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CHAPTER

. as_hand Internal Controls

AFTER STUDYING THIS CHAPTER YOU SHOULD E ABLE TO:L01 Understand the impact of accounting scandals and the passage of theSarbanes-Oxley Act.L 2 Identify the components responsibilities and limitations of internal control.L 3 Define cash and cash equivalents.L 4 Understand controls over cash receipts and cash disbursements.LOS Reconcile a bank statement.L 6 Account for petty cash.L 7 Identify the major inflows and outflows of cash.

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INTERN L CONTROLS RE BOX OFFICE HITAccording to research conducted by the Association of Certified Fraud Examiners (ACFE,www.acfe.com, U.S. organizations lose an estimated $650 billion to employee fraud eachvear This occurs despite increased emphasis on antifraud controls and recent legislation tocombat fraud. While some employees steal office supplies, inventory, and equipment theasset most often targeted is cash. Cash fraud includes skimming cash receipts before theyare recorded, stealing cash that has already been recorded, and falsely disbursing cash through fraudulentbilling, expense reimbursement or payroll.This means companies that rely heavily on cash transactions are especially susceptible to employee

fraud. For example, consider a company like Regal ntertainment Group (NYSE: R , one of thelargest motion picture exhibitors in the world. The company operates more than 6,000 screens and sellsnearlv 300 million tickets per year, generating revenues each year of about $2.5 billion. The companystates that Revenues are generated principally through admissions and concessions sales with proceedsreceived in cash at the point of sale. The primary way a company like RGC can minimize cash losses dueto employee fraud is to establish strong systems for internal control.Toward that end, RGC makes extensive use of its point-of-service information technology for the

management of its theatres. The revenue streams generated by admissions and concessions are fullysupported by information systems to monitor cash flow and to detect fraud and inventory theft. Simplerapproaches to internal control include separation of duties. For example, one person sells tickets andanother collects the tickets. This prevents the ticket seller from stealing a moviegoer's cash and thenallowing admission without a ticket being produced by the ticket machine. At the end of the day, thenumber of tickets produced by the machine should exactly match the cash collected.

We discuss much more about fraud and ways to prevent it in this chapter. You can practice your skillsmpreventing and detecting fraud at a movie theatre in Problem 4-lA at the end of the chapter.

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/. ~ \ . . \ \ . . J v _n l 1 - CHAPTER 4 Cash and Internal Controlsc_6- . _ } , : # ~ f ) _ -Itosits and Cred its Withdraws and Deb its Daily Balance

Date Amount Desc. Date No . Amount Desc. Date Amount3/5 $3 ,600 DEP 3/8 293 2,100 CHK 3/5 7,4003/9 3,000 NOTE 3/ 12 294 2,900 CHK 3/ 8 5,3003/22 1,980 DEP 3/ 15 400 EFT 3/9 8,3003/31 20 INT 3/22 750 NSF 3/ 12 5,400

3/ 26 296 1,900 CHK 3/ 15 5,0003/ 28 200 DC 3/22 6,2303/31 50 sc 3/26 4,330

3/28 4,130- - 8,600 8,300 3/31 4,100Desc DEP Customer depos it INT Interest earned SC Service chargesNOTE Note collected CHK Customer check NSF Nonsufficient fundsEFT Elec tronic funds transfe r DC Debit card

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ILLUSTRATION 4-6Bank Reconciliat ion

ILLUSTRATION 4-7Bank Statement

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168

ILLUSTRATION 4 8ompany Records o f

Cash Activities

Timing differences

CHAPTER 4 Cash and Internal Con t rols

Let's compgre the bank statement with Starlight's o.wn records of cash activityover the same period, as shown in Illustration 4-8.

