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

Major Provisions Oversight board Corporate executive accountability Nonaudit services Auditors to Retain of work papers Auditor rotation Conflicts of interest Hiring of auditor Internal control Major Provisions of the Sarbanes-Oxley Act of

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 4-7

Framework for Internal Control 4-8

Components of Internal Control oControl 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. oRisk Assessment: _identifies and analyzes internal and external risk factors that could prevent a company’s objectives from being achieved. oMonitoring: _includes formal procedures for reporting control deficiencies. 4-9

oControl 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 oInformation and Communication: _depend on the reliability of the accounting information system itself. Components of Internal Control 4-10

Responsibilities for Internal Control oEveryone 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. oThe 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. oA 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. oThe 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. 4-11

Limitations of Internal Control oInternal control systems will more likely detect operating and reporting errors. oNo internal control system can turn a bad employee into a good one. oInternal control systems are especially susceptible to collusion. 4-12

Part B Cash 4-13

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. 4-14

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. 4-15

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. 4-16

Acceptance of Credit/Debit Cards CASH RECEPITS CREDIT CARD DEBIT CARD It does not remove cash from the cardholder’s account after each transaction. It removes cash directly from the cardholder’s bank account at the time of use. 4-17

Cash Disbursements oManagers should design proper control for cash disbursements to prevent any unauthorized payments and ensure proper recording. oConsistent with our discussion of cash receipts, cash disbursements include not only disbursing physical cash, but also writing checks and using credit and debit cards. oAll these forms of payment constitute cash disbursement and require formal internal control procedures. 4-18

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. 4-19

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: 4-20

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. 4-21

Bank Reconciliation oTiming differences in cash occur when the company records transactions either before or after the bank records the same transaction. oErrors can be made either by the company or its bank and may be accidental or intentional. Possible Differences 1. Timing 2. Errors Company’s Cash Records Bank’s Cash Records Bank Reconciliation Bank Statement Deposits Withdrawals Reconciled Bank Balance = Reconciled Company Balance Possible Differences 1. Timing 2. Errors 4-22

Bank Statement 4-23

Company Records of Cash Activities Starlight Drive-In Cash Account Records March 1, 2012 to March 31, 2012 DepositsChecks DateDesc.AmountDateNo.Desc.Amount 3/5Sales receipts$3,6003/6293Salaries$2,100 3/22Sales receipts1,9803/11294Rent2,600 3/31Sales receipts2,2003/21295Utilities1,200 3/24296Insurance1,900 3/30297Supplies900 $7,780$8,700 Summary of Transactions Beginning Cash balance March 1, 2012DepositsChecks Ending Cash Balance March 31, 2012 $3,800$7,780$8,700$2,

Step 1:Reconciling the Bank’s Cash Balance oCash transactions recorded by a company, but not yet recorded by its bank, include deposits outstanding and checks outstanding. oDeposits 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. 4-25

oFew 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. oNSF checks: Checks drawn on nonsufficient funds or “bad” checks from customers. oIn addition, we adjust the company’s balance for any company errors. Step 2: Reconciling the Company’s Cash Balance 4-26

Reconciling the Bank Statement 4-27

Step 3: Adjusting the Company’s Cash Balance 4-28

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. 4-29

Account for Petty Cash oAccounting for the petty cash fund involves recording transactions oEstablish the fund, oRecognize expenditures from the fund, oReplenish the fund as the cash balance becomes sufficiently low. oAt any given time, the cash remaining in the fund plus all receipts should equal the amount of the fund. 4-30

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: Assume Starlight has the following expenditures from the petty cash fund during May: 4-31

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. 4-32

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. 4-33

oOperating activities include cash transactions involving revenue and expense events during the period. oInvesting activities include cash investments in long- term assets and investment securities. oFinancing 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 4-34

External Transactions of Eagle Golf Academy 4-35

External Transactions of Eagle Golf Academy 4-36

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. 4-37

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 − 4-38

Comparison of Net Income and Free Cash Flows of Krispy Kreme and Starbucks 4-39

End of Chapter