AFTER STUDYING THIS CHAPTER, YOU SHOULD BE ABLE TO: L01 Understand the impact of accounting scandals and the passage of the Sarbanes-Oxley Act. L02 Identify the components, responsibilities, and limitations of internal control. L03 Define cash and cash equivalents. L04 Understand controls over cash receipts and cash disbursements. LOS Reconcile a bank statement. L06 Account for petty cash. L07 Identify the major inflows and outflows of cash. in INTERNAL CONTROLS ARE A BOX-OFFICE HIT According to research conducted by the Association of Certified Fraud Examiners (ACFE, www.acfe.com), U.S. organizations lose an estimated $650 billion to employee fraud each vear. This occurs despite increased emphasis on antifraud controls and recent legislation to combat fraud. While some employees steal office supplies, inventory, and equipment, the asset most often targeted is cash. Cash fraud includes skimming cash receipts before they are recorded, stealing cash that has already been recorded, and falsely disbursing cash through fraudulent billing, expense reimbursement, or payroll. This means companies that rely heavily on cash transactions are especially susceptible to employee fraud. For example, consider a company like Regal Entertainment Group (NYSE: RGC), one of the largest motion picture exhibitors in the world. The company operates more than 6,000 screens and sells nearlv 300 million tickets per year, generating revenues each year of about $2.5 billion. The company states that "Revenues are generated principally through admissions and concessions sales with proceeds received in cash at the point of sale." The primary way a company like RGC can minimize cash losses due to employee fraud is to establish strong systems for internal control. Toward that end, RGC makes extensive use of its point-of-service information technology for the management of its theatres. The revenue streams generated by admissions and concessions are fully supported by information systems to monitor cash flow and to detect fraud and inventory theft. Simpler approaches to internal control include separation of duties. For example, one person sells tickets and another collects the tickets. This prevents the ticket seller from stealing a moviegoer's cash and then allowing admission without a ticket being produced by the ticket machine. At the end of the day, the number of tickets produced by the machine should exactly match the cash collected. We discuss much more about fraud and ways to prevent it in this chapter. You can practice your skills m preventing and detecting fraud at a movie theatre in Problem 4-lA at the end of the chapter. 158 PART A L01 Understand the impact of accounting scandals and the passage of the Sarbanes-Oxley Act. CHAPTER 4 Cash and Internal Controls INTERNAL CONTROLS Accounting Scandals Managers are (entrusted with the resources of both the company's lenders (liabili- ties) 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 infor- mation to cover up their company's poor operating performance) They hoped to fool investors into overvaluing the company's stock. Two of the highest-profile cases of accounting fraud in U.S. history are the col- lapses of(Enron and WorldCom.J Enron questionable accounting practicd to avoid reporting billions in debt and losses in its financial statements. WorldCom misclassified certain expenditures to overstate assets and profitability by $11 bil- lion. Other common types of financial statement fraud include fictitious revenues from a phantom customer, improperly valuing assets, and mismatching revenues and expenses As the Enron and WorldCom frauds (as well as several others) were being uncov- ered in 2001 and 2002, the stock prices of these companies plummeted, resulting in investor losses of nearly $200 billion. Employees of these companies also suffered. Both firms declared bankruptcy, resulting in employee termination; reduced sala- ries and increased workloads for those who were left; and loss of employee retire- ment funds, stock options, and health benefits. Where were the auditors of Enron and WorldCom? Recall from Chapter 1 that all public companies are required to have an independent party, an auditor, provide reasonable assurance that financial statements are free of material misstatements. 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, (.t\rthur At the time, many would have argued that Arthur Andersen was the most prestigious and most trusted audit firm in the world. How did billions of dollars of fraud go unreported? The high-profile scandals led to an extensive(investigation of Arthur Andersen by the Securities and Exchange Commission This action, along with subse- quent events, damaged the auditor's reputation so severely that most of its clients fled to other auditors to avoid being associated with the Andersen name. By the end of 2002, Arthur Andersen was no longer in business. SARBANES-OXLEY ACT OF 2002 In response to these corporate accounting scandals and to public outrage over seemingly widespread unethical behavior 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 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 inter- nal control procedures. Some of the major provisions of SOX are discussed briefly in Illustration 4-1. KEY POINT The accounting scandals in the early 2000s prompted passage of the Sarbanes- Oxley Act (SOX). Among other things, SOX sets forth a variety of new guide- lines related to auditor-client relations and additional internal controls. pr I Hi otl In a
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e- at ae s. 'Of I t s s d :r s / . _ n l 1 - CHAPTER 4 Cash and Internal Controls c_6- '-It< Oversight board. The Public Company Accounting Oversight Board (PCAOB) has the authority to establish standards dealing with auditing, quality control, ethics, independence, and other activities relating to the preparation of audited financial reports. Corporate executive accountability. Corporate executives must personally certify the company's financial statements and financial disclosures. Severe financial penalties and the possibility of imprisonment are consequences of fraudulent misstatement. Nonaudit services. It's unlawful for the auditors of public companies to also perform certain nonaudit services for their clients, such as consulting. Retention of work papers. Auditors of public companies must retain all work papers for seven years or face a prison term for willful violations. Auditor rotation. Lead audit partners are required to rotate off the audit client every five years. Conflicts of interest. Audit firms are not allowed to audit public companies whose chief executives worked for the audit firm and participated in that company's audit during the preceding year. Hiring of auditor. Audit firms are hired by the audit committee of the board of directors of the company, not by company management. Internal control. Section 404 of the act requires that company management document and assess the effectiveness of all internal control processes that could affect financial reporting. Company auditors express an opinion on whether management's assessment of the effectiveness of internal control is fairly stated. Framework for Internal Control From a financial accounting perspective,(intemal control is a company's plan to I) improve the accuracy and reliability of accounting information and (2) safe- guard the company's assets.)Effective internal control builds a wall to prevent mis- use of company funds by employees and fraudulent or errant financial reporting. Strong internal control systems allow greater reliance by investors on reported financial statements. ( A framework for designing an internal control system is provided by thE\ Com- mittee of Sponsoring Organizations (COSO) of the Treadway in 1985, COSO i{ dedicated to improving the quality of financial reporting through, among other things, effective internal COSO suggests that internal control consists of five interrelated components (www.coso.org) listed in Illustration 4-2 and discussed next. Risk Assessment Control Activities Internal Controls Information and Communication Monitoring 159 ILLUSTRATION 4-1 Major Provisions of the Sarbanes-Oxley Act of 2002 L02 Identify the components, responsibilities, and