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7-1

7
FRAUD, INTERNAL
CONTROL, AND CASH

7-2
Accounting, Fourth Edition
Study Objectives

1. Define fraud and internal control.


2. Identify the principles of internal control activities.
3. Explain the applications of internal control principles to cash
receipts.
4. Explain the applications of internal control principles to cash
disbursements.
5. Prepare a bank reconciliation.
6. Explain the reporting of cash.
7. Discuss the basic principles of cash management.
8. Identify the primary elements of a cash budget.

7-3
Fraud, Internal Control, and Cash

Fraud and Managing and


Reporting
Internal Cash Controls Use of a Bank Monitoring
Cash
Control Cash

Fraud Cash receipts Bank Cash Basic


The controls statements equivalents principles
Sarbanes- Cash Reconciling Restricted
Oxley Act disbursements the bank cash
Internal controls account
control
Principles of
internal
control
activities
Limitations

7-4
Fraud and Internal Control

Fraud
Dishonest act by an employee that results in personal benefit
to the employee at a cost to the employer.

Three factors that


contribute to
fraudulent activity.

Illustration 7-1

7-5 SO 1 Define fraud and internal control.


Fraud and Internal Control

The Sarbanes-Oxley Act


 All publicly traded U.S. corporations are required to
maintain an adequate system of internal control.

 Corporate executives and boards of directors must


ensure that these controls are reliable and effective.

 Independent outside auditors must attest to the adequacy


of the internal control system.

 SOX created the Public Company Accounting Oversight


Board (PCAOB).

7-6 SO 1 Define fraud and internal control.


Fraud and Internal Control

Internal Control
Methods and measures adopted to:

1. Safeguard assets.

2. Enhance accuracy and reliability of accounting records.

3. Increase efficiency of operations.

4. Ensure compliance with laws and regulations.

7-7 SO 1 Define fraud and internal control.


Fraud and Internal Control

Internal Control
Five Primary Components:

1. Control environment.

2. Risk assessment.

3. Control activities.

4. Information and communication.

5. Monitoring.

7-8 SO 1 Define fraud and internal control.


Fraud and Internal Control

Principles of Internal Control Activities


Establishment of Responsibility
Control is most effective when only one person is responsible
for a given task.

Segregation of Duties
Related duties should be assigned to different individuals.

Documentation Procedures
Companies should use prenumbered documents and all
documents should be accounted for.

7-9 SO 2 Identify the principles of internal control activities.


Fraud and Internal Control

Principles of Internal Control Activities


Illustration 7-2

Physical
Controls

7-10 SO 2 Identify the principles of internal control activities.


Fraud and Internal Control

Principles of Internal Control Activities


Independent Internal Verification
1. Records periodically verified by an employee who is
independent.
2. Discrepancies reported to management.

Human Resource Controls


1. Bond employees.
2. Rotate employees’ duties and require vacations.
3. Conduct background checks.

7-11 SO 2 Identify the principles of internal control activities.


7-12
7-13
Fraud and Internal Control

Limitations of Internal Control


 Costs should not exceed benefit.
 Human element.
 Size of the business.

7-14 SO 2 Identify the principles of internal control activities.


7-15
Cash Controls

Cash Receipts Controls

Illustration 7-4

7-16
SO 3
Cash Controls

Cash Receipts Controls

7-17
SO 3
Illustration 7-5

Cash
Receipts
Controls

Over-the-Counter
Receipts

Important internal
control principle—
segregation of
record-keeping from
physical custody.

7-18 SO 3 Explain the applications of internal control principles to cash receipts.


Cash Receipts Controls

Mail Receipts:
 Mail receipts should be opened by two people, a list
prepared, and each check endorsed.
 Each mail clerk signs the list to establish responsibility
for the data.
 Original copy of the list, along with the checks, is sent
to the cashier’s department.
 Copy of the list is sent to the accounting department for
recording. Clerks also keep a copy.

7-19 SO 3 Explain the applications of internal control principles to cash receipts.


Cash Controls

Review Question
Permitting only designated personnel to handle cash
receipts is an application of the principle of:
a. segregation of duties.
b. establishment of responsibility.
c. independent check.
d. other controls.

7-20 SO 3 Explain the applications of internal control principles to cash receipts.


Cash Controls

Cash Disbursements Controls


Generally, internal control over cash disbursements is
more effective when companies pay by check, rather
than by cash.

Applications:
 Voucher system
 Petty cash fund

7-21
SO 4 Explain the applications of internal control
principles to cash disbursements.
Cash Controls

Cash Disbursements
Controls

Illustration 7-6

7-22
SO 4
Cash Controls

Cash Disbursements
Controls

Illustration 7-6

7-23
SO 4
7-24
Cash Controls

Review Question
The use of prenumbered checks in disbursing cash is an
application of the principle of:

a. establishment of responsibility.

b. segregation of duties.

c. physical, mechanical, and electronic controls.

d. documentation procedures.

