2Fraud, Internal Control, and Cash Chapter 7Fraud, Internal Control, and CashFinancial Accounting, IFRS EditionWeygandt Kimmel Kieso
3Study Objectives Define fraud and internal control. Identify the principles of internal control activities.Explain the applications of internal control principles to cash receipts.Explain the applications of internal control principles to cash disbursements.Describe the operation of a petty cash fund.Indicate the control features of a bank account.Prepare a bank reconciliation.Explain the reporting of cash.
4Fraud, Internal Control, and Cash Fraud and Internal ControlCash Receipts ControlsCash Disbursement ControlsControl Features: Use of a BankReporting CashFraudInternal controlPrinciples of internal control activitiesLimitationsOver-the-counter receiptsMail receiptsVoucher system controlsPetty cash fund controlsMaking depositsWriting checksBank statementsReconciling the bank accountElectronic funds transfer (EFT) systemCash equivalentsRestricted cashCompensating balances
5Fraud and Internal Control Dishonest act by an employee that results in personal benefit to the employee at a cost to the employer.Illustration 7-1Why does fraud occur?SO 1 Define fraud and internal control.
6p. 299 How Do Employees Steal? Q: How can companies reduce the likelihood of fraudulent disbursements?A: Some common-sense approaches are to make sure only certain designated individuals can sign checks. In addition, make sure that different personnel approve payments and make payments.Answer on notes page
7Fraud and Internal Control Methods and measures adopted to:Safeguard assets.Enhance accuracy and reliability of accounting records.Increase efficiency of operations, andEnsure compliance with laws and regulations.SO 1 Define fraud and internal control.
8Fraud and Internal Control Internal control systems have five primary componentsA control environmentRisk assessmentControl activitiesInformation and communicationMonitoringSO 1 Define fraud and internal control.
9Fraud and Internal Control Principles of Internal Control ActivitiesMeasures vary withmanagement’s assessment of the risks faced.size and nature of the company.Six principles of controls activities:Establishment of responsibilitySegregation of dutiesDocumentation proceduresPhysical controlsIndependent internal verificationHuman resource controlsSO 2 Identify the principles of internal control activities.
10Fraud and Internal Control Principles of Internal Control ActivitiesESTABLISHMENT OF RESPONSIBILITYControl is most effective when only one person is responsible for a given task.SEGREGATON OF DUTIESRelated duties, including physical custody and record keeping, should be assigned to different individuals.DOCUMENTATION PROCEDURESCompanies should use prenumbered documents and all documents should be accounted for.SO 2 Identify the principles of internal control activities.
14Fraud and Internal Control Principles of Internal Control ActivitiesPHYSICAL CONTROLSIllustration 7-2SO 2 Identify the principles of internal control activities.
15Fraud and Internal Control Principles of Internal Control ActivitiesINDEPENDENT INTERNAL VERIFICATIONVerify records periodically or on a surprise basis.Verify records by an employee who is independent.Discrepancies reported to management.Illustration 7-3SO 2 Identify the principles of internal control activities.
16Fraud and Internal Control Principles of Internal Control ActivitiesHUMAN RESOURCE CONTROLSBond employees.Rotate employees’ duties and require vacations.Conduct background checks.SO 2 Identify the principles of internal control activities.
20p. 307 Internal Control and Human Resources Q: Why would unsupervised employees or employees who report to each other represent potential internal control threats?A. An unsupervised employee may have a fraudulent job (or may even be a fictitious person—e.g., a person drawing a paycheck without working).Or, if two employees supervise each other, there is no real separation of duties, and they can conspire to defraud the company.Answer on notes page
21Fraud and Internal Control Limitations of Internal ControlCosts should not exceed benefit.Human element.Size of the business.SO 2 Identify the principles of internal control activities.
22Cash Receipts Controls Over-the-Counter ReceiptsIllustration 7-4Establishment of ResponsibilityOnly designated personnel are authorized to handle cash receipts (cashiers)Documentation ProceduresUse remittance advice (mail receipts), cash register tapes, and deposit slipsIndependent Internal VerificationSupervisors count cash receipts daily; treasurer compares total receipts to bank deposits dailySegregation of DutiesDifferent individuals receive cash, record cash receipts, and hold the cashPhysical ControlsStore cash in safes and bank vaults; limit access to storage areas; use cash registersHuman Resource ControlsBond personnel who handle cash; require employees to take vacations; deposit all cash in bank dailySO 3 Explain the applications of internal control principles to cash receipts.
23Cash Receipts Controls Cash consists of coins, currency, checks, money orders, and money on hand or on deposit in a bank.Cash receipts come from:cash salescollections on account from customersreceipt of interest, rent, and dividendsinvestments by ownersbank loansproceeds from the sale of noncurrent assetsSO 3 Explain the applications of internal control principles to cash receipts.
