Chapter 04

Cash and Internal Controls

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Part A

Internal Controls

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LO1 Discuss the Impact of Accounting Scandals and the Passage of the Sarbanes-Oxley Act

o Managers are entrusted with the resources of both the company’s lenders (liabilities) and owners (stockholders' equity).

o Managers of the company act as stewards or caretakers of the company’s assets.

o In recent years some managers have shirked their ethical responsibilities.

o In many cases, top executives misreported accounting information to cover up their company’s poor operating performance and hoped to fool investors into overvaluing the company’s stock.

o Managers are entrusted with the resources of both the company’s lenders (liabilities) and owners (stockholders' equity).

o Managers of the company act as stewards or caretakers of the company’s assets.

o In recent years some managers have shirked their ethical responsibilities.

o In many cases, top executives misreported accounting information to cover up their company’s poor operating performance and hoped to fool investors into overvaluing the company’s stock.

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Recent Accounting Scandals and Response

FRAUD FIRM FRAUD FIRM

AUDIT FIRM

Arthur Andersen

AUDIT FIRM

Arthur Andersen

WorldCom WorldCom Enron Enron

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Sarbanes-Oxley Act of 2002

Congress passed the Sarbanes-Oxley Act, also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly referred to as SOX.

Congress passed the Sarbanes-Oxley Act, also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly referred to as SOX.

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Internal control

Hiring of auditor

Conflicts of interest

Auditor rotation

Auditors to

Retain of

work papers

Nonaudit

services

Corporate

executive

accountability

Oversight board

Major

Provisions

Major Provisions of the Sarbanes-Oxley Act of 2002

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LO2 Identify the Components, Responsibilities, and Limitations of Internal Control

From a financial accounting perspective, internal control is a company’s plan to:

o Safeguard the company’s assets.

o Improve the accuracy and reliability of accounting information

o Effective internal control builds a wall to prevent misuse of company funds by employees and fraudulent or errant financial reporting

From a financial accounting perspective, internal control is a company’s plan to:

o Safeguard the company’s assets.

o Improve the accuracy and reliability of accounting information

o Effective internal control builds a wall to prevent misuse of company funds by employees and fraudulent or errant financial reporting

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Framework for Internal Control

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Components of Internal Control

o Control Environment:

_ sets the overall ethical tone of the company with respect to internal control. It includes formal policies related to management’s philosophy, assignment of responsibilities, and organizational structure.

o Risk Assessment:

_ identifies and analyzes internal and external risk factors that could prevent a company’s objectives from being achieved.

o Monitoring: _ includes formal procedures for reporting control

deficiencies.

o Control Environment:

_ sets the overall ethical tone of the company with respect to internal control. It includes formal policies related to management’s philosophy, assignment of responsibilities, and organizational structure.

o Risk Assessment:

_ identifies and analyzes internal and external risk factors that could prevent a company’s objectives from being achieved.

o Monitoring: _ includes formal procedures for reporting control

deficiencies.4-9

o Control Activities:_ are the policies and procedures that help ensure

that management’s directives are being carried out. The two general types of control activities are:▪ Detective controls designed to detect errors or fraud that

already have occurred; Examples: Separation of duties, Physical controls, Proper authorization, Employee management

▪ Preventive controls designed to keep errors or fraud from occurring in the first place. Examples: Reconciliations, Performance reviews

o Information and Communication: _ depend on the reliability of the accounting

information system itself.

o Control Activities:_ are the policies and procedures that help ensure

that management’s directives are being carried out. The two general types of control activities are:▪ Detective controls designed to detect errors or fraud that

already have occurred; Examples: Separation of duties, Physical controls, Proper authorization, Employee management

▪ Preventive controls designed to keep errors or fraud from occurring in the first place. Examples: Reconciliations, Performance reviews

o Information and Communication: _ depend on the reliability of the accounting

information system itself.