7-25
SO 4 Explain the applications of internal control
principles to cash disbursements.
Cash Controls

Cash Disbursements Controls

Voucher System
 Network of approvals, by authorized individuals, to
ensure all disbursements by check are proper.
 A voucher is an authorization form prepared for
each expenditure.

7-26
SO 4 Explain the applications of internal control
principles to cash disbursements.
Cash Controls

Cash Disbursements Controls


Petty Cash Fund - Used to pay small amounts.
Involves:
1. establishing the fund,

2. making payments from the fund, and

3. replenishing the fund.

7-27
SO 4 Explain the applications of internal control
principles to cash disbursements.
Control Features: Use of a Bank

Contributes to good internal control over cash.


 Minimizes the amount of currency on hand.
 Creates a double record of bank transactions.
 Bank reconciliation.

7-28
Control Features: Use of a Bank
Illustration 7-7

Bank Statements
Debit Memorandum
 Bank service charge
 NSF (not sufficient
funds)

Credit Memorandum
 Collect notes
receivable.
 Interest earned.

7-29
Control Features: Use of a Bank

Review Question
The control features of a bank account do not include:

a. having bank auditors verify the correctness of the


bank balance per books.

b. minimizing the amount of cash that must be kept on


hand.

c. providing a double record of all bank transactions.

d. safeguarding cash by using a bank as a depository.

7-30
Control Features: Use of a Bank

Reconciling the Bank Account


Reconcile balance per books and balance per bank to
their adjusted (corrected) cash balances.
Reconciling Items:
1. Deposits in transit.

2. Outstanding checks. Time Lags


3. Bank memoranda.

4. Errors.

7-31 SO 5 Prepare a bank reconciliation.


Control Features: Use of a Bank

Reconciliation Procedures Illustration 7-8

+ Deposit in Transit + Notes collected by bank


- Outstanding Checks - NSF (bounced) checks
+/- Bank Errors - Check printing or other
service charges
+/- Book Errors
CORRECT BALANCE CORRECT BALANCE

7-32 SO 5 Prepare a bank reconciliation.


7-33
Control Features: Use of a Bank

7-34 SO 5 Prepare a bank reconciliation.


Control Features: Use of a Bank

Illustration: Prepare a bank reconciliation at April 30.

Cash balance per bank statement $15,907.45


Deposit in transit 2,201.40
Outstanding checks (5,904.00)
Adjusted cash balance per bank $12,204.85

Cash balance per books $11,589.45


Error in check No. 443 36.00
NSF check (425.60)
Bank service charge (30.00)
Collection of notes receivable 1,035.00
Adjusted cash balance per books $12,204.85

7-35 SO 5 Prepare a bank reconciliation.


Control Features: Use of a Bank

Illustration: Journalize the adjusting entries at April 30


on the books of Laird Company.
Dr. Cr.
Apr. 30 Cash 615.40
Bank fee expense 45.00
Accounts receivable 425.60
Notes receivable
Interest revenue
1,000.00
Accounts payable
50.00
36.00
7-36 SO 5 Prepare a bank reconciliation.
Control Features: Use of a Bank

Review Question
The reconciling item in a bank reconciliation that will
result in an adjusting entry by the depositor is:

a. outstanding checks.

b. deposit in transit.

c. a bank error.

d. bank service charges.

7-37 SO 5 Prepare a bank reconciliation.


Control Features: Use of a Bank

Electronic Funds Transfers (EFT)


 Disbursement systems that uses wire, telephone, or
computers to transfer cash balances between
locations.

7-38 SO 5 Prepare a bank reconciliation.


7-39
Reporting Cash

Most liquid asset, listed first.


Illustration 7-11

Cash equivalents Restricted cash

7-40 SO 6 Explain the reporting of cash.


Reporting Cash

Review Question
Which of the following statements correctly describes the
reporting of cash?

a. Cash cannot be combined with cash equivalents.

b. Restricted cash funds may be combined with Cash.

c. Cash is listed first in the current assets section.

d. Restricted cash funds cannot be reported as a current


asset.

7-41 SO 6 Explain the reporting of cash.


Managing and Monitoring Cash

Basic Principles of Cash Management


Illustration 7-13

7-42 SO 7 Discuss the basic principles of cash management.


Managing and Monitoring Cash

Cash Budget
► Shows anticipated
cash flows,
usually over a
one- to two-year
period.
► Contributes to
more effective
cash
management.
7-43
SO 8 Identify the primary elements of a cash budget.
Appendix

Operation of the Petty Cash Fund

Petty Cash Fund - Used to pay small amounts.


Involves:
1. establishing the fund,

2. making payments from the fund, and

3. replenishing the fund.

7-44 SO 9 Explain the operation of a petty cash fund.


