting firms and internal audits of assets such as inventory.

Why should the person who keeps the records of an asset not be the person responsible for its custody?

Why should the responsibility for maintaining the accounting records be separated from the responsibility for operations?

What are the limitations of internal controls?

Why should the responsibility for related transactions be divided among different departments or individuals?