Financial Accounting Fourth Edition

Cash and
Internal Controls

CHAPTER

4 Spiceland Thomas Herrmann

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Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2
BARINGS Bank
Founded in 1762; Headquarter in London
Financed the Louisiana Purchase
Personal bank to the Queen

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Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4
 http://www.nickleeson.com/index.html

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Part A
INTERNAL CONTROLS

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Incorrect Financial Statements
Reasons:
Errorsaccidental errors in recording
transactions or applying accounting principles
Frauda person intentionally deceives another
person for personal gain or to damage that
person
Occupational fraud: the use of ones occupation for
personal enrichment through the deliberate misuse or
misapplication of the employers resources

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Illustration 41
The Fraud Triangle

Opportunity the situation

allows the fraud to occur.
Opportunity
Motivation someone feels
the need to commit fraud,
such as the need for money.
Fraud
Rationalization justification
for the deceptive act by the
Motivation Rationalization one committing the fraud.

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Internal Controls
Internal controls attempt to eliminate the
opportunity element of fraud
Internal controls represent plans to:
Safeguard the companys assets
Improve the accuracy and reliability of accounting
information

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Learning Objective 1

LO41 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 companys lenders and owners
Managers act as stewards or caretakers of the
companys assets
Some managers have shirked their ethical
responsibilities
Top executives misused or misreported the
companys funds

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Accounting Fraud in U.S. History

Enron WorldCom

Avoided reporting billions in Misclassified expenditures to

debt and losses overstate assets and profitability

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The WorldCom Case
WorldCom - What Went Wrong

http://www.youtube.com/watch?v=7g_d-phoUrU
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 related to:
Internal control procedures
Auditor-client relations

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 Illustration 42
Major Provisions of the
Sarbanes-Oxley Act of 2002
Oversight board
Corporate
executive
accountability
Nonaudit services
Retention of work Auditors of public companies must retain all work papers for seven years or face a prison term for willful
violation.
papers
Auditor rotation
Conflicts of
interest
Hiring of auditor
Internal control
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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 executives must personally certify the companys financial statements and financial disclosures.
Severe financial penalties and the possibility of imprisonment are consequences of fraudulent
misstatement.
Its unlawful for the auditors of public companies to also perform certain nonaudit services, such as
investment advising, for their clients.
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.
Audit firms are not allowed to audit public companies whose chief executives worked for the audit firm
and participated in that companys audit during the preceding year.
Audit firms are hired by the audit committee of the board of directors of the company, not by company
management.
Section 404 of the act requires (a) 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 managements assessment of the effectiveness of internal control is fairly stated.
Smaller companies are exempt from requirement (b).
15
Key Point
The accounting scandals in the early 2000s
prompted passage of the Sarbanes-Oxley Act
(SOX). Among other stipulations, SOX sets forth
a variety of guidelines related to auditor-client
relations and additional internal controls.
Section 404, in particular, requires company
management and auditors to document and
assess the effectiveness of a companys internal
controls.

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Concept Check 41
Which of the following statements is NOT true
of the Sarbanes-Oxley Act of 2002?
a. All companies in the U.S. fall under its
provisions.
b. It helped establish guidelines for internal
control procedures.
c. It helped establish corporate executive
accountability.
d. It helped establish guidelines for auditor-
client relations.
The Sarbanes Oxley Act of 2002 applies to companies who are
required to file financial statements with the SEC. It does not
apply to all companies in the U.S.
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Learning Objective 2

LO42 Identify the components, responsibilities, and

limitations of internal control.

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Illustration 43
Components of Internal Control
Methods for collection of relevant information and communication in a timely
manner, enabling people to carry out their responsibilities.

Continual monitoring of internal activities and

reporting of deficiencies is required.
Monitoring includes formal procedures for
reporting control deficiencies.
Monitoring
Control activities are the policies and
procedures that help ensure that managements
directives are being carried out. These activities
Control Activities
include authorizations, reconciliations, and
separation of duties.

Risk assessment identifies and analyzes internal

and external risk factors that could prevent a
Risk Assessment
companys objectives from being achieved.

