Chapter 4: Internal Controls, Accounting for Cash, and Ethics McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives Identify the key elements of a strong system of internal control. Prepare a bank reconciliation. Discuss the role of ethics in the accounting profession. Discuss the auditor’s role in financial reporting. The learning objectives in this chapter are: Identify the key elements of a strong system of internal control. Prepare a bank reconciliation. Discuss the role of ethics in the accounting profession. Discuss the auditor’s role in financial reporting.

An Integrated Framework Control Environment – integrity and ethical values of a company Risk Assessment – management identification of potential risks Control Activities – internal controls Information and Communication – internal and external reporting process Monitoring – over time assessment and correction of internal controls The Enron and WorldCom accounting scandals had such devastating effects that they led congress to pass the Sarbanes-Oxley Act of 2002 (SOX).Section 404 of Sarbanes-Oxley requires a statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting by public companies. This section includes an assessment of the controls and the identification of the framework used for the assessment. The framework established by The Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 1992 is the de facto standard by which SOX compliance is judged. COSO’s framework titled Internal Control––An Integrated Framework recognizes five interrelated components including: 1. Control Environment. The integrity and ethical values of the company, including its code of conduct, involvement of the board of directors, and other actions that set the tone of the organization. 2. Risk Assessment. Management’s process of identifying potential risks that could result in misstated financial statements and developing actions to address those risks. 3. Control Activities. These are the activities usually thought of as “the internal controls.” They include such things as segregation of duties, account reconciliations, and information processing controls that are designed to safeguard assets and enable an organization to timely prepare reliable financial statements. 4. Information and Communication. The internal and external reporting process, and includes an assessment of the technology environment. 5. Monitoring. Assessing the quality of a company’s internal control over time and taking actions as necessary to ensure it continues to address the risks of the organization.

Internal Controls Separation of Duties Quality of Employees Bonded Employees Required Absences Procedures Manual Authority and Responsibility Prenumbered Documents Physical Control Performance Evaluations The more common control activities of the internal control framework include: Separation of duties – This means that the functions of authorization, recording , and custody of assets should be performed by separate individuals to prevent corruption. Quality of Employees - A business is only as good as the people it employs and properly trains. Bonded Employees – Employees with high levels of personal integrity are bonded by a company that provides insurance protection for potential losses caused by employee dishonesty. Required Absences - Employees should be required to take regular vacations and their duties should be rotated periodically, so they cannot cover up fraudulent activities by always being present. Procedures Manual - Appropriate accounting procedures should be documented in a procedures manual and periodic reviews should ensure that procedures are followed. Authority and Responsibility - Businesses should prepare an authority manual that establishes a definitive chain of command, with both specific and general authorizations. Prenumbered Documents – Prenumbered documents reduce the likelihood of unauthorized transactions. Physical Control - Unannounced physical counts should be conducted randomly to verify safeguarding of company-owned assets and records. Performance Evaluations - Internal and external audits serve as independent verification of performance.

Limitations Internal controls can be circumvented by collusion among employees. Two or more employees working together can hide embezzlement by covering for each other. No system can prevent all fraud. Good internal controls minimize fraud and increase likelihood of detection. A system of internal controls is designed to prevent or detect errors and fraud, but no system is foolproof. Internal controls can be circumvented by collusion among employees. Two or more employees working together can hide embezzlement by covering for each other. No system can prevent all fraud. Good internal controls minimize fraud and increase likelihood of detection.

Accounting for Cash Controlling Cash Cash receipts should be recorded immediately upon receipt and deposited intact daily. Up to date signature card should be maintained. Controlling Cash A deposit ticket should be used for all deposits. A monthly bank reconciliation should be prepared by an independent party. Cash inflows and outflows must be managed to prevent a shortage or surplus of cash. Controlling cash, more than any other asset, requires strict adherence to internal control procedures. To effectively control cash, a company should make all disbursements using checks, thereby providing a record of cash payments. Cash receipts should be deposited in a bank on a timely basis. It is important as part of this process to understand four main types of forms associated with a bank checking account. These are: (1) A bank signature card that shows the bank account number and the signatures of the people authorized to sign checks; (2) Each deposit of cash or checks should be accompanied by a deposit ticket, which normally identifies the account number and the name of the account, (3) Cash disbursements should be made by prenumbered bank check, which affects three parties: (a) the person or business writing the check (the payer); (b) the bank on which the check is drawn; and (c) the person or business to whom the check is payable (the payee); and (4) Companies receive a bank statement that shows a record of their checking account; from this they can prepare a bank reconciliation to explain the differences between the cash balance reported on the bank statement and the cash balance recorded in the depositor’s accounting records. Cash disbursements should be made by prenumbered check.

