978-0078025549 Chapter 4 Lecture Note

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 LO4-3 Define cash and cash equivalents.

 LO4-4 Understand controls over cash receipts and cash disbursements.

 LO4-5 Reconcile a bank statement.

 LO4-6 Account for petty cash.

 LO4-7 Identify the major inflows and outflows of cash.

Analysis

 LO4-8 Assess earnings quality by comparing net income and cash flows.

Teaching Suggestions

Part A of the chapter begins with a discussion of occupational fraud and accounting scandals. In some

instances, managers have acted unethically in reporting their companies’ performance. Most students are

surprised by the fact that published financial statements contain fraudulent amounts. This discussion

flows into the need for regulation, such as the Sarbanes-Oxley Act, and internal controls as outlined by

the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. The components of

an internal control system are discussed within the context of a movie theatre, a business familiar to all

students.

The discussion of general internal controls in Part A then moves to a discussion of cash controls in

Part B. One reason for the focus on cash is that cash is the most liquid of a company’s assets and therefore

may be the easiest to lose internal control over. Discussion of cash receipts and cash disbursements are

provided, including checks, debit cards, and credit cards. An illustrated example of a bank reconciliation

is also provided. Since most students are familiar with cash, the different forms of cash payments, and

bank statements, relating internal controls to cash topics makes the purpose and operation of internal

controls more apparent.

Given the focus on internal controls related to cash, Part B ends with a discussion of how cash is

reported to those outside the company. It is briefly mentioned that cash is reported as an asset in the

balance sheet, but the discussion primarily focuses on reporting cash in the statement of cash flows. The

statement of cash flows presented is that of Eagle Golf Academy discussed in Chapters 1-3. [Note: The

detailed discussion of the statement of cash flows is saved for Chapter 11. Here, the statement is

introduced briefly.] A good way to explain amounts reported in the statement of cash flows is to refer

students back to the original ten external transactions of Eagle Golf Academy introduced in Chapter 2.

Which of the ten transactions involved cash? These are the ones reported in the statement of cash flows.

Since adjusting entries never involve cash, the adjusting entries discussed in Chapter 3 do not affect

amounts reported in the statement of cash flows.

The final section of the chapter involves an analysis of earnings quality, comparing Krispy Kreme and

Starbucks. Students should be familiar with these two companies. The analysis emphasizes the

importance of earnings by looking at its trend relative to that of free cash flows (operating cash flows plus

investing cash flows). When these two amounts trend in the same direction, then the current earnings

trend is more likely to continue.

Assignment Charts

Questions

Learning

Objective(s) Topic

Time

(Min.)

1 LO4-1 Define occupational fraud 5

2 LO4-1 Explain internal control 5

3 LO4-1 Discuss what managerial stewardship means 5

4 LO4-1 Understand managers motivation to manipulate 5

5 LO4-1 Explain the fraud triangle 5

6 LO4-1 Outline the major provisions of the Sarbanes-Oxley Act 5

7 LO4-2 Describe the components of internal control 5

8 LO4-2 Describe the difference between preventive controls and

detective controls

9 LO4-2 Explain separate of duties 5

10 LO4-2 Identify responsibility for internal control 5

11 LO4-2 Recognize limitations of internal control 5

12 LO4-2 Define collusion 5

13 LO4-2 Describe likelihood of fraud by top-level employees 5

14 LO4-3 Define cash and cash equivalents 5

15 LO4-3 Describe how to record a purchase with a check 5

16 LO4-4 Discuss controls for cash receipts 5

17 LO4-4 Describe how credit card sales are reported 5

18 LO4-4 Describe how debit card sales are reported 5

19 LO4-4 Discuss controls for cash disbursements 5

20 LO4-4 Understand a credit card 5

21 LO4-5 Identify the purpose of a bank reconciliation 5

22 LO4-5 Explain differences between the company’s and bank’s

cash balance

23 LO4-5 Describe timing differences in the cash balance 5

24 LO4-5 Make adjustments related to the bank reconciliation 5

25 LO4-6 Explain a petty cash fund

26 LO4-6 Describe managerial control over the petty cash fund

27 LO4-7 Explain the relation between the balance sheet and

statement of cash flows

28 LO4-7 Describe operating, investing, and financing cash flows

29 LO4-8 Recognize how to determine quality of earnings

30 LO4-8 Compute quality of earnings

Brief Exercises

Learning

Objective(s) Topic

Time

(Min.)

