Ch. 4 Cash and Internal Controls

Question 1

Occupational fraud

Answer 1

• The use of one’s occupation for personal enrichment through the deliberate misuse of misapplication of the employing organization’s resources.
• Companies expect to lose on average 7% of their total revenues to fraud each year.
• Cash is the asset most commonly misappropriated.

Question 2

Internal controls

Answer 2

A company’s plans to:

(1) safeguard the company’s assets and
(2) improve the accuracy and reliability of accounting information.

Question 3

Sarbanes-Oxley Act (SOX)

Answer 3

Known as the “Public Company Accounting Reform and Investor Protection Act of 2002” and commonly referred to as SOX; the act established a variety of new guidelines related to auditor-client relations and internal control procedures.

Question 4

Separation of duties

Answer 4

• One of 4 preventive controls
• Authorizing transactions, recording transactions, and maintaining control of the related assets should be separated among employees.

Question 5

Collusion/Limitations of Internal control

Answer 5

• -2 or more people acting in coordination to circumvent internal controls.
• Theft is much more difficult to detect.
• Fraud cases that involve collusion are typically several times more severe than are fraud cases involving a single perpetrator.
• -Top-level employees who have the ability to override internal control features also have opportunity to commit fraud.
• Effective internal controls and ethical employees alone cannot ensure a company’s success, or even survival.

Question 6

Cash

Answer 6

Currency, coins, balances in savings and checking accounts, items acceptable for deposit in these accounts (such as checks received from customers), and cash equivalents.

Question 7

Cash equivalents

Answer 7

• Short-term investments that have a maturity date no longer than 3 months from the date of purchase.
• These include:
  
  • money market funds
  • treasury bills
  • certificates of deposit
• Cash and cash equivalents usually are combined and reported as a single asset in the balance sheet of most companies.

Question 8

Bank reconciliation

Answer 8

• Matching the balance of cash in the bank account with the balance of cash in the company’s own records.
• A company’s cash balance as recorded in its books rarely equals the cash balance reported in the bank statement.
• Timing differences in cash occur when the company records transactions either before or after the bank records the same transaction.
• Errors can be made either by the company or its bank and may be accidental or intentional.
• Bank reconciliation connects the company’s cash balance to the bank’s cash balance by identifying differences due to timing and errors.

Question 9

Deposits outstanding

Answer 9

Cash receipts of the company that have not been added to the bank’s record of the company’s balance.

Question 10

Checks outstanding

Answer 10

Checks the company has written that have not been subtracted from the bank’s record of the company’s balance.

Question 11

NSF checks

Answer 11

• Checks drawn on non-sufficient funds, or “bad” checks from customers.
• NSF checks are later recorded as Accounts Receivable because the customer wrote a bad check and owes the company that amount
• (Bounced check)

Question 12

Petty cash fund

Answer 12

• Small amount of cash kept on hand to pay for minor purchases. (postage, office supplies, delivery charges, entertainment expenses).
• Accounting for the petty cash fund involves recording transactions to (1) establish the fund, (2) recognize expenditures from the fund, (3) replenish the fund as the cash balance becomes sufficiently low.
• 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 (petty-cash custodian).
• A reasonable lasting period is a week or a month.

Question 13

Earnings quality

Answer 13

• The ability of net income to help predict future performance of the company.
• Which number is more useful in helping us to predict the long-term profitability of the company? Net Income of $500 or net cash flows from operating activities of -$4,600?
• When net income does not provide a good indicator of future performance, its earnings quality is said to be low.

Question 14

Free cash flow

Answer 14

• Operating cash flows plus investing cash flows during the period.
• This measure represents the cash that is free to repay debt and distribute to stockholders.
• Companies whose fee cash flow is declining relative to the trend in net income are likely to have a lower-quality earnings.
• Common technique used by investors for measuring earnings quality is by comparing the trend in a company’s net income to its trend in free cash flow.
• When trend in Net Income is up while the trend in free cash flows is down, a company is more likely to experience falling profits in the coming years.

