1. Cash and Internal Controls
Chapter 04
Cash and Internal Controls
This chapter is divided into two parts
Part A: Internal controls
Part B: Cash
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.

2. Part A Internal Controls 4-2
To minimize occupational fraud, companies implement formal procedures known as internal controls. These represent a company’s plan to (1) safeguard the company’s assets and (2) improve the accuracy and reliability of accounting information.
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3. LO1 Discuss the Impact of Accounting Scandals and the Passage of the Sarbanes-Oxley Act
Managers are entrusted with the resources of both the company’s lenders (liabilities) and owners (stockholders' equity).
Managers of the company act as stewards or caretakers of the company’s assets.
In recent years some managers have shirked their ethical responsibilities.
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.
Managers are entrusted with the resources of both the company’s lenders (liabilities) and owners (stockholders' equity). In this sense, managers of the company act as stewards or caretakers of the company’s assets. However, in recent years some managers have shirked their ethical responsibilities and misused or misreported the company’s funds. In many cases, top executives misreported accounting information to cover up their company’s poor operating performance. They hoped to fool investors into overvaluing the company’s stock.
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4. Recent Accounting Scandals and Response
AUDIT FIRM
Arthur Andersen
WorldCom
Enron
Two of the highest-profiled cases of accounting fraud in U.S. history are the collapses of Enron and WorldCom.
Enron used questionable accounting practices to avoid reporting billions in debt and losses in its financial statements. WorldCom misclassified certain expenditures to overstate assets and profitability by $11 billion.
In the cases of Enron and WorldCom, the external audit failed to detect billions of dollars of fraud. Both companies had the same audit firm, Arthur Andersen. The high-profile scandals led to an extensive investigation of Arthur Andersen by the Securities and Exchange Commission (SEC). This action, along with subsequent events, damaged the auditor’s reputation so severely that by the end of 2002, Arthur Andersen was no longer in business.
Other common types of financial statement fraud include creating fictitious revenues from a phantom customer, improperly valuing assets, hiding liabilities, and mismatching revenues and expenses.
You can check the following link for other recent accounting scandals:
The accounting scandals in the early 2000s prompted passage of the Sarbanes-Oxley Act (SOX).
FRAUD FIRM
FRAUD FIRM
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5. 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.
In response to these corporate accounting scandals and to public outrage over seemingly widespread unethical behaviour of top executives, 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. SOX applies to all companies that are required to file financial statements with the SEC and represents one of the greatest reforms in business practices in U.S. history.
The act established a variety of new guidelines related to auditor-client relations and internal control procedures.
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6. LO2 Identify the Components, Responsibilities, and Limitations of Internal Control
From a financial accounting perspective, internal control is a company’s plan to:
Safeguard the company’s assets.
Improve the accuracy and reliability of accounting information
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:
(1) Safeguard the company’s assets.
(2) Improve the accuracy and reliability of accounting information and
Effective internal control builds a wall to prevent misuse of company funds by employees and fraudulent or errant financial reporting. Strong internal control systems allow greater reliance by investors on reported financial statements.
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7. Part B
Cash
Among all of the company’s assets, cash is the one most susceptible to employee fraud.
Before discussing specific controls related to cash, let us first get a good understanding of what “cash” includes.
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8. LO3 Define Cash and Cash Equivalents
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.
The amount of cash recorded in a company’s balance sheet 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.
Checks are written instruments instructing a bank to pay a specific amount from the check maker’s account.
The balance of cash also includes cash equivalents, which are defined as short-term investments that have a maturity date no longer than three months from the date of purchase. Few examples of such investments are money market funds, treasury bills, and certificates of deposit.
The important point to understand is that cash and cash equivalents usually are combined and reported as a single asset in the balance sheet of most companies.
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9. 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.
Management must safeguard all assets against possible misuse. Again, because cash is especially susceptible to theft, internal control of cash is a key issue.
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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10. LO5 Reconcile a Bank Statement
A bank reconciliation matches the balance of cash in the bank account with the balance of cash in the company’s own records.
A company’s cash balance as recorded in its books rarely equals the cash balance reported in the bank statement.
Differences in these balances occur because of either timing differences or errors.