Operation of the Petty Cash Fund

Illustration: If Laird Company decides to establish a $100 fund


on March 1, the entry is:

March 1 Petty cash 100


Cash
100

7-45 SO 9 Explain the operation of a petty cash fund.


Operation of the Petty Cash Fund

Illustration: On March 15 the petty cash custodian requests a


check for $87. The fund contains $13 cash and petty cash
receipts for postage $44, supplies $38, and miscellaneous
expenses $5. The entry is:

March 15 Postage expense 44


Supplies 38
Miscellaneous expense 5
Cash
87

7-46 SO 9 Explain the operation of a petty cash fund.


Operation of the Petty Cash Fund

Illustration: Assume in the preceding example that the


custodian had only $12 in cash in the fund plus the receipts as
listed. The request for reimbursement would therefore be for
$88. The entry is:

March 15 Postage expense 44


Supplies 38
Miscellaneous expense 5
Cash over and short 1
Cash
88

7-47 SO 9 Explain the operation of a petty cash fund.


Key Points
 The fraud triangle discussed in this chapter is applicable to all
international companies. Some of the major frauds on an
international basis are Parmalat (Italy), Royal Ahold (the
Netherlands), and Satyam Computer Services (India).

 Rising economic crime poses a growing threat to companies,


with nearly half of all organizations worldwide being victims of
fraud in a recent two-year period (PricewaterhouseCoopers’
Global Economic Crime Survey, 2005). Specifically, 44% of
Romanian companies surveyed experienced fraud in the past
two years.

7-48
Key Points
 Globally, the number of companies reporting fraud increased
from 37% to 45% since 2003, a 22% increase. The cost to
companies was an average US$1.7 million in losses from
“tangible frauds,” that is, those that result in an immediate and
direct financial loss.

 Accounting scandals both in the United States and


internationally have re-ignited the debate over the relative
merits of GAAP, which takes a “rules-based” approach to
accounting, versus IFRS, which takes a “principles-based”
approach. The FASB announced that it intends to introduce
more principles-based standards.
7-49
Key Points
 On a lighter note, at one time Ig Nobel Prize in Economics went
to the CEOs of those companies involved in the corporate
accounting scandals of that year for “adapting the mathematical
concept of imaginary numbers for use in the business world.”
The Ig Nobel Prizes (read Ignoble, as not noble) are a parody of
the Nobel Prizes and are given each year in early October for 10
achievements that “first make people laugh, and then make
them think.”
 While most companies have internal control systems in place,
many have never completely documented them, nor had an
independent auditor attest to their effectiveness. Both of these
actions are required under SOX.
7-50
Key Points
 One study estimates the cost of SOX compliance for U.S.
companies at over $35 billion, with audit fees doubling in the
first year of compliance. At the same time, examination of
internal controls indicates lingering problems in the way
companies operate.
 The SOX internal control standards apply only to companies
listed on U.S. exchanges. There is continuing debate over
whether foreign issuers should have to comply.
 The accounting and internal control procedures related to cash
is essentially the same under both IFRS and this textbook. In
addition, the definition used for cash equivalents is the same.
7-51
Key Points
 Most companies report cash and cash equivalents together
under IFRS, as shown in this textbook. In addition, IFRS follows
the same accounting policies related to the reporting of
restricted cash.
 IFRS defines both cash and cash equivalents as follows.
► Cash is comprised of cash on hand and demand deposits.
► Cash equivalents are short-term, highly liquid investments
that are readily convertible to known amounts of cash and
which are subject to an insignificant risk of changes in
value.

7-52
Looking into the Future
High-quality international accounting requires both high-quality
accounting standards and high-quality auditing. Similar to the
convergence of GAAP and IFRS, there is movement to improve
international auditing standards. The International Auditing and
Assurance Standards Board (IAASB) functions as an
independent standard-setting body. It works to establish high-
quality auditing and assurance and quality-control standards
throughout the world. Whether the IAASB adopts internal
control provisions similar to those in SOX remains to be seen.

7-53
Non-U.S companies that follow IFRS:

a) do not normally use the principles of internal control


activities used in this textbook.

b) often offset cash with accounts payable on the balance


sheet.

c) are not required to follow SOX.

d) None of the above.

7-54
Which of the following is the correct accounting under IFRS
for cash?

a) Cash cannot be combined with cash equivalents.

b) Restricted cash funds may be reported as a current or


non-current asset depending on the circumstances.

c) Restricted cash funds cannot be reported as a current


asset.

d) Cash on hand is not reported on the balance sheet as


Cash.
7-55
The Sarbanes Oxley Act of 2002 applies to:

a) all U.S. companies listed on U.S. exchanges.

b) all companies that list stock on any stock exchange in


any country.

c) all European companies listed on European


exchanges.

d) Both (a) and (c).

7-56
Copyright

“Copyright © 2011 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser
may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility for
errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.”

7-57

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