limitations of internal control. ILLUSTRATION 4-2 Components of Internal Control 160 Ethical tone of top management Risk of failing to achieve company objectives Accountability through separation of duties \ Reliable financial accounting information \ ILLUSTRATION 4-3 Regal Entertainment's Discussion of Internal Controls and Financial Reporting Continual monitoring of internal activities) CHAPTER 4 Cash and Internal Controls COMPONENTS OF INTERNAL CONTROL Control Environment The control environment refers to overall top-to-bottom attitude of the com- pany with respect to internal Management is largely&esponsible for set ting a tone of ethical value and competence among its employees. Formal policies related to management's philosophy, assignment of responsibility, organizational structure, and employee development help management to set a foundation for all other components of internal control. Risk Assessment Because business conditions change continually, companies should develop formal policies to assess the risk that internal or external sources are preventing a com- pany from achieving its objectives. (Risk assessment procedures include periodic reviews of internal controls, assessing management's oversight of internal control, developing solutions to known cases of internal control failures, and determining whether each division or operation within a company is meeting its objectives) Control Activities lA critical aspect of an internal control system is separation of duties, where individu- als who have physical responsibility for assets should not also have access to account- ing records:}Control activities also include systems for cash payments, authorizing purchases, reviewing operating performance, and safeguarding assets. Information and Communication The purposes of accounting systems are to accurately measure business transac- tions and reliably report those transaction!( so management and the company's stakeholders can make informed decisions) For this to occur, employees at all levels must understand the importance of high-quality information. (Lower-level employ- ees must report information accurately and in a timely manner to those higher in the organization. Top executives of a company then must effectively communicate this information to external parties such as investors and creditors Illustration 4-3 provides the description given by Regal Entertainment Group in its annual report of the relationship between internal controls and financial reporting. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Monitoring Management needs to monitor the internal control system, just like any other sys- tem. Any control deficiencies spotted by employees should be reported immediately to management. Movie Theatre Example Let's relate the five components of internal control back to operating a movie the- atre. The control environment is greatly affected by the overall attitudes and actions watch I risk fac changit Cant atre sh cashiet tant m emplo: so on) Infc inforn office byha bit W< of the Me to ac tivel) ber c sure RES EveJ nal sibi eacl req1 a de aSS< rep $3. alii int let au com- set- icies ional Dr all rmal com- "odic
tmng vidu- unt- tents, s. sac- any's evels play- er in icate roup ncial ny; ted on sys- ately ; the- tions CHAPTER 4 Cash and Internal Controls of management. If employees notice unethical discussion or behavior by manage- ment, then they are more likely to behave in a similar manner, wasting the compa- ny's resources.Wouldn't you be more comfortable investing in or lending to a movie theatre if it wt!re run by a highly ethical person, rather than someone of question- able character? Risk assessment includes careful consideration of external risk factors. What external risk factors do movie theatres face? Well, the risk that viewers will just watch movies on DVD or On Demand at home is certainly an important external risk factor. Companies must constantly assess their competitiveness in an ever- changing business environment. Control activities include separation of duties( The accountant at the movie the- atre should not also have direct access to company cash by filling in as a ticket cashier or being responsible for the daily cash deposits) Otherwise, the accoun- tant may be able to[steal cash and cover it up in the accounting records) Similarly, employees who have physical control of theatre inventory (candy bars, T-shirts, and o on) should also not be in charge of accounting for it. Information and communication depend on the reliability of the accounting information system itself. If the accountant's office looks like a typical professor's office (papers everywhere) and you learn the company still does all its accounting by hand without a computer, wouldn't you, as an investor or lender, be just a little bit worried? There should be a system in place to ensure that current transactions of the company are reflected in current reports. Monitoring is the final component of internal control. The theatre manager needs to actively review daily operations to ensure that control procedures work effec- tively. For instance, he should compare daily cash from ticket sales with the num- ber of tickets issued, compare concession sales with units purchased, and make ure employees are paid only for actual hours worked. RESPONSIBILITIES FOR INTERNAL CONTROL Everyone in a company has an impact on the operation and effectiveness of inter- nal controls, but top executives are the ones who must take final respon- sibility for their establishment and The 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 A recent survey by the Financial Executives Institute of 24 7 executives reports that the total cost to a company of complying with Section 404 averages $3.8 million. The 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.) To see how this information gets reported, let's look at Illustration 4-4, which provides an excerpt from Regal Entertainment's auditor's report. In our opinion, management's assessment that Regal Entertainment Group maintained effective internal control over financial reporting is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Regal Entertainment Group maintained, in all material respects, effective internal control over financial reporting, based on criteria established in Internal Control- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 161 ILLUSTRATION 4-4 Excerpt from Regal Entertainment's Auditor's Report Related to Effectiveness of Internal Controls 162 ILLUSTRATION 4-5 Regal Entertainment's Discussion of Limitations of Internal Controls Decision Point PARTB L03 Define cash and cash equivalents. CHAPTER 4 Cash and Internal Controls LIMITATIONS OF INTERNAL CONTROL Unfortunately, financial misstatements can occur even with the best internal con- trol systems. While better internal control systems will more likely detect operating and reporting errors, no internal control system can turn a bad employee into a good one. Internal control systems are especially susceptible to collusion( Collu- sion occurs when two or more people act in coordination to circumvent internal controls.\ Going back to our movie theatre example, if the ticket cashier and the ticket taker, or the ticket cashier and the accountant, decide to work together to steal cash, theft will be much more difficult to detect. Most fraud cases fall into this category. fraud involving collusion is nearly five times greater than fraud involving a single individual) Finally, because there are natural risks to running any business,{effective inter nal controls and ethical employees alone cannot ensure a company's success, or even survival) Regal Entertainment recognizes the limitations of internal con trois and provides an explicit discussion of this issue in its annual report, as shown in Illustration 4-5. Management recognizes that there are inherent limitations in the effectiveness of any internal control over financial reporting, including the possibility of human error and the circumvention or overriding of internal control. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control over financial reporting may vary over time. Question , - Does the company maintain adequate internal controls? KEY POINT Accounting Information
