Chapter 04

Chapter
4
Cash and
Internal Control
“Cash” recorded in Balance Sheet often
includes
Cash
AND
Cash equivalents
2
Cash
 What is cash?
 The asset readily available to pay debts
 Examples:
 Currency and coins
 Balances in savings and checking accounts, as

well as items acceptable for deposit in these
accounts
 E.g. checks received from customers.
LO1
Cash Equivalents
 Short-term investments
 Readily convertible to cash
 With a maturity date no
longer than three months
from the date of purchase
Examples:
 Certificates of deposit
 U.S. Treasury bills with maturity of
three months or shorter
 Money market funds
Understand Controls over Cash
Receipts and Cash Disbursements
Cash Controls:
_ management must safeguard all assets against
possible misuse. Again, because cash is especially
susceptible to theft, internal control of cash is a key
issue.
Cash Receipts:
_ most businesses receive payment from the sale of
products and services either in the form of cash or as
a check received immediately or through the mail.
6
Cash Management
 Necessary to ensure company
has neither too little nor too
much cash on hand
 Tools
• Cash flows statement
• Bank reconciliations
• Petty cash funds
LO2
Reconcile a Bank
Statement
 A bank reconciliation matches 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.
 Differences in these balances occur because of either
timing differences or errors.
 It is the possibility of these errors, or even outright
fraudulent activities, that make the bank reconciliation
a useful cash control tool.
8
Bank Reconciliation
Bank’s (cash) balance before adjustment: Firm’s book (cash) balance before adjustment:
+ Deposits in transit + Interest earned on bank account

+ Customer notes collected
- Checks outstanding + Interest earned on notes
- NSF checks from customer
+/-Bank’s error - Service charges
+/- Firm’s error in book
Adjusted bank balance
Adjusted book balance
Bank Reconciliation – Step 1
Trace deposits listed on the bank statement
to the books. Identify the deposits in transit.
Add to the bank balance.
Deposits in transit:
Recent deposits not yet
reflected on bank
statement
Example of Reconciliation
Bank Statement Adjustments: Deposits
Bank’s cash balance

before adjustment, June 30 $3,308.59
Add: Deposit in transit 642.30
Trace checks cleared by the bank to the
books. Identify outstanding checks. Subtract
from the bank balance.
Outstanding checks:
Checks written but not yet
cleared by bank
Bank Statement Adjustments: Checks and Deposits
Outstanding
Bank’s cash balance
before adjustment, June 30 $3,308.59
Add: Deposit in transit 642.30
Deduct: Outstanding checks:

No. 496 $ 79.89
No. 501 213.20
No. 502 424.75 (717.84)
List all other additions (credit memoranda)
shown on the bank statement. Add to the
book balance.
Credit memoranda:
Interest earned,
customer notes collected,
etc.
Cash Account Adjustments: Credit Memoranda
Balance per books, June 30 $2,895.82
Add: Customer note collected $500.00
Interest on customer note 50.00
Interest earned during June 15.45 565.45
List all other subtractions (debit memoranda)
shown on the bank statement. Subtract from
the book balance.
Debit memoranda:
NSF checks, service charges, etc.
Cash Account Adjustments: Debit Memoranda
Book cash balance before adjustment, June 30
$2,895.82
Interest earned during June 15.45 565.45
Deduct: NSF check $245.72

Collection fee on note 16.50
Service charge for lockbox 20.00 (282.22)
Identify errors made by

the bank or the company
in recording the
transactions during the
period.
Human error:
recorded as
$471.25 at book
Cash Account Adjustments: Debit Memoranda
Book cash balance before adjustment, June 30
$2,895.82
Interest earned during June 15.45
Error in recording check 498 54.00 619.45
Deduct: NSF check $245.72

Collection fee on note 16.50
Service charge for lockbox 20.00 (282.22)
Use the information collected in steps 1 through 5 to prepare the
bank reconciliation.
Bank Reconciliation
Balance per bank $$$ Adjusted

: balances
Adjusted balance $$$ for book
and bank
Balance per books $$$ must
: agree
Adjusted balance $$$
Bank Reconciliation Adjusting
Entries
Bank Reconciliation
Balance per bank $$$

: Book
Adjusted balance $$$ adjustments
are the basis
Balance per books $$$ for
: adjusting
Adjusted balance $$$ entries
Bank Reconciliation Adjusting
Entries
Accounts Receivable 245.72
Collection Fee Expense 16.50
Rent Expense—Lockbox 20.00
Cash 337.23
Notes Receivable 500.00
Interest Revenue 65.45
Supplies 54.00
To record bank reconciliation adjustments.
Account for Petty Cash
 Companies like to keep a small amount of cash on
hand at the company’s location for minor purchases
such as postage, office supplies, delivery charges, and
entertainment expense
 To pay for these minor purchases, companies keep
some minor amount of cash on hand in a petty cash
fund.
 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. This employee is often
referred to as the petty‐cash custodian.
29
Identify the Major Inflows
and Outflows of Cash
Companies report cash in two ways.

• First, it is reported as an asset in the balance sheet under
current assets and represents cash available for spending at
the end of the reporting period. It provides only the final
balance for cash.
• Secondly, reports information about cash receipts and
payments during the period in a statement of cash flows.
• From the statement of cash flows, investors know a
company’s cash inflows and cash outflows related operating,
investing and financing activities.
30
External Transactions of Eagle Golf Academy
Assess earnings quality by comparing net
income and cash flows
Earnings quality is the ability of current net
income to help us predict the future
performance of a company.
_ When net income does not provide a good
indicator of future performance, the lower its
earnings quality is said to be.
_ Comparing the trend in a company’s reported
net income to its trend in free cash flow, also
provides earnings quality of a company.
_ Companies whose free cash flow is declining
relative to the trend in net income are likely to
have lower-quality earnings.
32
Comparing Net Income to Free Cash
Flows
Net income Free Cash Flows
Income Statement of
Statement Cash Flows
Operating Investing
Revenue − Expenses Cash Flow + Cash Flow
33
Comparison of Net Income and Free Cash
Flows of Krispy Kreme and Starbucks
34
Internal Control System
 Consists of the policies and
procedures necessary to
ensure:
• The safeguarding of an
entity’s assets
• The reliability of its
accounting records
• The accomplishment of
its overall objectives
LO3
Limitations of Internal Control
o Internal control systems will more likely detect operating
and reporting errors.
o No internal control system can turn a bad employee into a
good one.
o Internal control systems are especially susceptible to

collusion.
4-36
Recent Accounting Scandals and
Response
AUDIT FIRM
Arthur
Andersen
Enron WorldCom
FRAUD FIRM FRAUD FIRM 37

Sarbanes-Oxley Act
of 2002 (SOX)
Act of Congress
intended to bring
reform to corporate
accountability and
stewardship in
response to corporate
scandals
End of Chapter 4

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Chapter

 Balances in savings and checking accounts, as

+ Deposits in transit + Interest earned on bank account

Bank’s cash balance

Deduct: Outstanding checks:

Deduct: NSF check $245.72

Identify errors made by

Deduct: NSF check $245.72

Balance per bank $$$ Adjusted

Balance per bank $$$

Companies report cash in two ways.

o Internal control systems are especially susceptible to

FRAUD FIRM FRAUD FIRM 37

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