©2009 The McGraw-Hill Companies, Inc.

Chapter 4

Cash and Internal Controls

©2009 The McGraw-Hill Companies, Inc.

Part A
Internal Controls

©2009 The McGraw-Hill Companies, Inc.

LO1 Understand the Impact of Accounting Scandals and the Passage of the Sarbanes-Oxley Act
o Managers are entrusted with the resources of both the company¶s lenders (liabilities) and owners (stockholders' equity). o Managers of the company act as stewards or caretakers of the company¶s assets. o In recent years some managers have shirked their ethical responsibilities and misused or misreported the company¶s funds. o 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.

©2009 The McGraw-Hill Companies, Inc.

Accounting Scandals
AUDIT FIRM Arthur Andersen






4-5 . also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly referred to as SOX.©2009 The McGraw-Hill Companies. Inc. Sarbanes-Oxley Act of 2002 Congress passed the Sarbanes-Oxley Act.

4-6 . o Nonaudit services: It is unlawful for the auditors of public companies to also perform certain nonaudit services for their clients. such as consulting. ethics. and other activities relating to the preparation of audited financial reports. Severe financial penalties and the possibility of imprisonment are consequences of fraudulent misstatement. o Corporate executive accountability: Corporate executives must personally certify the company¶s financial statements and financial disclosures. Major Provisions of the Sarbanes.©2009 The McGraw-Hill Companies. quality control.Oxley Act of 2002 o Oversight board: The Public Company Accounting Oversight Board has the authority to establish standards dealing with auditing. Inc. independence.

4-7 .Oxley Act of 2002 o Retention of work papers: Auditors of public companies must retain all work papers for seven years or face a prison term for willful violations. Inc.©2009 The McGraw-Hill Companies. o Auditor rotation: Lead audit partners are required to rotate off the audit client every five years. Major Provisions of the Sarbanes. o 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.

Inc. Major Provisions of the Sarbanes.Oxley Act of 2002 o Hiring of auditor: Audit firms are hired by the audit committee of the board of directors of the company.©2009 The McGraw-Hill Companies. 4-8 . o 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. not by company management.

Inc. From a financial accounting perspective. internal control is a company¶s plan to: o Improve the accuracy and reliability of accounting information o Safeguard the company¶s assets. LO2 Identify the Components. and Limitations of Internal Control. Responsibilities. Effective internal control builds a wall to prevent misuse of company funds by employees and fraudulent or errant financial reporting 4-9 .©2009 The McGraw-Hill Companies.

©2009 The McGraw-Hill Companies. Inc. Framework for Internal Control Control Environment Risk Assessment Internal Controls Information and Communication Control Activities Monitoring 4-10 .

o Information and Communication Reliable financial accounting information. Inc. o Control Activities Accountability through separation of duties.©2009 The McGraw-Hill Companies. Components of Internal Control o Control Environment Ethical tone is set by top management o Risk Assessment Risk of failing to achieve company objectives. o Monitoring Continual monitoring of internal activities. 4-11 .

©2009 The McGraw-Hill Companies. ‡ The CEO and CFO sign a report each year assessing whether the internal controls are adequate. Responsibilities for Internal Control ‡ Everyone in a company has an impact on the operation and effectiveness of internal controls. 4-12 . but that the company¶s auditors provide an opinion on management¶s assessment.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. but the top executives are the ones who must take final responsibility for their establishment and success. ‡ A recent survey by the Financial Executives Institute of 247 executives reports that the total cost to a company of complying with Section 404 averages $3. Inc. Section 404 of SOX requires not only that companies document their internal controls and assess their adequacy.

o Internal control systems are especially susceptible to collusion. Inc.©2009 The McGraw-Hill Companies. Limitations of Internal Control o Internal control systems will more likely detect operating and reporting errors. 4-13 . o No internal control system can turn a bad employee into a good one.

©2009 The McGraw-Hill Companies. Part B Cash . Inc.

coins. as well as items acceptable for deposit in these accounts. o Cash equivalents: Short-term investments that have a maturity date no longer than three months from the date of purchase. 4-15 . LO3 Define Cash and Cash Equivalents Cash and Cash Equivalents o Cash: Includes currency. such as checks received from customers.©2009 The McGraw-Hill Companies. Inc. and balances in savings and checking accounts.

