Chapter 04 lecture

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Spiceland Financial 2nd Ed

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  • This chapter is divided into two parts Part A: Internal controls Part B: Cash
  • To minimize occupational fraud, companies implement formal procedures known as internal controls. These represent a company’s plan to (1) safeguard the company’s assets and (2) improve the accuracy and reliability of accounting information.
  • Managers are entrusted with the resources of both the company’s lenders (liabilities) 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 information to cover up their company’s poor operating performance. They hoped to fool investors into overvaluing the company’s stock.
  • Two of the highest-profiled cases of accounting fraud in U.S. history are the collapses of Enron and WorldCom. Enron used questionable accounting practices to avoid reporting billions in debt and losses in its financial statements. WorldCom misclassified certain expenditures to overstate assets and profitability by $11 billion. 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, Arthur Andersen. The high-profile scandals led to an extensive investigation of Arthur Andersen by the Securities and Exchange Commission (SEC). This action, along with subsequent events, damaged the auditor’s reputation so severely that by the end of 2002, Arthur Andersen was no longer in business. Other common types of financial statement fraud include creating fictitious revenues from a phantom customer, improperly valuing assets, hiding liabilities, and mismatching revenues and expenses. The accounting scandals in the early 2000s prompted passage of the Sarbanes-Oxley Act (SOX).
  • In response to these corporate accounting scandals and to public outrage over seemingly widespread unethical behaviour 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. 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 internal control procedures.
  • 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. The board consists of five members who are appointed by the Securities and Exchange Commission. 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, such as consulting, for their clients. Retention of work papers. Auditors of public companies must retain all work papers for seven years or face a prison term for willful violation. Auditor rotation. The lead auditor in charge of auditing a particular company (referred to as the audit partner ) must rotate off that company within five years and allow a new audit partner to take the lead. 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 and (b) that company auditors express an opinion on whether management’s assessment of the effectiveness of internal control is fairly stated.
  • From a financial accounting perspective, internal control is a company’s plan to: (1) Safeguard the company’s assets. (2) Improve the accuracy and reliability of accounting information and Effective internal control builds a wall to prevent misuse of company funds by employees and fraudulent or errant financial reporting. Strong internal control systems allow greater reliance by investors on reported financial statements .
  • Methods for collection of relevant information and communication in a timely manner, enabling people to carry out their responsibilities. A framework for designing an internal control system was provided by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Formed in 1985, COSO is dedicated to improving the quality of financial reporting through, among other things, effective internal controls. COSO suggests that internal control consists of five interrelated components, listed in the slide and discussed next.
  • Control Environment: The overall attitudes and actions of management greatly affect the control environment. If employees notice unethical behavior or comments by management, they are more likely to behave in a similar manner, wasting the company’s resources. Risk Assessment: includes careful consideration of internal and external risk factors. Monitoring: of internal controls needs to occur on an ongoing basis. Continual monitoring of internal activities and reporting of deficiencies is required.
  • Control Activities: include a variety of policies and procedures used to protect a company’s assets. There are two general types of control activities: detective and preventive. Detective controls are designed to detect errors or fraud that already have occurred; Preventive controls are designed to keep errors or fraud from occurring in the first place. Common examples of preventive controls include: Separation of duties Authorizing transactions, recording transactions, and maintaining control of the related assets should be separated among employees. 2. Physical controls over assets and accounting records. 3. Proper authorization to prevent improper use of the company’s resources. 4. Employee management. The company should provide employees with appropriate guidance to ensure they have the knowledge necessary to carry out their job duties. Some examples of detective controls include: Reconciliations. Management should periodically determine whether the amount of physical assets of the company (cash, supplies, inventory, and other property) match—reconcile with—the accounting records. 2. Performance reviews. The actual performance of individuals or processes should be checked against their expected performance. Information and communication depend on the reliability of the accounting information system itself. A system should be in place to ensure that current transactions of the company are reflected in current reports. Methods for collection of relevant information and communication in a timely manner, enabling people to carry out their responsibilities.