E.E.J Management's discussion, auditor's opinion Analysis b If management or the auditor notes any deficiencies in internal controls, financial accounting information may be unreliable. Internal control refers to a company's plan to improve the accuracy and reli- ability of accounting information and safeguard the company's assets. Five key components to an internal control system are (1) control environment, (2) risk assessment, (3) control activities, (4) information and communica- tion, and (5) monitoring. CASH Cash and Cash Equivalents Before discussing specific controls related to cash, let's first get a good understand- ing of what "cash" includes. (!he 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 1. 2. 3. 4. COll- ating 1to a C>llu- !rnal l the !r to this ving tter- :ess,
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as m CHAPTER 4 Cash and Internal Controls customers. Checks are writ.!;en instructing a bank to pay a specific amount from the check maker's account. ) The balance of cash also cash equivalents) which are defined as term investments that have a maturity date no longer than three months from the date of purchase.) Common examples of such investments market funds, treasury bills, and certificates of deposit) You may be familiar with these types of short-term investments. 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. KEY POINT Cash includes not only currency, coins, balances in checking accounts, and checks and money orders received from customers, but also cash equivalents, defined as investments that mature within three months (such as money market funds, treasury bills, and certificates of deposit). Investors and creditors closely monitor the amount of cash a company holds. The company(peeds enough cash, or enough other assets that can quickly be converted to cash, to pay obligations as they become due) Available cash also helps a com- pany respond quickly to new, profitable opportunities before competitors d(}. On the other hand, having too much cash leads to (nefficient use of funds and could be a signal that a company's management does not see additional opportunities for profitable usually view excess cash as a negativt:j. Cash Controls Management must safeguard all assets against possible misuse. Because cash is the most liquid asset and the one most easily stolen, 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. 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 along with 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. An additional control for cash receipts is to allow customers to pay with debit cards.)Debit cards (sometimes referred to as check cards) (work just like a check and withdraw funds directly from the cardholder's bank account at the time of use) Accepting them provides an additional control by teducing employees' need to directly handle cash'\ Cash in the amount of the sale is automatically deposited in the company's bank. a customer uses cash, a check, or a debit card to make a purchase, the company records the transaction as a cash sale) 163 Decision Maker's Perspective l04 Understand controls over cash receipts and cash disbursements. Controls over cash receipts 164 I CHAPTER 4 Cash and Internal Controls Let's assume you decide to treat your friends to-a movie. The total cost for tickets is $100 and the movie theatre allows you the option of paying with cash, a check, or a debit card. The theatre will record your payment using any of these methods as a cash sale. Debit Credit ---- Cash ................ .. ... .... ...................................................................... . 100 Ticket Revenue ....... ....... ................ ....................................... . 100 (Ticket sales with cash, check, or debit card) The term debit card can cause some confusion for someone taking the first accounting course. Throughout this course, we refer to an increase in cash as a debit to cash. However, using your debit card will result in a decrease in your cash account. It's the merchant's cash account that increases and is deb- ited. Don't let this confuse you. Credit cards can also provide a control for cash receipts. Like debit cards, credit cards offer customers a way to purchase goods and services without a physical exchange of cash. '{hey differ, however, in that credit cards don't remove cash from the cardholder's account after each transaction. The term credit card is derived from the fact that the issuer, such as Visa or MasterCard, extends credit (or lends money) to the cardholder each time the cardholder uses the credit card. The card- holder has a specified grace period before he or she has to pay the credit card bal- ance in full. If the balance is not paid by the end of the grace period, the issuing company will charge a fee (interest) <tredit card companies charge the retailer, not the customer, for the use of the credit card) This charge generally\I"anges from 2% to 4% of the amount of the sale, Because the credit card company aeposits cash into the retailer's account immedi- ately, companies record credit card sales in the same way as cash sales, even though the consumer doesn't pay cash.(From the seller's perspective, the only difference between a cash sale and a credit card sale is that the company must pay a fee to the credit card company for allowing the customer to use a credit card. For example, suppose you use your MasterCard to pay for movie tickets for you and your friends. The total cost is $100 and MasterCard charges the movie theatre a service fee of 3% or $3. The movie theatre would record a cash sale at the time you purchase the tickets with your credit card. Cash ............................................................................................... . Service Fee Expense ..................................................................... . Ticket Revenue ......................................................................... . (Ticket sales with credit card and 3% service fee) CASH DISBURSEMENTS Debit Credit ----- 97 3 100 Managers should design( proper control for cash disbursements to prevent any unauthorized payments and ensure proper recording.) Consistent with our discus- sion of cash receipts, cash disbursements include not only physical cash, 0 ickets !heck, thods !dit )0 ::>- redit 'sical from rived ends :ard- bal- uing fthe sale ledi- mgh ~ n 1 fee ou tre a you lit any :::us- :tsh, CHAPTER 4 Cash and Internal Controls Question , - Should the company allow its customers to use credit cards? ETHICAL DILEMMA Accounting Information ~ .E.] Credit sales, service fee expense, internal controls Analysis When the benefits of credit card use (increased sales, reduced handling of cash by employees) exceed the costs (service fee expense and credit card fraud). the company benefits. Jill is starting her sophomore year of college. The only way she can pay for tuition and school supplies is to take out a student loan. To make living costs more affordable, she shares an apartment with two other girls. One week after Jill starts classes, her car breaks down. She pays a $120 towing bill to get the car to the service station, and then the mechanic tells her the car has suffered major engine failure. The cost to fix the problem will be $1,600, which is a fair price for damage of this nature. She has enough money left from her student loans to pay the bill, but she knows this will put her behind for the next several months' rent. The mechanic tells her that if she pays cash, instead of writing a check or paying with a debit card or credit card, he will charge her only $1,300. When she asks the reason for the $300 discount, he tells her "If you pay cash, there's no record of our transaction and I won't have to pay taxes. I already pay too much taxes and this will save us both money." What should Jill do? Another mechanic is likely to charge her full price and she would have to pay an additional towing charge. but also ~ t i n g checks and using debit cards) All these forms of payment constitute cash disbursement and require formal internal control procedures. When you pur- chase $100 worth of movie tickets for you and your friends, you would record the following transaction, regardless of whether you pay with cash, a check, or a debit card. Debit Credit ----- Entertainment Expense ................................................................ . 100 Cash .. ............. ............. .......... ................................................. . 100 (Ticket purchases with cash, check, or debit card) Because credit cards allow the purchaser to delay payment for several weeks or even months, you record the purchase of $100 worth of movie tickets with a credit card as follows. Debit Credit ----- Entertainment Expense ............. ................. ...... .... ........................ . 100 Credit Card Payable ................................. ............................ . 100 (Ticket purchases with credit card) 165 Decision Point 166 Controls over cash disbursements LOS Reconcile a bank statement. CHAPTER 4 Cash and Internal Controls 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. 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. ) KEY POINT Because cash is the most liquid asset of a company, controls over cash receipts and cash disbursements are an important part of a company's overall internal control system. Bank Reconciliation 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. If you have your own checking account, you know that the balance of cash in your checkbook often does not equal the balance of cash in your bank account. Why is that? One possibility is that you (or your bank) made a recording error. More likely, though, you've written a check or made a deposit that hasn't yet reached the bank, or maybe the bank has made an adjustment you haven't yet recorded. It's the same for a business. A company's cash balance as recorded in its books rarely equals the cash balance reported in the bank statement. The reasons for the differences are the same as well( Differences in these balances occur because of either timing differences or errors\ It is the possibility of these errors, or even outright fraud- ulent activities, that make the bank reconciliation a useful cash control tool. friming differences in cash occur when the company records transactions either before or after the bank records the same transaction.J For example, when a movie theatre pays its popcorn supplier $200 by check, the company records a decrease in cash immediately, but the bank doesn't record a decrease in cash until the popcorn supplier later deposits the check. If the supplier waits a week before depositing the check, the balance of cash in the company's records will be reduced one week earlier than will the bank's. Sometimes the bank is the first to record a transaction. The bank could charge a $50 service fee for processing the company's transaction, immediately reducing the bank's record of the company's balance for cash. However, the company may not be immedi- ately aware of this. Only when the monthly bank statement is sent will the company become aware of the cash reduction. In this case, the bank's balance for cash reflects a cash transaction before the company's balance can reflect the same transaction. l.[3rrors can be made either by the company or its bank and may be acci- dental or n t e n t i o n ~ An accidental error might occur if the company mistakenly were tor imprope the resul deposits tion will A bar balance in Illus P.O. Ode (432 Ace ~ ing ~ o r l to [l ttrol I e of rds. rour ty is I (ely, mk, toks I the :her .ud- ()DS ple, 'rds ntil ore ced 50 I 1k's !di- my :sa - :ci- I nly CHAPTER 4 Cash and Internal Controls were to record a check being-written for $117 as $171 in its records, or if the bank improperly processed a deposit of $1,100 as a $1, 010 deposit. An intentional error is the result of theft. If the company records a daily deposit of $5,000 but an employee deposits only $500 into the bank account and pockets the rest, the bank reconcilia- tion will reveal the missing $4,500. A bank reconciliation connects the company's cash balance to the bank's cash balance by identifying differences due to timing and errors. This concept is shown in Illustration 4-6. Company's Cash Records Differences 1. Timing 2. Errors Bank Reconciliation Reconciled Bank Balance Reconciled Company Balance Bank's Cash Records Bank Statement Deposits Differences [ Withdrawals 1. Timing 2. Errors To see how a bank reconciliation is prepared, let's examine the bank statement of Starlight Drive-In. At the end of March, First Bank sends the bank statement in Illustration 4-7 to Starlight. P.O. Box 26788 First Bank Member FDIC Odessa, TX 797 60 A Name You Can Trust (432) 799-BANK Account Holder: Starl ight Drive-In Account Number: 4061009619 I 221 B Baker Street Odessa, TX 79760 Statement Dat e : March 31, 2010 Account Summary Beginning Balance Deposits and Credits Withdraws and Debits Ending Balance March 1, 2010 No. Total No. Total March 31 , 2010 $3,800 4 $8,600 7 $8,300 $4,100 Account Details Det>osits and Credits Withdraws and Debits Daily Balance Date Amount Desc. Date No. Amount Desc. Date Amount 3/5 $3,600 DEP 3/ 8 293 $2, 100 CHK 3/5 $7,400 3/9 3,000 NOTE 3/ 12 294 2,900 CHK 3/ 8 5,300 3/ 22 1,980 DEP 3/ 15 400 EFT 3/ 9 8,300 3/31 20 INT 3/22 750 NSF 3/ 12 5,400 3/ 26 296 1,900 CHK 3/ 15 5,000 3/ 28 200 DC 3/ 22 6,230 3/ 31 50 sc 3/ 26 4,330 3/ 28 4,130 - - -- $8,600 $8,300 3/31 $4,100 Desc. DEP Customer deposit INT Interest earned SC Service charges NOTE Note collected CHK Customer check NSF Nonsufficient funds EFT Electroni c funds transfe r DC Debit card 167 ILLUSTRATION 4-6 Bank Reconcil iation ILLUSTRATION 4-7 Bank Statement 168 ILLUSTRATION 4-8 Company Records of Cash Activities Timing differences CHAPTER 4 Cash and Internal Cont rols Let's compgre the bank statement with Starlight's o.wn records of cash activity over the same period, as shown in Illustration 4-8. STARLIGHT DRIVE-IN Cash Account Records March 1, 2010, to March 31 , 2010 Deposits Checks Dat e 3/5 3/22 3/31 Desc. Sales receipts Sales receipts Sales receipts Beginning Cash Balance March 1, 2010 $3,800 Amount Date No. $3,600 3/6 293 1,980 3/11 294 2,200 3/21 295 3/24 296 3/30 297 $7,780 Summary of Transactions Deposits Checks $7, 780 $8,700 Desc. Salaries Rent Utilities Insurance Supplies Amount $2,100 2,600 1,200 1,900 900 $8,700 Ending Cash Balance March 31 , 2010 $2,880 First Bank's ending balance of cash ($4,100) differs from Starlight's ending bal- ance of cash ($2,880). To reconcile these balances, we need to identify (1) timing differences created by cash activity reported by either First Bank or Starlight but not recorded by the other and (2) any errors. COMMON MISTAKE Notice that bank statements refer to an increase (or deposit) in the cash bal- ance as a credit and a decrease (or withdrawal) as a debit . This terminology is the opposite of that used in financial accounting, where debit refers to an increase in cash and credit refers to a decrease in cash. The reason is that the financial accounting records are prepared from a company's perspective, while the bank statement is prepared from a bank's perspective. When a com- pany makes a deposit, the bank's liability to the company (a credit account) increases. When a company withdraws cash from its bank account, the bank's liability to the company decreases. RECONCILING THE BANK'S CASH BALANCE Cash transactions recorded by a company, but not yet recorded by its bank, include deposits outstanding and checks outstanding. Deposits outstanding are cash receipts of the company that have not been added to the bank's record of the com- pany's balance. Checks outstanding are checks the company has written that have not been subtracted from the bank's record of the company's balance. Once the bank receives the deposits outstanding, the bank's records will increase. Similarly, once the bank receives the checks outstanding, the bank's records will decrease} We also need to check for and correct any bank errors. Comparing the deposits recorded by Starlight (Illustration 4-8) to those reported on the bank statement (Illustration 4-7) reveals that the deposit of $2,200 on March 31 is not reflected in the bank's balance by the end of March. This is a deposit outstanding. Comparing the checks written by Starlight to those reported in the bank state- ment shows that the bank received checks #293, #294, and #296 by the end of March.
