1. ©2009 The McGraw-Hill Companies, Inc. Chapter 4 Cash and Internal Controls

2. ©2009 The McGraw-Hill Companies, Inc. Part A Internal Controls

3. 4-3 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.

4. 4-4 Accounting Scandals Enron AUDIT FIRM Arthur Andersen WorldCom FRAUD FIRM

5. 4-5 Sarbanes-Oxley Act of 2002 Congress passed the Sarbanes-Oxley Act, also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly referred to as SOX.

6. 4-6 Major Provisions of the Sarbanes- Oxley Act of 2002 o Oversight board: The Public Company Accounting Oversight Board has the authority to establish standards dealing with auditing, quality control, ethics, independence, and other activities relating to the preparation of audited financial reports. o 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. o Nonaudit services: It is unlawful for the auditors of public companies to also perform certain nonaudit services for their clients, such as consulting.

7. 4-7 Major Provisions of the Sarbanes- 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. o Auditor rotation: Lead audit partners are required to rotate off the audit client every five years. 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.

8. 4-8 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, not by company management. 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.

9. 4-9 LO2 Identify the Components, Responsibilities, and Limitations of Internal Control. 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. Effective internal control builds a wall to prevent misuse of company funds by employees and fraudulent or errant financial reporting

10. 4-10 Framework for Internal Control

11. 4-11 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 Control Activities Accountability through separation of duties. o Information and Communication Reliable financial accounting information. o Monitoring Continual monitoring of internal activities.

12. 4-12 Responsibilities for Internal Control  Everyone in a company has an impact on the operation and effectiveness of internal controls, but the top executives are the ones who must take final responsibility for their establishment and success.  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 assessment.  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 $3.8 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.

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

14. ©2009 The McGraw-Hill Companies, Inc. Part B Cash

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

16. 4-16 LO4 Understand Controls over Cash Receipts and Cash Disbursements 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. Cash Controls

17. 4-17 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.

18. 4-18 Additional Control for Cash Receipts CASH RECEPITS DEBIT CARD CREDIT CARD It removes cash directly from the cardholder’s bank account at the time of use. It does not remove cash from the cardholder’s account after each Transaction.

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

20. 4-20 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.

21. 4-21 Important elements of a cash disbursement control system include the following steps : 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.

22. 4-22 LO5 Reconcile a Bank Statement o Another important control used by nearly all companies to help maintain control of cash is a bank reconciliation. o A bank reconciliation matches the balance of cash in the bank account with the balance of cash in the company’s own records. o A company’s cash balance as recorded in its books rarely equals the cash balance reported in the bank statement. o Differences in these balances occur because of either timing differences or errors. o It is the possibility of these errors, or even outright fraudulent activities, that make the bank reconciliation a useful cash control tool.

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

24. 4-24 Bank Statement

25. 4-25 Company Records of Cash Activities Starlight Drive-In Cash Account Records March 1, 2010 to March 31, 2010 DepositsChecks DateDesc.AmountDateNo.Desc.Amount 3/5Sales receipts$3,6003/6293Salaries$2,100 3/22Sales receipts1,9803/11294Rent2,600 3/31Sales receipts2,2003/21295Utilities1,200 3/24296Insurance1,900 3/30297Supplies900 $7,780$8,700 Summary of Transactions Beginning Cash balance March 1, 2010DepositsChecks Ending Cash Balance March 31, 2010 $3,800$7,780$8,700$2,880

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

27. 4-27 Reconciling the Company’s Cash Balance o Few examples of cash transactions recorded by the bank, but not yet recorded by the company are - 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. o NSF checks: Checks drawn on nonsufficient funds or “bad” checks from customers. o In addition, we adjust the company’s balance for any company errors.

28. 4-28 Reconciling the Bank Statement

29. 4-29 Final Step in the Reconciliation Process

30. 4-30 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, office supplies, delivery charges, and entertainment expense o To pay for these minor purchases, companies keep some minor amount of cash on hand in a petty cash fund. 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.

31. 4-31 Account for Petty Cash o The fund should have just enough cash to make minor expenditures over a reasonable period. o Given 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. o At any given time, the cash remaining in the fund plus all receipts should equal the amount of the fund. o The receipts are important to ensure proper use of the funds and for recording expenditures each time the fund is replenished.

32. 4-32 Petty Cash 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: Assume Starlight has the following expenditures from the petty cash fund during May:

33. 4-33 Petty Cash 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:

34. 4-34 LO7 Identify the Major Inflows and Outflows of Cash o 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. o Cash activities of a business enterprise are the most fundamental events upon which investors and lenders base their decisions. o 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. o 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. o Cash activities of a business enterprise are the most fundamental events upon which investors and lenders base their decisions. o 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.

35. 4-35 Identify the Major Inflows and Outflows of Cash o Companies report cash in two ways. o First, it is reported as an asset in the balance sheet under current assets and represents cash available for spending at the end of the reporting period. It provides only the final balance for cash. o Secondly, reports information about cash receipts and payments during the period in a statement of cash flows. o From the statement of cash flows, investors know a company’s cash inflows and cash outflows related operating, investing and financing activities. o Companies report cash in two ways. o First, it is reported as an asset in the balance sheet under current assets and represents cash available for spending at the end of the reporting period. It provides only the final balance for cash. o Secondly, reports information about cash receipts and payments during the period in a statement of cash flows. o From the statement of cash flows, investors know a company’s cash inflows and cash outflows related operating, investing and financing activities.

36. 4-36 o Operating activities include cash transactions involving revenue and expense events during the period. o Investing activities include cash investments in long-term assets and investment securities. o 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.

37. 4-37 External Transactions of Woods Golf Academy

38. 4-38 External Transactions of Woods Golf Academy

39. 4-39 Comparing Net Income to Free Cash Flows Net income Income Statement RevenueExpenses Statement of Cash Flows Operating Cash Flow Investing Cash Flow + Free Cash Flows −

40. 4-40 Comparison of Net Income and Free Cash Flows of Krispy Kreme and Starbucks

41. 4-41 Comparison of Stock Price Movements of Krispy Kreme and Starbucks

42. ©2009 The McGraw-Hill Companies, Inc. End of Chapter 4