  • 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 nearly $4 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.
  • Unfortunately, even with the best internal control systems, financial misstatements can occur. 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 . Collusion occurs when two or more people act in coordination to circumvent internal controls. Most fraud cases fall into this category. Fraud cases that involve collusion are typically several times more severe than are fraud cases involving a single perpetrator. Top-level employees who have the ability to override internal control features also have opportunity to commit fraud. Finally, because there are natural risks to running any business, effective internal controls and ethical employees alone cannot ensure a company’s success, or even survival .
  • Among all of the company’s assets, cash is the one most susceptible to employee fraud. Before discussing specific controls related to cash, let us first get a good understanding of what “cash” includes.
  • The 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 customers. Checks are written instruments instructing a bank to pay a specific amount from the check maker’s account. The balance of cash also includes cash equivalents, which are defined as short-term investments that have a maturity date no longer than three months from the date of purchase. Few examples of such investments are money market funds, treasury bills, and certificates of deposit. 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.
  • Management must safeguard all assets against possible misuse. Again, because cash is especially susceptible to theft, internal control of cash is a key issue. 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.
  • 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, including 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. 5. Accept credit cards or debit cards, to limit the amount of cash employees handle.
  • The term credit card is derived from the fact that the issuer, such as Visa or MasterCard , extends credit (lends money) to the cardholder each time the cardholder uses the card. Cash in the amount of the sale automatically is deposited in the company’s bank. Credit card companies earn revenues primarily in two ways. First, the cardholder has a specified grace period before he or she has to pay the credit card balance in full. If the balance is not paid by the end of the grace period, the issuing company will charge a fee (interest). Second, credit card companies charge the retailer, not the customer, for the use of the credit card. From the seller’s perspective, the only difference between a cash sale and a credit card sale is that the seller must pay a fee to the credit card company for allowing the customer to use a credit card. 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. the use of debit cards by customers results in a fee being charged to the retailer. However the fees charged for debit cards are typically much lower than those charged for credit cards.
  • Managers should design proper control for cash disbursements to prevent any unauthorized payments and ensure proper recording. Consistent with our discussion of cash receipts, cash disbursements include not only disbursing physical cash, but also writing checks and using credit cards and debit cards to make payments. All these forms of payment constitute cash disbursement and require formal internal control procedures.
  • 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.
  • 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. A company’s cash balance as recorded in its books rarely equals the cash balance reported in the bank statement. Differences in these balances most often occur because of either timing differences or errors. It is the possibility of these errors, or even outright fraudulent activities, that make the bank reconciliation a useful cash control tool.
  • Timing differences in cash occur when the company records transactions either before or after the bank records the same transaction. Errors can be made either by the company or its bank and may be accidental or intentional. 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 the slide. Reconciling the bank account involves three steps: (1) reconciling the bank’s cash balance, (2) reconciling the company’s cash balance, and (3) adjusting the company’s cash balance.
  • 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 the slide to Starlight.
  • Let us compare the bank statement with Starlight’s own records of cash activity over the same period, as shown in the slide. First Bank’s ending balance of cash ($4,100) differs from Starlight’s ending balance of cash ($2,880). To understand why these two cash balances differ, 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. Six cash transactions recorded by First Bank are not reported in Starlight’s cash records by the end of March: 1. Note received by First Bank on Starlight’s behalf ($3,000), which includes interest of $200. 2. Interest earned by Starlight on its bank account ($20). 3. NSF check ($750). 4. Debit card purchase of office equipment by an employee ($200). 5. Electronic funds transfer (EFT) related to the payment of advertising ($400). 6. Service charge ($50).
  • 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 company’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 cash balance will increase. Similarly, once the bank receives the checks outstanding, the bank’s cash balance will decrease. We also need to check for and correct any bank errors.
