Internal ControlInternal Control Assess - firm can maximize possibility of Assess - firm can maximize possibility of

accurate financial reporting and efficiencyaccurate financial reporting and efficiency Assess - minimize the risk of fraud or theft - Assess - minimize the risk of fraud or theft -

asset lossasset loss Ensure reliability of financial statementsEnsure reliability of financial statements Keep company on course toward profitability Keep company on course toward profitability

goals and achievement of its mission, minimize goals and achievement of its mission, minimize surprises along the waysurprises along the way

Allow management to deal with rapidly changing Allow management to deal with rapidly changing economic and competitive environments, shifting economic and competitive environments, shifting customer demands and priorities, and customer demands and priorities, and restructuring for future growthrestructuring for future growth

Internal Control - definedInternal Control - definedProcess - provide reasonable assurance Process - provide reasonable assurance

regarding achievement of objectivesregarding achievement of objectivesEffectiveness and efficiency of operations - basic Effectiveness and efficiency of operations - basic

business objectives, performance and business objectives, performance and profitability goals and safeguarding of resourcesprofitability goals and safeguarding of resources

Reliability of financial reporting - published Reliability of financial reporting - published financial statementsfinancial statements

Compliance with applicable laws and regulationsCompliance with applicable laws and regulationsCan do: help an entity achieve performance and Can do: help an entity achieve performance and

profitability goals, prevent loss of resources, profitability goals, prevent loss of resources, reliable financial reporting, comply with laws and reliable financial reporting, comply with laws and regulations, help get to where it wants to go, regulations, help get to where it wants to go, avoid pitfalls and surprises along the wayavoid pitfalls and surprises along the way

Analyzing internal control

Bemis Company is a rapidly growing start-up business. Its recordkeeper, who was hired one year ago,left town after the company’s manager discovered that a large sum of money had disappeared overthe past six months. An audit disclosed that the recordkeeper had written and signed several checksmade payable to her fiancé and then recorded the checks as salaries expense. The fiancé, who cashedthe checks but never worked for the company, left town with the recordkeeper. As a result, the companyincurred an uninsured loss of $84,000. Evaluate Bemis’s internal control system and indicatewhich principles of internal control appear to have been ignored.HELP!

Five interrelated components - how run Five interrelated components - how run business - integrated with the management business - integrated with the management processprocess Control Environment - tone of organization, Control Environment - tone of organization,

control consciousness of employees - discipline, control consciousness of employees - discipline, structure, integrity, structure, integrity,

Risk Assessment - internal and external sources Risk Assessment - internal and external sources of risk to achievement of objectivesof risk to achievement of objectives

Control Activities - policies and procedures - Control Activities - policies and procedures - management directives are carried out, actions are management directives are carried out, actions are takentaken

Information and Communication - pertinent Information and Communication - pertinent information - identified, captured and information - identified, captured and communicated - people carry out responsibilitiescommunicated - people carry out responsibilities

Monitoring - assess quality over timeMonitoring - assess quality over time

Control EnvironmentControl Environment Integrity and ethical valuesIntegrity and ethical values Commitment to competenceCommitment to competence Participation of board of directors or audit Participation of board of directors or audit

committeecommittee Management’s philosophy and operating Management’s philosophy and operating

stylestyle Organizational structure Organizational structure Assignment of authority and Assignment of authority and

responsibilities responsibilities Human resource policies and practices Human resource policies and practices

Risk AssessmentRisk Assessment Changes may occur in the operating Changes may occur in the operating

environmentenvironment New personnel may become involved New personnel may become involved Information systems may changeInformation systems may change Rapid growth Rapid growth New technologies New technologies New products or services New products or services Restructuring Restructuring Foreign operations Foreign operations New accounting pronouncements New accounting pronouncements

Control Activities Control Activities Segregation of duties Segregation of duties Proper authorization Proper authorization Assets safeguarded Assets safeguarded Compare actual to booksCompare actual to booksEmployees of integrity Employees of integrity Record properly and on a timely basisRecord properly and on a timely basis

Information and CommunicationInformation and Communication

Identify and record all valid Identify and record all valid transactions transactions

Provide timely description of Provide timely description of transactions transactions

Properly measure transactions Properly measure transactions Record transactions in a timely Record transactions in a timely

manner manner

Monitoring Monitoring Assess controls on a timely basis Assess controls on a timely basis

and make modifications when and make modifications when appropriate.appropriate.