The control environment sets the overall ethical

tone of the company with respect to internal
Control Environment control. It includes formal policies related to
managements philosophy, assignment of
responsibilities, and organizational structure.
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Illustration 44
Regal Entertainments Discussion
of Internal Controls Over Financial
Reporting
REGAL ENTERTAINMENT GROUP
Notes to the Financial Statement (excerpt)
A companys internal control over financial reporting includes those policies and
procedures that (1) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the company are being made only in
accordance with authorizations of management and directors of the company; and (3)
provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the companys assets that could have a material effect on
the financial statements.

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Control ActivitiesMovie Theatre Example
Preventive controls
Separation of duties Employee selling movie tickets should
not also account for cash at the theatre.
Physical controls Concession supplies should be kept in a
locked room with access allowed only to authorized personnel.
Proper authorization Only theatre management should be
authorized to make purchases over a certain amount.
Employee management Employees should be made fully
aware of the companys internal control procedures, ethical
responsibilities, and channels for reporting irregular activities.
E-commerce controls The theatre should maintain and
systematically check the firewall settings to prevent
unauthorized access to accounts and credit card numbers.
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Control ActivitiesMovie Theatre Example
Detective controls
Reconciliations Management should periodically determine
whether the amount of physical assets of the company (cash,
concession items, movie t-shirts, etc.) agree with the
accounting records.
Performance reviews The amount of concessions sold should
be compared to the number of tickets sold over a period of
time.
Audits Hire an independent auditor to assess the theatres
internal control procedures to detect any deficiencies or
fraudulent behavior of employees.

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Responsibilities for Internal Control

CEO and CFO:

Sign a report each year certifying adequacy of
internal controls
Auditors:
Provide an opinion on managements assessment
of internal control over financial reporting
Provide their own opinion on companys internal
control over financial reporting

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Concept Check 42
If a company places cash receipts from the day in a
safe or bank deposit box, this would be an example
of:
a. Separation of duties
b. Physical control
c. Reconciliation
d. Performance review

This is an example of a physical control. Important items (like cash

receipts) should be kept in safe placeslike a safe or a bank deposit box.

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Illustration 45
Excerpt from Regal Entertainments
Auditors Report Related to
Effectiveness of Internal Controls

REGAL ENTERTAINMENT GROUP

Auditors Report (excerpt)
In our opinion, managements assessment that Regal Entertainment Group maintained
effective internal control over financial reporting is fairly stated, in all material respects,
based on criteria established in Internal ControlIntegrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our
opinion, Regal Entertainment Group maintained, in all material respects, effective internal
control over financial reporting, based on criteria established in Internal Control
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).

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Limitations of Internal Control
An effective internal control system cant turn a
bad employee 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 have opportunity to commit
fraud
Effective internal controls and ethical employees
alone cannot ensure success or even survival

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Illustration 46
Regal Entertainments Discussion
of Limitations of Internal Controls

REGAL ENTERTAINMENT GROUP

Management Discussion and Analysis (excerpt)
Management recognizes that there are inherent limitations in the effectiveness of any
internal control over financial reporting, including the possibility of human error and the
circumvention or overriding of internal control. Accordingly, even effective internal control
over financial reporting can provide only reasonable assurance with respect to financial
statement preparation. Further, because of changes in conditions, the effectiveness of
internal control over financial reporting may vary over time.

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Concept Check 43
Everyone in the company has an impact on the
operations and effectiveness of internal control,
but who must take final responsibility?
a. Internal auditors
b. Top executives
c. The firms attorney
d. The majority shareholder

The top executives are the ones who must take final responsibility for the
establishment and success of internal controls. The CEO and CFO sign a
report each year assessing whether the internal controls are adequate.

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Part B
CASH

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Learning Objective 3

LO43 Define cash and cash equivalents.

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Illustration 47
Components
of the
Total Cash
Balance

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Concept Check 44
Which of the following would NOT be considered a
cash equivalent?
a. Credit card sales for the day
b. Debit card sales for the day
c. Money orders received from customers
d. Certificate of deposit (CD) that matures one year
from now
Cash includes currency, coins, savings accounts, checking accounts, credit
card sales, debit card sales, and other cash equivalents. Cash equivalents
are generally defined as investments that mature within three months
from the date of purchase, such as money market funds, treasury bills,
and certificates of deposit. Since the CD doesnt mature until 1 year from
now, it would NOT be considered a cash equivalent.
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Learning Objective 4

LO44 Understand controls over cash receipts and

cash disbursements.

