7-1

7-2 Fraud, Internal Control, and Cash Kimmel ● Weygandt ● Kieso Financial Accounting, Eighth Edition 7

7-3 Apply internal control principles to cash. CHAPTER OUTLINE Define fraud and the principles of internal control. 1 2 LEARNING OBJECTIVES Identify the control features of a bank account. 3 Explain the reporting of cash and the basic principles of cash management. 4

7-4 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 Fraud triangle FRAUD LEARNING OBJECTIVE Define fraud and the principles of internal control. 1 LO 1

7-5  Applies to publicly traded U.S. corporations.  Required to maintain a 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). THE SARBANES-OXLEY ACT LO 1

7-6 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. INTERNAL CONTROL LO 1

7-7 Review Question Internal control is used in a business to enhance the accuracy and reliability of its accounting records and to:  safeguard its assets.  prevent fraud.  produce correct financial statements.  deter employee dishonesty. LO 1 INTERNAL CONTROL

7-8 Five Primary Components: 1.Control environment. 2.Risk assessment. 3.Control activities. 4.Information and communication. 5.Monitoring. INTERNAL CONTROL LO 1

7-9 Establishment of Responsibility  Control is most effective when only one person is responsible for a given task.  Establishing responsibility often requires limiting access only to authorized personnel, and then identifying those personnel. PRINCIPLES OF INTERNAL CONTROL ACTIVITIES LO 1

7-10 Segregation of Duties  Different individuals should be responsible for related activities.  The responsibility for record- keeping for an asset should be separate from the physical custody of that asset. PRINCIPLES OF INTERNAL CONTROL ACTIVITIES LO 1

7-11 Documentation Procedures  Companies should use prenumbered documents, and all documents should be accounted for.  Employees should promptly forward source documents for accounting entries to the accounting department. PRINCIPLES OF INTERNAL CONTROL ACTIVITIES LO 1

7-12 Physical Controls PRINCIPLES OF INTERNAL CONTROL ACTIVITIES ILLUSTRATION 7-2 Physical controls LO 1

7-13  Records periodically verified by an employee who is independent.  Discrepancies reported to management. Independent Internal Verification PRINCIPLES OF INTERNAL CONTROL ACTIVITIES ILLUSTRATION 7-3 Comparison of segregation of duties principle with independent internal verification principle LO 1

7-14 Human Resource Controls  Bond employees who handle cash.  Rotate employees’ duties and require vacations.  Conduct background checks. PRINCIPLES OF INTERNAL CONTROL ACTIVITIES LO 1

7-15 Review Question The principles of internal control do not include:  establishment of responsibility.  documentation procedures.  management responsibility.  independent internal verification. LO 1 PRINCIPLES OF INTERNAL CONTROL

7-16  Costs should not exceed benefit.  Human element.  Size of the business. ▼ HELPFUL HINT Controls may vary with the risk level of the activity. For example, management may consider cash to be high risk and maintaining inventories in the stockroom as lower risk. Thus, management would have stricter controls for cash. LIMITATIONS OF INTERNAL CONTROL LO 1

7-17 Identify which control activity is violated in each of the following situations. Control Activities DO IT! 1 1.The person with primary responsibility for reconciling the bank account and making all bank deposits is also the company’s accountant. 2.Wellstone Company’s treasurer received an award for distinguished service because he had not taken a vacation in 30 years. 3.In order to save money on order slips and to reduce time spent keeping track of order slips, a local bar/restaurant does not buy prenumbered order slips. Segregation of duties Human resource controls Documentation procedures SOLUTION LO 1

7-18 Cash Receipt Controls LEARNING OBJECTIVE Apply internal control principles to cash. 2 LO 2 ILLUSTRATION 7-4 Application of internal control principles to cash receipts

7-19 CASH RECEIPT CONTROLS ILLUSTRATION 7-4 Application of internal control principles to cash receipts LO 2

7-20 Important internal control principle— segregation of record-keeping from physical custody. Over-the-Counter Receipts CASH RECEIPT CONTROLS ILLUSTRATION 7-5 Control of over-the-counter receipts LO 2

7-21 Mail Receipts  Mail receipts should be opened by two people, a list prepared, and each check endorsed “For Deposit Only.”  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. CASH RECEIPT CONTROLS LO 2

7-22 Review Question Permitting only designated personnel such as cashiers to handle cash receipts is an application of the principle of:  segregation of duties.  establishment of responsibility.  independent internal verification.  human resource controls. LO 2 CASH RECEIPT CONTROLS

7-23 Generally, internal control over cash disbursements is more effective when companies pay by check or electronic funds transfer (EFT) rather than by cash. Applications:  Voucher System Controls  Petty Cash Fund (Appendix 7A) CASH DISBURSEMENT CONTROLS LO 2

7-24 CASH DISBURSEMENT CONTROLS ILLUSTRATION 7-6 Application of internal control principles to cash disbursements LO 2

