1. Spiceland | Thomas | Herrmann Financial Accounting Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Cash and Internal Controls Chapter 4

2. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-2 Learning Objectives Discuss the impact of accounting scandals and the passage of the Sarbanes-Oxley Act Identify the components, responsibilities, and limitations of internal control Define cash and cash equivalents Understand controls over cash receipts and cash disbursements Reconcile a bank statement

3. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-3 Learning Objectives Account for petty cash Identify the major inflows and outflows of cash Assess earnings quality by comparing net income and cash flows

4. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Part A Internal Controls 4-4

5. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-5 Incorrect Financial Statements Reasons Errors—accidental errors in recording transactions or applying accounting principles Fraud—a person intentionally deceives another person for personal gain or to damage that person Occupational fraud: the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employer’s resources.

6. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-6 The Fraud Triangle Motive (or pressure) RationalizationOpportunity

7. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-7 Internal Controls Eliminate opportunity Represent plans to: Safeguard the assets Improve accuracy and reliability of information

8. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 1 Discuss the impact of accounting scandals and the passage of the Sarbanes-Oxley Act 4-8

9. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-9 Accounting Scandals and Response by Congress Managers are entrusted with the resources of both the company’s lenders and owners Managers act as stewards or caretakers of the company’s assets Some managers have shirked their ethical responsibilities Top executives misreported and fooled investors into overvaluing the company’s stock

10. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-10 Accounting fraud in U.S. history WorldComEnron Avoided reporting billions in debt and losses Misclassified expenditures to overstate assets and profitability

11. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-11 Sarbanes-Oxley Act of 2002 Passed by Congress Also known as the Public Company Accounting Reform and Investor Protection Act of 2002 Applies to all companies that are required to file financial statements with the SEC Established guidelines on: Internal control procedures Auditor-client relations

12. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-12 Major Provisions of the Sarbanes-Oxley Act of 2002 Oversight board Corporate executive accountability Nonaudit services Retention of work papers Auditor rotation Conflicts of interest Hiring of auditor Internal control

13. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 2 Identify the components, responsibilities, and limitations of internal control 4-13

14. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-14 Illustration 4.2—Components of Internal Control

15. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-15 Control Activities Preventive controls Separation of duties Physical controls Proper authorization Employee management E-commerce controls Detective controls Reconciliations Performance reviews Audits

16. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-16 Responsibilities for Internal Control The CEO and CFO to sign a report each year assessing adequacy of internal controls Auditors to provide an opinion on management’s assessment Auditor to express its own opinion on company’s internal control over financial reporting

17. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-17 Limitations of Internal Control Bad employee cannot be turned into a good one Internal control systems are especially susceptible to collusion Collusion: two or more people acting together to circumvent internal controls. Top-level employees who can override internal control procedures can commit fraud Effective internal controls and ethical employees cannot ensure success or even survival

18. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Part B Cash 4-18

19. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 3 Define cash and cash equivalents 4-19

20. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-20 Cash and Cash Equivalents Cash Currency Coins Balances in savings and checking accounts Checks Cash equivalents— mature within three months Money market funds Treasury bills Certificates of deposit

21. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 4 Understand controls over cash receipts and cash disbursements 4-21

22. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-22 Cash Controls Controls over cash receipts Separate duties of handling cash and verifying receipts Deposit cash daily Prefer credit cards or debit cards Controls over cash disbursements Prefer payments by check, debit card, or credit card Separate duties of authorizing payments and verifying purchases Verify records against purchase receipts Place authorization and documentation procedures Separate disbursement and collections duties

23. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 5 Reconcile a bank statement 4-23

24. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-24 Bank Reconciliation Bank reconciliation: matching the balance of cash in the bank account with the balance of cash in the company’s own records

25. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-25 Illustration 4.6—Bank Reconciliation Timing differences Errors

26. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-26 Illustration 4.7—Bank Statement

27. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-27 Illustration 4.8—Company Records of Cash Activities

28. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-28 Illustration 4.8—Company Records of Cash Activities (concluded)

29. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-29 Step 1: Reconciling the Bank’s Cash Balance Deposits outstanding: cash receipts of the company that have not been added to the bank’s record of the company’s balance Checks outstanding: checks the company has written that have not been subtracted from the bank’s record of the company’s balance

30. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-30 Step 2: Reconciling the Company’s Cash Balance Interest earned by the company Collections made by the bank on the company’s behalf Service fees Charges for NSF checks NSF checks: Customers’ checks written on “nonsufficient funds,” otherwise known as “bad” checks

31. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-31 Step 3: Adjusting the Company’s Cash Account Balance Update the balance in its Cash account: To adjust for the items used to reconcile the company’s cash balance

32. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-32 Illustration 4.9—Reconciling the Bank Statement

33. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 6 Account for petty cash 4-33

34. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-34 Petty Cash Fund Petty cash fund: small amount of cash kept on hand to pay for minor purchases Accounting for the petty cash fund involves recording for: Establishing the fund Recognizing expenditures from the fund Replenishing the fund

35. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-35 Example—Petty Cash Fund Establishing a petty cash fund of $500

36. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-36 Example—Petty Cash Fund Expenditures from the petty cash fund

37. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-37 Example—Petty Cash Fund Replenishing the petty cash fund

38. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 7 Identify the major inflows and outflows of cash 4-38

39. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-39 Reporting Cash Balance sheet Statement of Cash Flows

40. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-40 Activities on Cash Flows Statement Operating activities Cash transactions involving revenues and expenses Investing activities Cash investments in long-term assets and investment securities Financing activities Transactions designed to finance the business through borrowing and owner investment

41. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-41 Which transactions involve the exchange of cash?

42. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-42 Which transactions involve the exchange of cash?

43. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-43 Statement of Cash Flows for Eagle Golf Academy

44. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 8 Assess earnings quality by comparing net income and cash flows 4-44

45. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-45 Comparing Net Income to Cash Flow Free cash flow: operating cash flows + investing cash flows during the period Earnings quality: the ability of current net income to help us predict the future performance of a company Declining free cash flow in relation to the trend in net income indicates lower-quality earnings

46. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4-46 Comparing Net Income to Cash Flow

47. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. End of Chapter 4 4-47