BE4-1 LO4-1 Identify terms associated with the Sarbanes-Oxley Act 5

BE4-2 LO4-2 Identify terms associated with components of internal

control

BE4-3 LO4-2 Define control activities associated with internal control 5

BE4-4 LO4-3 Identify cash and cash equivalents 5

BE4-5 LO4-4 Determine cash sales 5

BE4-6 LO4-4 Record cash expenditures 5

BE4-7 LO4-5 Identify terms associated with a bank reconciliation 5

BE4-8 LO4-5 Prepare a bank reconciliation 10

BE4-9 LO4-5 Reconcile timing differences in the bank’s balance 5

BE4-10 LO4-5 Reconcile timing differences in the company’s balance 5

BE4-11 LO4-5 Record adjustments to the company’s cash balance 5

BE4-12 LO4-5 Prepare a bank reconciliation 5

BE4-13 LO4-6 Record petty cash expenditures 5

BE4-14 LO4-7 Match types of cash flows with their definition 5

BE4-15 LO4-7 Determine operating cash flows 5

BE4-16 LO4-7 Determine investing cash flows 5

BE4-17 LO4-7 Determine financing cash flows 5

BE4-18 LO4-8 Calculate free cash flow 5

Exercises

Learning

Objective(s) Topic

Time

(Min.)

E4-1 LO4-1 Answer true-or-false questions about occupational fraud 15

E4-2 LO4-1 Answer true-or-false questions about the Sarbanes-Oxley

Act

E4-3 LO4-2 Answer true-or-false questions about internal controls 15

E4-4 LO4-2 Determine control activity violations 15

E4-5 LO4-3 Calculate the amount of cash to report 15

E4-6 LO4-4 Discuss internal control procedures related to cash

receipts

E4-7 LO4-4 Discuss internal control procedures related to cash

disbursements

E4-8 LO4-4 Discuss internal control procedures related to cash 10

E4-9 LO4-5 Calculate the balance of cash using a bank reconciliation 10

E4-10 LO4-5 Calculate the balance of cash using a bank reconciliation 10

E4-11 LO4-5 Calculate the balance of cash using a bank reconciliation 10

E4-12 LO4-6 Record transactions for the petty cash fund 10

E4-13 LO4-6 Record transactions for the petty cash fund 10

E4-14 LO4-7 Classify cash flows 10

E4-15 LO4-7 Calculate net cash flows 10

E4-16 LO4-7 Calculate operating cash flows 10

E4-17 LO4-7 Calculate investing cash flows 10

E4-18 LO4-7 Calculate financing cash flows 10

E4-19 LO4-7 Compare operating cash flows to net income 15

E4-20 LO4-8 Determine earnings quality 15

Problems

Learning

Objective(s) Topic

Time

(Min.)

P4-1A LO4-4 Discuss control procedures for cash receipts 15

P4-2A LO4-5 Prepare the bank reconciliation and record cash

adjustments

P4-3A LO4-5 Prepare the bank reconciliation and record cash

adjustments

P4-4A LO4-7 Prepare the statement of cash flows 15

P4-5A LO4-7 Record transactions, post to the cash T-account, and

Prepare the statement of cash flows

P4-1B LO4-4,4-5 Prepare a bank reconciliation and discuss cash

procedures

P4-2B LO4-5 Prepare the bank reconciliation and record cash

adjustments

P4-3B LO4-5 Prepare the bank reconciliation and record cash

adjustments

P4-4B LO4-7 Prepare the statement of cash flows 15

P4-5B LO4-7 Record transactions, post to the cash T-account, and

prepare the statement of cash flows

Additional

Perspectives Topic

Time

(Min.)