  • Some examples of cash transactions recorded by the bank, but not yet recorded by the company, 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. NSF checks: Checks drawn on nonsufficient funds or “bad” checks from customers. In addition, we adjust the company’s balance for any company errors.
  • Comparing Starlight’s record of checks written to those in the bank statement reveals an error by Starlight. Check #294 for rent was written 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 Bank Reconciliation. If the bank were aware of all deposits made and all checks written by the company, the bank’s balance for cash would be $4,200. 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, a company must update the balance in its cash account, to adjust for the items used to reconcile the company’s cash balance. We record these adjustments 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, Similarly, we record items that decrease the company’s cash by a credit to cash Most of the accounts are easy to understand. We credit notes receivable because the note has been received, decreasing that asset account (−$2,800). We recognize interest revenue ( + $220) as earned. Cash outflows related to expenses (advertising, service charge, and rent) and asset purchases need to be recorded. Finally, we debit accounts receivable, increasing that asset account ( + $750) to show that the customer who paid with an NSF check still owes the company money.
  • 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 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 putting that amount of withdrawn cash in the hands of an employee who becomes responsible for it.
  • The fund should have just enough cash to make minor expenditures over a reasonable period. Given appropriate documentation, such as a receipt for the purchase of the $10 pizza for the staff meeting or of office supplies, the petty-cash custodian 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 provided in the slide. Starlight had four expenditures from the petty cash fund in May.
  • Also at the end of the period, the petty cash fund may need to be replenished. Management can withdraw cash of $330 from the checking account and give it to the petty-cash custodian so the fund’s balance will once again be $500. To maintain the control objective of separation of duties, the petty-cash custodian 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.
  • 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 reporting 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. Companies 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 operating, investing, and financing. We’ll provide a complete discussion 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 involve long-term assets. 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 dividends to stockholders to be financing activities. So, financing activities tend to involve 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 Eagle Golf Academy introduced in Chapters 1 through 3. For convenience, those transactions are repeated in the slide. Which transactions involve the exchange of cash? All transactions except (5) and (7) are either the receipt (inflow) or payment (outflow) of cash. Only transactions involving cash affect a company’s cash flows.
  • The slide presents the statement of cash flows for Eagle Golf Academy using what’s called the direct method of reporting operating activities. In Chapter 11 we’ll discuss the indirect method. Corresponding transaction numbers are in parentheses. The major source of cash inflow for Eagle is the issuance of common stock. Eagle has also received cash from bank borrowing, which must be repaid. The company is also investing heavily in its future by purchasing equipment. Eagle 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 inflows. While Eagle 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. The final amount reported in the statement of cash flows, $6,200, is the same amount of cash reported in the balance sheet.
  • We refer to the ability of current net income to help us predict the future performance of a company as earnings quality . When net income does not provide a good indicator of future performance, the lower its earnings quality is said to be. 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 its trend in free cash flow. A simple way to calculate a company’s free cash flow is its operating cash flows plus investing cash flows during the period.
  • 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. A simple way to calculate a company’s free cash flows is its operating cash flows plus investing cash flows during the period. This measure represents the cash that is free to distribute to stockholders and repay debt. Companies whose free cash flows are declining relative to the trend in net income are likely to have lower-quality earnings.
  • As the charts show, both Krispy Kreme 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. The pattern should have raised concerns about the long-term profit-generating ability of Krispy Kreme. Indeed, in 2005, Krispy Kreme’s growth in net income could no longer be sustained and decreased dramatically because the company did not have sufficient cash to maintain profitable operations. In comparison, Starbucks’ upward trend in net income showed no signs of slowing as of 2004. However, that trend would last for only a few more years. Notice that Starbucks’ free cash flow began falling in 2006, while net income continued to rise. Again, the difference in trends between net income and free cash flow should have been a warning to investors. An upward trend in net income cannot be sustained indefinitely without a sufficient supply of cash. As predicted by the falling trend in free cash flow in 2006 and 2007, Starbucks’ net income experienced a sharp decline beginning in 2008. These examples demonstrate the predictive ability of comparing a company’s trend in net income and free cash flow. When the trend in net income is upward while the trend in free cash flow is downward, a company is more likely to experience falling profits in the coming years.