STARLIGHT DRIVE-INCash Account RecordsMarch 1, 2010, to March 3 , 2 1

Deposits ChecksDate3/53/223/31

Desc.Sales receiptsSales receiptsSales receipts

BeginningCash BalanceMarch 1, 2 1

$3,800

Amount Date No.$3,600 3/6 2931,980 3/11 2942,200 3/21 2953/24 2963/30 297$7,780Summary of Transactions

Deposits Checks$7,780 $8,700

Desc.SalariesRentUtilitiesInsuranceSupplies

Amount$2,1002,6001,2001,900900$8,700

EndingCash BalanceMarch 3 , 2010

$2,880First Bank's ending balance of cash ($4,100) differs from Starlight's ending bal

ance of cash ($2 ,880). To reconcile these balances, we need to identify 1) timingdifferences created by cash activity reported by either First Bank or Starlight butnot recorded by the other and (2) any errors.

COMMON MISTAKE

Notice that bank statements refer to an increase (or deposit) in the cash bal-ance as a credit and a decrease (or withdrawal) as a debit This terminologyis the opposite of that used in financial accounting, where debit refers to anincrease in cash and credit refers to a decrease in cash. The reason is thatthe financial accounting records are prepared from a company's perspective,while the bank statement is prepared from a bank's perspective. When a com -pany makes a deposit, the bank's liability to the company (a credit account)increases. When a company withdraws cash from its bank account, thebank's liability to the company decreases.

RECONCILING THE BANK S CASH BALANCECash transactions recorded by a company, but not yet recorded by its bank, includedeposits outstanding and checks outstanding. Deposits outstanding are cashreceipts of the company that have not been added to the bank's record of the com-panys balance. Checks outstanding are checks the company has written that havenot been subtracted from the bank's record of the company's balance. Once thebank receives the deposits outstanding , the bank's records will increase. Similarly,once the bank receives the checks outstanding, the bank's records will decrease}Wealso need to check for and correct any bank errors.

Comparing the deposits recorded by Starlight (Illustration 4-8) to those reportedon the bank statement (Illustration 4-7) reveals that the deposit of 2,200 onMarch 31 is not reflected in the bank's balance by the end of March. This is adeposit outstanding.

Comparing the checks written by Starlight to those reported in the bank state-ment shows that the bank received checks 293, 294, and 296 by the end of March.

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CHAPTER 4 Cash and Internal Controls

This means checks 295 (for $1,200) and 297 (for $900) remain outstanding andare not reflected in the bank's balance. The reconciled bank balance is calculated onthe left side of Illustration 4-9.RECONCILING THE COMPANY S CASH BALANCEWhat are some examples of cash transactions recorded by the bank, but not yetrecorded by the company?/ These would include items such as interest earnedby the company, collections made by the bank on the company s behalf, servicecharges, and charges for NSF checks-checks drawn on nonsufficient funds orbad checks from customers\Jn addition, we adjust the company s balance for anycompany errors.

Six cash transactions recorded by First Bank (Illustration 4-7) are not reportedin Starlight's cash records (Illustration 4-8) by the end of March:1 Note collected by First Bank on Starlight's behalf ($3,000), which includesinterest of $200.2 Interest earned by Starlight on its bank account ($20).

169

3 Electronic funds transfer related to the payment of advertising ($400). Timing differences4 NSF check ($750).5 Debit card purchase of office equipment by employee ($200).6 Service charge ($50).

COMMON MISTAKEStudents sometimes mistake an NSF check as a bad check written y thecompany instead of to the company. When an NSF check occurs, the company must adjust its balance of cash downward to reverse the increase incash it recorded at the time it received the check from the customer, becausethe customer did not have enough funds to cover the check.

In addition to the amounts related to timing differences, we need to address oneother reconciling item. Comparing Starlight's record of checks written to those inthe bank statement reveals an error by Starlight. Check 294 for rent was written Company errorfor $2,900, but Starlight's accountant recorded it incorrectly as $2,600. First Bankprocessed the check for the correct amount of $2,900. This means Starlight needsto reduce its cash balance by an additional $300 for rent expense. The reconciledcompany balance is calculated on the right side of Illustration 4-9.