AP4-1 Continuing Problem: Great Adventures 45

AP4-2 Financial Analysis: American Eagle Outfitters, Inc. 40

AP4-3 Financial Analysis: The Buckle, Inc. 40

AP4-4 Comparative Analysis: American Eagle Outfitters Inc., vs. The Buckle,

Inc.

AP4-5 Ethics 20

AP4-6 Internet Research 30

AP4-7 Written Communication 25

Chapter Quiz Questions

The following multiple-choice questions are 10 unique quiz questions that correspond to the 10 questions

at the end of each chapter. Each question covers the same learning objective but with a little different

twist. The correct answer is highlighted in bold for each item.

LO4-1

1. Managers should act:

a. As creditors of the company.

b. As owners of the company.

c. As stewards of the company’s assets.

d. In their own best interest.

LO4-1

2. Sarbanes-Oxley Act (SOX) was passed in response to:

a. Increasing inflation.

b. Corporate scandals involving unethical behavior of top executives.

c. Increasing pressure of foreign competition for American products and services.

d. The establishment of the Securities and Exchange Commission (SEC).

LO4-2

3. What is a direct purpose of internal controls?

a. Improve the accuracy and reliability of accounting information.

b. Help managers determine which projects are likely to be more profitable.

c. Assist top executives in planning employment capacity.

d. Minimize tax payments to the Internal Revenue Service (IRS).

LO4-3

4. Which of the following is considered cash for financial reporting purposes?

a. Inventory that is likely to be sold within three months.

b. Amounts to be collected from customers.

c. Amounts owed to suppliers.

d. Balances in savings accounts.

LO4-4

5. Which of the following generally would be considered a good internal control over cash payments?

a. Employees responsible for making cash disbursements should also be in charge of cash receipts.

b. Ensure checks are serially numbered and signed only by authorized employees.

c. The employee who authorizes payment should also be the employee who prepares the check.

d. Require only one signature for larger checks.

LO4-5

6. When preparing a bank reconciliation, nonsufficient funds (NSF) checks would be:

a. Added to the company’s cash balance.

b. Added to the bank’s cash balance.

c. Subtracted from the company’s cash balance.

d. Subtracted from the bank’s cash balance.

LO4-5

7. When preparing a bank reconciliation, outstanding checks would be:

a. Added to the company’s cash balance.

b. Added to the bank’s cash balance.

c. Subtracted from the company’s cash balance.

d. Subtracted from the bank’s cash balance.

LO4-6

8. At any given time, the amount of cash in the petty cash fund should equal:

a. All vouchers written during the accounting period.

b. The established balance of the fund less all vouchers written during the accounting period.

c. The amount of cash withdrawn from the fund during the accounting period.

d. The amount of cash used to establish the fund.

LO4-7

9. Operating cash flows would include which of the following?

a. Payment for prepaid insurance.

b. Receipt of cash from selling a building.

c. Payment of dividends to stockholders.

d. Receipt of cash from bank borrowing.

LO4-7

10. Financing cash flows would include which of the following?

a. Payment of salaries to employees.

b. Sale of services to customers for cash.

c. Repayment of long-term borrowing to the bank.

d. Purchase of equipment for cash for company operations.

Alternate Let’s Review

Problem #1

At the end of April, Classic Cinema’s accounting records show a cash balance of $5,240. The April bank

statement reports a cash balance of $6,700. The following information is gathered from the bank

statement and company records:

Checks outstanding $3,200 Customer’s NSF check $1,100

Deposits outstanding 800 Service fees 100

Interest earned 80

In addition, Classic discovered it correctly paid for utilities with a check for $350 but incorrectly recorded

the check in the company’s records for $530. The bank correctly processed the check for $350.

Required:

1. Prepare a bank reconciliation for the month of April.

2. Adjust the balance of cash in the company’s records.

Solution:

Classic Cinema

Bank Reconciliation

April 30

Bank’s Cash Balance Company’s Cash Balance

Per bank statement $ 6,700 Per general ledger $ 5,240

Deposits outstanding + 800 Interest earned + 80

Company error + 180

Checks outstanding − 3,200 Service charge − 100

NSF check − 1,100

Bank balance per

reconciliation $ 4,300

Company balance per

reconciliation $ 4,300

April 30 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260

Interest Revenue . . . . . . . . . . . . . . . . 80

Utilities Expense . . . . . . . . . . . . . . . . 180

(Record interest earned and check correction)

Service Fees Expense . . . . . . . . . . . . . . . . . . . . 100

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . 1,100

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

(Record NSF check and bank service fee)

Alternate Let’s Review

Problem #2

A company reports in its current year each of the transactions listed below.