  • Chapter 04 lecture

    1. 1. Chapter 04 Cash and Internal Controls McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
    2. 2. Part A Internal Controls 4-
    3. 3. LO1 Discuss the Impact of Accounting Scandals and the Passage of the Sarbanes-Oxley Act <ul><li>Managers are entrusted with the resources of both the company’s lenders (liabilities) and owners (stockholders' equity). </li></ul><ul><li>Managers of the company act as stewards or caretakers of the company’s assets. </li></ul><ul><li>In recent years some managers have shirked their ethical responsibilities. </li></ul><ul><li>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. </li></ul>4-
    4. 4. Recent Accounting Scandals and Response FRAUD FIRM FRAUD FIRM 4- AUDIT FIRM Arthur Andersen WorldCom Enron
    5. 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. 4-
    6. 6. Major Provisions of the Sarbanes-Oxley Act of 2002 4- Internal control Hiring of auditor Conflicts of interest Auditor rotation Auditors to Retain of work papers Nonaudit services Corporate executive accountability Oversight board Major Provisions
    7. 7. LO2 Identify the Components, Responsibilities, and Limitations of Internal Control <ul><li>From a financial accounting perspective, internal control is a company’s plan to: </li></ul><ul><li>Safeguard the company’s assets. </li></ul><ul><li>Improve the accuracy and reliability of accounting information </li></ul><ul><li>Effective internal control builds a wall to prevent misuse of company funds by employees and fraudulent or errant financial reporting </li></ul>4-
    8. 8. Framework for Internal Control 4-
    9. 9. Components of Internal Control <ul><li>Control Environment: </li></ul><ul><ul><li>sets the overall ethical tone of the company with respect to internal control. It includes formal policies related to management’s philosophy, assignment of responsibilities, and organizational structure. </li></ul></ul><ul><li>Risk Assessment: </li></ul><ul><ul><li>identifies and analyzes internal and external risk factors that could prevent a company’s objectives from being achieved. </li></ul></ul><ul><li>Monitoring: </li></ul><ul><ul><li>includes formal procedures for reporting control deficiencies. </li></ul></ul>4-
    10. 10. <ul><li>Control Activities: </li></ul><ul><ul><li>are the policies and procedures that help ensure that management’s directives are being carried out. The two general types of control activities are: </li></ul></ul><ul><ul><ul><li>Detective controls designed to detect errors or fraud that already have occurred; Examples: Separation of duties, Physical controls, Proper authorization, Employee management </li></ul></ul></ul><ul><ul><ul><li>Preventive controls designed to keep errors or fraud from occurring in the first place. Examples: Reconciliations, Performance reviews </li></ul></ul></ul><ul><li>Information and Communication: </li></ul><ul><ul><li>depend on the reliability of the accounting information system itself. </li></ul></ul>Components of Internal Control 4-
    11. 11. Responsibilities for Internal Control <ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>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 nearly $4 million. </li></ul><ul><li>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. </li></ul>4-
    12. 12. Limitations of Internal Control <ul><li>Internal control systems will more likely detect operating and reporting errors. </li></ul><ul><li>No internal control system can turn a bad employee into a good one. </li></ul><ul><li>Internal control systems are especially susceptible to collusion. </li></ul>4-
    13. 13. Part B Cash 4-
    14. 14. LO3 Define Cash and Cash Equivalents <ul><li>Cash: </li></ul><ul><ul><li>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. </li></ul></ul><ul><li>Cash equivalents: </li></ul><ul><ul><li>short-term investments that have a maturity date no longer than three months from the date of purchase. </li></ul></ul>4-
    15. 15. LO4 Understand Controls over Cash Receipts and Cash Disbursements <ul><li>Cash Controls: </li></ul><ul><ul><li>management must safeguard all assets against possible misuse. Again, because cash is especially susceptible to theft, internal control of cash is a key issue. </li></ul></ul><ul><li>Cash Receipts: </li></ul><ul><ul><li>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. </li></ul></ul>4-