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Cash Controls
Controls over cash receipts
Each day: an employee should open mail and list checks
Each day: a different employee should deposit cash and checks into
the companys bank account
As soon as possible: a separate employee should record cash receipts
in the accounting records
Accept credit cards or debit cards to limit the amount of cash handled
Controls over cash disbursements
Disbursements should be made by check, debit card, or credit card
Authorize all expenditures; authorizing employee should not also
prepare the check
Checks should be serially numbered and should require two signatures
for large amounts
Periodically agree debit and credit card statements to purchase
receipts
Set maximum purchase limits
Separate cash disbursement and cash receipt duties

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Learning Objective 5

LO45 Reconcile a bank statement.

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Bank Reconciliation
The balance of cash in the companys records may not equal
the balance of cash in the banks records

A bank reconciliation matches the balance of cash in the bank

account with the balance of cash in the companys own
records
Timing differences occur when the company records
transactions either before or after the bank records the same
transactions
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Illustration 48
Bank Statement
(balance per bank statement = $4,100)
P.O. Box 26788
Odessa, TX First Bank Member FDIC
79760 A Name You Can Trust
(432) 799-BANK
Account Number: 4061009619
Account Holder: Starlight Drive-In Statement Date: March 31, 2018
221B Baker Street
Odessa, TX 79760 Account Summary
Beginning Balance Deposits and Credits Withdrawals and Debits Ending Balance
March 1, 2018 No. Total No. Total March 31, 2018
$3,800 4 $8,600 7 $8,300 $4,100
Account Details
Deposits and Credits Withdrawals and Debits Daily Balance
Date Amount Desc. Date No. Amount Desc. Date Amount
3/5 $3,600 DEP 3/8 293 $2,100 CHK 3/5 $7,400
3/9 3,000 NOTE 3/12 294 2,900 CHK 3/8 5,300
3/22 1,980 DEP 3/15 400 EFT 3/9 8,300
3/31 20 INT 3/22 750 NSF 3/12 5,400
3/26 296 1,900 CHK 3/15 5,000
3/28 200 DC 3/22 6,230
3/31 50 SF 3/26 4,330
3/28 4,130
$8,600 $8,300 3/31 $4,100
Desc. DEP Customer deposit INT Interest earned SF Service fees
NOTE Note collected CHK Customer check NSF Nonsufficient funds
EFT Electronic funds transfer DC Debit card

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Illustration 49
Company Records of Cash Activities
(balance per company records = $2,880)
STARLIGHT DRIVE-IN
Cash Account Records
March 1, 2018, to March 31, 2018
Deposits Checks
Date Description Amount Date No. Description 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 Ending
Cash Balance Cash Balance
March 1, 2018 + Deposits Checks = March 31, 2018
$3,800 $7,780 $8,700 $2,880

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Step 1:
Reconcile the Banks Cash Balance
Cash transactions recorded by the company,
but not yet recorded by its bank:
Deposits outstanding: cash receipts of the
company that have not been added to the banks
record of the companys balance
Checks outstanding: checks the company has
written that have not been subtracted from the
banks record of the companys balance

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Example
Comparing Receipts and Disbursements
Cash receipts of the company Cash receipts known by the bank
Deposits Deposits and Credits
Date Desc. Amount Date Amount Desc.
3/5 Sales receipts $3,600 3/5 $3,600 DEP
3/22 Sales receipts 1,980 3/9 3,000 NOTE
3/31 Sales receipts 2,200 3/22 1,980 DEP
3/31 20 INT
Deposit Outstanding
(not in current bank balance)

Checks written by the company Checks known by the bank

#293 $2,100 #293 $2,100
#294 $2,600 #294 $2,900
#295 $1,200 (error fixed later)
#296 $1,900 #296 $1,900
#297 $900

Checks Outstanding
(not in current bank balance)

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 Illustration 410
Bank Reconciliation
STARLIGHT DRIVE-IN
Bank Reconciliation
March 31, 2018
Banks Cash Balance Companys Cash Balance
Per bank statement $4,100 Per general ledger $ 2,880
Deposits outstanding: +2,200
3/31 = $2,200

