Operating, Financing, Investing Activities

1. Operating, Financing, Investing Activities Elements of Internal Controls YOU ARE HERE! Conversion Cycle Expenditure Cycle Revenue Cycle Internal Controls Over Cash Chapter 2 Operating Cycles and Internal Control

2. Chapter 2 - Operating Cycles and Internal Control PART ONE:INTRODUCTION

3. CHAPTER 2 LEARNING OBJECTIVES L.O.1: Identify the activities of a business as operating, investing, or financing. L.O.2: Understand the principles of internal controls as they are applied to business transactions. L.O.3: Describe the sequence of activities in the expenditure cycle.

4. CHAPTER 2 LEARNING OBJECTIVES L.O.4: Describe the sequence of activities in the revenue cycle. L.O.5: Describe the sequence of activities in the conversion cycle. L.O.6: Apply the principles of internal control as they relate to cash transactions.

5. Operating Activities Exhibit 2.1 $ Profits$ Long-lived assets used in operations Cash for owners and creditors Cash for investing Investing Activities Financing Activities Cash from owners and creditors to purchase long-lived assets The Relationship Among Business Activities

6. BUSINESS ACTIVITIES Expenditure Conversion Revenue Operating Activities Profit-making activities of the business enterprise such as sales to customers purchases of merchandise, and paying employees.

7. BUSINESS ACTIVITIES Investing Activities Activities involving the purchase or sale of long-term assets used in the business operations Purchasing delivery vans for the business Purchasing buildings for office space

8. BUSINESS ACTIVITIES Received from First State Bank in exchange for issuance of note $200,000 Financing Activities Activities in which the business obtains cash or other non-cash means to pay investments in long-term assets, repay money borrowed from creditors or reward owners. Cash received by the business by borrowing from the bank Cash received by selling stock to investors to raise financial resources for the business

9. Operating activities are those directed associated with profit-making. The purchase of another company, regardless of the reason, is an investing activity. While related to profit-making, the act of investing is not directly associated with profit-making. PAUSE AND REFLECT If one company buys another because the products of the purchased company will complement the product line of the purchaser and make both companies more profitable, is the purchase an operating or an investing activity?

10. USE OF OPERATING PROFITS Exhibit 2.2 • For operating activities such as replacing sold inventory, expanding inventory, extending credit to customers. • For investing activities such as acquiring new buildings and machinery, major research and development of products, and employee training programs. • For financing activities such as repayments to creditors and dividends to stockholders.

11. Investing Activities Operating Activities Purchasing equipment Repairs and maintenance on equipment Financing Activities Borrowing money from bank Paying interest on the loan DISTINGUISHING OPERATING FROM FINANCING AND INVESTING ACTIVITIES

12. 1977 Foreign Corrupt Practices Act …publicly owned companies are required to maintain detailed accounting records and documented systems of internal control... A system of internal control is good business practice and a legal requirement WHAT ARE INTERNAL CONTROLS? An internal control system is a set of policies and procedures designed to meet three objectives: • promote operational efficiency. • ensure accuracy of accounting information. • encourage management and employee compliance with applicable laws and regulations.

13. Receiving value in goods and services for money; maximizing use of limited resources. Promoting operating efficiency Reliable financial statements and accurate information on company activities. Accuracy of accounting information Examples of Internal Controls Compliance with laws and regulations Compliance with labor laws and specific industry requirements.

14. ELEMENTS OF INTERNAL CONTROL SYSTEMS • Proper authorization of transactions • Separate incompatible duties • Adequate documents and records • Physical control over assets and documents • Independent checks on performance

15. Corporate levels of authority Purchasing: An approved list of suppliers will be used and the purchasing manager must approve all purchasing requests Example PROPER AUTHORIZATION Proper Authorization One way to ensure that employees follow company policies is to ensure that the person responsible for certain activities has the authority to enforce the policies associated with those activities.

16. SEPARATING INCOMPATIBLE DUTIES • If one company employee performs certain combinations of activities, it sometimes makes it too easy and inviting to violate company policies. • Dividing the responsibilities for duties among two or more employees is called separation, or segregation of incompatible duties. Balancing the checkbook Depositing cash in bank

17. Airline tickets Meal credit card slips Hotel bill Daily sales reports MAINTAINING ADEQUATE DOCUMENTATION AND RECORDS Properly recording transactions allow managers to trace responsibility for transactions so that they can maintain employee accountability. Company travel and expense report Business purpose and results

18. Workplace Security and Safety Rules PHYSICALLY CONTROLLING ASSETS AND DOCUMENTS Companies protect physical assets and accounting records by limiting access to approved personnel. Companies protect both human and physical resources by enforcing company security and safety rules.