nt 10 0 0 0 0 0 bal- ling but 1de :tsh m- :tve the rly, We ted on ;; a te- :h. CHAPTER 4 Cash and Internal Controls This means checks #295 (for $1,200) and #297 (for $900) remain outstanding and are not reflected in the bank's balance. The reconciled bank balance is calculated on the left side of Illustration 4-9. RECONCILING THE COMPANY'S CASH BALANCE What are some examples of cash transactions recorded by the bank, but not yet recorded by the company?/ These would include 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-checks drawn on nonsufficient funds or "bad" checks from customers\Jn addition, we adjust the company's balance for any company errors. Six cash transactions recorded by First Bank (Illustration 4-7) are not reported in Starlight's cash records (Illustration 4-8) by the end of March: 1. Note collected by First Bank on Starlight's behalf ($3,000), which includes interest of $200. 2. Interest earned by Starlight on its bank account ($20). 169 3. Electronic funds transfer related to the payment of advertising ($400). Timing differences 4. NSF check ($750). 5. Debit card purchase of office equipment by employee ($200). 6. Service charge ($50). COMMON MISTAKE Students sometimes mistake an NSF check as a bad check written by the company instead of to the company. When an NSF check occurs, the com- pany must adjust its balance of cash downward to reverse the increase in cash it recorded at the time it received the check from the customer, because the customer did not have enough funds to cover the check. In addition to the amounts related to timing differences, we need to address one other reconciling item. Comparing Starlight's record of checks written to those in the bank statement reveals an error by Starlight. Check #294 for rent was written Company error for $2,900, but Starlight's accountant recorded it incorrectly as $2,600. First Bank processed the check for the correct amount of $2,900. This means Starlight needs to reduce its cash balance by an additional $300 for rent expense. The reconciled company balance is calculated on the right side of Illustration 4-9. Bank's Cash Balance Before reconciliation Deposits outstanding: 3/31 = $2,200 Checks outstanding: #295 = $1,200 #297 = $ 900 After reconciliation STARLIGHT DRIVE-IN Bank Reconciliation March 31, 2010 $4, 100 +2,200 - 2,100 $4,200 Cash Balance Before reconciliation Note received Interest earned from note Interest earned from bank EFT for advertising NSF check Debit card for office equip. Service charge Corrected rent expense error After reconciliation $2,880 + 2,800 +200 20 - 400 - 750 200 - 50 - 300 $4,200 '---------Reconciled---------....l ILLUSTRATION 4-9 Reconciling the Bank Statement 170 ILLUSTRATION 4-10 Entries to Adjust the Company's Cash Balance *' CHAPTER 4 Cash and Internal Controls If the bank ~ e r e aware of all deposits made and all checks written by the com- pany, the bank's balance for cash would be $4,iOO. Similarly, once the company adjusts its balance for information revealed in the bank statement, its cash balance is $4,200. The fact that the two balances match provides some indication that cash is not being mishandled by employees. (As a final step in the reconciliation process, the company must update t h ~ ba)ance of cash for the items used to reconcile the company's cash balance We record these entries once the bank reconciliation is complete. Remember, these are amounts the company didn't know until it received the bank statement. We record items that increase the company's cash with a debit to cash, whereas we record items that decrease the company's cash with a credit to cash. Illustration 4-10 demonstrates the entries needed to adjust Starlight's cash balance for recon- ciliation items. March 31, 2010 Debit Credit -- - Cash ................................. .. ......................................................... . 3,020 Notes Receivable . 00000 00000 00000 0000000 00000000 000000000000 00 ................ .. 2,800 Interest Revenue ..... 00 oo ... oo ... 00 oo ... oo ...... 00 oo .................... oo .... .. 220 (Reconcile cash increases) 00 00 ........ .. 00 ........ 00 ........................ . Advertising Expense ... .. .... .... ........ .. ... .. ................ ..................... . 400 Accounts Receivable .................................................................. . 750 Office Equipment ...................................................................... . 200 Service Charge Expense 00 ....... oo ..... 00 ........ 00 00 .......... 00 ..... 00 oo ... 00 ... 00 50 Rent Expense ............................................................................. . 300 Cash .................................................................................... . 1,700 (Reconcile cash decreases) Most of the accounts are easy to understand. We credit notes receivable since the note has been received. We recognize interest revenue as earned. Cash outflows related to expenses (advertising, service charge, and rent) and asset purchases need to be recorded. Finally, we debit accounts receivable to show that the customer who paid with an NSF check still owes the company money. COMMON MISTAKE Some students try to prepare adjusting entries for deposits outstanding, checks outstanding, or a bank error. The company does not need to adjust for these items because they are already properly recorded in the company's accounting records. KEY POINT In a bank reconciliation we adjust the bank's balance for (1) cash transactions already recorded by the company but not yet recorded by the bank and (2) bank errors. Similarly, we adjust the company's balance for (1) cash transactions already recorded by the bank but not yet recorded by the company and (2) company errors. After we adjust both the bank balance and company balance, the two should equal. At the ance o lowing Che Dep, In ad $220 bank Requi I 1. Pre 2. Pre Sol uti: 1. 2. Apr Ca. se A ~ age1 pan! diffj neo For evei exp om- any .nee :ash lthe ce I tese eas on bn- tee ws ed ho
I
CHAPTER 4 Cash and Internal Control s At the end of April 2010, Showtime Theatre's accounting records show a cash bal- ance of $4,800. The April bank statement reports a cash balance of $3,700. The fol- lowing information is gathered from the bank statement and company records: Checks outstanding $1 ,900 Deposits outstanding 1,600 Interest earned 70 Customer's NSF check $1 ,300 Service charges 200 In addition, Showtime discovered it correctly paid for advertising with a check for $220 but incorrectly recorded the check in the company's records for $250. The bank correctly processed the check for $220. Required: I. Prepare a bank reconciliation for the month of April2010. 