Bank s ash BalanceBefore reconciliatio nDeposits outstanding:

3/31 = $2,200Checks outstanding:

295 = $1,200297 = $ 900

After reconciliation

STARLIGHT DRIVE-INBank Reconciliation

March 31 2010

$4, 100+2,200

- 2,100

$4,200

o ash BalanceBefore reconciliationNote received

Interest earned from noteInterest earned from bankEFT for advertisingNSF checkDebit card for office equip.Service chargeCorrected rent expense error

After reconciliation

$2,880+ 2,800+ 200

20- 400750200

50300

$4,200---------Reconciled---------....l

ILLUSTRATION 4 9Reconciling the BankStatement

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170

ILLUSTRATION 4-10Entries to Adjustthe Company's CashBalance

*

CH PTER 4 Cash and Internal Controls

f the bank ~ e r e aware of all deposits made and all checks written by the company, the bank's balance for cash would be $4,iOO. Similarly, once the companyadjusts its balance for information revealed in the bank statement, its cash balanceis 4,200. The fact that the two balances match provides some indication that cashis not being mishandled by employees.( sa final step in the reconciliation process, the company must updateba)ance of cash for the items used to reconcile the company s cash balanceWe record these entries once the bank reconciliation is complete. Remember, theseare amounts the company didn't know until it received the bank statement.We record items that increase the company's cash with a debit to cash, whereaswe record items that decrease the company's cash with a credit to cash. Illustration4-10 demonstrates the entries needed to adjust Starlight's cash balance for reconciliation items.

March 31 2010 Debit Credit-Cash ................................. ......................................................... . 3,020Notes Receivable . . . . . . . . . . . . . . . . . 2,800Interest Revenue ..... 220Reconcile cash increases) . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Advertising Expense ... .... .... ........ ... ................ ..................... . 400Accounts Receivable .................................................................. . 750Office Equipment ...................................................................... . 200Service Charge Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... 50Rent Expense ............................................................................. . 300

Cash .................................................................................... . 1,700Reconcile cash decreases)

Most of the accounts are easy to understand. We credit notes receivable sincethe note has been received. We recognize interest revenue as earned. Cash outflowsrelated to expenses (advertising, service charge, and rent) and asset purchases needto be recorded. Finally, we debit accounts receivable to show that the customer whopaid with an NSF check still owes the company money.

OMMON MIST KESome students try to prepare adjusting entries for deposits outstanding,checks outstanding, or a bank error. The company does not need to adjustfor these items because they are already properly recorded in the company'saccounting records.

KEY POINTIn a bank reconciliation we adjust the bank s balance for (1) cash transactionsalready recorded by the company but not yet recorded by the bank and(2) bank errors. Similarly, we adjust the company s balance for (1) cashtransactions already recorded by the bank but not yet recorded by thecompany and (2) company errors. After we adjust both the bank balanceand company balance, the two should equal.

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I

CHAPTER 4 Cash and Internal Controls

At the end of April 2010, Showtime Theatre'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 ,900Deposits outstanding 1,600Interest earned 70

Customer's NSF check 1 ,300Service charges 200

In addition, Showtime discovered it correctly pa id for advertising with a check for220 but incorrectly recorded the check in the company s records for 250. Thebank correctly processed the check for 220.RequiredI. Prepare a bank reconciliation for the month of April2010.2. Prepare entries to adjust the balance of cash in the company's records.Solution:I.

SHOWTIME THEATREBank Reconciliation

April 30 2 1Bank s Cash Balance C o m ~ s Cash Balance

Before reconciliat ion 3,700 Before reconcil iat ionDeposits outst and ing + 1,600 Interest earned

Company errorChecks outstanding - 1,900 Service charge

NSF check- After reconciliation 3,400 fte r reconciliation2.

April 30 2010Cash ................................. ...... ............. .. ................... .. ........... ....... ..

Interest Revenue ..................... .................. ..... ...... .............. ..dvertising Expense ......... ... ..................... ........... ......... ..... .. .