Use internal auditors to reviewUse internal auditors to reviewTest controls Test controls

Other factors to considerOther factors to consider Size of organizationSize of organization Ownership characteristics Ownership characteristics Nature of businessNature of business Diversity and complexity of activitiesDiversity and complexity of activities Data processing methods Data processing methods Legal and regulatory environment of Legal and regulatory environment of

the business the business

Under Sarbanes Oxley ActUnder Sarbanes Oxley Act CEO and CFO certification CEO and CFO certification CEO - ultimately responsible - ownership of CEO - ultimately responsible - ownership of

system, sets tone at top, provide leadership, system, sets tone at top, provide leadership, directiondirection

Board of directors - provide governance, Board of directors - provide governance, guidance, oversightguidance, oversight

Management - accountable - board of Management - accountable - board of directorsdirectors

Responsibility of everyone - part of job Responsibility of everyone - part of job descriptiondescription

Internal control report Internal control report Document system so others can reviewDocument system so others can review SEC will review every 3 years SEC will review every 3 years

CEO, CFO CertificationCEO, CFO CertificationExplicitly must evaluate and report Explicitly must evaluate and report

on effectiveness of internal controlon effectiveness of internal controlDisclose to audit committee any Disclose to audit committee any

material deficiencies in financial material deficiencies in financial controlscontrols

Report any changes in ICReport any changes in ICReport any corrective actions Report any corrective actions

CEO, CFO ReportCEO, CFO ReportAssess effectiveness within 90 days of Assess effectiveness within 90 days of

filing datesfiling dates Design disclosure controls and Design disclosure controls and

procedures procedures “ “ ..are intended to cover a broader range of ..are intended to cover a broader range of

information than is covered by internal information than is covered by internal controls related to financial reporting.. controls related to financial reporting.. They are intended to ensure that an issuer They are intended to ensure that an issuer maintains commensurate procedures for maintains commensurate procedures for gathering, analyzing and disclosing all gathering, analyzing and disclosing all information that is required to be information that is required to be disclosed…” disclosed…”

Internal Control Report Internal Control Report A part of annual report A part of annual report Management responsible for internal Management responsible for internal

control control States a conclusion on the States a conclusion on the

effectiveness of IC effectiveness of IC External auditor has to attest to External auditor has to attest to

company’s internal control under company’s internal control under PCAOB rules (Public Company PCAOB rules (Public Company Accounting Oversight Board)Accounting Oversight Board)

Capital BudgetingCapital BudgetingPlanning process used to determine a firm’s Planning process used to determine a firm’s

long term investmentslong term investments Insure that firms have assets that will be Insure that firms have assets that will be

profitableprofitableBefore purchase asset - analysis, using Before purchase asset - analysis, using

estimates of performance - earn some minimum estimates of performance - earn some minimum returnreturn

Does not want new asset to dilute ROI, ROEDoes not want new asset to dilute ROI, ROE

Capital BudgetingCapital Budgeting Methods - not consider time value of money:Methods - not consider time value of money:

Payback period - length of time to recover the cost of an Payback period - length of time to recover the cost of an investmentinvestment

Using estimates of yearly profitsUsing estimates of yearly profits = cost of project/annual cash inflows= cost of project/annual cash inflows I.e. - if a project costs $100,000 and was expected to return I.e. - if a project costs $100,000 and was expected to return

$20,000 annually, the payback period would be $20,000 annually, the payback period would be $100,000/$20,000, or five years$100,000/$20,000, or five years

ROI - using estimates of sales, costs, etc. - determine if ROI - using estimates of sales, costs, etc. - determine if the return on investment is higher than cost of capitalthe return on investment is higher than cost of capital

Ratio of money gained or lost on an investment relative to the Ratio of money gained or lost on an investment relative to the amount of money investedamount of money invested

I.e. - $1,000 investment earns $50 profit = 50/1,000 = 5%, I.e. - $1,000 investment earns $50 profit = 50/1,000 = 5%, compared to $100 investment earns $20 profit = 20/100 = 20%compared to $100 investment earns $20 profit = 20/100 = 20%

Capital BudgetingCapital Budgeting If appears to be profitable - more complex capital If appears to be profitable - more complex capital

budgeting analysis is donebudgeting analysis is done NPV - net present value - using expected returns and NPV - net present value - using expected returns and

cost of capital, add value to firm after making the cost of capital, add value to firm after making the required cost of capitalrequired cost of capital

Measures excess or shortfall of cash flowsMeasures excess or shortfall of cash flows Year 1 - Interest: $100 * 10% = $10 + $100 = $110 Year 1 - Interest: $100 * 10% = $10 + $100 = $110 NPV: $110 / 1.1 = $100NPV: $110 / 1.1 = $100 Year 2 – Interest: $110 + ($110 * 10 %) = $11 + $110 = $121Year 2 – Interest: $110 + ($110 * 10 %) = $11 + $110 = $121 NPV: $121/(1.1 * 1.1) = $100NPV: $121/(1.1 * 1.1) = $100

IRR - internal rate of return - equates the estimated IRR - internal rate of return - equates the estimated profits to the cost to see what rate of return actually isprofits to the cost to see what rate of return actually is

Annualized effective compound return rate earned on invested Annualized effective compound return rate earned on invested capital - yield on investmentcapital - yield on investment

Good investment if greater than alternative investmentGood investment if greater than alternative investment

Beg. End End End End End End EndYr. 1 Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5 Yr. 6 Yr. 7

Cash Outflow (300,000)Working Cap. (30,000) 30,000

Oper. Exp. (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000)Overhaul (30,000)Cost Savings 135,000 135,000 135,000 135,000 135,000 135,000 135,000Salvage Value 24,000Cash Flows (330,000) 75,000 75,000 75,000 75,000 45,000 75,000 129,000