Question 15

Association of Certified Fraud Examiners (ACFE)

Answer 15

Worlds largest anti-fraud organization

Question 16

Cash controls

Answer 16

• Bank reconciliation

- Petty cash fund

Question 17

Major provisions of SOX (8)

Answer 17

• Oversight board: 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 5 members who are appointed by SEC.
• Corporate executive accountability: Corporate executives must personally certify the company’s financial statements and financial disclosures. Severe financial penalties and the possibility of imprisonment are consequences of fraudulent misstatement.
• Nonaudit services: It’s unlawful for the auditors of public companies to also perform certain nonaudit services, such as consulting, for their clients.
• Retention of work papers: Auditors of public companies must retain all work papers for 7 years or face a prison term for willful violation.
• Auditor rotation: The lead auditor in charge of auditing a particular company (referred to as the audit partner) must rotate off that company within 5 years and allow a new audit partner to take the lead.
• Conflicts of interest: Audit firms are not allowed to audit public companies whose chief executives worked for the audit firm and participated in that company’s audit during the preceding year.
• Hiring of auditor: Audit firms are hired by the audit committee of the board of directors of the company, not by company management.
• Internal control: 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 management’s assessment of the effectiveness of internal control is fairly stated.

Question 18

Components of Internal Control (5)

Answer 18

• COSO (Committee of Sponsoring Organizations)
  4. Monitoring*
  3. Control Activities*
  2. Risk Assessment*
  1. Control Environment*
• Information and Communication (side of triangle)
• Inside the triangle* (1 being the bottom, 4 being the top)

Question 19

Control Environment

Answer 19

• One of 5 components of Internal Control
• Sets the overall ethical tone of the company with respect to internal control.
• It includes formal policies related to management’s philosophy, assignment of responsibilities, and organizational structure.
• The overall attitudes and actions of management greatly affect the control environment.

Question 20

Risk Assessment

Answer 20

-One of 5 components of Internal Control
-Identifies and analyses internal and external risk factors tat could prevent a company’s objectives from being achieved.
-Internal risks: include issues such as unsafe lighting, faulty equipment, unsanitary bathroom, and employee incompetence.
External risks: include vendor supplying low-grade/unsafe supplies, security, decline in demand.

Question 21

Control Activities

Answer 21

• One of 5 components of Internal Control
• Policies and procedures that help ensure that management’s directives are being carried out.
• These activities include authorizations, reconciliations, and separation of duties.
• Policies/procedures are used to protect a company’s assets.
• 2 types:
• Preventive: separation of duties, physical controls, proper authorization, employee management.
• Detective controls: Reconciliations, performance reviews.

Question 22

Physical Controls

Answer 22

• One of 4 preventive controls
• Over assets and accounting records.
• Each night money from sales should be placed in a safe or deposited at the bank.
• Important documents should be kept in fireproof files, and electronic records should be backed up daily and require user-ID and password for access.
• Supplies should be locked in a room with access allowed only to authorized personnel.

Question 23

Proper Authorization

Answer 23

• One of 4 preventive controls
• To prevent improper use of the company’s resources.
• Formal guidelines on how to handle cash receipts and make purchases.
• ie. only management should be authorized to make purchases over a certain amount.

Question 24

Employee Management

Answer 24

• One of 4 preventive controls
• Company should provide employees with appropriate guidance to ensure they have the knowledge necessary to carry out their job duties.
• Employees should be made fully aware of the company’s internal control procedures, ethical responsibilities, and channels for reporting irregular activities.

Question 25

Reconciliations

Answer 25

- One of 2 detective controls - Management should periodically determine whether the amount of physical assets of the company (cash, supplies, inventory, and other property) match-reconcile with-the accounting records. - ie: accounting personnel should routinely reconcile the company's cash records with those of its bank, and any discrepancy should be investigated.

Question 26

Performance Reviews

Answer 26

- One of 2 detective controls - The actual performance of individuals or processes should be checked against their expected performance. - ie: movie theater. comparing amount of food with the number of tickets, employees could be wasting food, stealing food, or giving it to friends for free, or vendors may be supplying lower-quality food, driving sales down. - Management may also wish to evaluate the overall performance of the theater by comparing ticket sales for the current year with that of the previous year.

Question 27

Monitoring

Answer 27

- One of 5 components of internal control - One of 5 components of internal control - Continual monitoring of internal activities and reporting of deficiencies is required. - Monitoring includes formal procedures for reporting control deficiencies. - Theater manager needs to actively review daily operations to ensure that control procedures work effectively. - ie: manager should compare concession sales with units purchased, and make sure employees are paid only for actual hours worked.