2. Prepare entries to adjust the balance of cash in the company's records. Solution: I. SHOWTIME THEATRE Bank Reconciliation April 30, 2010 Bank's Cash Balance C o m ~ s Cash Balance Before reconciliation $3,700 Before reconcil iation Deposits out st anding + 1,600 Interest earned Company error Checks outstanding - 1,900 Service charge NSF check - -- After reconciliation $3,400 After reconcili ation --- 2. April 30, 2010 Cash ................................. ...... ............. .. .... ............... .. ........... ....... .. . Interest Revenue .... ................. .... .............. ..... ...... ...... ..... ... .. . Advertising Expense ......... ... ....... .............. ........... ......... ..... .. . (Reconcile cash increases) Service Charge Expense .... .... .. .. ...... .. .................. .. .......... .... .. ..... .. . Accounts Receivable ...... .... ... .. ...... ...... ... .............. ....... ....... ....... .... . Cash ...... ... .. .............. ..... ............... ...... .. ....... .. ...... ................... . (Reconcile cash decreases) Debit $4,800 + 70 + 30 - 200 - 1,300 $3,400 Credit -- 100 70 30 200 1,300 1,500 (In the uncommon event that the two reconciled balances do not equaVthen man- agement investigates the discrepancy to check for wrongdoing or errors by com- pany employees or the bank. ( If it cannot resolve the discrepancy, it records the difference to the cash short and over account) This account \serves as a miscella- neous expense or revenue) depending on whether it has a debit or credit balance. For example, suppose a company is unable to account for $100 of cash. In this event, the company records the following transaction, increasing miscellaneous expenses and decreasing cash. 171 Stop and Review Go 172 L06 Account for petty cash. CHAPTER 4 Cash and Internal Controls Debit Credit Cash Short and Over ........ .. ... ..... .... .... .... ..... ..... ... .. ... ... ...... ......... .. . 100 Cash ...... ........ .. .... ...... .. ... ........ .. ... ... .. ........... .. .. .............. ......... . 100 (Loss of $100 cash) Petty Cash You probably pay for most of what you buy with a check, debit card, or credit card. However, it's nice to have a little cash in your wallet for emergency or impulse expenditures. For example, you might decide to buy a box of Girl Scout cookies from your neighbor or soda from a machine. In the same way, most 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 expenses. If the office manager orders a $10 pizza for a staff meeting, it would be inconvenient and costly to write and process a check for such a small amount. Furthermore, it would be time consuming to run to the bank for a $10 cash with- drawal. 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 giving the withdrawn cash to an employee who becomes responsible for it. The fund should have just enough cash to make minor expenditures over a reasonable period (such as a week or a month):);iven appropriate documentation, such as a receipt for the purchase of office supplies, the employee responsible for the fund will disburse cash to reimburse the purchaser. At any given time, the cash remaining in the fund plus all receipts should equal the amount of the fund. The receipts are important to ensure proper use of the funds and for recording expenditures each time the fund is replenished. 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: May 1 Debit Credit Petty Cash (on hand) .. .......................................................... ...... ... . 500 Cash (checki ng account) ... .... ... .. ................ .. ... .. .. .......... .......... . 500 (Establish the petty cash fund) Assume Starlight has the following expenditures from the petty cash fund during May: Date Expenditure Amount May 7 Post age $ 75 May 16 Office supplies 120 May 20 Office group lunch 50 May 26 Del ivery charges 85 $330 By the end of May, the petty cash fund has distributed $330, leaving $170 in the fund (along with receipts for $330). No entries are recorded at the time of these expenditures. Instead, the firm will replenish the petty cash fund at the end of the month and record the expenditures for the appropriate amounts at that time as follows: May 31 Postage Office su Entertair Delivery Ca! (Re Aspa checkin so separat; involve1 Wha could 1: for $20 short a To] cas exr ReF To tr d i SC\
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nent buld I unt. vith- lt of :ash >an ugh or 1ase n to )}us .t to the :ash it ing the ese the as CHAPTER 4 Cash and Internal Controls May 31 Debit Credit -- Postage expense .......................................................................... . 75 Office supplies .............................................................................. . 120 Entertainment expense ............ .... .............. .. ......... ... .................... . 50 Delivery expense .......................................................................... . 85 Cash (checking account) ......................................................... . 330 (Replenish the petty cash fund) As part of the reimbursement, management will withdraw cash of $330 from the checking account and give it to the employee responsible for the petty cash fund so the fund's balance will once again be $500. To maintain the control objective of separation of duties, the employee responsible for the petty cash fund should not be involved in accounting, nor in the process of writing or approving checks. What if only $150 is left in the petty cash fund, when there should be $170? It could be that $20 was stolen from the fund, or the fund could be missing a receipt for $20. If the question is not resolved, the firm will likely charge the $20 to the cash short and over account. KEY POINT To pay for minor purchases, companies keep some cash on hand in a petty cash fund. The petty cash fund is replenished at the end of the period and the expenditures are recorded. Reporting Cash To this point, we've considered several internal controls related to cash. Here, we discuss how companies report cash activities and how this information is useful to decision makers. Cash activities of a business enterprise are the most fundamental events upon which investors and lenders base their decisions. Where does a com- pany get its cash? Where does a company usually spend its cash? These are impor- tant issues in determining management's efficient use of a company's resources and in predicting future performance. 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 report- ing 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. Com- panies 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 (1) operating activities, (2) investing activities, and (3) financing We'll provide a complete dis- cussion 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. Operating activities include cash transactions involving revenue and expense events during the period. In other words, operating activities include the cash effect of the same activities that are reported in the income statement. Investing activities, as the name implies, include cash investments in long-term assets and investment securities. When the firm later sells those assets, we consider those transactions investing activities also. So, investing activities tend to affect long-term assets. 