chapter 04 cash and internal controls mcgraw-hill/irwin copyright © 2011 by the mcgraw-hill...
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Chapter 04
Cash and Internal Controls
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Part A
Internal Controls
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LO1 Discuss 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.
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.
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.
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.
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Recent Accounting Scandals and Response
FRAUD FIRMFRAUD FIRM
AUDIT FIRM
Arthur Andersen
AUDIT FIRM
Arthur Andersen
WorldCom WorldCom Enron Enron
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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.
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.
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LO2 Identify the Components, Responsibilities, and Limitations of Internal Control
From a financial accounting perspective, internal control is a company’s plan to:
o Safeguard the company’s assets. o Improve the accuracy and reliability of
accounting informationo Effective internal control builds a wall to prevent
misuse of company funds by employees and fraudulent or errant financial reporting
From a financial accounting perspective, internal control is a company’s plan to:
o Safeguard the company’s assets. o Improve the accuracy and reliability of
accounting informationo Effective internal control builds a wall to prevent
misuse of company funds by employees and fraudulent or errant financial reporting
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Part B
CashCash
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LO3 Define Cash and Cash Equivalents
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.
Cash equivalents: _ short-term investments that have a maturity
date no longer than three months from the date of purchase.
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.
Cash equivalents: _ short-term investments that have a maturity
date no longer than three months from the date of purchase.
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LO4 Understand Controls over Cash Receipts and Cash Disbursements
Cash Controls:_ management must safeguard all assets
against possible misuse. Again, because cash is especially susceptible to theft, 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:_ management must safeguard all assets
against possible misuse. Again, because cash is especially susceptible to theft, 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.
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LO5 Reconcile a Bank Statement
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.
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.
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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 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.
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 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.
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LO7 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.
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LO8 Assess earnings quality by comparing net income and cash flows
Earnings quality is the ability of current net income to help us predict the future performance of a company. _ When net income does not provide a good
indicator of future performance, the lower its earnings quality is said to be.
_ Comparing the trend in a company’s reported net income to its trend in free cash flow, also provides earnings quality of a company.
_ Companies whose free cash flow is declining relative to the trend in net income are likely to have lower-quality earnings.
Earnings quality is the ability of current net income to help us predict the future performance of a company. _ When net income does not provide a good
indicator of future performance, the lower its earnings quality is said to be.
_ Comparing the trend in a company’s reported net income to its trend in free cash flow, also provides earnings quality of a company.
_ Companies whose free cash flow is declining relative to the trend in net income are likely to have lower-quality earnings.
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Comparing Net Income to Free Cash Flows
Net incomeNet income
Income StatementIncome Statement
RevenueRevenue ExpensesExpenses
Statement of Cash FlowsStatement of Cash Flows
OperatingCash Flow
OperatingCash Flow
Investing Cash Flow
Investing Cash Flow+
Free Cash FlowsFree Cash Flows
−
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Comparison of Net Income and Free Cash Flows of Krispy Kreme and Starbucks
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End of Chapter 04
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