19. Cash deposit records Cash receipt records PROVIDING INDEPENDENT CHECKS ON PERFORMANCE This involves having another employee who was not involved in the original activity, such as a supervisor, check employee work.

20. No, prenumbering will not stop the theft of the document. Prenumbering will allow the company to detect that the document is missing. Physically securing the documents to limit access is the best protection against document theft. PAUSE AND REFLECT An employee takes a prenumbered document and uses it to make a purchase for his or her personal use. Will prenumbered documents prevent this misappropriation? Why or why not? What type of internal control might prevent this?

21. Expenditure Cycle Operating Activities Revenue Cycle Conversion Cycle

22. Expenditure cycle Revenue cycle Business Functions Marketing Human Resources Accounting and Finance Inventory (merchandising) Goods for resale, Services, Other inputs (utilities, insurance, etc) Cash EXPENDITURE AND REVENUE CYCLES FOR MERCHANDISING AND SERVICE FIRMS Exhibit 2.3 Vendors Suppliers Employee (labor market) Customers Goods and services Cash

23. Acquiring merchandise Acquiring services Expenditure cycle Acquiring raw materials EXPENDITURE CYCLE • Determine needs for goods and services. • Select vendors and place orders. • Receiving, securing and storing the goods. • Paying for goods and services.

24. Purchase requisition Purchase order Receiving report Vendors invoice Exhibit 2.5 DOCUMENTS FOUND IN A TYPICAL EXPENDITURE CYCLE • Initiates approved order. • Provides vendor with specifics of goods required. • Provides record of goods received. • Requests payment for goods.

25. Vendor’s Invoice 2% discount for 10 days; full amount due in 30 days Final activity in expenditure cycle 300 monogrammed tee-shirts per order…...$3,000 Terms: 2/10, net 30 PAYING FOR GOODS AND SERVICES IN THE EXPENDITURE CYCLE Final activity in expenditure cycle A $60 discount is offered; $2,940 will pay the invoice in full during this period.

26. ANNUALIZED COST OF DISCOUNTS LOST Discount % 1-Discount% Times 365 days Invoice period - Discount Period Equals ANNUALIZED INTEREST COST

27. Why is this amount so high? ILLUSTRATION OF ANNUALIZED COST OF 2/10, N/30 DISCOUNT LOST 2% 100%-2% Times 365 days 30-10 Equals 37.2%

28. The actual cost of foregoing the discount is $1,500 ($50,000 x .03). Expressed as an annual percentage the interest cost equals 37.6%. A business with serious cash problems may also not be able to borrow cash on a short-term basis to pay the discount. PAUSE AND REFLECT Assume a company buys $50,000 worth of goods from a vendor on credit with terms 3/30, n/60. Due to serious cash problems, it pays the bill 65 days after it received the vendor’s invoice. What is the annualized cost of not taking the discount? What other factors might affect your answer?

29. Selling goods Collecting payment from customers Revenue cycle Selling services REVENUE CYCLE • Generate customer orders. • Approve customer credit. • Ship goods to customers. • Bill credit customers. • Collect from customers.

30. Customer or sales order Bill of lading Sales invoice Sales slip Remittance advice Exhibit 2.11 DOCUMENTS FOUND IN A TYPICAL REVENUE CYCLE • Initiates customer order. • Shipping document evidence of contract with carrier. • Requests payment from customer, or • Sales slip. • Record payment bycustomer.

31. BILL OF LADING 300 monogrammed tee shirts….. $3,000 FOB SHIPPING POINT BILL OF LADING 300 monogrammed tee shirts….. $3,000 FOB DESTINATION SHIPPING GOODS TO CUSTOMERS IN THE REVENUE CYCLE FOB destination means legal title passes to the customer when the goods are received by the customer. FOB shipping point means legal title passes to the customer when the goods are shipped to the customer.