Components of Internal Control

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Responsibilities for Internal Control

o Everyone in a company has an impact on the operation and effectiveness of internal controls, but the top executives are the ones who must take final responsibility for their establishment and success.

o The CEO and CFO sign a report each year assessing whether the internal controls are adequate. Section 404 of SOX requires not only that companies document their internal controls and assess their adequacy, but that the company’s auditors provide an opinion on management’s assessment.

o A recent survey by the Financial Executives Institute of 247 executives reports that the total cost to a company of complying with Section 404 averages nearly $4 million.

o The Public Company Accounting Oversight Board (PCAOB) further requires the auditor to express its own opinion on whether the company has maintained effective internal control over financial reporting.

o Everyone in a company has an impact on the operation and effectiveness of internal controls, but the top executives are the ones who must take final responsibility for their establishment and success.

o The CEO and CFO sign a report each year assessing whether the internal controls are adequate. Section 404 of SOX requires not only that companies document their internal controls and assess their adequacy, but that the company’s auditors provide an opinion on management’s assessment.

o A recent survey by the Financial Executives Institute of 247 executives reports that the total cost to a company of complying with Section 404 averages nearly $4 million.

o The Public Company Accounting Oversight Board (PCAOB) further requires the auditor to express its own opinion on whether the company has maintained effective internal control over financial reporting.

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Limitations of Internal Control

o Internal control systems will more likely detect operating and reporting errors.

o No internal control system can turn a bad employee into a good one.

o Internal control systems will more likely detect operating and reporting errors.

o No internal control system can turn a bad employee into a good one.

o Internal control systems are especially susceptible to collusion.

o Internal control systems are especially susceptible to collusion.

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Part B

CashCash

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LO3 Define Cash and Cash Equivalents

Cash: _ includes currency, coins, and balances in

savings and checking accounts, as well as items acceptable for deposit in these accounts, such as checks received from customers.

Cash equivalents: _ short-term investments that have a maturity

date no longer than three months from the date of purchase.

Cash: _ includes currency, coins, and balances in

savings and checking accounts, as well as items acceptable for deposit in these accounts, such as checks received from customers.

Cash equivalents: _ short-term investments that have a maturity

date no longer than three months from the date of purchase.

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LO4 Understand Controls over Cash Receipts and Cash Disbursements

Cash Controls:_ management must safeguard all assets

against possible misuse. Again, because cash is especially susceptible to theft, internal control of cash is a key issue.

Cash Receipts:_ most businesses receive payment from the

sale of products and services either in the form of cash or as a check received immediately or through the mail.

Cash Controls:_ management must safeguard all assets

against possible misuse. Again, because cash is especially susceptible to theft, internal control of cash is a key issue.

Cash Receipts:_ most businesses receive payment from the

sale of products and services either in the form of cash or as a check received immediately or through the mail.

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Internal control over cash receipts could include the following steps:

1. Record all cash receipts as soon as possible. Theft is more difficult once a record of the cash receipt has been made.

2. Open mail each day, and make a list of checks received, including the amount and payer’s name.

3. Designate an employee to deposit cash and checks into the company’s bank account each day, different from the person who receives cash and checks.

4. Have another employee record cash receipts in the accounting records. Verify cash receipts by comparing the bank deposit slip with the accounting records.

5. Accept credit cards or debit cards, to limit the amount of cash employees handle.

1. Record all cash receipts as soon as possible. Theft is more difficult once a record of the cash receipt has been made.

2. Open mail each day, and make a list of checks received, including the amount and payer’s name.

3. Designate an employee to deposit cash and checks into the company’s bank account each day, different from the person who receives cash and checks.

4. Have another employee record cash receipts in the accounting records. Verify cash receipts by comparing the bank deposit slip with the accounting records.

5. Accept credit cards or debit cards, to limit the amount of cash employees handle.

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Acceptance of Credit/Debit Cards

CASH RECEPITS

CREDIT CARDCREDIT CARDDEBIT CARDDEBIT CARD

It does not removecash from the cardholder’s account after each transaction.

It does not removecash from the cardholder’s account after each transaction.

It removes cashdirectly from the cardholder’sbank account at the time of use.

It removes cashdirectly from the cardholder’sbank account at the time of use.

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Cash Disbursements

o Managers should design proper control for cash disbursements to prevent any unauthorized payments and ensure proper recording.

o Consistent with our discussion of cash receipts, cash disbursements include not only disbursing physical cash, but also writing checks and using credit and debit cards.

o All these forms of payment constitute cash disbursement and require formal internal control procedures.

o Managers should design proper control for cash disbursements to prevent any unauthorized payments and ensure proper recording.

o Consistent with our discussion of cash receipts, cash disbursements include not only disbursing physical cash, but also writing checks and using credit and debit cards.

o All these forms of payment constitute cash disbursement and require formal internal control procedures.

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Important elements of a cash disbursement control system include the following steps:

1. Make all disbursements, other than very small ones, by check, debit card, or credit card. This provides a permanent record of all disbursements.

2. Authorize all expenditures before purchase and verify the accuracy of the purchase itself. The employee who authorizes payment should not also be the employee who prepares the check.