(Reconcile cash increases)Service Charge Expense .... .... .. .. ...... .. .................. .. .......... .... .. ..... .. .Accounts Receivable ...... .... ... .. ............ ................. ....... ....... ....... ....

Cash ......... .. .............. ..... ............... ...... .. ....... .. ...... ................... .(Reconcile cash decreases)

Deb it

4,800+ 70+ 30

- 200- 1,300

3,400

Credit100

7030

2001,300

1,500

(In the uncommon event that the two reconciled balances do not equaVthen man-agement investigates the discrepancy to check for wrongdoing or errors by com-pany employees or the bank.( If it cannot resolve the discrepancy, it records thedifference to the cash short and over account) This account \serves as a miscellaneous expense or revenue) depending on whether it has a debit or credit balance.For example, suppose a company is unable to account for 1 00 of cash . In thisevent, the company records the following transaction, increasing miscellaneousexpenses and decreasing cash.

171

Stop and eview

o

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172

L 6Account for petty cash .

CHAPTER 4 Cas h and Internal Controls

Debit CreditCash Short and Over ........ .. ........ .... .... .... ..... ..... ... .. ...... ...... ......... .. 100

Cash ...... ........ .. .......... .. ... ........ .. ... ..... ........... .. .. .............. ......... . 100(Loss of 100 cash)

Petty CashYou probably pa y for most of what you bu y with a check, debit card , or creditcard. However, it's nice to have a little cash in your wallet for emergency or impulseexpenditures. For example, you might decide to buy a box of Girl Scout cookiesfrom your neighbor or soda from a machine. In the same way, most companieslike to keep a small amount of cash on hand at the company's location for minorpurchases such as postage, office supplies, delivery charges , and entertainmentexpenses. f the office manager orders a 10 pizza for a staff meeting, it wouldbe inconvenient and costly to write and process a check for such a small amount.Furthermore, it would be time consuming to run to the bank for a 10 cash withdrawal. To pay for these minor purchases,(companies keep some minor amount ofcash on hand in a petty cash fund.(Management establishes a petty cash fund by writing a check for cashagainst the company s checking account and giving the withdrawn cash to anemployee who becomes responsible for it. The fund should have just enoughcash to make minor expenditures over a reasonable period (such as a week ora month): ; iven appropriate documentation, such as a receipt for the purchaseof office supplies , the employee responsible for the fund will disburse cash toreimburse the purchaser. At any given time , the cash remaining in the fund plusall receipts should equal the amount of the fund. The receipts are important toensure proper use of the funds and for recording expenditures each time thefund is replenished.

Suppose that at the beginning of May, Starlight Drive-In establishes a petty cashfund of 500 to pay for minor purchases. The entry to establish the fund is:

May 1 Deb it Cred itPetty Cash (on hand) .. .......................................................... ...... ... . 500

Cash checking account) ... .... ... .. ................ .. ... .. .. .......... .......... . 500(Establish th p tty cash fund)

Assume Starlight has the following expenditures from the petty cash fund duringMay:Date Expenditure AmountMay 7 Postage 75May 16 Office supp lies 120May 20 Office group lunch 50May 26 Del ivery charges 85330

By the end of May, the petty cash fund has distributed 330, leaving 170 in thefund (along with receipts for 330). No entries are recorded at the time of theseexpenditures. Instead, the firm will replenish the petty cash fund at the end of themonth and record the expenditures for the appropriate amounts at that time asfollows:

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CHAPTER 4 Cash and Internal Controls

May 3 Debit CreditPostage expense .......................................................................... . 75Office supplies .............................................................................. 120Entertainment expense ............ .... .............. .. ......... ... .................... . 50Delivery expense .......................................................................... . 85

Cash checking account) ......................................................... 330Replenish th petty cash fund)

s part of the reimbursement, management will withdraw cash of 330 from thechecking account and give it to the employee responsible for the petty cash fundso the fund's balance will once again be 500. To maintain the control objective ofseparation of duties, the employee responsible for the petty cash fund should not beinvolved in accounting, nor in the process of writing or approving checks.What if only 150 is left in the petty cash fund, when there should be 170? Itcould be that 20 was stolen from the fund, or the fund could be missing a receiptfor 20. If the question is not resolved, the firm will likely charge the 20 to the cashshort and over account.

