Limitations of the internal control system

You are an accountant at a local CPA firm that is auditing the accounting records of ABC Company. You have been asked to educate the accounting department about the limitations of the internal control system in preparation for an upcoming audit. During your audit, you have identified that because of a weak internal control system, an adjusting entry for prepaid insurance was not recorded for the first 3 months of the year at $500 per month.

·         Identify the limitations of the internal control system. Provide at least 3 limitations.

·         Provide at least 2 examples of internal control procedures, and explain how these procedures can be implemented.

·         Identify symptoms of a lack of internal control.

·         Explain the impact of the missing journal entry on the financial statements of the company.

The Accounting Equation

The Importance of the Accounting Equation

The accounting equation, the transactions behind it, and the rules for its use are to business

like the scoring, rules, and regulations are to a game of baseball. If each baseball team played

by different rules and scored the game differently, no one would know which team is the best

or, for that matter, understand what was going on as they watched the game being played.

Without the use of the accounting equation, businesses could not be compared to each other

and owners and investors would not be able to determine the profit or loss of a company.

The Accounting Equation

The accounting equation on the surface looks very simple: Assets = Liabilities + Owner's

Equity. However, like in the game of baseball, there are many rules and plays (transactions)

that occur before the home run is scored, or the accounting equation is finalized for a business.

The assets of a business include all the company's resources. Examples are land, building,

manufacturing equipment, office equipment and furniture, and inventory. A company's liabilities

are what it owes to creditors. This could be money the company borrowed to buy equipment or

money it owes for the purchase of supplies and inventory. These liabilities are subtracted from

the owner's equity to arrive at the VALUE or assets of the business. The owner's equity

includes the cash the owner puts into the business, the assets that are transferred into the

business, and the net income (income after all expenses are accounted for) that remains in the

business. Both sides of the accounting equation must be equal.

The Rules

The rules or guidelines for tracking business activities were developed over many years of

business practice. Rules were developed and regulatory agencies were created to continue to

develop, regulate, and publish the rules by which the game of business would be played. The

rules are called the Generally Accepted Accounting Principles and the regulatory agency is the

Financial Accounting Standards Board (FASB).

The Transactions and Chart of Accounts

The transactions record the plays or activities of the business. All transactions are either debits

or credits to an account. An example is a company that buys a piece of manufacturing

equipment costing $10,000 and uses cash. What has it done? It has traded one asset for

another (cash for equipment). The cash account is reduced by $10,000 (as a credit) and the

equipment account is increased by $10,000 (as a debit). All transactions are two sided. Each

must have a debit and a credit.

It takes many accounts to organize and control a business. This list of accounts is called the

chart of accounts. Some examples are assets (which include cash, inventory, capital

equipment, supplies, and accounts receivable) and liabilities (which include accounts payable,

wages payable, and long-term loans). In the evaluation (audit) and control of a business, one

of the most important reviews is to analyze each transaction for each account to make sure

that each transaction has an offsetting posting (debit and credit). Once all transactions are

correctly posted to each account, a summary of all accounts must be posted to reports or

forms. This shows the performance of the business. Types of Forms/Reports

The most widely used reports are the income statement, balance sheet, and the statement of

cash flows. The income statement is a report of the activity of a business through time

(month/year). The balance sheet is a snapshot of the business at a single point in time (monthend, year-end) and reports the values of the accounting equation. The statement of cash flows

is a report of the availability of cash and use of cash through time - usually monthly

Special Income Statement Items

Generally accepted accounting principles (GAAP) require that the following irregular items

(items that do not happen frequently in the regular course of business) be listed separately in

the income statement:

Discontinued operations

Extraordinary items

Unusual gains and losses

Changes in accounting principles

Changes in estimates Discontinued Operations

Discontinued operations occur when the results of operations and cash flows of a segment of

an entity are eliminated and are no longer considered part of continuing operations and the

company no longer participates in that segment of the operation. If either of these conditions

is not met, an entity cannot separately disclose the transaction as a discontinued operation.

When an organization decides to dispose of a segment of its operations, certain aspects of the

transaction must be reported separately, and disclosures must be presented in the financial

statement notes. On the income statement, a separate category for the gain or loss

calculations from the disposal of the assets of that segment of the entity must be included.

Also, the results of operations for the disposed business segment are reported in discontinued

operations section.

Extraordinary Items

Extraordinary items are material transactions that are unusual in nature and occur

infrequently. All characteristics must exist for an item to be classified as an extraordinary

item on the income statement. If the transaction does meet the one or more of the criteria for

extraordinary items—material, unusual, and infrequent— then the item is shown net of tax

below the discontinued operations sections of the income statement. An earthquake in the Midwest would be considered material, unusual, and infrequent for that area, so it would

qualify as an extraordinary item.

Unusual Gains and Losses

Material gains and losses that are either unusual or occur infrequently (but not both) cannot

be included as an extraordinary item and are instead considered unusual gains and losses.

These transactions are presented with the normal revenue and expense income statement

sections. If the transaction is material, then the items are disclosed separately on the income

statement; however, if the transaction is immaterial, then the items are combined with other

items on the income statement. An example of a transaction that was included as an unusual

gain or loss because it did not qualify as an extraordinary item was Hurricane Katrina. The

FASB ruled that because that area of the country is prone to hurricanes, it was not unusual

for a hurricane to occur. Therefore, any losses were classified as unusual but not

extraordinary. This was a shock to many organizations.

Changes in Accounting Principles

A change in accounting principle occurs when an organization adopts a new accounting

principle that is different from the one previously used such as changing from LIFO to FIFO

or straight-line depreciation to double declining balance. A company calculates the change in

accounting principle by making a retrospective adjustment to the financial statements. This

basically means restating the financial statements. The retroactive adjustment restates the

previous years' financial statements on using the newly adopted principle. The company also

records the cumulative effect of the change for prior periods as an adjustment to beginning

retained earnings of the earliest year presented in the financial statements. Most companies

will release 2 years of financial information in their annual report, but there is not a set

amount of years that must be disclosed when a change in accounting principle occurs.

Detailed information of the change in the accounting principle is also disclosed in the notes

to the financial statements. It is extremely important for accountants and users of financial

information to understand the transaction that the financial statements and notes be used in

conjunction with each other.

Changes in Estimates

When accountants prepare the financial statements of an entity, many estimates are used in

all phases of preparation—such as the estimated useful life that is used in the calculation of

depreciation. Adjustments that occur because of the use of estimates are used in the

determination of income for the current period, and future periods and are not treated as

changes in the accounting principle on the income statement. Therefore, it is extremely

important to understand the difference between a change in accounting principle and a

change in the accounting estimate, as they are handled differently on the income statement.

In addition, changes in estimates are not considered errors such as prior period adjustments

(that would be recorded in the statement of retained earnings or extraordinary item