3. Make sure checks are serially numbered and signed only by authorized employees. Require two signatures for larger checks.

1. Make all disbursements, other than very small ones, by check, debit card, or credit card. This provides a permanent record of all disbursements.

2. Authorize all expenditures before purchase and verify the accuracy of the purchase itself. The employee who authorizes payment should not also be the employee who prepares the check.

3. Make sure checks are serially numbered and signed only by authorized employees. Require two signatures for larger checks.

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4. Periodically check amounts shown in the debit card and credit card statements against purchase receipts. The employee verifying the accuracy of the debit card and credit card statements should not also be the employee responsible for actual purchases.

5. Set maximum purchase limits on debit cards and credit cards. Give approval to purchase above these amounts only to upper-level employees.

6. Employees responsible for making cash disbursements should not also be in charge of cash receipts.

4. Periodically check amounts shown in the debit card and credit card statements against purchase receipts. The employee verifying the accuracy of the debit card and credit card statements should not also be the employee responsible for actual purchases.

5. Set maximum purchase limits on debit cards and credit cards. Give approval to purchase above these amounts only to upper-level employees.

6. Employees responsible for making cash disbursements should not also be in charge of cash receipts.

Important elements of a cash disbursement control system include the following steps:

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LO5 Reconcile a Bank Statement

o A bank reconciliation matches the balance of cash in the bank account with the balance of cash in the company’s own records.

o A company’s cash balance as recorded in its books rarely equals the cash balance reported in the bank statement.

o Differences in these balances occur because of either timing differences or errors.

o It is the possibility of these errors, or even outright fraudulent activities, that make the bank reconciliation a useful cash control tool.

o A bank reconciliation matches the balance of cash in the bank account with the balance of cash in the company’s own records.

o A company’s cash balance as recorded in its books rarely equals the cash balance reported in the bank statement.

o Differences in these balances occur because of either timing differences or errors.

o It is the possibility of these errors, or even outright fraudulent activities, that make the bank reconciliation a useful cash control tool.

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Bank Reconciliation

o Timing differences in cash occur when the company records transactions either before or after the bank records the same transaction.

o Errors can be made either by the company or its bank and may be accidental or intentional.

o Timing differences in cash occur when the company records transactions either before or after the bank records the same transaction.

o Errors can be made either by the company or its bank and may be accidental or intentional.

PossibleDifferences1. Timing2. Errors

Company’s Cash Records

Bank’sCash Records

BankReconciliation

BankStatement

•Deposits•Withdrawals

Reconciled Bank Balance

=Reconciled

Company Balance

PossibleDifferences1. Timing2. Errors

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Bank Statement

Date No.

3/5 293

3/9 294

3/22

3/31

296

A Name You Can Trust

Member FDICP.O. Box 26788

Odessa, TX 79760

(432) 799-BANK

First Bank

Statement Date:

Account Holder: Starlight Drive-In

221B Baker Street, Odessa, TX 79760

4061009619

March 31, 2012

Account Number:

Account SummaryBeginning Balance

1-Mar-12

Deposits and Credits Withdraws and Debits

Ending Balance

31-Mar-12No. Total No. Total

$8,300 $4,100 $3,800 4 $8,600 7

Account DetailsDeposits and Credits Withdraws and Debits Daily Balance

Amount Desc. Date Amount

Desc. Date Amount

$3,600 DEP 3/8 $2,100 CHK 3/5 $7,400

3,000 NOTE 3/12 2,900 CHK 3/8 5,300

1,980 DEP 3/15 400 EFT 3/9 8,300

20 INT 3/22 750 NSF 3/12 5,400

3/26 1,900 CHK 3/15 5,000

3/28 200 DC 3/22 6,230

3/31 50 SC 3/26 4,330

3/28 4,130

$8,600 $8,300 3/31 $4,100

Desc. DEP Customer deposit INT Interest earned SC Service charges

NOTE Note collected CHK Customer check NSF Non-sufficient funds

EFT Electronic funds transfer DC Debit card

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Company Records of Cash ActivitiesStarlight Drive-In