KEY POINTTo pay for minor purchases, companies keep some cash on hand in a pettycash fund. The petty cash fund is replenished at the end of the period and theexpenditures are recorded.

Reporting CashTo this point, we've considered several internal controls related to cash. Here, wediscuss how companies report cash activities and how this information is useful todecision makers. Cash activities of a business enterprise are the most fundamentalevents upon which investors and lenders base their decisions. Where does a company get its cash? Where does a company usually spend its cash? These are important issues in determining management s efficient use of a company s resources andin predicting future performance.Companies report cash in two ways. As we already discussed in Chapter 3,(cashis reported as an asset in the balance sheet. The amount is typically reported as acurrent asset and represents cash available for spending at the end of the reporting period. The balance sheet provides only the final balance for cash. t does notprovide any details regarding cash receipts and payments during the period. Companies report information about cash receipts and payments during the period ina statement of cash flows. From the statement of cash flows, investors know acompany's cash inflows and cash outflows related to (1) operating activities,2) investing activities, and 3) financing c t i v i t i e s We'll provide a complete discussion of the statement of cash flows in Chapter 11. Here, we briefly introduce thebasics of the statement to help you understand that its purpose is to report activityrelated to the key topic of this chapter-cash.Operating activities include cash transactions involving revenue and expenseevents during the period. In other words, operating activities include the cash effectof the same activities that are reported in the income statement.Investing activities as the name implies, include cash investments in long-termassets and investment securities. When the firm later sells those assets, we considerthose transactions investing activities also. So, investing activities tend to affectlong-term assets.

173

L07Identify the major inflowsand outflows of cash .

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174

ILLUSTR TION 4 11External Transactionsof Woods GolfAcademy

Which transactionsinvolve the exchangeof cash?

Decision Maker sPerspective

CHAPTER 4 Cash and Internal Controls

Financing activities include transactions designed to raise cash or finance thebu siness . There are two ways to do this: borrow cash from lenders or raise cashfrom stockholders. We also consider cash outflows to repay debt and cash dividends to stockholders to be financing activities. So, financing activit ies tend toaffect liabilities and stockholders' equity.It's easiest to understand cash flow information by looking at the underlyingtr ansactions. To do this, we'll refer back to the external transactions of Woods GolAcademy introduced in Chapters 1-3. For convenience, those transactions arerepeated in Illustration 4- 11.

Type of CashTransaction External transactions in January activity involved1) Sell shares of common stock for 25,000 Financing I' to obtain the funds necessary to start theI business.2) orrow 10,000 from the local bank and sign Financing Ia note promising to repay the full amount of

the debt in three years.

l 3) Purchase equipment necessary for giving golf Investing Itraining, 24,000.4) Purchase one year of rent in advance for I6,000 ( 500 per month). Operating5) Purchase suppl ies on account , 2,300 . Operating X6) Provide golf training to customers for cash, Operating I3,600.

(7) Provide golf training to customers on account, Operating X2,500.8) Receive cash in advance for 10 golftraining Operating Isessions to be given in the future, 600.

(9) Pay salaries to employees, 2,800. Operating I1 0) Pay cash dividends of 200 to shareholders. Financing I

Wh ich tr ansactions involve the exchange of cash ? All transactions except (5) and(7) are either the receipt or payment of cash( Only transactions involving cashaffect a company's c sh flows J D \ U L L . ~Illustration 4-1 2 presents the statement of cash flows for Woods Golf Academyusing what's called the tfirect method of repor ting operating activitiek. In Chapter11 we'll discuss the indirect method Corresponding transaction numbers are inparentheses.

From the statement of cash flows, investors an d credi tors can see that the majorsource of cash inflow for Woods is the issuance of common stock, a financing activity. Woods has also received cash from bank borrowing which must be repaid. Thecompany is also investing heavily in its future by pu rchas ing equipment . Woodsreports this amount as an investing outflow.