24Over-the-Counter Receipts Illustration 7-5SO 3 Explain the applications of internal control principles to cash receipts.
25Cash Receipts Controls Mail ReceiptsMail receipts should be opened by two people, a list prepared, and each check endorsed.Copy of the list, along with the checks and remittance advices, sent to cashier’s department.Cashier adds the checks to the over-the-counter receipts, prepares a daily cash summary and makes the daily bank deposit.Copy of list sent to treasurer’s office for comparison with total shown on daily cash summary.SO 3 Explain the applications of internal control principles to cash receipts.
26Cash Receipts Controls Review QuestionPermitting 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. human resource controls.SO 3 Explain the applications of internal control principles to cash receipts.
27Cash Disbursement Controls Generally, internal control over cash disbursements is more effective when companies pay by check, rather than by cash.Applications:Voucher systemPetty cash fundSO 4 Explain the applications of internal control principles to cash disbursements.
28Cash Disbursement Controls Illustration 7-6Documentation ProceduresUse prenumbered checks; checks must have an approved invoice; require employees to use corporate credit cards for reimbursableexpensesEstablishment of ResponsibilityOnly designated personnel are authorized to sign checks (treasurer) and approve vendorsIndependent Internal VerificationCompare checks to invoices; reconcile bank statement monthlyHuman Resource ControlsBond personnelwho handle cash;require employeesto take vacations;conduct backgroundchecksSegregation of DutiesDifferent individuals approve and make payments; check signers do not record disbursementsPhysical ControlsStore blank checks in safes, with limited access; print check amounts by machine in indelible ink
29Review Question Cash Disbursement Controls 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.SO 4 Explain the applications of internal control principles to cash disbursements.
30Cash Disbursement Controls Voucher System ControlsVoucher SystemNetwork of approvals, by authorized individuals, to ensure all disbursements by check are proper.A voucher is an authorization form prepared for each expenditure.SO 4 Explain the applications of internal control principles to cash disbursements.
31Cash Disbursement Controls Petty Cash Fund ControlsPetty Cash Fund - Used to pay small amounts.Involves:establishing the fund,making payments from the fund, andreplenishing the fund.SO 5 Describe the operation of a petty cash fund.
32Cash Disbursement Controls Illustration: If Laird Company decides to establish a $100 fund on March 1, the journal entry is:Mar. 1Petty cash 100Cash 100SO 5 Describe the operation of a petty cash fund.
33Cash Disbursement Controls Illustration: Assume that on March 15 Laird’s petty cash custodian requests a check for $87. The fund contains $13 cash and petty cash receipts for postage $44, freight-out $38, and miscellaneous expenses $5. The general journal entry to record the check is:Mar. 15Postage expense 44Freight-out 38Miscellaneous expense 5Cash 87SO 5 Describe the operation of a petty cash fund.
34Cash Disbursement Controls Illustration: Occasionally, the company may need to recognize a cash shortage or overage. Assume that Laird’s petty cash custodian has only $12 in cash in the fund plus the receipts as listed. The request for reimbursement would, therefore, be for $88, and Laird would make the following entry:Mar. 15Postage expense 44Freight-out 38Miscellaneous expense 5Cash over and short 1Cash 88SO 5 Describe the operation of a petty cash fund.
35Control 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.SO 6 Indicate the control features of a bank account.
36Control Features: Use of a Bank Illustration 7-8Making Bank DepositsAuthorized employee should make deposit.Bank Code NumbersReverse SideFront SideSO 6 Indicate the control features of a bank account.
37Control Features: Use of a Bank Writing ChecksWritten order signed by depositor directing bank to pay a specified sum of money to a designated recipient.Illustration 7-9MakerPayeePayerSO 6 Indicate the control features of a bank account.
38Control Features: Use of a Bank Illustration 7-10Bank StatementsDebit MemorandumBank service chargeNSF (not sufficient funds)Credit MemorandumCollect notes receivable.Interest earned.SO 6 Indicate the control features of a bank account.
39Review Question Control Features: Use of a Bank The control features of a bank account do not include:having bank auditors verify the correctness of the bank balance per books.minimizing the amount of cash that must be kept on hand.providing a double record of all bank transactions.safeguarding cash by using a bank as a depository.SO 6 Indicate the control features of a bank account.
40Control Features: Use of a Bank Reconciling the Bank AccountReconcile balance per books and balance per bank to their adjusted (corrected) cash balances.Reconciling Items:Deposits in transit.Outstanding checks.Errors.Bank memoranda.SO 7 Prepare a bank reconciliation.
41Control Features: Use of a Bank Reconciliation ProceduresIllustration 7-11+ Deposit in Transit- Outstanding Checks+- Bank Errors+ Notes collected by bank- NSF (bounced) checks- Check printing or other service charges+- Company ErrorsCORRECT BALANCECORRECT BALANCESO 7 Prepare a bank reconciliation.