Cash Account RecordsMarch 1, 2012 to March 31, 2012

Deposits Checks

Date Desc. Amount Date No. Desc. Amount

3/5 Sales receipts $3,600 3/6 293 Salaries $2,100

3/22 Sales receipts 1,980 3/11 294 Rent 2,600

3/31 Sales receipts 2,200 3/21 295 Utilities 1,200

3/24 296 Insurance 1,900

3/30 297 Supplies 900

$7,780 $8,700

Summary of Transactions

BeginningCash balanceMarch 1, 2012 Deposits Checks

EndingCash Balance

March 31, 2012

$3,800 $7,780 $8,700 $2,880

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Step 1:Reconciling the Bank’s Cash Balance

o Cash transactions recorded by a company, but not yet recorded by its bank, include deposits outstanding and checks outstanding.

o Deposits outstanding are cash receipts of the company that have not been added to the bank’s record of the company’s balance.

o Checks outstanding are checks the company has written that have not been subtracted from the bank’s record of the company’s balance.

o Cash transactions recorded by a company, but not yet recorded by its bank, include deposits outstanding and checks outstanding.

o Deposits outstanding are cash receipts of the company that have not been added to the bank’s record of the company’s balance.

o Checks outstanding are checks the company has written that have not been subtracted from the bank’s record of the company’s balance.

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o Few examples of cash transactions recorded by the bank, but not yet recorded by the company are - items such as interest earned by the company, collections made by the bank on the company’s behalf, service charges, and charges for NSF checks.

o NSF checks: Checks drawn on nonsufficient funds or “bad” checks from customers.

o In addition, we adjust the company’s balance for any company errors.

o Few examples of cash transactions recorded by the bank, but not yet recorded by the company are - items such as interest earned by the company, collections made by the bank on the company’s behalf, service charges, and charges for NSF checks.

o NSF checks: Checks drawn on nonsufficient funds or “bad” checks from customers.

o In addition, we adjust the company’s balance for any company errors.

Step 2: Reconciling the Company’s Cash Balance

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Reconciling the Bank Statement

Before reconciliation $2,880 Deposits outstanding: +2,800

3/31 = $2,200 +200+20

Checks outstanding: -750#295 = $1,200 -200#297 = $900 -400

-50-300

After reconciliation $4,200 $4,200 After reconciliationCorrected rent expense error

+2,200

Service chargeEFT for advertising

Interest earned on bank accountInterest earned from note

Debit card for office equipment-2,100 NSF check

Note received

Starlight Drive-InBank Reconciliation

March 31, 2012

Bank’s Cash Balance Company’s Cash Balance$4,100 Before reconciliation

Reconciled

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Debit Credit3,020

2,800220

750200400

50300

1,700(Reconcile cash decreases)

Advertising Expense . . . . . . . . . . . . . . . . . Service Charge Expense . . . . . . . . . . . . . Rent Expense . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . .

(Reconcile cash increases)

Accounts Receivable . . . . . . . . . . . . . . . . Office Equipment . . . . . . . . . . . . . . . . . . . .

March 31, 2012Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Notes Receivable . . . . . . . . . Interest Revenue . . . . . . . . .

Step 3: Adjusting the Company’s Cash Balance

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LO6 Account for Petty Cash

o Companies like to keep a small amount of cash on hand at the company’s location for minor purchases such as postage, office supplies, delivery charges, and entertainment expense

o To pay for these minor purchases, companies keep some minor amount of cash on hand in a petty cash fund.

o Management writes a check for cash against the company’s checking account and puts that amount of withdrawn cash in the hands of an employee who becomes responsible for it. This employee is often referred to as the petty-cash custodian.

o Companies like to keep a small amount of cash on hand at the company’s location for minor purchases such as postage, office supplies, delivery charges, and entertainment expense

o To pay for these minor purchases, companies keep some minor amount of cash on hand in a petty cash fund.

o Management writes a check for cash against the company’s checking account and puts that amount of withdrawn cash in the hands of an employee who becomes responsible for it. This employee is often referred to as the petty-cash custodian.

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Account for Petty Cash

o Accounting for the petty cash fund involves recording transactionso Establish the fund,o Recognize expenditures from the fund,o Replenish the fund as the cash balance

becomes sufficiently low.o At any given time, the cash remaining in the fund

plus all receipts should equal the amount of the fund.

o Accounting for the petty cash fund involves recording transactionso Establish the fund,o Recognize expenditures from the fund,o Replenish the fund as the cash balance

becomes sufficiently low.o At any given time, the cash remaining in the fund

plus all receipts should equal the amount of the fund.