Checks outstanding: 2,100

#295 = $1,200
#297 = $ 900

Bank balance per

reconciliation $4,200

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Step 2:
Reconcile the Companys Cash Balance
Cash transactions recorded by bank but not company
Common items that will increase the companys cash
balance include:
Collections made by the bank on the companys behalf
Interest earned on average daily balance
Common items that will decrease the companys cash
balance include:
NSF checks (customers checks written on nonsufficient
funds, otherwise known as bad checks)
Debit card purchases
Electronic funds transfers (EFTs)
Bank service fees
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 Illustration 48
Bank Statement
(balance per bank statement = $4,100)
P.O. Box 26788
Odessa, TX First Bank Member FDIC
79760 A Name You Can Trust
(432) 799-BANK
Account Number: 4061009619
Account Holder: Starlight Drive-In Statement Date: March 31, 2018
221B Baker Street
Odessa, TX 79760 Account Summary
Beginning Balance Deposits and Credits Withdrawals and Debits Ending Balance
March 1, 2018 No. Total No. Total March 31, 2018
$3,800 4 $8,600 7 $8,300 $4,100
Account Details
Deposits and Credits Withdrawals and Debits Daily Balance
Date Amount Desc. Date No. Amount Desc. Date Amount
3/5 $3,600 DEP $20 3/8 293 $2,100 CHK 3/5 $7,400
3/9 3,000 NOTE interest 3/12 294 2,900 CHK Fix $300 3/8 5,300
3/22 1,980 DEP 3/15 400 EFT error 3/9 8,300
3/31 20 INT 3/22 750 NSF 3/12 5,400
3/26 296 1,900 CHK 3/15 5,000
Items not yet added to 3/28 200 DC 3/22 6,230
companys cash balance 3/31 50 SF 3/26 4,330
Items not yet subtracted from 3/28 4,130
$8,600 the companys cash balance $8,300 3/31 $4,100
Desc. DEP Customer deposit INT Interest earned SF Service fees
NOTE Note collected CHK Customer check NSF Nonsufficient funds
EFT Electronic funds transfer DC Debit card

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 Illustration 410
Bank Reconciliation
STARLIGHT DRIVE-IN
Bank Reconciliation
March 31, 2018
Banks Cash Balance Companys Cash Balance
Per bank statement $4,100 Per general ledger $ 2,880
Deposits outstanding: +2,200 Note received +2,800
3/31 = $2,200 Interest earned from note +200
Interest earned on bank account +20
Checks outstanding: 2,100 NSF check 750
#295 = $1,200 Debit card for office equipment 200
#297 = $ 900 EFT for advertising 400
Service fee 50
Corrected rent expense error 300
Bank balance per Company balance per
reconciliation $4,200 reconciliation $4,200

Reconciled
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 Illustration 411
Summary of Items Included in the
Bank Reconciliation
Banks Companys
Cash Balance Cash Balance
Per bank statement Per general ledger

Timing + Deposits outstanding + Notes received by bank

Differences Checks outstanding + Interest received
NSF checks
Unrecorded debit cards
Unrecorded ETFs
Bank service fees

Errors Bank errors Company errors

= Bank balance per reconciliation = Company balance per reconciliation

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Concept Check 45
Which of the following items would be found on the
bank side, or the left-hand side, of the bank
reconciliation?
a. Interest income received on the account
b. Deposit outstanding
c. NSF check from a customer
d. Service fee charged by the bank

The common items that are shown on the left-hand side of the bank
reconciliation include deposits outstanding, checks outstanding, and
bank errors. All of the other items would appear on the companys
side, or the right-hand side, of the bank reconciliation.

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Concept Check 46
How would an NSF check from a customer be
treated on a bank reconciliation?
a. Addition on the bank side
b. Deduction on the bank side
c. Addition on the company side
d. Deduction on the company side
An NSF check would be shown on the companys sidethe right-hand
sideand it would be shown as a deduction. This is because when the
company originally deposited the customers check, they increased the
Cash account. Now that the check has been discovered to be an NSF
check, or a nonsufficient funds check, the company must reverse the
cash out of its books, resulting in a decrease, or a deduction, on the
companys side of the bank reconciliation.
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Common Mistake
Sometimes students mistake an NSF check as a
bad check written by the company instead of
one written to the company. When an NSF check
occurs, the company has deposited a customers
check, but the customer did not have enough
funds to cover the check. The company must
adjust the balance of the cash account
downward to reverse the increase in cash it
recorded at the time of the deposit.