173 L07 Identify the major inflows and outflows of cash. 174 ILLUSTRATION 4-11 External Transactions of Woods Golf Academy Which transactions involve the exchange of cash? Decision Maker's Perspective CHAPTER 4 Cash and Internal Controls Financing 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. We also consider cash outflows to repay debt and cash divi dends to stockholders to be financing activities. So, financing activities tend to affect liabilities and stockholders' equity. It's easiest to understand cash flow information by looking at the underlying transactions. To do this, we'll refer back to the external transactions of Woods Golf Academy introduced in Chapters 1-3. For convenience, those transactions are repeated in Illustration 4- 11. Type of Cash Transaction External transactions in January activity involved (1) Sell shares of common stock for $25,000 Financing .I ' to obtain the funds necessary to start the I business. (2) Borrow $10,000 from the local bank and sign Financing .I a note promising to repay the full amount of the debt in three years. l (3) Purchase equipment necessary for giving golf Investing .I training, $24,000. (4) Purchase one year of rent in advance for .I $6,000 ($500 per month). Operating (5) Purchase supplies on account, $2,300. Operating X (6) Provide golf training to customers for cash, Operating .I $3,600. (7) Provide golf training to customers on account, Operating X $2,500. (8) Receive cash in advance for 10 golftraining Operating .I sessions to be given in the future, $600. (9) Pay salaries to employees, $2,800. Operating .I (1 0) Pay cash dividends of $200 to shareholders. Financing .I Which transactions involve t he exchange of cash? All transactions except (5) and (7) are either the receipt or payment of cash( Only transactions involving cash affect a company's cash flowsJ D \\ U L L . ~ Illustration 4-12 presents the statement of cash flows for Woods Golf Academy using what's called the tfirect method of reporting operating activitiek. In Chapter 11 we'll discuss the indirect method. Corresponding transaction numbers are in parentheses. From the statement of cash flows, investors and creditors can see that the major source of cash inflow for Woods is the issuance of common stock, a fi nancing activ- ity. Woods has also received cash from bank borrowing, which must be repaid. The company is also investing heavily in its future by purchasing equipment. Woods reports this amount as an investing outflow. Net cash flows from operating activities are -$4,600. This means that cash outflows related to operating activities exceed infl ows. Stated another way, cash outflows related to expense activities exceed cash inflows related to revenue activities. While Woods reports net income of $500 in its income statement (see Illustration 3-12 in Chapter 3), these same activities are not able to generate positive cash flows for the company. Ultimately, companies must be able to generate positive operating cash flows to maintain long-term success. :e the cash divi- nd to lying :Golf s are rv:d and ash ~ y oter ~ in :tjor :tiv- fhe ods IWS lWS tile : in the tsh CHAPTER 4 Cash and Internal Controls WOODS GOLF ACADEMY Statement of Cash Flows For the month ended January 31 Cash Flows from Operating Activities Cash inflows: From customers (6 and 8) Cash outflows: For salaries (9) For rent (4) Net cash flows from operating activities Cash Flows from Investing Activities Purchase equipment (3) Net cash flows from investing activities $4,200 (2,800) (6,000) (24,000) ($4,600) (24,000) Cash Flows from Financing Activities Issue common stock (1) Borrow from bank (2) Pay dividends (1 0) Net cash flows from financing activities Net increase in cash Cash at the beginning of the month Cash at the end of the month 25,000 10,000 ___j.?QQ) 34,800 6,200 .o. $6,200 The final amount reported in the statement of cash flows, $6,200, is the same amount of cash reported in the balance sheet. You can verify this is the case for Woods Golf Academy by referring back to the balance sheet reported in Illustration 3-14 in Chapter 3. Question , - How much cash is the company generating from internal versus external sources? KEY POINT Accounting Information ~ EEl Statement of cash flows Analysis 'b Cash flows generated from internal sources include operating and investing activities. Cash flows generated from external sources generally include transactions between the company and its lenders and stockholders. The statement of cash flows reports all cash activities for the period. Operat- ing activities include those transactions involving revenue and expense activi- ties. Investing activities include cash investments in long-term assets and investment securities. Financing activities include transactions designed to finance the business through borrowing and owner investment. 175 ILLUSTRATION 4-12 Statement of Cash Flows for Woods Golf Academy } Numbers in parentheses (in the left-hand column) correspond to the external transactions of Woods Golf Academy in Illustration 4-11 . Only transactions that involve the exchange of cash are included in the statement of cash flows. Decision Point 176 CHAPTER 4 Cash and Internal Cont rols QUICK QUIZ Indicate whether a company reports each of the following transactions as an operating, investing, or f inancing cash flow in the statement of cash flows. Transaction Type of Cash Flow 1. Pay employees' wages. 2. Obtain a loan at the bank. 3. Purchase a bui lding with cash. 4. Purchase equipment with a note payable. Solutions: 1. Operating; 2. Financing; 3. Investi ng; 4. Not reported on the statement of cash flows because no cash is involved in the transaction. COMPARING NET INCOME TO 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. We discussed an example of this above by comparing the net income of Woods Golf Academy ($500) to its net cash flows from operations (-$4,600). If you were considering an investment in Woods Golf Academy, would you consider net income of $500 to be a reliable indicator of the profit-generating potential of the com- pany, given that it has net cash flows from operating activities of -$4,600? In some instances, net income may not provide a good indicator of future performance. We refer to (the ability of net income to report the true underlying performance of the company as eamings quality J 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 free cash flows ) A simple way to calculate a company's free cash flows is hs operating cash flows plus investing cash flows during the periodi. This measure represents fhe cash that is free to distribute to stockholders and repay debt) Companies whose ee cash flows are declining relative to the trend in net income are likely to have lower-quality earnings!. Let's look at an example. In 1937 Vernon Rudolph bought a secret doughnut rec- ipe from a French chef in New Orleans, rented a building in Winston-Salem, North Carolina, and began selling doughnuts. Since then, Krispy Kreme has grown into a leading branded specialty retailer across the country, producing over a billion doughnuts a year. To illustrate the preference of not relying on a single measure like net income in isolation, we compare Krispy Kreme below with Starbucks Corporation. As the charts below show, both Krispy K.reme 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. This indicates that Starbucks' net income is backed by cash, whereas Krispy Kreme's is not. The pattern should raise concerns about the long-term profit-generating abil- ity of Krispy Kreme. In 2005, Krispy Kreme's growth in net income could no longer be sustained and decreased dramatically. In comparison, Starbucks' upward trend in net income showed no signs of slowing. Thus, we see from these two companies that t income that is backed by cash is more likely to persist into the future than is net income not backed by cashJ It's pe: r -ual- ;. In : the rded DWS. )Ods Nere orne om- orne .We : the ings free ting ents lOSe 1ave rec- ::>rth into lion ;ure tcks sive OWS ispy rhis :'sis tbil- lger end n.ies han $100 $50 $0 -$50 -$100 -$150 -$200 -$250 _...... 1999 CHAPTER 4 Cash and Internal Controls Krispy Kreme {in millions) .. \ / 2004v 2005 ---- I' \ \ \. [ Net Income Free Cash Flows I Starbucks {in millions) $800,------------------------------------------------.