    16. 16. Internal control over cash receipts could include the following steps: <ul><li>Record all cash receipts as soon as possible. Theft is more difficult once a record of the cash receipt has been made. </li></ul><ul><li>Open mail each day, and make a list of checks received, including the amount and payer’s name. </li></ul><ul><li>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. </li></ul><ul><li>Have another employee record cash receipts in the accounting records. Verify cash receipts by comparing the bank deposit slip with the accounting records. </li></ul><ul><li>Accept credit cards or debit cards, to limit the amount of cash employees handle. </li></ul>4-
    17. 17. Acceptance of Credit/Debit Cards CREDIT CARD DEBIT CARD It does not remove cash from the cardholder’s account after each transaction. It removes cash directly from the cardholder’s bank account at the time of use. 4- CASH RECEPITS
    18. 18. Cash Disbursements <ul><li>Managers should design proper control for cash disbursements to prevent any unauthorized payments and ensure proper recording. </li></ul><ul><li>Consistent with our discussion of cash receipts, cash disbursements include not only disbursing physical cash, but also writing checks and using credit and debit cards. </li></ul><ul><li>All these forms of payment constitute cash disbursement and require formal internal control procedures. </li></ul>4-
    19. 19. Important elements of a cash disbursement control system include the following steps: <ul><li>Make all disbursements, other than very small ones, by check, debit card, or credit card. This provides a permanent record of all disbursements. </li></ul><ul><li>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. </li></ul><ul><li>Make sure checks are serially numbered and signed only by authorized employees. Require two signatures for larger checks . </li></ul>4-
    20. 20. <ul><li>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. </li></ul><ul><li>Set maximum purchase limits on debit cards and credit cards. Give approval to purchase above these amounts only to upper-level employees. </li></ul><ul><li>Employees responsible for making cash disbursements should not also be in charge of cash receipts. </li></ul>Important elements of a cash disbursement control system include the following steps: 4-
    21. 21. LO5 Reconcile a Bank Statement <ul><li>A bank reconciliation matches the balance of cash in the bank account with the balance of cash in the company’s own records. </li></ul><ul><li>A company’s cash balance as recorded in its books rarely equals the cash balance reported in the bank statement. </li></ul><ul><li>Differences in these balances occur because of either timing differences or errors. </li></ul><ul><li>It is the possibility of these errors, or even outright fraudulent activities, that make the bank reconciliation a useful cash control tool. </li></ul>4-
    22. 22. Bank Reconciliation <ul><li>Timing differences in cash occur when the company records transactions either before or after the bank records the same transaction. </li></ul><ul><li>Errors can be made either by the company or its bank and may be accidental or intentional. </li></ul>Possible Differences 1. Timing 2. Errors 4- Possible Differences 1. Timing 2. Errors Company’s Cash Records Bank’s Cash Records Bank Reconciliation <ul><li>Bank </li></ul><ul><li>Statement </li></ul><ul><li>Deposits </li></ul><ul><li>Withdrawals </li></ul>Reconciled Bank Balance = Reconciled Company Balance
    23. 23. Bank Statement 4-
    24. 24. Company Records of Cash Activities 4- Starlight Drive-In Cash Account Records March 1, 2012 to March 31, 2012 Deposits Checks Date Desc. Amount Date No. Desc. Amount 3/5 Sales receipts $3,600 3/6 293 Salaries $2,100 3/22 Sales receipts 1,980 3/11 294 Rent 2,600 3/31 Sales receipts 2,200 3/21 295 Utilities 1,200 3/24 296 Insurance 1,900 3/30 297 Supplies 900 $7,780 $8,700 Summary of Transactions Beginning Cash balance March 1, 2012 Deposits Checks Ending Cash Balance March 31, 2012 $3,800 $7,780 $8,700 $2,880