Required:

Indicate whether each transaction should be reported as an operating, investing, or financing cash flow in

the company’s statement of cash flows, and whether each is a cash inflow or outflow.

Transaction Type of Cash Flow Inflow or Outflow

1. Issue common stock for cash.

2. Receive cash from customers.

3. Sell equipment for cash.

4. Pay cash for advertising.

Solution:

1. Financing—inflow. 2. Operating—inflow. 3. Investing—inflow.

4. Operating—outflow.

Key Points by Learning Objective

LO4-1 Discuss the impact of accounting scandals and the passage of the Sarbanes-Oxley Act.

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 company’s internal controls.

LO4-2 Identify the components, responsibilities, and limitations of internal control.

Internal control refers to a company’s plan to improve the accuracy and reliability of accounting

information and safeguard the company’s assets. Five key components to an internal control system are

(1) control environment, (2) risk assessment, (3) control activities, (4) monitoring, and (5) information

and communication. Control activities include those designed to prevent or detect fraudulent or erroneous

behavior.

LO4-3 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 cash equivalents, defined as investments that mature within three

months from the date of purchase (such as money market funds, Treasury bills, and certificates of

deposit).

LO4-4 Understand controls over cash receipts and cash disbursements.

Because cash is the asset of a company most susceptible to employee fraud, controls over cash receipts

and cash disbursements are an important part of a company’s overall internal control system. Important

controls over cash receipts include segregation of duties for those who handle cash and independent

verification of cash receipts. Important controls over cash disbursements include payment by check, credit

card, or debit card, segregation of duties, and various authorization and documentation procedures.

LO4-5 Reconcile a bank statement.

In a bank reconciliation we calculate the bank’s balance for (1) cash transactions already recorded by the

company but not yet recorded by the bank and (2) bank errors. Similarly, we calculate the company’s

balance for (1) cash transactions already recorded by the bank but not yet recorded by the company and

(2) company errors. After we complete the calculations, the amounts for the bank balance and the

company balance should be equal. Any adjustments to the company’s balance need to be recorded.

LO4-6 Account for petty cash.

To pay for minor purchases, companies keep some cash on hand in a petty cash fund. At the end of the

period, expenditures from the petty cash fund are recorded, and the fund is replenished.

LO4-7 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 revenues and expenses. Investing activities include cash investments in

long-term assets and investment securities. Financing activities include transactions designed to finance

the business through borrowing and owner investment.

Analysis

LO4-8 Assess earnings quality by comparing net income and cash flows.

Companies whose free cash flow is decreasing relative to net income are likely to have lower earnings

quality than are other companies, all else being equal.

Common Mistakes

Common Mistake

The term debit card can cause some confusion for someone in the first accounting

course. Throughout this course, we refer to an increase in cash as a debit to cash.

However, using your debit card will result in a decrease in your cash account. It’s the

merchant’s cash account, not yours, that increases and is debited. Don’t let this

confuse you.

Common Mistake

Notice that bank statements refer to an increase (or deposit) in the cash balance as a

credit and a decrease (or withdrawal) as a debit. This terminology is the opposite of

that used in financial accounting, where debit refers to an increase in cash and credit

refers to a decrease in cash. The reason for the difference in terminology is a

difference in perspective: When a 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. Similarly, a withdrawal of cash from the bank is

viewed by the company as a decrease to its Cash account, so it is recorded with a

credit, but the bank views this withdrawal as a decrease to the amount owed to the

company, so it debits its liability.

Common Mistake

Students sometimes 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 customer’s check but the customer did not have enough funds to cover

the check. The company must adjust its balance of cash downward to reverse the

increase in cash it recorded at the time of deposit. The effect of this bounced

customer check creates an account receivable for the company until the customer

honors the funds it owes.