©2009 The McGraw-Hill Companies. internal control of cash is a key issue. Because cash is the most liquid asset and the one most easily stolen. LO4 Understand Controls over Cash Receipts and Cash Disbursements Cash Controls Management must safeguard all assets against possible misuse. Inc. 4-16 . 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.

Theft is more difficult once a record of the cash receipt has been made. 4-17 Internal control over cash receipts could include the following steps: ©2009 The McGraw-Hill Companies. . and make a list of checks received along with the amount and payer's name. 3. Verify cash receipts by comparing the bank deposit slip with the accounting records. 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. Inc. Open mail each day. 4. Record all cash receipts as soon as possible. Have another employee record cash receipts in the accounting records.1. 2.

Inc. Additional Control for Cash Receipts CASH RECEPITS DEBIT CARD It removes cash directly from the cardholder¶s bank account at the time of use.©2009 The McGraw-Hill Companies. 4-18 . CREDIT CARD It does not remove cash from the cardholder¶s account after each Transaction.

o All these forms of payment constitute cash disbursement and require formal internal control procedures.©2009 The McGraw-Hill Companies. Cash Disbursements o Managers should design proper control for cash disbursements to prevent any unauthorized payments and ensure proper recording. cash disbursements include not only disbursing physical cash. o Consistent with our discussion of cash receipts. but also writing checks and using debit cards. 4-19 . Inc.

Important elements of a cash disbursement control system include the following steps: ©2009 The McGraw-Hill Companies. Require two signatures for larger checks. Authorize all expenditures before purchase and verify the accuracy of the purchase itself. Make sure checks are serially numbered and signed only by authorized employees. debit card. This provides a permanent record of all disbursements. 2. 1. The employee who authorizes payment should not also be the employee who prepares the check. Inc. Make all disbursements. 4-20 . other than very small ones. or credit card. 3. by check.

©2009 The McGraw-Hill Companies. Inc. Give approval to purchase above these amounts only to upper-level employees. 6. Periodically check amounts shown in the debit card and credit card statements against purchase receipts. Employees responsible for making cash disbursements should not also be in charge of cash receipts. 5. The employee verifying the accuracy of the debit card and credit card statements should not also be the employee responsible for actual purchases. Important elements of a cash disbursement control system include the following steps: 4. 4-21 . Set maximum purchase limits on debit cards and credit cards.

©2009 The McGraw-Hill Companies. 4-22 . LO5 Reconcile o o a Bank Statement o o o Another important control used by nearly all companies to help maintain control of cash is a bank reconciliation. that make the bank reconciliation a useful cash control tool. Inc. A company¶s cash balance as recorded in its books rarely equals the cash balance reported in the 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. Differences in these balances occur because of either timing differences or errors. or even outright fraudulent activities. It is the possibility of these errors.

Errors can be made either by the company or its bank and may be accidental or intentional. Bank Reconciliation o Timing differences in cash occur when the company records transactions either before or after the bank records the same transaction. Timing Withdrawals 2. Errors . Errors 4-23 o Company¶s Cash Records Differences 1. Inc. Timing 2. Bank Reconciliation Reconciled Bank Balance = Reconciled Company Balance Bank¶s Cash Records Bank Statement Differences Deposits 1.©2009 The McGraw-Hill Companies.

©2009 The McGraw-Hill Companies. Bank Statement 4-24 . Inc.

Inc.700 4-25 .780 Summary of Transactions Beginning Cash balance March 1. 2010 Deposits Date Desc.980 2.100 2.900 900 $8. Amount Date No. 2010 to March 31.200 3/6 3/11 3/21 3/24 3/30 293 294 295 296 297 Salaries Rent Utilities Insurance Supplies $2.800 Ending Cash Balance March 31. 2010 $2.600 1.780 Checks $8.700 $7.880 Deposits $7. Company Records of Cash Activities Starlight Drive-In Cash Account Records March 1. Amount 3/5 3/22 3/31 Sales receipts Sales receipts Sales receipts $3. Checks Desc.©2009 The McGraw-Hill Companies.600 1. 2010 $3.200 1.

but not yet recorded by its bank. o Checks outstanding are checks the company has written that have not been subtracted from the bank¶s record of the company¶s balance. Reconciling the Bank s Cash Balance o Cash transactions recorded by a company.©2009 The McGraw-Hill Companies. o Deposits outstanding are cash receipts of the company that have not been added to the bank¶s record of the company¶s balance. 4-26 . include deposits outstanding and checks outstanding. Inc.

and charges for NSF checks. but not yet recorded by the company are . o NSF checks: Checks drawn on nonsufficient funds or ³bad´ checks from customers. 4-27 . collections made by the bank on the company¶s behalf. Reconciling the Company s Cash Balance o Few examples of cash transactions recorded by the bank. Inc. o In addition.©2009 The McGraw-Hill Companies. we adjust the company¶s balance for any company errors. service charges.items such as interest earned by the company.