Net cash flows from operating activities are - 4,600. This means that cash outflowsre lated to operating activities exceed in flows. Stated another way, cash outflowsre lated to expense activities exceed cash inflows re lated to revenue activities. WhileWoods reports net income of 500 in its income statement (see Illustration 3-12 inChapter 3), these same activities are not able to generate positive cash flows for thecompany. Ultimately companies must be able to generate positive operating cashflows to maintain long-term success.

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CHAPTER 4 Cash and Internal Controls

WOODS GOLF ACADEMYStatement of Cash Flows

For the month ended January 3Cash Flows from Operating ctivities

ash inflows:From customers 6 and 8)ash outflows:For salaries 9)For rent 4)

Net cash flows from operating activitiesCash Flows from Investing ctivities

Purchase equipment 3)Net cash flows from investing activities

4,200(2,800)(6,000)

(24,000)

( 4,600)

(24,000)Cash Flows from Financing ctivities

Issue common stock 1)Borrow from bank 2)Pay dividends 1 0)

Net cash flows from financing activitiesNet increase in cashCash at the beginning of the monthCash at the end of the month

25,00010,000

___j.?QQ)34,8006,200.o.6,200

The final amount reported in the statement of cash flows, 6,200, is the sameamount of cash reported in the balance sheet. You can verify this is the case forWoods Golf Academy by referring back to the balance sheet reported in Illustration3 14 in Chapter 3.

Question,-How much cash is thecompany generating frominternal versus externalsources?

KEY POINT

ccounting InformationEEl

Statement of cash flows

nalysis'bCash flows generated frominternal sources includeoperating and investingactivities. Cash flowsgenerated from externalsources generally includetransactions between thecompany and its lenders andstockholders.

The statement of cash flows reports all cash activities for the period. Operat-in activities include those transactions involving revenue and expense activities. Investing activities include cash investments in long term assets andinvestment securities. inancing activities include transactions designed tofinance the business through borrowing and owner investment.

175

ILLUSTRATION 4 12Statement of CashFlows for Woods Golf

cademy

}Numbers in parenthesesin the left-hand column)correspond to theexternal transactions ofWoods Golf Academy inIllustration 4-11 .

Only transactions thatinvolve the exchange ofcash are included in thestatement of cash flows.

Decision Point

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76 CH PTER 4 Cash and Intern al Controls

QUICK QUIZInd icate whether a company reports each of the following transactions as an operating,investing, or f inancing cash flow in the statement of cash flows .Transaction Type of Cash Flow1. Pay employees wages.2. bta in a loan at the bank.3. Pu rchase a build ing w ith cash .4. Purchase equipment with a note payable.Solutions1 Operating; 2 Financing; 3. Investi ng; 4 Not reported on the statement o f cash flows because no cash isinvolved in the transaction.

COMPARING NET INCOME TO CASH FLOWSThe difference between revenues and expenses-net income-provides an accrualbasis measure of the company's ability to create wealth for its stockholders. Ingeneral, the greater a company's net income, the greater will be the value of thecompany to stockholders. However, the timing of revenues and expenses recordedunder accrual-basis accounting may differ from the timing of operating cash flowsWe discussed an example of this above by comparing the net income of WoodsGolf Academy ( 500) to its net cash flows from operations (- 4,600). f you wereconsidering an investment in Woods Golf Academy, would you consider net incomeof 500 to be a reliable indicator of the profit-generating potential of the company, given that it has net cash flows from operating activities of - 4,600? In someinstances , net income may not provide a good indicator of future perform ance . Werefer to th ability of net income to report the true underlying performance of thecompany as eamings quality