Question 28

Information and Communication

Answer 28

- One of 5 components of internal control - Depend on the reliability of the accounting information system itself. - A system should be in place to ensure that current transactions of the company are reflected in current reports - Employees also should be aware of procedures in place to deal with any perceived internal control failures. - ie: anonymous tip hotline to encourage communication about unethical activities. - Employee tips historically have been the most common means of detecting employee fraud.

Question 29

Responsibilities for Internal control

Answer 29

- Everyone in a company has an impact on the operation and effectiveness of internal controls, but the top executives are the ones who must take final responsibility for their establishment and success. (CEO, CFO). - Section 404 of SOX requires companies to document their internal controls and assess their adequacy and requires auditors to provide opinion on managements assessment. - PCOB further requires auditor to express opinion on effectiveness of internal control over financial reporting.

Question 30

How much cash is enough?

Answer 30

- The company needs enough cash, or enough other assets that can be quickly converted to cash, to pay obligations as they become due. - Available cash also helps a company respond quickly to new, profitable opportunities before competitors do. - On the other hand, having too much cash leads to inefficient use of funds and can signal company's management doesn't see additional opportunities for profitable expansion. - Investors usually view excess cash as a negative.

Question 31

Controls over cash receipts

Answer 31

1. Record all cash receipts as soon as possible. Theft is more difficult once a record of the cash receipt has been made. 2. Open mail each day, and make a lost of checks received, including the amount and payer's name. 3. Designate an employee to deposit cash/checks into company's bank account each day, different form person receiving cash and checks. 4. Have another employee record cash receipts in the accounting records. Verify cash receipts by comparing bank deposit slip with accounting records. 5. Accept credit cards or debit cards, to limit the amount of cash employees handle.

Question 32

Acceptance of credit/debit cards

Answer 32

- When the cardholder uses the card, cash in the amount of the sale automatically is deposited in the company's bank. - Credit card companies earn revenues primarily in 2 ways: (1) charging interest for late payments, (2) credit card companies charge the retailer, not the customer, for the use of the credit card. This charge ranges from 2%-4% of the amount of the sale. - Debit cards charge a lower fee to retailers. Cash ...................................... 1,940 Service Fee Expense ............. 60 Service Revenue ......................... 2,0000 (sell $2,000 worth of tickets with credit card and 3% service fee)

Question 33

Controls over cash disbursements

Answer 33

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 and verify the accuracy of the purchase itself. The employee who authorizes payments should not also be the employee who prepares the check. 3. Make sure checks are serially numbered and signed only by authorized employees. Require 2 signatures for larger checks. 4. Periodically check amounts shown in debit and credit card statements against purchase receipts. The employee verifying the accuracy of the debit and credit card statements should not also be the employee responsible for actual purchases. 5. Set maximum purchase limits on debit and credit cards. Give approval to purchase above these amounts only to upper-level employees. 6. Employees responsible for making cash disbursements should not also be in charge of cash receipts.

Question 34

Example of Timing Difference

Answer 34

- When a movie theater pays its popcorn supplier $200 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. - Other times, the bank is the 1st to record a transaction. (Bank could charge a $50 service fee, immediately reducing the bank's record of the company's balance fro cash. - However the company may not be immediately aware of this fee (until they receive bank statement)

Question 35

Bank Statements

Answer 35

- From the bank's perspective - Bank statements record cash the opposite way of that used in financial statements. - When a company makes a deposit, the bank's liability to the company (a credit account) increases. When a company withdrawals cash from its bank account, the bank's liability to the company decreases. Dr Cr -------------I--------------- Cash - I Cash + I

Question 36

Bank reconciliation steps

Answer 36

* Step 1: Reconciling the bank's cash balance--Deposits outstanding and Checks outstanding. (cash transactions recorded by company but not by bank). * Step 2: Reconciling the company's cash balance--Cash transactions recorded by the bank but not by the company. (interest earned by the company, collections made by the bank, service fees, charges for NSF checks). * Step 3: Adjusting company's cash balance. - If the company cannot resolve the discrepancy, it records the difference to either miscellaneous expense or miscellaneous revenue.

Question 37

Reporting cash

Answer 37

Companies report cash in 2 ways: - Balance Sheet - Statement of Cash Flows

Question 38

Cash Analysis

Answer 38

- Timing of revenues and expenses recorded under accrual-basis accounting may differ from the timing of operating cash flows. * Earnings quality * Comparing Net Income to Cash Flow--Free cash flow.