Chapter 4

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Chapter

4


Page 4
-
1


Chapter 4 Outline (pages 164
-

1
8
9
)

Cash and Internal Controls


PART A: Internal Controls


Sarbanes
-
Oxley Act of 2002 (SOX)


Management (Corporate Executives) are

responsible for the financial statements and
effectiveness of its internal control structure

and procedures.


Auditor

must assess the company’s internal control and report as to its effectiveness. Auditor
must be independent

cannot provide non
-
audit services. Auditors must retain work papers for
seven years. Lead audit partners are required
to rotate off the audit client every five years.


Audit committee

is a subset of the Board of Directors

they act as a direct contact between the
stockholders and the auditors. The audit committee hires the auditor.


CEO and CFO

must certify the financial
statements fairly represent the financial position and th
e
results of operations and a statement that the company’s internal controls are adequate.


Purpose of Internal Control

Financial Accounting perspective:


1. Improve the accuracy and reliability of
accounting information.

2. Safeguard the company’s assets.


COSO (Committee on Sponsoring Organizations)
FRAMEWORK


Control Environment

-
The success of an internal control system depends on the operating style of management and
the competency of the people

responsible for the system

ethical tone of top management


-
Personnel policies and practices are important components of the internal control system


Risk Assessment

Continually assessing the risks associated with forces preventing the company from reachi
ng its
goals


Control Activity

Separation
of duties: should separate “custody
-

authorization


reporting”


Information and Communication

The purpose of accounting is to provide relevant and reliable information to decision makers.
Providing accurate info
rmation is an important aspect of internal controls.


Chapter

4


Page 4
-
2

Monitor

Monitor the internal control system to make sure it is adequate


Limitations of Internal Control

Collusion


PART B: Cash


Cash and Cash Equivalents

-
readily convertible to known amounts of cash

-
readily available to pay debts

Examples

-
checks from others

(CASH)

-
savings accounts

(CASH)

-
Treasury bills (T
-
bills) with original maturity of three months or less

(CASH EQUIVALENT)

-
Money market accounts

(CASH)

-
commercia
l paper (
original maturity of th
ree months or less
)

(CASH EQUIVALENT)


Practice
:
Is the following a


Cash and Cash Equivalent


account

(
state YES, if NO
, identify the
account)


A cashier’s check


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-
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Control over Cash Receipts


1. Record all cash receipts as soon as possible.

2. Person 1: Open mail each day and make a l
ist of checks received (amount and payer’s name).

3. Person 2: S
hould make daily deposits.

4. Person 3: Records cash receipts in the accounting records (use bank deposit slips to verify).


“CASH” Sales

Cash/Checks
/
Debit Cards


Cash (A+)

100




Sale (R+


卅S)


㄰1

Chapter

4


Page 4
-
3

Credit Cards


Credit card

service

fee

(service fee)

an expense


Cash (A+)

97


Service

fee (E+



-
)

3



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Control over Cash Disbursements

1.

All cash disbursements should be made by check/debi
t card/credit card.

2.

Expenditures should be authorized before purchase and accuracy of purchase should be
verified. The person who authorizes should not prepare the check.

3.

Use serial numbered checks. Only authorized person(s) should sign the check.

4.

Debit/Credit card statements should be checked against purchase receipts. The person
verifying the statements should not be the person who made the purchases.

5.

Set limits on purchases for credit/debit cards.

6.

Separate the duties of the person respo
nsible for making cash disbursements from the person
in charge of cash receipts.


Cash/Checks/Debit card

act like cash


Credit Card

creates a liability


Bank Reconciliation

Timing differences

Errors


Illustration 4
-
7 on page 17
8

(Bank Statement)

Illustrati
on 4
-
8 on page 1
7
8

(Company Records of Cash Activities)


-
Outstanding checks

-

Outstanding deposits (
deposits in transit
)

-
NSF Check

-
Service charge

-
Customer note and interest

-
Interest earned


Reconciliation of the
Bank Statement

and the
Cash Account (L
edger)


Bank
Account (Statement)

v.

C
ompany C
ash Account

(Ledger)

+/
-

items that
are recorded in

Company
C
ash

account

(ledger)

but
ARE NOT recorded on
the
B
ank statement
. For example:


+/
-

items that
are recorded on the
Bank
Statement

but
ARE NOT recorde
d in the
Company Cash

account

(ledger)
. For example:

-

outstanding checks


-

bank service charge

+
outstanding deposits

(
deposits in transit
)


-

NSF



+ amounts collected by bank



+ interest earned

Fix errors where they exist


Fix errors where they

exist

The goal is to get both accounts to be the same (
include everything

in both accounts).