Reconciling the Bank Account The bank reconciliation reports on the differences between the balance on the bank statement and the balance in the general ledger cash account. The reconciliation results in the true cash balance that will appear on the balance sheet. The bank reconciliation reports on the differences between the balance on the bank statement and the balance in the general ledger cash account. The reconciliation results in the true cash balance that will appear on the balance sheet. A typical format for determining the true cash balance if you start with the bank balance adds deposits in transit minus outstanding checks. A typical format for determining the true cash balance if you start with the book balance adds accounts receivable collections and interest earned less bank service charges and non-sufficient funds checks.

Green Shades Resorts, Inc.’s bank reconciliation for September. The September 30th balance on the bank statement is $3,516.45, and the Cash general ledger balance on this date is $3,361.22. There was a deposit in transit in the amount of $724.11. The bank erroneously deducted a $25 check drawn on the books of Green Valley Resorts from our account. At September 30th there were three checks outstanding. Check 639 dated 9/18, for $13.75; Check 646 dated 9/20, for $29.00; and Check 672 dated 9/27, for $192.50. During the month of September the bank collected an account receivable for us in the amount of $940. A check actually written for $36.45 for supplies was erroneously recorded in our records by the bookkeeper as $63.45. The bank assessed a service charge of $8.40 for September and we deposited a NSF check in the amount of $289.51. Now we’ll go through the example which illustrates how to prepare the bank reconciliation for Green Shades Resorts, Inc. (GSRI).

Bank Reconciliation Notice in the adjustment to the bank balance deposits in transit and the bank error are added and the outstanding checks are subtracted to result in a true cash balance of $4,030.31. When making the adjustments to the book balance, we should arrive at the same amount.

Bank Reconciliation Notice that two of the four adjustments increase the unadjusted book balance and the other two decrease the unadjusted cash balance. Because the true balance determined from the perspective of the bank statement agrees with the true balance determined from the perspective of GSRI’s books, the bank statement has been successfully reconciled with the accounting records.

The Fraud Triangle Opportunity Key to protecting yourself and your company: personal integrity. Unfortunately, it takes more than a code of conduct to stop fraud. People frequently engage in activities that they know are unethical or even criminal. The auditing profession has identified three elements that are typically present when fraud occurs, including: The availability of an opportunity. The existence of some form of pressure leading to an incentive. The capacity to rationalize. These three interrelated elements are frequently called the fraud triangle. Pressure Rationalization

Role of the Independent Auditor How can a financial analyst know that a company really did follow GAAP? Audits CPAs Certified Public Accountants Part I How can a financial analyst know that a company really did follow generally accepted accounting principles? Part II Analysts and other users rely on audits conducted by certified public accountants. An audit is a detailed examination of a company’s financial statements and underlying accounting records. The primary roles of an independent auditor are: Conducts a financial audit. Assumes both legal and professional responsibilities to the public as well as to the company paying the auditor. Determines if financial statements are materially correct rather than absolutely correct. Presents conclusions in an audit report that includes an opinion as to whether the statements are prepared in conformity with generally accepted accounting principles. Maintains professional confidentiality of client records. However, this does not exempt the auditor from legal obligations such as testifying in court.

Materiality and Financial Audits Auditors do not guarantee that financial statements are absolutely correct—only that they are materially correct. Material Item An error, or other reporting problem, that would influence the decision of an average prudent investor. Part I As mentioned in the primary roles of auditors on the previous slide, auditors do not guarantee that financial statements are absolutely correct—only that they are materially correct. The question then becomes “How big is material?”. The concept of materiality is very subjective. In 2009, ExxonMobil had approximately $311 billion of sales! A $1 million error in computing sales at ExxonMobil is like a $1 error in computing the pay of a person who makes $311,000 per year—not material at all! Part II An error, or other reporting problem, is material if knowing about it would influence the decision of an average prudent investor.

Types of Audit Opinions Unqualified Adverse Part I Once an audit is complete, the auditors present their conclusions in a report that includes an audit opinion. If auditors are satisfied that the financial statements are “fair”, they issue an unqualified audit report. An unqualified audit report indicates that the financial statements are useful and that creditors and investors can trust what is reported. Part II The most negative report an auditor can issue is an adverse opinion. An adverse opinion means that one or more departures from Generally Accepted Accounting Principles are so material the financial statements do not present a fair picture of the company’s status. Part III A qualified opinion falls between an unqualified and an adverse opinion. A qualified opinion means that for the most part, the company’s financial statements are in compliance with Generally Accepted Accounting Principles, but the auditors have reservations about something in the statements. The auditor’s report explains why the opinion is qualified. Part IV If an auditor is unable to perform the audit procedures necessary to determine whether the statements are prepared in accordance with Generally Accepted Accounting Principles, the auditor cannot issue an opinion on the financial statements. Instead, the auditor issues a disclaimer of audit opinion. A disclaimer is neither negative nor positive. It simply means that the auditor is unable to obtain enough information to confirm compliance with Generally Accepted Accounting Principles. Qualified Disclaimer

End of Chapter Four End of Chapter 4.