It is the possibility of these errors, or even outright fraudulent activities, that make the bank reconciliation a useful cash control tool.
Another important control used by nearly all companies to help maintain control of cash is a bank reconciliation.
A bank reconciliation matches the balance of cash in the bank account with the balance of cash in the company’s own records.
A company’s cash balance as recorded in its books rarely equals the cash balance reported in the bank statement.
Differences in these balances most often occur because of either timing differences or errors.
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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11. LO6 Account for Petty Cash
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
To pay for these minor purchases, companies keep some minor amount of cash on hand in a petty cash fund.
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.
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
To pay for these minor purchases, companies keep some minor amount of cash on hand in a petty cash fund.
Management establishes a petty cash fund by writing a check for cash against the company’s checking account and putting that amount of withdrawn cash in the hands of an employee who becomes responsible for it.
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12. LO7 Identify the Major Inflows and Outflows of Cash
Companies report cash in two ways.
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.
Secondly, reports information about cash receipts and payments during the period in a statement of cash flows.
From the statement of cash flows, investors know a company’s cash inflows and cash outflows related operating, investing and financing activities.
Companies report cash in two ways. As we already discussed in Chapter 3, cash is reported as an asset in the balance sheet. The amount is typically reported as a current asset and represents cash available for spending at the end of the reporting period. The balance sheet provides only the final balance for cash. It does not provide any details regarding cash receipts and payments during the period.
Companies report information about cash receipts and payments during the period in a statement of cash flows. From the statement of cash flows, investors know a company’s cash inflows and cash outflows related to operating, investing, and financing. We’ll provide a complete discussion of the statement of cash flows in Chapter 11. Here, we briefly introduce the basics of the statement to help you understand that its purpose is to report activity related to the key topic of this chapter—cash. .
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13. 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.
We refer to the ability of current net income to help us predict the future performance of a company as earnings quality . When net income does not provide a good indicator of future performance, the lower its earnings quality is said to be.
One of the more common techniques used by investors for measuring earnings quality relies on comparing the trend in a company’s reported net income to its trend in free cash flow. A simple way to calculate a company’s free cash flow is its operating cash flows plus investing cash flows during the period.
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14. Comparing Net Income to Free Cash Flows
Income Statement
Statement of Cash Flows
The difference between revenues and expenses—net income—provides an accrual-basis measure of the company’s ability to create wealth for its stockholders. In general, the greater a company’s net income, the greater will be the value of the company to stockholders. However, the timing of revenues and expenses recorded under accrual-basis accounting may differ from the timing of operating cash flows.
A simple way to calculate a company’s free cash flows is its operating cash flows plus investing cash flows during the period. This measure represents the cash that is free to distribute to stockholders and repay debt.
Companies whose free cash flows are declining relative to the trend in net income are likely to have lower-quality earnings.
Revenue
Expenses
Operating
Cash Flow
Investing
Cash Flow − +
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15. Comparison of Net Income and Free Cash Flows of Krispy Kreme and Starbucks
As the charts show, both Krispy Kreme and Starbucks enjoyed explosive increases in net income over the 1999–2004 period. However, their free cash flows (or strict cash-basis net incomes) tell a very different story. Notice that Krispy Kreme’s free cash is falling over this period, while Starbucks’ is increasing. The pattern should have raised concerns about the long-term profit-generating ability of Krispy Kreme. Indeed, in 2005, Krispy Kreme’s growth in net income could no longer be sustained and decreased dramatically because the company did not have sufficient cash to maintain profitable operations.
In comparison, Starbucks’ upward trend in net income showed no signs of slowing as of However, that trend would last for only a few more years. Notice that Starbucks’ free cash flow began falling in 2006, while net income continued to rise. Again, the difference in trends between net income and free cash flow should have been a warning to investors.
An upward trend in net income cannot be sustained indefinitely without a sufficient supply of cash. As predicted by the falling trend in free cash flow in 2006 and 2007, Starbucks’ net income experienced a sharp decline beginning in These examples demonstrate the predictive ability of comparing a company’s trend in net income and free cash flow. When the trend in net income is upward while the trend in free cash flow is downward, a company is more likely to experience falling profits in the coming years.
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16. End of Chapter 04
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