Chapter 4 Financial 3 Ed

Spiceland | Thomas | Herrmann

Financial Accounting

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Cash andInternal Controls

Chapter 4


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Learning Objectives

• Discuss the impact of accounting scandals and the passage of the Sarbanes-Oxley Act

• Identify the components, responsibilities, and limitations of internal control

• Define cash and cash equivalents• Understand controls over cash receipts and cash

disbursements• Reconcile a bank statement


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Learning Objectives

• Account for petty cash• Identify the major inflows and outflows of cash• Assess earnings quality by comparing net income

and cash flows


Part A

Internal Controls

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Incorrect Financial Statements

• Reasons• Errors—accidental errors in recording transactions

or applying accounting principles• Fraud—a person intentionally deceives another

person for personal gain or to damage that person• Occupational fraud: the use of one’s occupation for

personal enrichment through the deliberate misuse or misapplication of the employer’s resources.


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The Fraud Triangle

Motive (or pressure)

Rationalization

Opportunity


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Internal Controls

• Eliminate opportunity• Represent plans to:

• Safeguard the assets• Improve accuracy and reliability of information


Learning Objective 1

Discuss the impact of accounting scandals and the passage of the Sarbanes-Oxley Act

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Accounting Scandals and Response by Congress

• Managers are entrusted with the resources of both the company’s lenders and owners

• Managers act as stewards or caretakers of the company’s assets

• Some managers have shirked their ethical responsibilities• Top executives misreported and fooled investors

into overvaluing the company’s stock


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Accounting fraud in U.S. history

WorldCom Enron

Avoided reporting billions in debt and losses

Misclassified expenditures to overstate assets and

profitability


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Sarbanes-Oxley Act of 2002

• Passed by Congress• Also known as the Public Company Accounting

Reform and Investor Protection Act of 2002• Applies to all companies that are required to file

financial statements with the SEC• Established guidelines on:

• Internal control procedures• Auditor-client relations


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Major Provisions of the Sarbanes-Oxley Act of 2002

• Oversight board• Corporate executive accountability• Nonaudit services• Retention of work papers• Auditor rotation• Conflicts of interest• Hiring of auditor• Internal control



Identify the components, responsibilities, and limitations of internal control

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Illustration 4.2—Components of Internal Control


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Control Activities

Preventive controls

• Separation of duties

• Physical controls

• Proper authorization

• Employee management

• E-commerce controls

Detective controls

• Reconciliations

• Performance reviews

• Audits


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Responsibilities for Internal Control

• The CEO and CFO to sign a report each year assessing adequacy of internal controls

• Auditors to provide an opinion on management’s assessment

• Auditor to express its own opinion on company’s internal control over financial reporting


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Limitations of Internal Control

• Bad employee cannot be turned into a good one• Internal control systems are especially susceptible

to collusion• Collusion: two or more people acting together to

circumvent internal controls.

• Top-level employees who can override internal control procedures can commit fraud

• Effective internal controls and ethical employees cannot ensure success or even survival


Part B

Cash

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Define cash and cash equivalents

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Cash and Cash Equivalents

• Cash• Currency• Coins• Balances in savings and checking accounts• Checks

• Cash equivalents—mature within three months

• Money market funds• Treasury bills• Certificates of deposit



Understand controls over cash receipts and cash disbursements

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Cash Controls

• Controls over cash receipts• Separate duties of handling cash and verifying receipts• Deposit cash daily• Prefer credit cards or debit cards

• Controls over cash disbursements• Prefer payments by check, debit card, or credit card• Separate duties of authorizing payments and verifying

purchases• Verify records against purchase receipts• Place authorization and documentation procedures• Separate disbursement and collections duties



Reconcile a bank statement

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Bank Reconciliation

• Bank reconciliation: matching the balance of cash in the bank account with the balance of cash in the company’s own records


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Illustration 4.6—Bank Reconciliation

• Timing differences• Errors


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Illustration 4.7—Bank Statement


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Illustration 4.8—Company Records of Cash Activities


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Illustration 4.8—Company Records of Cash Activities (concluded)


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Step 1: Reconciling the Bank’s Cash Balance

• Deposits outstanding: cash receipts of the company that have not been added to the bank’s record of the company’s balance

• Checks outstanding: checks the company has written that have not been subtracted from the bank’s record of the company’s balance


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Step 2: Reconciling the Company’s Cash Balance

• Interest earned by the company• Collections made by the bank on the company’s

behalf• Service fees• Charges for NSF checks

• NSF checks: Customers’ checks written on “nonsufficient funds,” otherwise known as “bad” checks


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Step 3: Adjusting the Company’s Cash Account Balance

• Update the balance in its Cash account:• To adjust for the items used to reconcile the

company’s cash balance


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Illustration 4.9—Reconciling the Bank Statement



Account for petty cash

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Petty Cash Fund

• Petty cash fund: small amount of cash kept on hand to pay for minor purchases

• Accounting for the petty cash fund involves recording for:• Establishing the fund• Recognizing expenditures from the fund• Replenishing the fund


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Example—Petty Cash Fund

• Establishing a petty cash fund of $500


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• Expenditures from the petty cash fund


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• Replenishing the petty cash fund



Identify the major inflows and outflows of cash

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Reporting Cash

• Balance sheet• Statement of Cash Flows


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Activities on Cash Flows Statement

• Operating activities• Cash transactions involving revenues and expenses

• Investing activities• Cash investments in long-term assets and investment

securities

• Financing activities• Transactions designed to finance the business through

borrowing and owner investment


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Which transactions involve the exchange of cash?


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Which transactions involve the exchange of cash?


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Statement of Cash Flows for Eagle Golf Academy



Assess earnings quality by comparing net income and cash flows

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Comparing Net Income toCash Flow

• Free cash flow: operating cash flows + investing cash flows during the period

• Earnings quality: the ability of current net income to help us predict the future performance of a company

• Declining free cash flow in relation to the trend in net income indicates lower-quality earnings


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Comparing Net Income toCash Flow


End of Chapter 4

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Chapter 4 Financial 3 Ed

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