Accounting 210: Chapter 4 (CASH & INTERNAL CONTROLS)

Total cash balance

- Coins & Currency - Checks recieved - Savings account - Checking Accounts - Credit Card sales - Debit Card sales - Cash Equivalents

Committee of Sponsoring Organizations (COSO)

Committee of Sponsoring Organizations of the Treadway Commission (or COSO) is a joint initiative of five private sector organizations and is dedicated to providing thought leadership through the development of frameworks and guidance on enterprise risk management, internal control, and fraud deterrence.

Increase in Revenues, Increases _______ & Increase in Expenses, Decreases __________

Total Stockholders' Equity Total Stockholders' Equity

Step 3: Update the Company's Cash account

We record the corrected items (adjustments) of Step 2 Faulty errors. * It is uncommon that two balances at the end of the bank reconililation schedule are not equal; if so it records as either "Miscellaneous Expense" or "Miscellaneous Revenue" depending on whether it has a debit or credit balance.

Top Level Employees who have the ability to override internal control features also have opportunity to

commit fraud. (chief financial officer-CFO uses company's funds to purchase a boat; fewer controls are in place to detect this misappropiation; If lower level suspects wrongdoing they may be unwilling to confront their boss about the issue.)

Sarbanes-Oxley Act of 2002 (SOX)

* Created in response to these corporate accounting scandals & to public outrage over seemingly widespread unethical behavior of top executives and CONGRESS passed this. * Provides auditor-client relations and addt'l internal controls * Also, known as the "Public Company Accounting Reform & Investor Protection Act of 2002" * Applies to all companies that are required to file financial statements with SEC (public companies) & represents one of the greatest reforms in business practices in U.S. history.

STEP 1: RECONCILE THE BANK'S CASH BALANCE:

- First, consider cash transactions recorded by the company, but not yet recorded by its bank. * Deposits outstanding: Cash receipts of the company that haven't been added to the bank's record of the company's balance. i.e. 3/31 Sales Receipts 2,200 - NOT YET REFLECTED IN THE BANK'S CASH BALANCE BY THE END OF MARCH. * Checks outstanding: Checks the company has written that haven't been subtracted from the bank's record of the company's balance. - We adjust the bank's cash balance by adding deposits outstanding and subtracting checks outstanding; also fix any bank errors if any.

bank reconciliation

- Matches the balance of cash in the bank account with the balance of cash in the company's own records. - Connects the company's cash balance to the bank's cash balance by identifying differences due to timing and errors. ------------------------------- * A company's cash balance as recorded in its books rarely = the cash balance reported in the bank statement. WHY? - Differences in these balances most often occur b/c of either timing differences or errors or fraudulent activities.

Components of Internal Control for the collection of revelant info and communication in a timely manner & allowing ppl to carry out their responsibility:

- Monitoring: Continuously of internal activities & reporting of deficiencies is required. Includes formal procedures for reporting control deficiencies. - Control activities: The policies & procedures that help ensure that management's directives are being carried out. (i.e. Authorizations, Reconcililations, & Separation of duties) - Risk assessment: Identifies & analyzes internal & external risk factors that could prevent a company's objectives from being achieved. - Control environment: Sets the overall ethical tone of the company w/ respect to internal control. (i.e. formal policies related to management's philosophy, assignment of responsibilities, & organizational structure. (Preventive Controls- Designed to keep errors or fraud from occurring in the first place.) (Detective Controls- Designed to detect errors or fraud that have already occurred) *

Effective/strong internal control:

1. Builds a wall to prevent misuse of company funds by employees and fraudulent or errant financial reporting. 2. Allow greater reliance by investors on reported financial statements.

Common Controls over cash disbursements include:

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 & 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 agree amounts shown in the debit card and credit card statements against purchase receipts. The employee verifying the accuracy of the debit and credit card statements shouldn't also be the employee responsible for actual purchases. 5. Set maximum purchase limits on debit card and credit cards. Give approval to purchase above these amts only to upper level employees. 6. Employees responsible for making cash disbursements shouldn't also be in charge of cash receipts.

Common controls over cash receipts include:

1. Open mail each day, & make a list of checks recieved, including the amount and payer's name. 2. Designate an employee to deposit cash & checks into the company's bank acct each day, different from the person who recieves cash and checks. 3. Have another employee record cash receipts in the acct'ing records as soon as possible. Verify cash receipts by comparing the bank deposit slip w/ the acct'ing records. 4. Accept credit cards or debit cards, to limit the amt of cash employees handle.