7-25 CASH DISBURSEMENT CONTROLS ILLUSTRATION 7-6 Application of internal control principles to cash disbursements LO 2

7-26 Review Question The use of prenumbered checks in disbursing cash is an application of the principle of:  establishment of responsibility.  segregation of duties.  physical controls.  documentation procedures. CASH DISBURSEMENT CONTROLS LO 2

7-27 Voucher System  A network of approvals by authorized individuals, acting independently, to ensure all disbursements by check are proper.  A voucher is an authorization form prepared for each expenditure in a voucher system. CASH DISBURSEMENT CONTROLS LO 2

7-28 L. R. Cortez is concerned about the control over cash receipts in his fast-food restaurant, Big Cheese. The restaurant has two cash registers. At no time do more than two employees take customer orders and enter sales. Work shifts for employees range from 4 to 8 hours. Cortez asks your help in installing a good system of internal control over cash receipts. Control over Cash Receipts DO IT! 2 SOLUTION ●A separate cash register drawer should be assigned to each employee at the start of each work shift, with register totals set at zero. ●Each employee should have access to only the assigned register drawer to enter all sales. LO 2

7-29 Control over Cash Receipts DO IT! 2 SOLUTION ●Each customer should be given a receipt. ●At the end of the shift, the employee should do a cash count. A separate employee should compare the cash count with the register tape (or point-of-sale records) to be sure they agree. ●Cortez should install an automated point-of-sale system that would enable the company to compare orders entered in the register to orders processed by the kitchen. LO 2

7-30 The use of a bank contributes significantly to good internal control over cash.  Minimizes the amount of currency on hand.  Creates a double record of bank transactions.  Bank reconciliation. ▼ HELPFUL HINT Essentially, the bank statement is a copy of the bank’s records sent to the customer or made available online for review. LEARNING OBJECTIVE Identify the control features of a bank account. 3 LO 3

7-31 EFTs  Are disbursement systems that use wire, telephone, or computers to transfer cash from one location to another.  Use is quite common.  Normally result in better internal control since no cash or checks are handled by company employees. ELECTRONIC FUNDS TRANSFER (EFT) SYSTEM LO 3

7-32 ILLUSTRATION 7-7 Bank statement BANK STATEMENTS Each month, the company receives from the bank a bank statement showing its bank transactions and balances.

7-33 Shows the following: 1.Checks paid and other debits that reduce the balance. ●Debit card transactions ●Electronic funds transfers for bill payments 2.Deposits and other credits that increase the balance. ●Direct deposit ●Automated teller machine ●Electronic funds transfer BANK STATEMENTS LO 3

7-34 Shows the following: 3.Debit Memorandum. ●Bank service charge ●NSF check (not sufficient funds) 4.Credit Memorandum. ●Collection of a notes receivable ●Interest earned 5.The account balance after each day’s transactions. BANK STATEMENTS LO 3

7-35 Review Question 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. BANK STATEMENTS LO 3

7-36 Reconcile balance per books and balance per bank to their “correct or true” balance. Reconciling Items: 1.Deposits in transit. 2.Outstanding checks. 3.Bank memoranda. 4.Errors. Time Lags RECONCILING THE BANK ACCOUNT LO 3

Deposits in transit - Outstanding checks +/- Bank errors +EFT collections and other deposits -NSF (bounced) checks -Service charges and other payments +/-Company errors CORRECT BALANCE RECONCILIATION PROCEDURES ILLUSTRATION 7-8 Bank reconciliation adjustments LO 3

7-38 BANK RECONCILIATION ILLUSTRATED The bank statement for Laird Company shows a balance per bank of $15, on April 30, On this date the balance of cash per books is $11, Laird determines the following reconciling items. Deposits in transit: April 30 deposit (received by bank on May 1). $2, Outstanding checks: No. 453, $3,000.00; No. 457, $1,401.30; No. 460, $1, , Other deposits: Unrecorded electronic receipt from customer on account on April 9 determined from bank statement. 1, Other payments: Unrecorded charges determined from the bank statement are as follows: Returned NSF check on April Debit and credit card fees on April Bank service charges on April Company errors: Check No. 443 was correctly written by Laird for $1,226 and was correctly paid by the bank on April 12. However, it was recorded as $1,262 on Laird’s books LO 3

7-39 Illustration: Prepare a bank reconciliation at April 30. Cash balance per bank statement $15, Deposit in transit2, Outstanding checks(5,904.00) Adjusted cash balance per bank$12, Cash balance per books $11, Electronic funds transfer received $1, Error in recording check No NSF check (425.60) Debit and credit card fees (120.00) Bank service charge (30.00) Adjusted cash balance per books$12, BANK RECONCILIATION ILLUSTRATED LO 3

7-40 Collection of Electronic Funds Transfer: Payment of account by customer. The entry is: Cash 1, Accounts Receivable1, Apr. 30 Entries From Bank Reconciliation BANK RECONCILIATION ILLUSTRATED LO 3