$200
19.9J 2001 2002 2003 2004 2005
[ Net Income Free Cash Flows I It's also interesting to see what happened to the companies' stock prices over this period. Stock Price
$1 o I 'f.:..oo-.= .,.......... ......._,_..............
2000 2001 2002 2003 2004 2005 2006 [ Starbucks -fl- Krispy Kreme ) Notice that along with Krispy Kreme's explosive growth in net income came an explosive growth in stock price. If you had purchased $1,000 of Krispy Kreme's stock during its initial offering on April 5, 2000, your investment would have grown to about $4,400 by the end of 2001. That's over four times your initial investment in just 21 months. However, investors did not appear to have under- stood the low quality of Krispy Kreme's net income. As late as 2003, inves- tors supported a high stock price for the company in the face of declining free cash flows. Fortune magazine called Krispy Kreme the "hottest brand in the land." However, starting in 2004, the downward spiral began. Finally in 2004 and 2005, investors recognized the failing operations of Krispy Kreme and the stock price plummeted, falling more than 90% from its all-time high. In sharp contrast, Starbucks' stock price continued to rise with its net income and free cash flows. 177 178 Decision Point Comparing free cash flows with net income can help in measuring the quality of earnings. CHAPTER 4 Cash and Internal Controls Question , - How are free cash flows helpful for predicting a company's net income? KEY POINT Accounting Information
Net income from the income statement and free cash flows (operating and investing) from the statement of cash flows Analysis b When free cash flows and net income have similar trends, net income is more likely to continue that trend in the future. Companies whose free cash flows are decreasing relative to their net income are likely to have lower earnings quality than are other companies, all else being equal. .. CAREER CORNER Professional financial analysts offer investment advice to their clients-banks, insurance companies, mutual funds, securities firms, and individual investors, to name a few. This advice usually comes in the form of a formal recommenda- tion (1 = strong buy, 2 = buy, 3 = hold; 4 = sell, 5 = strong sell). Before giv- ing an opinion about a stock, analysts develop a detailed understanding of a company's operations through discussions with management, analysis of com- petitors, and projections of industry trends. Analysts also develop a detailed understanding of a company's financial statements, including its earnings qual- ity. Analysts typically do not recommend companies with lower-quality earn- ings. Understanding a company's earnings quality comes from having a good grasp of accrual-basis accounting. This is why many finance majors and MBA students, pursuing a career as a financial analyst, take additional accounting- related courses when earning their degree and even after graduation. Financial analysts' stock recommendations are available on most financial websites. KEY POINTS BY LEARNING OBJECTIVE L01 Understand the impact of accounting scandals and the passage of the Sarbanes-Oxley Act. The accounting scandals in the early 2000s prompted passage of the Sarbanes- Oxley Act (SOX). Among other things, SOX sets forth a variety of new guidelines related to auditor-client relations and additional internal controls. L02 Identify the components, responsibilities, and limitations of internal control. Internal control refers to a company's plan to improve the accuracy and reliability of accounting information and safeguard the company's assets. Five key components to an internal control system are (1) control environment, (2) risk assessment, (3) control activities, (4) information and communication, and (5) monitoring. L03 Define cash and cash equivalents. Cash includes not only currency, coins, balances in checking accounts, and checks and money orders received from customers, but also cash equivalents, defined as investments that mature within three months (such as money market funds, treasury bills, and certificates of deposit). L04 LOS LO LO
nd ore rend L. l.- l- .es- d CHAPTER 4 Cash and Int ernal Controls L04 Understand controls ruter cash receipts and cash disbursements:- Because cash is the most liquid asset of a company, controls over cash receipts and cash disbursements are an important part of a company's overall internal control system. LOS Reconcile a bank statement. In a bank reconciliation we adjust the bank's balance for (1) cash transactions already recorded by the company but not yet recorded by the bank and (2) bank errors. Similarly, we adjust the company's balance for (1) cash transactions already recorded by the bank but not yet recorded by the company and (2) company errors. After we adjust both the bank balance and company balance, the two should equal. L06 Account for petty cash. To pay for minor purchases, companies keep some cash on hand in a petty cash fund. The petty cash fund is replenished at the end of the period and the expenditures are recorded. L07 Identify the major inflows and outflows of cash. The statement of cash flows reports all cash activities for the period. Operating activities include those transactions and events involving revenues and expenses. Investing activities include cash investments in long-term assets and investment securities. Financing activities include transactions designed to finance the business through borrowing and owner investment. Companies whose free cash flows are decreasing relative to their net income are likely to have lower earnings quality than are other companies, all else being equal. GLOSSARY Bank reconciliation: Matching the balance of cash in the bank account with the balance of cash in the company's own records. p . 166 Cash: Currency, coins, balances in savings and checking accounts, items acceptable for deposit in these accounts, such as checks received from customers, and cash equivalents. p . 162 Cash equivalents: Short-term investments that have a maturity date no longer than three months from the date of purchase. p. 163 Checks outstanding: Checks the company has written that have not been subtracted from the bank's record of the company's balance. p. 168 Collusion: Two or more people acting in coordination to circumvent internal controls. p. 162 Deposits outstanding: Cash receipts of the company that have not been added to the bank's record of the company's balance. p . 168 Earnings quality: The ability of net income to report the true underlying performance of the company. p . 176 Internal control: A company's plan to (1) improve the accuracy and reliability of accounting information and (2) safeguard the company's assets. p. 159 NSF checks: Checks drawn on nonsufficient funds or "bad" checks from customers. p . 169 Petty cash fund: Small amount of cash kept on hand to pay for minor purchases. p. 172 Separation of duties: Individuals who have physical responsibility for assets should not also have access to accounting records. p. 160 179