Chapter 4- Financial Accounting

Errors

Accidental errors in recording transactions or applying accounting rules 

Fraud

occurs when a person intentionally deceives another person for personal gain or to damage that person

• Association of Certified Fraud Examiners (ACFE) 

Occupational Fraud

The use of ones occupation for personal enrichment through the deliberate misuse or misapplication of the employer's resources 

• Motives: maximizing their compensation, increasing the company's stock price, and preserving their jobs 

Fraud Triangle

The three elements present for every fraud- motivation, rationalization, and opportunity 

• Opportunity: the situation allows the fraud to occur 

• Motivation: someone feels the need to commit fraud, such as the need for money 

• Rationalization: justification for the deceptive act by the one committing the fraud 

Internal Controls

A company's plans to (1) safeguard the company's assets and (2) improve the accuracy and reliability of accounting information 

• Attempt to eliminate the opportunity element of fraud

  • Top executives are the ones who must take final responsibility for their establishment and success 

Accounting Scandals and Response by Congress

• Enron: Avoided reporting billions in debt and losses 

• WorldCom: misclassified expenditures to overstate assets and profitability 

Reason Sarbanes-Oxley Act was created

Sarbanes-Oxley Act (SOX)

Established a variety of guidelines related to auditor-client relations and internal control procedures 

• passed by congress

• A response to corporate accounting scandals of Enron and WorldCom

• Applies to all companies that file financial statements with the SEC (public companies only) 

Public Company Accounting Oversight Board (PCAOB)

Oversee audits of public companies

• Requires the auditor to express opinion on whether the company maintained effective internal control over financial reporting

Corporate executive accountability

Corporate execs must certify the company's financial statements and disclosures (sign off on them) 

• Consequences of fraudulent misstatement: Severe financial penalties and the possibility of imprisonment 

Nonaudit service

Illegal for the auditors of public companies to also perform certain nonaudit services, such as investment advising, for their clients 

Retention of work papers

Auditors of public companies must retain all work papers for seven years or face a prison term for willful violation 

Auditor Rotation

the lead auditor in charge of auditing a particular company must rotate off that company within five years and allow a new audit partner to take the lead 

Conflicts of Interest

Audit firms cant audit public companies whose chief execs worked for the audit firm and participated in that company's audit during the preceding year (if you audit a company you can't buy their stock) 

Hiring of auditor

Firms are hired by the audit committee of the board of directors of the company, not by company management 

Internal Control (requires)

Section 404 requires

• Management documents and assesses the effectiveness of all internal control processes that could affect financial reporting 

• Company auditors express an opinion on if management's assessment of the effectiveness of internal control is fair (smaller companies exempt from this one)

Methods for collection of relevant information and communication in timely manner 

Committee of Sponsoring Organizations (COSO) of the Treadway Commission (Framework provided by them)

• Monitoring

• Control Activities

• Risk Assessment

• Control Environment

Monitoring

Continual watching of internal activities and deficiencies reporting 

• includes formal procedures for reporting control deficiencies

Control Activities

The policies and procedures that help ensure management’ orders are carried out

• happen most often

• Includes authorizations, reconciliations, and separation of duties 

  • Preventive controls: designed to keep errors or fraud from occurring in the first place 

  • Detective controls: designed to detect errors or fraud that already have occurred

Risk Assessment

Identifies and analyzes internal and external risk factors that could prevent a company's objectives from being achieved 

Control Environment

Sets overall ethical tone of the company with respect to internal control 

• Includes formal policies related to management's philosophy, assignment of responsibilities, and organizational structure 

• Starts at the top with management 

Preventive Controls

Separation of duties

physical controls

proper authorization

employee management

E-commerce controls

Detective controls (reactive)

Reconciliations: periodically determine if physical assets agree with records

Performance review: actual v expected performance

Audits: auditor attests to adequacy of internal control procedures

Limitations of Internal Control

Collusion

• two or more people acting in coordination to circumvent internal controls

Cash

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

Cash Equivalents

Short-term investments that have a maturity date no longer than three months from the date of purchase

• Ex: investments are money market funds, treasury bills, and certificates of deposit 

Acceptance of Cash and Checks

More susceptible to theft, fraud, and being lost or destroyed

• Different employees to receive and deposit 

Credit Cards

Reduces employee’s need to directly handle cash

• Service fee total sales x percent of service fee

Acceptance of Debit Cards

work like a check and withdraw funds directly from the cardholder’s bank account at the time of use

Bank Reconciliation

Matching the balance of cash in the bank account with the balance of cash in the company's own records 

• Differences in balances from timing differences or errors 

• For reconciliation to be complete, the reconciled bank balance must equal the reconciled company balance 

• Once of the most important internal controls for cash 

Bank Reconciliation: Timing Differences

Occur when the company records transactions either before or after the bank records the same transactions 

• Ex: when a company receives cash for selling products and services, the company records an increase to cash immediately. The bank, however, doesn't record an increase until the cash is later deposited 

Three steps to reconcile bank accounts

1. Reconcile the bank’s cash balance (doesn’t need journal entry): values the company has recorded but bank has not

   1. + deposits outstanding

   2. - checks outstanding

   3. ± bank errors

2. Reconcile the company’s cash balance: values the bank has recorded but the company has not

   1. + notes received by bank

   2. + interest received

   3. - unrecorded payments

   4. - NSF checks from customers

   5. - bank service fees

   6. ± company errors

3. Update the company’s cash account by recording items identified in step 2

Deposits outstanding

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

Checks outstanding

checks written by the company but not yet reflected as a decrease in the bank’s cash balance

NSF check

A check received from a customer and deposited by a company that is later determined by the bank to have nonsufficient funds 

• Cash balance adjusts downward to reverse the increase in cash recorded at time of deposit, but also creates an account receivable until the customer honors the funds

Purchase Cards

Company-issued debit cards or credit cards that allow authorized employees to make purchases on behalf of the company 

Petty Cash Fund

Small amount of cash kept on hand to pay for minor purchases 

• Ex: pay for pizza delivery 

Accounting for the petty cash fund involves: 

• Establishing the fund (debit: petty cash credit: cash)

• Recognizing expenditures from the fund (debit: expense credit: cash)

• Replenishing the fund 

Expenditures with credit cards

• Not paid immediately 

• Recorded as credit to Accounts Payable until paid

• If accountant decides to pay the credit card balance at reconciliation, then credit to cash instead 

Expenditures with petty cash fund

• Decrease the Cash account (not petty cash) 

  • Because we didn't record expenditures at the time we made them from the petty cash fund, instead we waited for the end of the month 

• Now record the expenditures, and also withdraw cash from the bank to replenish the petty cash fund

Which statements is cash reported in

the balance sheet and statement of cash flows

• Balance Sheet

  • balance of cash

  • snapshot at end of period

• Statement of Cash Flows

  • inflows/outflows

  • covers a period of time

  • operating, investing, and financing

Operating Activities

Include cash transactions involving revenue and expense events during the period 

• Cash received from customers, cash paid for rent, utilities, supplies, and salaries 

Investing activities

Include cash transactions involving long-term assets and investment securities 

• Purchase or sale of land, equipment, and building for cash 

Financing activities

Include transactions designed to raise cash or finance the business: borrow cash from lenders or raise cash from stockholders 

• Issue common stock or pay dividends; borrow or repay debt 

The cash flow that’s related most directly to the company’s profitability

net cash flows from operating activities

Ratio of liquid cash

Cash assets / noncash assets

• having too much cash shows idle resources that aren’t producing revenues