Cash and Internal Controls

1. Cash andInternal Controls Chapter 4

2. 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

3. Learning Objectives • Account for petty cash • Identify the major inflows and outflows of cash • Assess earnings quality by comparing net income and cash flows

4. 4-4 Part A Internal Controls

5. 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.

6. The Fraud Triangle

7. Internal Controls • Eliminate opportunity • Represent plans to: • Safeguard the assets • Improve accuracy and reliability of information

8. 4-8 Learning Objective 1 Discuss the impact of accounting scandals and the passage of the Sarbanes-Oxley Act

9. 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

10. Accounting fraud in U.S. history Enron WorldCom Avoided reporting billions in debt and losses Misclassified expenditures to overstate assets and profitability

11. 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

12. 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

13. 4-13 Learning Objective 2 Identify the components, responsibilities, and limitations of internal control

14. Control Activities Preventive controls Detective controls • Separation of duties • Physical controls • Proper authorization • Employee management • E-commerce controls • Reconciliations • Performance reviews • Audits

15. 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

16. 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

17. 4-17 Part B Cash

18. 4-18 Learning Objective 3 Define cash and cash equivalents

19. 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

20. 4-20 Learning Objective 4 Understand controls over cash receipts and cash disbursements

21. 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

22. 4-22 Learning Objective 5 Reconcile a bank statement

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

24. Illustration 4.6—Bank Reconciliation • Timing differences • Errors

25. 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

26. 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

27. 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

28. 4-28 Learning Objective 6 Account for petty cash

29. 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

30. 4-30 Learning Objective 7 Identify the major inflows and outflows of cash

31. Reporting Cash • Balance sheet • Statement of Cash Flows

32. 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

33. 4-33 Learning Objective 8 Assess earnings quality by comparing net income and cash flows

34. 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

35. 4-35 End of Chapter 4