One of the more common techniques used by investors for measuring earningsquality relies on (comparing the trend in a company's reported net income to frcash flows ) A simple way to calculate a company's free cash flows is hs operatingcash flows plus investing cash flows during the periodi. This measure representsfhe cash that is fr to distribute to stockholders and repay debt) Companies whose

ee cash flows are declining relative to the trend in net income are likely to havelower-quality earnings .Let's look at an example. In 1937 Vernon Rudolph bought a secret doughnut recipe from a French chef in New Orleans, rented a building in Winston-Salem, NorthCarolina, and began selling doughnuts. Since then, Krispy Kreme has grown intoa leading branded specialty retailer across the country, producing over a billiondoughnuts a year. To illustrate the preference of not re lying on a single measurelike net income in isolation, we compare Krispy Kreme below with StarbucksorporationAs the charts below show, both Krispy K.reme and Starbucks enjoyed explosiveincreases in net income over the 1999-2004 period. However, their{free cash flows

(or strict cash-basis net incomes) tell a very different story. Notice that KrispyKreme's free cash is falling over this period, while Starbucks' is increasing. Thisindicates that Starbucks' net income is backed by cash, whereas Krispy Kreme 's isnot. The pattern should raise concerns about the long-term profit-generating ability of Krispy Kreme. In 2005, Krispy Kreme 's growth in net income could no longerbe sustained and decreased dramatically. In comparison, Starbucks' upward trendin net income showed no signs of slowing. Thus, we see from these two companiesthat income that is backed by cash is more likely to persist into the future thanis net income not backed by cashJ

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$100$50

$0- 50

- 100- 150- 200- 250

_

1999

CHAPTER 4 Cash and Internal Controls

Krispy Kreme {in millions

\ /2 2 o o ; w o 3 2004v 2005

I \ \ \.[ Net Income Free Cash Flows I

Starbucks {in millions800,------------------------------------------------.

6 0 0 + - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ~4 0 0 + - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ~

$200 - - - - - - : : ; ; ; ; ; t e ~ : : : : : : : : ~ : _ _ - ~ - - - ~0 + - - - - . - ~ - - - - - - - - - - - - . - - - - - . - - - ~

19.9J 2001 2002 2003 2004 2005- 2 0 0 ~ - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ~[ Net come Free Cash Flows I

It's also interesting to see what happened to the companies' stock prices over thisperiod.

Stock Price5 0 , - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ~

4 0 + - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ~3 0 + - - - - - - - - - - - - - - - - - - - - - - - ~ - - - - ~

2 0 + - - - - - - - L - - - - - - - - - - - - - - - - - ~ - - - - - - - - - - - - - - - - ~1 o I f.:..oo-.= . .......... ......._ _.............. ~ , . . ,

0 + - - - - - . - - - - . - - - - ~ - - - - ~ - - - - . - - - - - ~ - - - - . - - - ~2000 2001 2002 2003 2004 2005 2006

[ Starbucks l Krispy Kreme

Notice that along with Krispy Kreme's explosive growth in net income came anexplosive growth in stock price. f you had purchased $1,000 of Krispy Kreme'sstock during its initial offering on April 5, 2000, your investment would havegrown to about $4,400 by the end of 2001. That's over four times your initialinvestment in just 21 months. However, investors did not appear to have understood the low quality of Krispy Kreme's net income. As late as 2003, investors supported a high stock price for the company in the face of declining freecash flows. ortune magazine called Krispy Kreme the hottest brand in theland. However, starting in 2004, the downward spiral began. Finally in 2004and 2005, investors recognized the failing operations of Krispy Kreme and thestock price plummeted, falling more than 90% from its all-time high. In sharpcontrast, Starbucks' stock price continued to rise with its net income and freecash flows.

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Decision Point

Comparing free cashflows with net incomecan help in measuringthe quality of earnings.

CH PTER 4 Cash and Internal Controls

Question,-How are free cash flowshelpful for predicting acompany s net income?

KEY POINT

ccounting Information

Net income from theincome statement andfree cash flows operatingand investing) from thestatement of cash flows

nalysisbWhen free cash flows andnet income have similartrends, net income is morelikely to continue that trendin the future.