Chapter

4


Page 4
-
4


After the bank reconciliation is completed, make sure to record the changes made to the cash
account.


Practice


Madison Company's cash ledger reports the foll
owing for the month ending March 31, 20
XX
.


Deposits

Date

Amount


Check No.

Date

Amount


3/4

$1,200


541

3/2

$5,100


3/11

1,200


54
2

3/8

800


3/18

3,700


543

3/12

2,
200


3/25

3,
400


544

3/19

1,100

Cash receipts 3/26


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3/
31

are outstanding.


c.

Checks 545 and 547 are outstanding.


d.

The deposit on 3/11 includes a customer's check for $400 that did not
clear the bank (NSF
check).

e.

Check 543 was written for $2,800 for office supplies in March. The bank properly recorded
the check for this amount.

f.


An automatic withdrawal for March rent was made on March 4 for $1,500.

g.

Madison's checking account ea
rns interest based on the average daily balance. The amount of
interest earned for March is $50.

h.


Last year, one of Madison's top executives borrowed $4,000 from Madison. On March 24, the
executive paid $4,200 ($4,000 borrowed amount plus $200 interest)

directly to the bank in
payment for the borrowing.

i.


The bank charged the following service fees: $30 for NSF check, $10 for automatic
withdrawal for rent payment, and $20 for collection of the loan amount from the executive.


Prepare
the bank

reconcili
ation for March 31, 20
XX
;
record the necessary cash adjustments.


Chapter

4


Page 4
-
5



Madison Company

Bank Reconciliation

March 31, 20
XX

Bank

Statement

Balance



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Petty cash fund:

money kept on hand for making minor cash purchases. The account is
replenished when necessary. Receipts are kept with the petty cash fund so expenses can
be
recognized periodically.


Chapter

4


Page 4
-
6

REPORTING CASH


Statement of Cash Flows


Direct method


Indirect method

starts with net income and makes adjustments to cash flows from operating
activities.


Operating activities


relate to items on the income statement in w
hich cash has been
received or paid. Also relate to changes in current assets and current
liabilities based on payment or receipt of cash.


Investing activities


cash paid or received from the purchase or sale of long term assets.


Financing activities


c
ash received (paid) to raise money for the company or finance the
business. Does not include interest paid.




Of the three activities above, which activity would you expect a company to show “positive cash
flows” consistently over time?




The final a
mount shown on the statement of cash flows should reconcile with the cash shown on
the balance sheet.


Practice


Name the

Cash F
low activity Operating, Investing, Financing for each item; use ( ) for cash
outflow
. If no cash flow put NONE.



Cash Flow Act
ivity

Use ( ) if outflow

Sell common stock to investors


Receive cash from customers


Pay for rent


Purchase a building with

cash


Sold truck used in the business


Paid dividend to stockholders


Provided services to customers on account


Pay utili
ty bill


Pay interest on loan


Bought supplies on credit



Chapter

4


Page 4
-
7

Practice


During the year, a company issues common stock for $60,000 and repays previously borrowed
amounts of $100,000. In addition, the company pays dividends of $8,000 to stockholders
, pays
t
he manager a salary of $52,000, pays landlord rent of $14,000

and
pays
interest of $500 to
creditors
. Determine the amount of
financing cash flows

the company would report in the
current year.







During the current year, a company provides services on a
ccount for $115,000. By the end of the
year, $85,000 of this amount was received. In addition, cash payments for the year were
employees' salaries, $55,000; office supplies, $8,000;
equipment
,
$29,000
;
and
utilities
,

$12
,000.
Determine the amount of
operat
ing cash flows

the company will report in the current year.









Comparing Net Income to Cash Flows


Net income


prepared using accrual accounting


Cash flow from operating activities


prepared using cash
-
basis accounting


Timing differences


Earnings q
uality
: the ability of net income to adequately forecast future cash flow



Free Cash Flows:

Operating cash flow + investing cash flow = free cash flow


-
shows amount of cash flow available to pay creditors and stockholders

-
declining free cash flow rela
tive to net income is an indicator o
f

lower quality of earnings


Practice


Net income

Operating

Investing

Financing

20X3

$15,000

$18,000

($10,000)

$5,000

20X4

18,000

22,000

(12,000)

(9,000)


What are the free cash flows for 20
X4
?

$