32. What are the implications to a purchaser and a seller when goods are shipped on the last date of year FOB shipping point? Or FOB destination? FOB shipping point means the seller has a sale and a purchaser has a purchase as soon as the goods are shipped. FOB destination means the seller does not have a sale and the purchaser does not have a purchase until the goods are received. PAUSE AND REFLECT

33. Conversion cycle Expenditure cycle Revenue cycle Goods for resale, Services, Other inputs (utilities, insurance, etc) Cash EXPENDITURE, REVENUE AND CONVERSION CYCLES FOR MANUFACTURING FIRMS Exhibit 2.4 Business Functions Vendors Suppliers Employees (labor market) • Marketing • Human Resources • Accounting and Finance • Inventory • (merchandising) Customers Combine raw materials, labor and other inputs to make products Productsand Services Cash

34. Input raw materials Input manufacturing overhead Conversion cycle Input labor CONVERSION CYCLE • Schedule productions. • Obtain raw materials. • Combine raw materials, labor and other resources to make the goods. • Store finished goods.

35. Most companies have multiple classifications. In some respects, McDonald’s is a manufacturing firm (makes fast food), a merchandising firm (sells fast food), and a service firm (cleans after meals). PAUSE AND REFLECT Is a fast-food company like McDonalds a manufacturing company? Why or why not?

36. Product design and engineering Process engineering Finished goods storage Production scheduling PRODUCTION PROCESS Manufacturing overhead (utilities, supervision, maintenance) Raw materials storage Employee labor THE PRODUCTION PROCESS AND CONVERSION CYCLE Exhibit 2.4

37. Bill of materials Operations list Production order Sales invoice Materials requisition Time ticket Exhibit 2.13 DOCUMENTS FOUND IN A TYPICAL CONVERSION CYCLE • Quantities of materials and parts for products. • Sequence of production operations. • Job or batch in production process. • Authorizes raw materials from storage. • Records employees’ time on production activities.

38. Customer cash receipt APPLYING INTERNAL CONTROLS TO PROTECT CASH Customer cash receipts help to ensure that all cash received by clerks is placed in cash registers. Cash must be secured at all times; either in a locked cash register or safe with access limited to only authorized employees.

39. CONTROLLING CASH RECEIPTS • Separate duties over custody of cash from those who maintain the accounting records (incompatible duties). • Deposit and record cash as soon as possible after receipt. • Have independent checks made on cash balances and cash handling procedures.

40. Los Angeles bank New York bank Chicago bank West coast customers Midwest customers East coast customers LOCKBOX COLLECTION SYSTEM FOR CASH RECEIPTS • Each day the local bank sends the home office a listing of customer receipts to update company records. • This provides a good cash control because it speeds up the receipt of cash and further segregates cash duties. • The business establishing bank accounts at locations near customers. • Customers mail payments to the local bank where the amounts are deposit in company bank accounts daily. Corporate Home Office Customer payments Daily cash receipt records

41. Segregate all cash disbursement activities Check authorization Check writing Check signing Check mailing Check recording CONTROLLING CASH DISBURSEMENTS Customers Goods and services Cash

42. VERIFYING A COMPANY’S CASH BALANCE Bank Reconciliation - It Takes Two! Balance Per Books + Adjustments - Adjustments Balance Per Bank + Adjustments - Adjustments Adjusted balance (Should be the same amount)

43. COMMON BANK RECONCILATION ITEMS • Deposits in transit • Outstanding checks • NSF checks • Bank credits and charges • Errors

44. DEPOSITS IN TRANSIT • The company knows about the deposits they made and they have already been entered in the accounts. • The bank has not yet received the deposits and the amounts are not yet in the bank balance. • You must add the deposit in transits to the balance per bank.

45. ACE Hardware Company $200 OUTSTANDING CHECKS • Company knows about the checks written and they have already been deducted in the company accounts. • Bank has not yet received the checks for payment and the amounts are not yet deducted from the bank balance. • You must subtract the outstanding check from the balance per bank.

46. NFS checks could be an early warning sign of a customer credit problem! NON SUFFICIENT FUND CHECKS • The company recorded this check as a deposit when received from the customer. • When the check was received for payment at the bank, the customer’s account had insufficient funds to cover the check, so it is called a “non-sufficient fund (NSF)” check. NSF • The bank reverses the credit for the deposit when this occurs, so the company must do the same on its books. • You must subtract the NSF check from the balance per company along with any fees the bank may have charged you for this.

47. Subtract from company balance Add to company balance BANK CHARGES, CREDITS AND OTHER ERRORS • Credits on the bank statement that do not appear in the company books such as interest earned on the account or amounts collected from customers by the bank. Hmm? Did I forget something? • Charges on the bank statement for checks that were not recorded in the books, bank charges such as check printing fees, monthly fees,or NSF check fees.