©2009 The McGraw-Hill Companies. Inc. Reconciling the Bank Statement 4-28 .

Final Step in the Reconciliation Process 4-29 .©2009 The McGraw-Hill Companies. Inc.

4-30 . and entertainment expense o To pay for these minor purchases. companies keep some minor amount of cash on hand in a petty cash fund.©2009 The McGraw-Hill Companies. office supplies. LO6 Account for Petty Cash o Companies like to keep a small amount of cash on hand at the company¶s location for minor purchases such as postage. o Management writes a check for cash against the company¶s checking account and gives the withdrawn cash to an employee who becomes responsible for it. delivery charges. Inc.

the cash remaining in the fund plus all receipts should equal the amount of the fund. Inc. o The receipts are important to ensure proper use of the funds and for recording expenditures each time the fund is replenished.©2009 The McGraw-Hill Companies. o Given appropriate documentation. the employee responsible for the fund will disburse cash to reimburse the purchaser. 4-31 . such as a receipt for the purchase of office supplies. o At any given time. Account for Petty Cash o The fund should have just enough cash to make minor expenditures over a reasonable period.

Inc. The entry to establish the fund is: Assume Starlight has the following expenditures from the petty cash fund during May: 4-32 . Starlight Drive-In establishes a petty cash fund of $500 to pay for minor purchases. Petty Cash Suppose that at the beginning of May.©2009 The McGraw-Hill Companies.

leaving $170 in the fund (along with receipts for $330).©2009 The McGraw-Hill Companies. 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: 4-33 . Instead. Petty Cash By the end of May. No entries are recorded at the time of these expenditures. Inc. the petty cash fund has distributed $330.

4-34 o o . Inc. we discuss how companies report cash activities and how this information is useful to decision makers. Where does a company get its cash? Where does a company usually spend its cash? These are important issues in determining management¶s efficient use of a company¶s resources and in predicting future performance. Cash activities of a business enterprise are the most fundamental events upon which investors and lenders base their decisions. LO7 Identify the Major Inflows and Outflows of Cash o We¶ve considered several internal controls related to cash. Here.©2009 The McGraw-Hill Companies.

Inc. Secondly. 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. Identify the Major Inflows and Outflows of Cash o Companies report cash in two ways. o o o 4-35 .©2009 The McGraw-Hill Companies. investing and financing activities. First. From the statement of cash flows. It provides only the final balance for cash. reports information about cash receipts and payments during the period in a statement of cash flows. investors know a company¶s cash inflows and cash outflows related operating.

There are two ways to do this: borrow cash from lenders or raise cash from stockholders. 4-36 .©2009 The McGraw-Hill Companies. Inc. o Operating activities include cash transactions involving revenue and expense events during the period. o Financing activities include transactions designed to raise cash or finance the business. o Investing activities include cash investments in long-term assets and investment securities.

Inc.©2009 The McGraw-Hill Companies. External Transactions of Woods Golf Academy 4-37 .

©2009 The McGraw-Hill Companies. Inc. External Transactions of Woods Golf Academy 4-38 .

Inc.©2009 The McGraw-Hill Companies. Comparing Net Income to Free Cash Flows Net income Free Cash Flows Income Statement Statement of Cash Flows Revenue í Expenses Operating Cash Flow + Investing Cash Flow 4-39 .

©2009 The McGraw-Hill Companies. Inc. Comparison of Net Income and Free Cash Flows of Krispy Kreme and Starbucks Starbucks (in millions) $800 $600 $400 $200 $0 1999 -$200 Net Income ree Cash 2000 2001 2002 2003 2004 2005     lows 4-40 .

Inc.©2009 The McGraw-Hill Companies. Comparison of Stock Price Movements of Krispy Kreme and Starbucks Stock Price $50 $40 $30 $20 $10 $0 2000 2001 2002 Starbucks 2003 2004 2005 2006 Krispy Kreme 4-41 .

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