7-41 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: Cash 36.00Apr. 30 Accounts payable36.00 NSF Check: As indicated earlier, an NSF check becomes an account receivable to the depositor. The entry is: Accounts receivable425.60Apr. 30 Cash BANK RECONCILIATION ILLUSTRATED LO 3

7-42 Bank Charges Expense: Fees for processing debit and credit card transactions are normally debited to the Bank Charges Expense account, as are bank service charges. The entry is: Bank Charge Expense150.00Apr. 30 Cash BANK RECONCILIATION ILLUSTRATED ILLUSTRATION 7-10 Adjusted balance in Cash account LO 3

7-43 Review Question The reconciling item in a bank reconciliation that will result in an adjusting entry by the depositor is:  outstanding checks.  deposit in transit.  a bank error.  bank service charges. BANK RECONCILIATION LO 3

7-44 Sally should treat the reconciling items as follows. (1) NSF check: Deduct from balance per books. (2) Electronic funds transfer: Add to balance per books. (3) Outstanding checks: Deduct from balance per bank. (4) Deposit in transit: Add to balance per bank. Sally Kist, owner of Linen Kist Fabrics, asks you to explain how she should treat the following reconciling items when reconciling the company’s bank account: (1) a debit memorandum for an NSF check, (2) a credit memorandum for an electronic funds transfer from a customer, (3) outstanding checks, and (4) a deposit in transit. SOLUTION Bank Reconciliation DO IT! 3 LO 3

7-45  Cash consists of coins, currency (paper money), checks, money orders, and money on hand or on deposit.  Balance sheet reports the amount of cash available at a given point in time. ► Listed first in the current assets section. ► Includes cash on hand, cash in banks, and petty cash.  Statement of cash flows shows the sources and uses of cash during a period of time. REPORTING CASH LEARNING OBJECTIVE Explain the reporting of cash and the basic principles of cash management. 4 LO 4

7-46 Cash equivalents are short-term, highly liquid investments that are both: 1.Readily convertible to known amounts of cash, and 2.So near their maturity that their market value is relatively insensitive to changes in interest rates. Cash Equivalents Cash that is not available for general use but rather is restricted for a special purpose. Restricted Cash REPORTING CASH LO 4

7-47 REPORTING CASH ILLUSTRATION 7-11 Balance sheet presentation of cash LO 4

7-48 Review Question 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. REPORTING CASH LO 4

7-49 ILLUSTRATION 7-12 Operating Cycle of a Merchandising Company MANAGING AND MONITORING CASH LO 4

7-50 ILLUSTRATION 7-13 Basic Principles of Cash Management MANAGING AND MONITORING CASH LO 4

7-51  Shows anticipated cash flows, usually over a one- to two-year period. ► Cash receipts ► Cash disbursements ► Financing activities  Enables the company to plan ahead to cover possible cash shortfalls and to make investments of idle funds.  Contributes to more effective cash management. CASH BUDGETING LO 4

7-52 ILLUSTRATION 7-15 Sample cash budget

7-53 Martian Company’s management wants to maintain a minimum monthly cash balance of $15,000. At the beginning of March, the cash balance is $16,500, expected cash receipts for March are $210,000, and cash disbursements are expected to be $220,000. How much cash, if any, must Martian borrow to maintain the desired minimum monthly balance? Cash Budget DO IT! 4b Beginning cash balance $ 16,500 Add: Cash receipts for March 210,000 Total available cash 226,500 Less: Cash disbursements for March 220,000 Excess of available cash over cash disbursements 6,500 Financing Add: Borrowings 8,500 Ending cash balance $ 15,000 LO 4

7-54 Involves: 1.establishing the fund, 2.making payments from the fund, and 3.replenishing the fund. Petty Cash Fund - Used to pay small amounts. ETHICS NOTE Petty cash funds are authorized and legitimate. In contrast, “slush” funds are unauthorized and hidden (under the table). LEARNING OBJECTIVE APPENDIX 7A: Explain the operation of a petty cash fund. 5a LO 5

7-55 Illustration: If Laird Company decides to establish a $100 fund on March 1, the entry is: Petty Cash100March 1 Cash100 ESTABLISHING THE PETTY CASH FUND LO 5

7-56  Management usually limits the size of expenditures.  Does not permit use of the fund for certain types of transactions.  Payments are documented on a prenumbered receipt.  Signatures of both the custodian and the individual receiving payment are required on the receipt.  Supporting documents should be attached to the receipt.  Custodian keeps the receipts in the petty cash box until the fund is replenished.  Sum of the receipts and money in the fund should equal the established total at all times. MAKING PAYMENTS FROM PETTY CASH LO 5

7-57 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: Postage Expense44March 15 Cash87 Supplies38 Miscellaneous Expense5 REPLENISHING THE PETTY CASH FUND LO 5

7-58 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: Cash Over and Short1 Cash88 Postage Expense44March 15 Supplies38 Miscellaneous Expense5 REPLENISHING THE PETTY CASH FUND LO 5