Chapter 7: Fraud, Internal Control, and Cash

5 Primary Components of Internal Control Systems

1. A control environment → "tone at the top," must be clear that organization values integrity and will not tolerate unethical activity 2. Risk Assessment → must identify risks, and figure out how to manage them 3. Control Activities → policies and procedures must be put in place to address specific risks 4. Information and Communication → internal control system must be clearly communicated inside the company and to appropriate external parties 5. Monitoring → internal control systems must be monitored for their adequacy and deficiencies must be reported to management

6 Principles of Control Activities

1. Establishment of responsibility 2. Segregation of duties 3. Documentation procedures 4. Physical controls 5. Independent internal verification 6. Human resource controls

Basic Principles of Cash Management

1. Increase the speed of receivables collection 2. Keep inventory levels low 3. Monitor payment of liabilities 4. Plan the timing of major expenditures 5. Invest idle cash

What causes the need for bank reconciliations?

1. Time lags that prevent one of the parties from recording the transaction in the same period. 2. Errors by either party in recording transactions.

Petty cash fund

A cash fund used to pay relatively small amounts.

NSF check

A check that is not paid by a bank because of insufficient funds in a bank account.

Electronic funds transfer (EFT)

A disbursement system that uses wire, telephone, or computer to transfer cash from one location to another.

Fraud

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

Bank service charge

A fee charged by a bank for the use of its services.

Define fraud and internal control.

A fraud is a dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. The fraud triangle refers to the three factors that contribute to fraudulent activity by employees: opportunity, financial pressure, and rationalization. Internal control consists of all the related methods and measures adopted within an organization to safeguard assets, enhance the reliability of accounting records, increase efficiency of operations, and ensure compliance with laws and regulations.

Bank statement

A monthly statement from the bank that shows the depositor's bank transactions and balances.

Voucher system

A network of approvals by authorized individuals, acting independently, to ensure that all disbursements by check are proper.

Cash Budget

A projection of anticipated cash flows, usually over a one- to two-year period.

Check

A written order signed by a bank depositor, directing the bank to pay a specified sum of money to a designated recipient.

Internal control

All the related methods and measures adopted within an organization to safeguard assets and enhance the reliability of accounting records, increase efficiency of operations, and ensure compliance with laws and regulations.

Voucher

An authorization form prepared for each expenditure in a voucher system.

Explain the reporting of cash

Cash is listed first in the current assets section of the balance sheet. Companies often report cash together with cash equivalents. Cash restricted for a special purpose is reported separately as a current asset or as a noncurrent asset, depending on when the company expects to use the cash.

Restricted cash

Cash that is not available for general use but instead is restricted for a particular purpose.

Outstanding checks

Checks issued and recorded by a company that have not been paid by the bank.

Internal auditors

Company employees who continuously evaluate the effectiveness of the company's internal control systems.

Deposits in transit

Deposits recorded by the depositor that have not been recorded by the bank.

Which internal control principle best relates to the problem described? Some cash payments are not recorded because checks are not prenumbered.

Documentation procedures

Which internal control procedure is applicable to cash receipts for this situation? Deposit slips are completed for each deposit.

Documentation procedures

To record an NSF check (to put nsf check back in receivables)

Dr. Accounts Receivable Cr. Cash

To correct error in recording a check

Dr. Cash Cr. Accounts Payable

To record cash shortfall (when drawer is short the money that should be in it according to register tape)

Dr. Cash Dr. Cash Over and Short Cr. Sales Revenue Cash Over and Short = INCOME STATEMENT ITEM Reported as MISCELLANEOUS EXPENSE when there is a cash shortfall and MISCELLANEOUS REVENUE when there is an overage

To record collection of note receivable by bank

Dr. Cash Dr. Miscellaneous Expense Cr. Notes Receivable Cr. Interest Revenue cash → collection of note receivable + interest earned - bank collection fee miscellaneous expense → collection fee notes receivable → collection of note receivable interest revenue

To record bank service charges

Dr. Miscellaneous Expense Cr. Cash

Treasurer

Employee responsible for the management of a company's cash.

Which internal control procedure is applicable to cash receipts for this situation? Only the treasurer holds cash receipts.

Establishment of responsbilities

Which internal control principle best relates to the problem described? Three people handle cash sales from the same cash register drawer.

Establishment of responsibility

Which internal control principle best relates to the problem described? The treasurer of the company has not taken a vacation for over 20 years.

Human resource controls

Which internal control procedure is applicable to cash receipts for this situation? All cashiers are bonded.

Human resource controls

Prepare a bank reconciliation.

In reconciling the bank account, it is customary to reconcile the balance per books and the balance per bank to their adjusted balance. The steps reconciling the Cash account are to determine deposits in transit, outstanding checks, errors by the depositor or the bank, and unrecorded bank memoranda.

Which internal control principle best relates to the problem described? Cash shortages are not discovered because there are no daily cash counts by supervisors.

Independent internal verification

Which internal control procedure is applicable to cash receipts for this situation? The treasurer compares the total cash receipts to the bank deposit daily.

Independent internal verification

Explain the applications of internal control principles to cash disbursements.

