Chapter 04 Cash and Internal Controls McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Part A Internal Controls 4-2

LO1 Discuss the Impact of Accounting Scandals and the Passage of the Sarbanes-Oxley Act oManagers are entrusted with the resources of both the company’s lenders (liabilities) and owners (stockholders' equity). oManagers of the company act as stewards or caretakers of the company’s assets. oIn recent years some managers have shirked their ethical responsibilities. oIn 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. 4-3

Recent Accounting Scandals and Response FRAUD FIRM AUDIT FIRM Arthur Andersen WorldCom Enron 4-4

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. 4-5

LO2 Identify the Components, Responsibilities, and Limitations of Internal Control From a financial accounting perspective, internal control is a company’s plan to: oSafeguard the company’s assets. oImprove the accuracy and reliability of accounting information oEffective internal control builds a wall to prevent misuse of company funds by employees and fraudulent or errant financial reporting 4-6

Part B Cash 4-7

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. 4-8

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. 4-9

LO5 Reconcile a Bank Statement oA bank reconciliation matches the balance of cash in the bank account with the balance of cash in the company’s own records. oA company’s cash balance as recorded in its books rarely equals the cash balance reported in the bank statement. oDifferences in these balances occur because of either timing differences or errors. oIt is the possibility of these errors, or even outright fraudulent activities, that make the bank reconciliation a useful cash control tool. 4-10

LO6 Account for Petty Cash oCompanies 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 oTo pay for these minor purchases, companies keep some minor amount of cash on hand in a petty cash fund. oManagement 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. 4-11

LO7 Identify the Major Inflows and Outflows of Cash oCompanies report cash in two ways. oFirst, 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. oSecondly, reports information about cash receipts and payments during the period in a statement of cash flows. oFrom the statement of cash flows, investors know a company’s cash inflows and cash outflows related operating, investing and financing activities. 4-12

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. 4-13

Comparing Net Income to Free Cash Flows Net income Income Statement RevenueExpenses Statement of Cash Flows Operating Cash Flow Investing Cash Flow + Free Cash Flows − 4-14

Comparison of Net Income and Free Cash Flows of Krispy Kreme and Starbucks 4-15

End of Chapter