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Petty Cash

Suppose that at the beginning of May, Starlight Drive-In establishes a petty cash fund of $500 to pay for minor purchases. The entry to establish the fund is:

Suppose that at the beginning of May, Starlight Drive-In establishes a petty cash fund of $500 to pay for minor purchases. The entry to establish the fund is:

May 1 Debit CreditPetty Cash (on hand)…………….. 500

Cash (checking account)…. 500(Establish the petty cash fund)

Assume Starlight has the following expenditures from the petty cash fund during May:

Assume Starlight has the following expenditures from the petty cash fund during May: Date Expenditure Amount

May 7 Postage $75May 16 Delivery charges 85May 20 Office group lunch 50May 26 Office supplies 120

$330

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Petty Cash

By the end of May, the petty cash fund has distributed $330, leaving $170 in the fund along with receipts for $330. However, the company did not record these transactions at the time these expenditures were made. By the end of the period, the expenditures from the petty cash fund must be recorded.

By the end of May, the petty cash fund has distributed $330, leaving $170 in the fund along with receipts for $330. However, the company did not record these transactions at the time these expenditures were made. By the end of the period, the expenditures from the petty cash fund must be recorded.

May 1 Debit CreditPostage Expense………………… 75Delivery Expense………………… 85Entertainment Expense………… 50Supplies .......................................... 120

Petty Cash (on hand)…………. 330(Recognize expenditures from the petty cash fund )

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LO7 Identify the Major Inflows and Outflows of Cash

o Companies report cash in two ways.

o First, it is reported as an asset in the balance sheet under current assets and represents cash available for spending at the end of the reporting period. It provides only the final balance for cash.

o Secondly, reports information about cash receipts and payments during the period in a statement of cash flows.

o From the statement of cash flows, investors know a company’s cash inflows and cash outflows related operating, investing and financing activities.

o Companies report cash in two ways.

o First, it is reported as an asset in the balance sheet under current assets and represents cash available for spending at the end of the reporting period. It provides only the final balance for cash.

o Secondly, reports information about cash receipts and payments during the period in a statement of cash flows.

o From the statement of cash flows, investors know a company’s cash inflows and cash outflows related operating, investing and financing activities.

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o Operating activities include cash transactions involving revenue and expense events during the period.

o Investing activities include cash investments in long-term assets and investment securities.

o Financing activities include transactions designed to raise cash or finance the business. There are two ways to do this: borrow cash from lenders or raise cash from stockholders.

o Operating activities include cash transactions involving revenue and expense events during the period.

o Investing activities include cash investments in long-term assets and investment securities.

o Financing activities include transactions designed to raise cash or finance the business. There are two ways to do this: borrow cash from lenders or raise cash from stockholders.

Activities on Cash Flows Statement

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External Transactions of Eagle Golf Academy

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External Transactions of Eagle Golf Academy

Cash inflows:From customers (6 and 8) $4,200

Cash outflows:For salaries (9) (2,800)For rent (4) (6,000)

Net cash flows from operating activities ($4,600)

Purchase equipment (3) (24,000)Net cash flows from investing activities (24,000)

Issue common stock (1) 25,000Borrow from bank (2) 10,000Pay dividends (10) (200)

Net cash flows from financing activities 34,800Net increase in cash 6,200Cash at the beginning of the month 0Cash at the end of the month $6,200

Cash Flows from Financing Activities

For the month ended January 31, 2012Statement of Cash FlowsEAGLE GOLF ACADEMY

Cash Flows from Investing Activities

Cash Flows from Operating Activities

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LO8 Assess earnings quality by comparing net income and cash flows

Earnings quality is the ability of current net income to help us predict the future performance of a company. _ When net income does not provide a good

indicator of future performance, the lower its earnings quality is said to be.

_ Comparing the trend in a company’s reported net income to its trend in free cash flow, also provides earnings quality of a company.

_ Companies whose free cash flow is declining relative to the trend in net income are likely to have lower-quality earnings.

Earnings quality is the ability of current net income to help us predict the future performance of a company. _ When net income does not provide a good

indicator of future performance, the lower its earnings quality is said to be.

_ Comparing the trend in a company’s reported net income to its trend in free cash flow, also provides earnings quality of a company.

_ Companies whose free cash flow is declining relative to the trend in net income are likely to have lower-quality earnings.

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Comparing Net Income to Free Cash Flows

Net incomeNet income

Income StatementIncome Statement

RevenueRevenue ExpensesExpenses

Statement of Cash FlowsStatement of Cash Flows

OperatingCash Flow

OperatingCash Flow

Investing Cash Flow

Investing Cash Flow+

Free Cash FlowsFree Cash Flows

−

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Comparison of Net Income and Free Cash Flows of Krispy Kreme and Starbucks

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End of Chapter 04

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