Internal controls over cash disbursements include: (a) having only specified individuals such as the treasurer authorized to sign checks; (b) assigning the duties of approving items for payment, paying the items, and recording the payment to different individuals; (c) using prenumbered checks and accounting for all checks, with each check supported by an approved invoice; after payment, stamping each approved invoice "paid"; (d) storing blank checks in a safe or vault with access restricted to authorized personnel, and using a machine with indelible ink to imprint amounts on checks; (e) comparing each check with the approved invoice before issuing the check, and making monthly reconciliations of bank and book balances; and (f) bonding personnel who handle cash, requiring employees to take vacations, and conducting background checks.

Explain the applications of internal control principles to cash receipts.

Internal controls over cash receipts include: (a) designating only personnel such as cashiers to handle cash; (b) assigning the duties of receiving cash, recording cash, and having custody of cash to different individuals; (c) obtaining remittance advices for mail receipts, cash register tapes or computer records for over-the-counter receipts, and deposit slips for bank deposits; (d) using company safes and bank vaults to store cash with access limited to authorized personnel, and using cash registers in executing over-the-counter receipts; (e) making independent daily counts of register receipts and daily comparisons of total receipts with total deposits; and (f) conducting background checks and bonding personnel who handle cash, as well as requiring them to take vacations.

Sarbanes-Oxley Act of 2002 (SOX)

Law that requires publicly traded companies to maintain adequate systems of internal control.

Bonding

Obtaining insurance protection against theft by employees.

Which internal control principle best relates to the problem described? A clothing store is experiencing a high level of inventory shortages because people try on clothing and walk out of the store without paying for the merchandise.

Physical control devices

(Principle of Control Activities) Documentation Procedures

Principle of control in which companies should establish procedures for documents

(Principle of Control Activities) Establishment of Responsibility

Principle of control in which control is most effective when only ONE person is responsible for a given task

(Principle of Control Activities) Segregation of Duties

Principle of control in which different individuals should be responsible for related activities, and the responsibility of record keeping for an asset should be separate from the physical custody of the asset

(Principle of Control Activities) Physical Controls

Principle of control related to the safeguarding of assets, they enhance the accuracy and reliability of the accounting records

(Principle of Control Activities) Independent Internal Verification

Principle of control that involves the review of data prepared by employees

(Principle of Control Activities) Human Resource Controls

Principle of control that partakes in... a. Bonding Employees who handle cash b. Rotating employees' duties and require employees to take vacations c. Conducting thorough background checks

Cash

Resources that consist of coins, currency, checks, money orders, and money on hand or on deposit in a bank or similar depository.

Which internal control principle best relates to the problem described? The person who is authorized to sign checks approves purchase orders for payment.

Segregation of duties

Which internal control principle best relates to the problem described? The same person opens incoming mail and posts the accounts receivable subsidiary ledger.

Segregation of duties

Which internal control procedure is applicable to cash receipts for this situation? The bookkeeper records cash receipts which are held by the treasurer.

Segregation of duties

Cash equivalents

Short-term, highly liquid investments that can be readily converted to a specific amount of cash and which are relatively insensitive to interest rate changes.

Discuss the basic principles of cash management.

The basic principles of cash management include: (a) increase the speed of receivables collection, (b) keep inventory levels low, (c) monitor the timing of payment of liabilities, (d) plan timing of major expenditures, and (e) invest idle cash.

Identify the principles of internal control activities.

The principles of internal control are establishment of responsibility; segregation of duties; documentation procedures; physical controls; independent internal verification; and human resource controls.

Bank reconciliation

The process of comparing the bank's balance of an account with the company's balance, and explaining the differences to make them agree.

Reconciliation Procedure

The starting point in preparing the reconciliation is to enter the balance per bank statement and balance per books on a schedule. Step 1: Deposits in Transit Step 2: Outstanding Checks Step 3: Errors Step 4: Bank Memoranda

Fraud triangle

The three factors that contribute to fraudulent activity by employees: Opportunity Financial pressure Rationalization.

Identify the primary elements of a cash budget.

The three main elements of a cash budget are the cash receipts section, cash disbursements section, and financing section.

Collection of a note should be ________ to/from the balance per bank

added

Deposits in transit should be _________ to/from the balance per bank

added

NFS checks should be ________ to/from the balance per books

deducted

Outstanding checks should be _________ to/from the balance her bank

deducted

Would this reconciling item require an adjusting entry to be made? Deposits in transit totaled $2,000.

no

Would this reconciling item require an adjusting entry to be made? Outstanding checks totaled $1,667.

no

Does this business practice strengthens or weakens a company's system of internal control? All payments are made with checks

strengthens a company's system of internal control

Does this business practice strengthens or weakens a company's system of internal control? Using renumbered sales tickets

strengthens a company's system of internal control

Does this business practice strengthens or weakens a company's system of internal control? Cashiers are not bonded

weakens a company's system of internal control

Does this business practice strengthens or weakens a company's system of internal control? Discouraging employees from taking paid vacations

weakens a company's system of internal control

Does this business practice strengthens or weakens a company's system of internal control? Two people handle cash sales from the same cash register drawer

weakens a company's system of internal control

Would this reconciling item require an adjusting entry to be made? A check written to the company for $350 by Grover Company was returned NSF.

yes

Would this reconciling item require an adjusting entry to be made? A debit memorandum reported an EFT of $178 to Paco Utilities.

yes

Would this reconciling item require an adjusting entry to be made? The bank charged the company $46 for printing checks.

yes