Financial Accounting
Cash and
Internal
Controls
Chapter 4
Spiceland | Thomas | Herrmann
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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
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
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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.
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The Fraud Triangle
Motive
(or pressure)
Rationalization
Opportunity
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Internal Controls
• Eliminate opportunity
• Represent plans to:
• Safeguard the assets
• Improve accuracy and reliability of information
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
4-7
Learning Objective 1
Discuss the impact of accounting scandals and the
passage of the Sarbanes-Oxley Act
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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
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Accounting fraud in U.S. history
Enron
WorldCom
Avoided reporting billions in
debt and losses
Misclassified expenditures to
overstate assets and
profitability
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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
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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
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Learning Objective 2
Identify the components, responsibilities, and
limitations of internal control
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4-13
Illustration 4.2—Components of
Internal Control
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Control Activities
Preventive controls
Detective controls
• Separation of duties
• Reconciliations
• Physical controls
• Performance reviews
• Proper authorization
• Audits
• Employee management
• E-commerce controls
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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
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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
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4-17
Learning Objective 3
Define cash and cash equivalents
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4-18
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
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4-19
Recording Cash Sales
• Whether a customer uses cash or check to make
a purchase, the company records the transaction
as a cash sale.
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4-20
Learning Objective 4
Understand controls over cash receipts and cash
disbursements
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4-21
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
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4-22
Credit Card Transactions
Example: Movie theatre accepts MasterCard as payment for $2,000 worth
of movie tickets. MasterCard charges a service fee of 3%. Moviegoers
don’t pay cash at the time of the sale, but MasterCard deposits cash less
the service fee. Therefore the theatre records the credit card transaction
as:
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4-23
Learning Objective 5
Reconcile a bank statement
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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
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4-25
Illustration 4.6—Bank Reconciliation
• Timing differences
• Errors
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Illustration 4.7—Bank Statement
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Illustration 4.8—Company
Records of Cash Activities
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Illustration 4.8—Company Records of
Cash Activities (concluded)
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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
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4-29
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
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4-30
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
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4-31
Illustration 4.9—Reconciling the
Bank Statement
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Example
•
At the end of April 2015, Showtime’s accounting records show a cash
balance of $4,800. The April bank statement reports a cash balance of
$3,700. The following information is gathered from the bank statement
and company records:
•
•
•
•
•
•
Checks outstanding - $1,900
Deposits outstanding - $1,600
Interest earned - $70
Customer’s NSF - $1,300
Service fee - $200
Showtime also discovered it correctly paid for advertising with a check for $220
but incorrectly recorded the check in the company’s records for $250. The bank
correctly processed the check for $220.
•
•
Prepare a bank reconciliation for the month of April 2015
Prepare entries to update the balance of cash in the company’s records.
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Example
Starlight Drive-In
Bank Reconciliation
3/31/2015
Banks cash balance
Per bank statement
Companys cash balance
$3,700
General ledger
$4,800
Deposits Outstanding
1,600
Interest earned
70
Checks outstanding
-1900
Company error
30
Bank balance per reconciliation
$3,400
Service fee
-200
NSF check
-1300
Company balance
4/30/15 Cash
Interest earned
Advertising expense
100
4/30/15 Service fee expense
Account Receivable
Cash
200
1300
70
30
1500
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$3,400