Discount 10% 1 0.909 0.829 0.751 0.683 0.621 0.564 0.513PV Amount (330,000) 68,175 62,175 56,325 51,225 27,945 42,300 66,177Sum of PV 374,322

NPV $44,322

Period

1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.870

2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.812 0.797 0.783 0.769 0.756

3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.731 0.712 0.693 0.675 0.658

4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.659 0.636 0.613 0.592 0.572

5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.593 0.567 0.543 0.519 0.497

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.535 0.507 0.480 0.456 0.432

7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.482 0.452 0.425 0.400 0.376

8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.434 0.404 0.376 0.351 0.327

9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 0.391 0.361 0.333 0.308 0.284

10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 0.352 0.322 0.295 0.270 0.247

11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 0.317 0.287 0.261 0.237 0.215

12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 0.286 0.257 0.231 0.208 0.187

13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 0.258 0.229 0.204 0.182 0.163

14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 0.232 0.205 0.181 0.160 0.141

15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 0.209 0.183 0.160 0.140 0.123

16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 0.188 0.163 0.141 0.123 0.107

17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 0.170 0.146 0.125 0.108 0.093

18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.153 0.130 0.111 0.095 0.081

19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 0.138 0.116 0.098 0.083 0.070

20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 0.124 0.104 0.087 0.073 0.061

25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092 0.074 0.059 0.047 0.038 0.030

30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057 0.044 0.033 0.026 0.020 0.015

35 0.706 0.500 0.355 0.253 0.181 0.130 0.094 0.068 0.049 0.036 0.026 0.019 0.014 0.010 0.008

40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 0.022 0.015 0.011 0.008 0.005 0.004

50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 0.009 0.005 0.003 0.002 0.001 0.001

Beg End End End EndYr. 1 Yr. 1 Yr. 2 Yr. 3 Yr. 4

Equipment 74,000

Revenue 19,800 27,000 32,400 32,400Salvage 6,000Expenses (3,000) (3,000) (3,000) (3,000)

Net Cash Flow (74,000) 16,800 24,000 29,400 35,400

Discount 1 0.893 0.797 0.712 0.636

PV (74,000) 15,002 19,128 20,933 22,514

Sum of PV 77,578

NPV $3,578

Purchase

Lease w/o contract

Lease with contract

Capital BudgetingCapital Budgeting What needed to compute either NPV or IRRWhat needed to compute either NPV or IRR

Expected revenuesExpected revenues Expected cash outflow for costsExpected cash outflow for costs Salvage values, if anySalvage values, if any Cost of capital or required rate of returnCost of capital or required rate of return Tax rateTax rate Tax shield from depreciation expenseTax shield from depreciation expense Layout each year’s profit and lost, discount to the present Layout each year’s profit and lost, discount to the present

and see if the value added is more than cost of projectand see if the value added is more than cost of project Discount rate?Discount rate?

Actual cost of financingActual cost of financing Agreed upon rate of returnAgreed upon rate of return Weighted average cost of capitalWeighted average cost of capital Current return on assets amountCurrent return on assets amount

ReadRead Introduction to Internal Control Process, Introduction to Internal Control Process, Download Cap. BudgProb.xls - print all tabs, Download Cap. BudgProb.xls - print all tabs, Download Capital Budgeting Problems.doc - print, Download Capital Budgeting Problems.doc - print, Assign #5Assign #5 - Internal Control Report - 3-4 pages, ( - Internal Control Report - 3-4 pages, (due due

2/24, 2/252/24, 2/25) – include firm, interview date, observation ) – include firm, interview date, observation time, name of person and title interviewed, how time, name of person and title interviewed, how effective? Opinion, suggestions – effective? Opinion, suggestions – include headingsinclude headings

Assign #6Assign #6 - - Turnover ratios - Target - Asset Turnover, Turnover ratios - Target - Asset Turnover, Inventory Turnover, Days in Inventory, A/R Turnover, Inventory Turnover, Days in Inventory, A/R Turnover, Days in Receivable, Accounts Payables Turnover, Days in Receivable, Accounts Payables Turnover, Days in Payables, Operating Cycle – 07-05 Days in Payables, Operating Cycle – 07-05 (due 2/8-(due 2/8-W, 2/4-R)W, 2/4-R)..

Assign #7Assign #7 - Solvency Ratios for Target, Inc - - Solvency Ratios for Target, Inc - Debt/Assets, L/T Debt/Assets, Debt/Equity, Debt/Assets, L/T Debt/Assets, Debt/Equity, Times Interest Earned, Leverage for years 07-Times Interest Earned, Leverage for years 07-05 (05 (due 2/17, 2/18due 2/17, 2/18); );

Leverage ratio = total liability and equity/ total Leverage ratio = total liability and equity/ total equityequity

Download - Financial Leverage worksheetDownload - Financial Leverage worksheet Download – Capital Budgeting ProblemDownload – Capital Budgeting Problem