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Step 3:
Update the Companys Cash Account
Look at items used to reconcile the companys
cash balance
Debit Cash for items that add to the balance
Credit Cash for items that subtract from the
balance

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Record items that increase cash
March 31, 2018 Debit Credit
Cash .. 3,020
Notes Receivable... 2,800
Interest Receivable (from note).. 200
Interest Revenue (from bank account) . 20

(Record collection on note and interest earned)

Record items that decrease cash

March 31, 2018 Debit Credit
Accounts Receivable 750
Equipment . 200
Advertising Expense . .. 400
Service Fee Expense 50
Rent Expense ... 300
Cash 1,700
(Record NSF check, equipment purchase, advertising payment, bank
service fee, and check correction for rent)
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Concept Check 47
How would an NSF check from a customer be
recorded in the accounting records?
a. Debit Accounts Receivable; Credit Cash
b. Debit Cash; Credit Accounts Receivable
c. Debit Accounts Payable; Credit Cash
d. Debit Cash; Credit Miscellaneous Expense
Accounts Receivable is debited in order to increase that asset
account to show that the customer who paid with an NSF check
still owes the company money. The Cash account is credited
because the company must adjust its balance of cash downward
to reverse the increase in cash it recorded at the time it received
the check from the customer.

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Common Mistake
Some students try to update the Cash account for
deposits outstanding, checks outstanding, or a
bank error. The company does not need to adjust
for these items related to reconciling the banks
balance because they are already properly
recorded in the companys accounting records.

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Learning Objective 6

LO46 Account for employee purchases.

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Account for Employee Purchases
Petty cash fund: small amount of cash kept on
hand to pay for minor purchases
Accounting for the petty cash fund involves:
Establishing the fund
Recognizing expenditures from the fund
Replenishing the fund
Company-issued debit and credit cards
Debit cards (and checks) captured in the bank
reconciliation
Credit card purchases need to be recorded

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Example
Employee Purchases
Establish a petty cash fund of $200
Remove cash from the bank and place it on
hand at the company
May 1 Debit Credit
Petty Cash (on hand) .. 200
Cash (checking account) .. 200
(Establish the petty cash fund)

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Employee Purchases
Petty Cash Fund Purchasing Manager Marketing Manager
(Cash) (Credit Card) (Credit Card)
Item Amount Item Amount Item Amount
Lunch $60 Supplies $800 Advertising $1,500
Delivery $90 Supplies $600 Postage $1,200

Record employee purchases

May 31 Debit Credit
Entertainment Expense 60
Delivery Expense ..... 90
Supplies ($800 + $600) .. 1,400
Advertising Expense . 1,500
Postage Expense . 1,200
Petty Cash 150
Accounts Payable 4,100
(Recognize employee expenditures)

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Employee Purchases

Replenish the petty cash fund

Withdraw additional cash from the bank
and place it on hand at the company
Petty cash fund increases to $200
May 1 Debit Credit
Petty Cash (on hand) .. 150
Cash (checking account) .. 150
(Replenish the petty cash fund)

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Analysis
CASH ANALYSIS

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Learning Objective 7

LO48 Assess cash holdings by comparing cash to

noncash assets.

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Example
Comparing Regal Entertainment to Cinemark
($ in millions) Cash and Cash Noncash
Equivalents Assets Ratio
Regal Entertainment $147.1 $2,392.4 6.1%
Cinemark Holdings $638.9 $3,513.1 18.2%

Trend in operating cash flows

($ in millions) Operating Cash Flows
Year Regal Entertainment Cinemark Holdings
2012 $346.6 $395.2
2013 $346.9 $309.7
2014 $349.1 $454.6

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Concept Check 49
Which of the following statements is true?
a. Having too much cash represents idle
resources that are not being used to
produce revenues.
b. One way to assess cash holdings is to
compare cash assets to noncash assets.
c. In recent years cash holdings have
increased tremendously.
d. All of the above are true.
All of the above statements about cash are true.

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Summary
1. LO41 Discuss the impact of accounting
scandals and the passage of the Sarbanes-
Oxley Act.
2. LO42 Identify the components,
responsibilities, and limitations of internal
control.
3. LO43 Define cash and cash equivalents.
4. LO44 Understand controls over cash
receipts and cash disbursements.

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Summary
1. LO45 Reconcile a bank statement.
2. LO46 Account for employee
purchases.
3. LO47 Assess cash holdings by
comparing cash to noncash assets.

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End of Chapter 4

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