    25. 25. Step 1:Reconciling the Bank’s Cash Balance <ul><li>Cash transactions recorded by a company, but not yet recorded by its bank, include deposits outstanding and checks outstanding. </li></ul><ul><li>Deposits outstanding are cash receipts of the company that have not been added to the bank’s record of the company’s balance. </li></ul><ul><li>Checks outstanding are checks the company has written that have not been subtracted from the bank’s record of the company’s balance. </li></ul>4-
    26. 26. <ul><li>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. </li></ul><ul><li>NSF checks: Checks drawn on nonsufficient funds or “bad” checks from customers. </li></ul><ul><li>In addition, we adjust the company’s balance for any company errors. </li></ul>Step 2: Reconciling the Company’s Cash Balance 4-
    27. 27. Reconciling the Bank Statement 4-
    28. 28. Step 3: Adjusting the Company’s Cash Balance 4-
    29. 29. LO6 Account for Petty Cash <ul><li>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 </li></ul><ul><li>To pay for these minor purchases, companies keep some minor amount of cash on hand in a petty cash fund. </li></ul><ul><li>Management writes a check for cash against the company’s checking account and puts that amount of withdrawn cash in the hands of an employee who becomes responsible for it. This employee is often referred to as the petty-cash custodian. </li></ul>4-
    30. 30. Account for Petty Cash <ul><li>Accounting for the petty cash fund involves recording transactions </li></ul><ul><ul><li>Establish the fund, </li></ul></ul><ul><ul><li>Recognize expenditures from the fund, </li></ul></ul><ul><ul><li>Replenish the fund as the cash balance becomes sufficiently low. </li></ul></ul><ul><li>At any given time, the cash remaining in the fund plus all receipts should equal the amount of the fund. </li></ul>4-
    31. 31. 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: 4- Assume Starlight has the following expenditures from the petty cash fund during May:
    32. 32. Petty Cash By the end of May, the petty cash fund has distributed $330, leaving $170 in the fund along with receipts for $330. However, the company did not record these transactions at the time these expenditures were made. By the end of the period, the expenditures from the petty cash fund must be recorded. 4-
    33. 33. LO7 Identify the Major Inflows and Outflows of Cash <ul><li>Companies report cash in two ways. </li></ul><ul><li>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. </li></ul><ul><li>Secondly, reports information about cash receipts and payments during the period in a statement of cash flows. </li></ul><ul><li>From the statement of cash flows, investors know a company’s cash inflows and cash outflows related operating, investing and financing activities. </li></ul>4-
    34. 34. <ul><li>Operating activities include cash transactions involving revenue and expense events during the period. </li></ul><ul><li>Investing activities include cash investments in long-term assets and investment securities. </li></ul><ul><li>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. </li></ul>Activities on Cash Flows Statement 4-
    35. 35. External Transactions of Eagle Golf Academy 4-
    36. 36. External Transactions of Eagle Golf Academy 4-
    37. 37. LO8 Assess earnings quality by comparing net income and cash flows <ul><li>Earnings quality is the ability of current net income to help us predict the future performance of a company. </li></ul><ul><ul><li>When net income does not provide a good indicator of future performance, the lower its earnings quality is said to be. </li></ul></ul><ul><ul><li>Comparing the trend in a company’s reported net income to its trend in free cash flow, also provides earnings quality of a company. </li></ul></ul><ul><ul><li>Companies whose free cash flow is declining relative to the trend in net income are likely to have lower-quality earnings. </li></ul></ul>4-
    38. 38. Comparing Net Income to Free Cash Flows Net income Income Statement Revenue Expenses Statement of Cash Flows Operating Cash Flow Investing Cash Flow + Free Cash Flows − 4-
    39. 39. Comparison of Net Income and Free Cash Flows of Krispy Kreme and Starbucks 4-
    40. 40. End of Chapter 04 4-

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