42Control Features: Use of a Bank Illustration: The bank statement for Laird Company (Illustration 7-12), shows a balance per bank of $15, on April 30, On this date the balance of cash per books is $11, Using the four reconciliation steps, Laird determines the following reconciling items.
43Control Features: Use of a Bank Illustration: a) Prepare a bank reconciliation at April 30.Cash balance per bank statement $15,907.45Add: Deposit in transit 2,201.40Less: Outstanding checks (5,904.00)Adjusted cash balance per bank $12,204.85Cash balance per books $11,589.45Add: Error in recording check noCollection of notes + interest - fee 1,035.00Less: NSF check (425.60)Bank service charge (30.00)Adjusted cash balance per books $12,204.85Illustration 7-12SO 7 Prepare a bank reconciliation.
44Control Features: Use of a Bank The company records each reconciling item used to determine the adjusted cash balance per books.Collection of Note Receivable: Assuming interest of $50 has not been accrued and collection fee is charged to Miscellaneous Expense, the entry is:Apr. 30Cash 1,035.00Miscellaneous expense 15.00Notes receivable 1,000.00Interest revenueSO 7 Prepare a bank reconciliation.
45Control Features: Use of a Bank Book Error: The cash disbursements journal shows that check no. 443 was a payment on account to Andrea Company, a supplier. The correcting entry is:Apr. 30CashAccounts payableSO 7 Prepare a bank reconciliation.
46Control Features: Use of a Bank NSF Check: As indicated earlier, an NSF check becomes an account receivable to the depositor. The entry is:Apr. 30Accounts receivableCashBank Service Charges: Depositors debit check printing charges (DM) and other bank service charges (SC) to Miscellaneous Expense. The entry is:Apr. 30Miscellaneous expense 30.00CashSO 7 Prepare a bank reconciliation.
47Review Question Control Features: Use of a Bank 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.SO 7 Prepare a bank reconciliation.
48Control Features: Use of a Bank Electronic Funds Transfers (EFT) SystemDisbursement systems that uses wire, telephone, or computers to transfer cash balances between locations.EFT transfers normally result in better internal control since no cash or checks are handled by company employees.SO 7 Prepare a bank reconciliation.
49Reporting CashCash consists of coins, currency (paper money), checks, money orders, and money on hand or on deposit in a bank or similar depository.Illustration 7-14Cash equivalentsRestricted cashCompensating balancesWhile cash equivalents are now frequently reported with cash, it appears likely that the IASB will end this practice in the future. Instead, items now referred to as cash equivalents will be reported as short-term investments.SO 8 Explain the reporting of cash.
50Review Question Reporting Cash Which of the following statements correctly describes the reporting of cash?Cash cannot be combined with cash equivalents.Restricted cash funds may be combined with Cash.Cash is listed first in the current assets section.Restricted cash funds cannot be reported as a current asset.SO 8 Explain the reporting of cash.
51Understanding U.S. GAAP Key Differences Fraud, Internal Control, and CashKey DifferencesThe fraud triangle discussed in this chapter is applicable to U.S. companies as well. Some of the most infamous U.S. fraud scandals are Enron, Worldcom, and, more recently, the Bernie Madoff ponzi scheme.After numerous corporate scandals, the U.S. Congress passed the Sarbanes-Oxley Act of 2002 (SOX). Under SOX, all publicly traded U.S. corporations are required to maintain an adequate system of internal control.As a result of SOX, corporate executives and boards of directors must ensure that internal controls are reliable and effective. In addition, independent outside auditors must attest to the adequacy of the internal control system.
52Understanding U.S. GAAP Key Differences Fraud, Internal Control, and CashKey DifferencesSOX created the Public Company Oversight Board (PCAOB), to establish auditing standards and regulate auditor activity.One study estimates the cost of 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. One study of first compliance with the internal-control testing provisions documented material weaknesses for about 13% of companies reporting in 2004 and 2005 (PricewaterhouseCoopers’ Global Economic Crime Survey, 2005).
53Understanding U.S. GAAP Key Differences Fraud, Internal Control, and CashKey DifferencesThe enhanced internal control standards apply only to large public companies listed on U.S. exchanges. There is continuing debate over whether foreign issuers should have to comply with this extra layer of regulation.Most companies report cash and cash equivalents together under IFRS and GAAP, as shown in this textbook. In addition, GAAP follows the same accounting policies related to the reporting of restricted cash.
54Understanding U.S. GAAP Looking to the Future Fraud, Internal Control, and CashLooking to the FutureHigh-quality international accounting requires both high-quality accounting standards and high-quality auditing. Similar to the convergence of GAAP and IFRS, there is a movement to improve both U.S. and 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. Also, under proposed new standards being developed jointly by the FASB and IASB for financial statement presentation, cash equivalents cannot be combined with cash.