Companies whose free cash flows are decreasing relative to their net income arelikely to have lower earnings quality than are other companies, all else being equal.

CAREER CORNERProfessional financial analysts offer investment advice to their clients-banks,insurance companies, mutual funds, securities firms, and individual investors,to name a few. This advice usually comes in the form of a formal recommendation 1 = strong bu y, 2 = buy, 3 = hold; 4 = sell, 5 = strong sell). Before giving an opinion about a stock, analysts develop a detailed understanding of acompany s operations through discussions with management, analysis of competitors, and projections of industry trends. Analysts also develop a detailedunderstanding of a company s financial statements, including its earnings quality. Analysts typically do not recommend companies with lower-quality earnings. Understanding a company s earnings quality comes from having a goodgrasp of accrual-basis accounting. This is why many finance majors and MBAstudents, pursuing a career as a financial analyst, take additional accountingrelated courses when earning their degree and even after graduation. Financialanalysts stock recommendations are available on most financial websites.

KEY POINTS BY LEARNING OBJECTIVEL 1 Understand the impact of accounting scandals and the passage of theSarbanes-Oxley Act.

The accounting scandals in the early 2000s prompted passage of the SarbanesOxley Act SOX). Among other things, SOX sets forth a variety of newguidelines related to auditor-client relations and additional internal controls.

L 2 Identify the components, responsibilities, and limitations of internal control.Internal control refers to a company s plan to improve the accuracyand reliability of accounting information and safeguard the company sassets. Five key components to an internal control system are 1) controlenvironment, 2) risk assessment, 3) control activities, 4) information andcommunication, and 5) monitoring.

L 3 Define cash and cash equivalents.Cash includes not only currency, coins, balances in checking accounts,and checks and money orders received from customers, but also cashequivalents, defined as investments that mature within three months (suchas money market funds, treasury bills, and certificates of deposit).

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CHAPTER 4 Cash and Int ernal Co ntrols

L04 Understand controls ruter cash receipts and cash disbursements :Because cash is the most liquid asset of a company, controls over cashreceipts and cash disbursements are an important part of a company'soverall internal control system.

OS Reconcile a bank statementIn a bank reconciliation we adjust the bank s balance for 1) cashtransactions already recorded by the company but not yet recorded by thebank and (2) bank errors . Similarly, we adjust the company s balance for1) cash transactions already recorded by the bank but not yet recorded by

the company and (2) company errors. After we adjust both the bank balanceand company balance, the two should equal.L06 Account for petty cash.

To pay for minor purchases, companies keep some cash on hand in a pettycash fund. The petty cash fund is replenished at the end of the period andthe expenditures are recorded.

L07 Identify the major inflows and outflows of cash.The statement of cash flows reports all cash activities for the period.Operating activities include those transactions and events involving revenuesand expenses. Investing activities include cash investments in long-termassets and investment securities. Financing activities include transactionsdesigned to finance the business through borrowing and owner investment.

Companies whose free cash flows are decreasing relative to their netincome are likely to have lower earnings quality than are other companies,all else being equal.

GLOSS RYBank reconciliation: Matching the balance of cash in the bank account with thebalance of cash in the company s own records. p . 166Cash: Currency, coins, balances in savings and checking accounts, itemsacceptable for deposit in these accounts, such as checks received from customers,and cash equivalent s. p . 162Cash equivalents: Short-term investments that have a maturity date no longerthan three months from the date of purchase. p. 163Checks outstanding: Checks the company has written that have not beensubtracted from the bank's record of the company s balance. p . 168Collusion: Two or more people acting in coordination to circumvent internalcontrols. p. 162Deposits outstanding: Cash receipts of the company that have not been added tothe bank's record of the company s balance. p . 168Earnings quality: The ability of net income to report the true underlyingperformance of the company. p . 176Internal control: A company s plan to 1) improve the accuracy and reliabilityof accounting information and (2) safeguard the company s assets. p. 159NSF checks: Checks drawn on nonsufficient funds or bad checks fromcustomers. p . 169

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