From the statement of cash flows, investors know a company's cash inflows & cash outflows related to:

1. Operating activities- cash transactions involving REVENUE & EXPENSE events during the period. Includes the cash affect of the same activities that are reported in the INCOME STATEMENT to calculate net income. 2. Investing activities- Include cash investments in LONG-TERM assets & investment securities. When the firm later sells those assets, we consider that investing activities as well. REMEMBER LONG-TERM ASSETS!! 3. Financing activities- Include transactions designed to RAISE CASH or FINANCE the business. 2 ways to do this: BORROW cash from LENDERS or RAISE cash from stockholders. Cash outflows to repay debt and cash dividends to stockholders to be financing activities. REMEMBER LIABILITIES & STOCKHOLDERS' EQUITY

Reconciling the bank account involves three steps:

1. Reconcile the bank's cash balance 2. Reconcile the company's cash balance 3. Update the company's cash account by recording items identified in step 2

examples of preventive controls

1. Separation of duties: Set of procedures intended to seperate duties among employees for authorizing transactions, recording transactions, & controlling related assets. (Fraud is prevented by not allowing the same person to be responsible for both controlling the asset & accounting for the asset.) 2. Physical Controls: Over assets and acct'ing records. (i.e. Important doc's should be kept in fireproof files, & electronic records should be backed up daily & require user-ID & password for access)(Concession supplies should be kept in a locked room w/ access allowed only to authorized personnel) 3. Proper Authorization: Prevents improper use of the company's resources. (i.e. Theater should establish formal guidelines on "how to handle cash reciepts & make purchases; ONLY MANAGEMENT should be authorized to make purchases over a certain amount) 4. Employee management: The company should provide employees w/ appropriate guidance to ensure they have the knowledge necessary to carry out their job duties. (i.e. Employees should be fully aware of the company's internal control procedures, ethical responsibilities, & channels for reporting irregular activities.) 5. E-commerce controls: The wide-range of electronic activities of a company. (i.e. buying & selling over the internet, digital information processing, & electronic communication; ONLY authorized personnel should have passwords to conduct electronic business transactions; the company should also maintain & systematically check the firewall settings to prevent unauthorized access to accounts & credit card #'s; All employees should update the systems antivirus software periodically.)

Credit Card companies earn money in two ways:

1. The cardholder has a specified "grace period" before he/she has to pay the credit card balance in full. If the balance isn't paid by the end of the grace period, the issuing company will charge a fee (interest). 2. Credit card companies charge the retailer, not the customer, for the use of the credit card. This charge generally renges from 2% to 4% of the amount of the sale. i.e. Suppose a movie theatre accepts MasterCard as payment of $2,000 worth of movie tickets, & MasterCard charges the movie theatre a service fee of 3% (or $60 on sales of $2,000). Moviegoers don't pay cash to the theatre at the time of sale, but MasterCard deposits cash, less the service fee expense, into the theatre's account usually within 24 hours. Therfore, the theatre records the $2,000 credit card transaction as $1,940 cash received & $60 service fee expense. CASH . 1,940 SERVICE FEE . 60 SERVICE REV. 2000

Companies issue incorrect financial statements for two reasons

ERRORS & FRAUD Accidental Errors in recording (or failing to record) transactions or in applying accounting rules. ^[may be unintentional, but can cause confusion & weaken investors & creditors' confidence] Fraud: When 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. (First Source--- Misuse of company's resources) (Second Source--- Financial statement manipulation)

Too much cash leads to

Inefficient use of funds and could be a signal that a company's mgmt doesn't see addt'l opportunities for profitable expansion. - As uncertainity in the business environement increases, companies hold more cash to prevent bankruptcy caused by short-term negative shocks in the business cycle.

Managers are entrusted with the resources of both the company's:

Lenders (Liabilities) & its Owners (Stockholders' Equity) * Managers act as stewards or caretakers of the company's assets.

Companies have the greatest ability to eliminate:

Opportunity - Companies implement formal-procedures known as INTERNAL CONTROLS Companies Plan to ..... 1. Safeguard the company's assets 2. Improve the accuracy & reliabilty of accounting information.

Acceptance of Credit Cards:

Provides an addt'l control by reducing employees' need to directly handle cash. - Credit Cards extend credit (lends $$) to the cardholder each time the cardholder uses the card. Meanwhile, the credit card company deposits cash in the company's bank for the amt of the sale, less service fees.

Acceptance of Debit Cards

Provides an addt'l control for cash receipts. * Work like a check & withdraw funds directly from the cardholder's bank acct at the time of use. * Will decrease your CASH acct; debit card refers to the banks liability to the company being decreased (debited) when the company uses a debit card.

Examples of Detective Controls

Reconcilations- Mgmt should periodically determine whether the amount of physical assets of the company (cash, supplies, inventory, & other property) agree w/ the acct'ing records. [i.e. Acct'ing personnel should routinely reconcile the company's cash records w/ those of its bank, & any discrepancy should be investigated.] Performance Reviews- The actual performance of individuals or processes should be checked against their expected performance. (i.e. the amt of concessions sold should be compared to the # of tickets sold over a period of time. If concession sales are lower than expected for a given # of tickets, employees could be wasting food, stealing snacks, or giving it to their friends for free. MANAGEMENT may also wish to evaluate the overall performance of the theatre by comparing ticket sales for the current year w/ ticket sales for the previous year. Audits- Many companies are required to have an independent auditor attest to the adequacy of their internal control procedures. Other companies can voluntarily choose each year to have an auditor assess their internal control procedures to detect any deficiencies or fraudulent behavior of employees.