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 bank’s balance because they are already properly recorded

in the company’s accounting records.

Decision Points

Question Accounting Information Analysis & Decision

Does the company

maintain adequate

internal controls?

Management’s discussion,

auditor’s opinion

If management or the auditor

notes any deficiencies in internal

controls, financial accounting

information may be unreliable.

Question Accounting Information Analysis & Decision

Should the

company allow its

customers to pay

by using credit

cards?

Credit sales, service fee

expense, internal controls

When the benefits of credit card

use (increased sales, reduced

handling of cash by employees)

exceed the costs (service fee

expense and credit card fraud),

the company benefits.

Question Accounting Information Analysis & Decision

Is the company

able to generate

enough cash from

internal sources to

sustain daily

operations?

Statement of cash flows Cash flows generated from

internal sources include operating

and investing activities. For

established companies, the sum of

these amounts should be positive.

Otherwise, the company will need

to rely on external funding

(lenders and stockholders), which

is not sustainable in the long term.

Question Accounting Information Analysis & Decision

How does free cash

flow predict a

company’s net

income?

Net income from the

income statement and free

cash flow (operating

and investing) from the

statement of cash flows

When free cash flow and net

income have similar trends, net

income is more likely to continue

that trend in the future.

Career Corner

Financial analysts offer investment advice to their clients—banks, insurance

companies, mutual funds, securities firms, and individual investors. This advice

usually comes in the form of a formal recommendation (buy, hold, or sell). Before

giving an opinion, analysts develop a detailed understanding of a company’s

operations through discussions with management, analysis of competitors, and

projections of industry trends. They also develop a detailed understanding 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 good

grasp of accrual-basis accounting. This is why many finance majors and MBA

students, pursuing careers as financial analysts, take additional accounting-related

courses when earning their degrees and even after graduation.

Ethical Dilemma

Suppose that shortly after finishing this course, you were sent to prison for a crime

you did not commit. While in prison, the warden learns that you have taken financial

accounting and are really good at “keeping the books.” In fact, you are so good at

accounting that you offer to teach other inmates basic financial skills that they’ll use

someday after being released. You find that teaching others these skills is quite

rewarding.

However, the warden has a sinister plan and asks for your help. He plans to

use his position of authority at the prison to steal money. He first uses prisoners as

low-cost labor to do projects around town. Because other legitimate companies

cannot compete with these low costs, they bribe the warden not to bid on jobs. The

warden asks you to use your accounting skills to participate in a financial scam by

falsifying documents and creating a false set of accounting records that will allow the

warden’s bribes to go undetected by state prison authorities. In other words, he wants

you to “cook the books.”

When you object to helping with this scam, the warden threatens to end your

tutoring sessions with other inmates and sentence you to solitary confinement. To

further sway your decision, he promises that if you’ll help, he’ll make your prison

life easy by giving you special meals and other favors.

What would you do in this situation? If you help the warden steal money,

you benefit personally and the other prisoners benefit by your continued tutoring

sessions. However, the warden often physically abuses the other prisoners, and

helping him steal money means that he’ll remain in his position for a long time,

continuing his abusive behavior.

Key issues

Benefitting personally vs. seeing others abused

Option 1: Continue to falsify the accounting records

You need to take care of yourself in prison. Prison life has a different set of rules.

You are not the one actually taking the bribes. You are merely following orders.

You are not the one abusing other inmates.

If you continue falsifying documents, you can continue to teach other inmates valuable financial

skills that will one day be essential when they are released from prison. This serves a greater

purpose.

Option 2: Discontinue falsifying the accounting records

By falsifying documents, you are just as guilty as the person (warden) stealing the money.

If the state authorities discover this scheme, you could receive additional jail time.

You are directly involved in helping the warden to force bribes from local companies. This

directly affects the finances of those companies (and their families).

By assisting the warden, you are directly linked to his abusive behavior of other inmates. While

you are not committing the physical abuse, you are helping to provide a setting where it can

continue.