Cash

Recorded in a company's balance sheet includes currency, coins, & balances in savings & checking accounts, as well as items acceptable for deposit in these accounts, such as checks received from customers. - In addition, when a company sells products or services to customers who use credit cards or debit cards, the cash collected from those sales is nearly always included in the total cash balance immediately. The reason is that cash from those transactions typically will be deposited electronically into the company's bank acct within a few days.

Step 2: Reconcile the company's cash balance:

Some common items that will increase the company's cash balance once the reconcilation occurs: - Bank collections: the company's behalf offer a convenient and safer way for the company to collect cash. Popular in certain business settings: recurring payments from customers, real estate transactions, collection agencies, and lending arrangements. (Companies may also "earn interest" based on the avg. daily balance of their checking or savings acct.; Other items in reconcililation will DECREASE the company's cash balance) - NSF Checks: Customers' checks are written on "nonsufficient funds." Bad check is written and company later finds out from the bank statement that customers' check was bad; have to decrease cash balance to UNDO the initial increase. - Employees sometimes use "debit cards" to make purchases. Doesn't show up as an transaction until the company's accountant examines the bank statement. - Electronic funds transfer (EFT's): Automatic transfers from one bank account to another (sometimes referred to as electronic checks or e-checks). i.e. Company having bill automatically withdrawn from its bank acct. - Banks charge "service fees" for various activities related to monthyly maintenance, overdraft penalities, ATM use, wire transfers, foreign currency exchanges, automatic payments, & other acct. services. Fees may not be known to company until examination of bank statement.

Fraud Triangle

The three factors that contribute to fraudulent activity by employees: opportunity, financial pressure, and rationalization. - Opportunity; the situation allows the fraud to occur. - Motivation; Someone feels the need to commit fraud, such as the need for money. - Rationalization; justification for the deceptive act by the one committing the fraud.

Errors can be made either by the company or its bank and may be:

accidental or intentional. Accidential Example: If company mistakingly were to record a check being written for $117 as $171 in its records, or if the bank improperly processed a deposit of $1,000 as a $1,010 deposit. Intentional Example: The result of theft. If the company records a daily deposit of $5,000 but an employee deposits only $500 into the bank account & pockets the rest, the bank reconcilation will reveal the missing $4,500.

restricted cash

cash that is not available for general use but instead is restricted for a particular purpose i.e Cash set aside by the company for specific purposes; repaying debt, purchasing equipment, or making investments in the future.

BANK STATEMENT: Deposit (increase) in the cash balance as a credit and a withdrawal (decrease) as a

debit. *When company makes a deposit, it views this as an increase to cash, so it records a debit to the Cash account. However, the bank views this same deposit as an increase in the amount owed to the company, or a liability, which is recorded as a credit. A withdrawal as a decrease to the amount owed to the company, so it debits its liability.

The balance sheet only provides the ______ balance for CASH.

final; * It doesn't provide any details regarding cash receipts and payments during the period in a statement about cash flows.

Cash EXAMPLE:

i.e. Movie theatre pays $1,000 to advertise its show time, it records the following transaction, regardless of whether it pays w/ cash, a check, or a debit card. Advertising Exp. 1,000 Cash . 1,000 (Purchasing advertising w/ cash, check, or debit card) B/c credit cards delay payment for several weeks or even months, if the theatre uses a credit card to pay for the $1,000 worth of advertising, this is how it would look: Advertising Exp . 1000 Accounts Payable . 1000 (Purchase advertising with credit card)

Acceptance of Customer Checks:

i.e. Local Theatre sells tickets for the entire day totaling $3,000. Some customers pay cash for those tickets, while others use a check. Regardless of method used, the theatre records all those ticket sales as "cash sales."

collusion

occurs when 2 or more ppl act in coordination to circumvent internal controls. (Several times severe than are fraud cases involving 1 person.) This suggests that collusion is effective in circumventing control procedures.

Top executives are the ones who must take final:

responsibility for their establishment & success * The CEO & 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 mgmt's assessment. * The Public Company Acct'ing Oversight Board (PCAOB) futher requires the auditor to express its own opinion on whether the company has maintained effective internal control over financial reporting.

cash equivalents

short-term investments that have a maturity date NO LONGER THAN 3 months from the date of purchase. i.e. Money market funds, Treasury bills, and cerificates of deposit.

Effective internal controls and ethical employees alone cannot ensure a company's _____, or even survival.

success.

Timing differences in cash occur when:

the company records transactions either before or after the bank records the same transactions. i.e. When the movie theatre pays its popcorn supplier $2,000 by check, the company records a decrease in cash immediately, but the bank doesn't record a decrease in cash until the popcorn supplier later deposits the check. If the supplier waits a week before depositing the check, the balance of cash in the company's records will be reduced one week earlier than will the bank's. - The bank's balance for cash reflects a cash transaction BEFORE the company's balance can reflect the same transaction.