ACC 298-CH 7 (Fraud and Internal Controls)

NSF Check

As indicated earlier, an NSF check becomes an accounts receivable to the depositor. The entry is as follows. Accounts Rec. (debit): 500 Cash (credit): 500

Purchasing Activities

Companies should, for example, assign related purchasing activities to different individuals. Related purchasing activities include ordering merchandise, approving orders, receiving goods, authorizing payment, and paying for goods or services. Various frauds are possible when one person handles related purchasing activities: •If a purchasing agent is allowed to order goods without obtaining supervisory approval, the likelihood of the purchasing agent receiving kickbacks from suppliers increases. •If an employee who orders goods also handles the invoice and receipt of the goods, as well as payment authorization, he or she might authorize payment for a fictitious invoice.

Internal Auditors

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

Risk Assessment

Component of internal control Companies must identify and analyze the various factors that create risk for the business and must determine how to manage these risks.

Monitoring

Component of internal control Internal control systems must be monitored periodically for their adequacy. Significant deficiencies need to be reported to top management and/or the board of directors.

Control Environment

Component of internal control It is the responsibility of top management to make it clear that the organization values integrity and that unethical activity will not be tolerated. This component is often referred to as the "tone at the top."

Information and Communication

Component of internal control The internal control system must capture and communicate all pertinent information both down and up the organization, as well as communicate information to appropriate external parties.

Control Activities

Component of internal control To reduce the occurrence of fraud, management must design policies and procedures to address the specific risks faced by the company.

A

Dewitt Company gathered the following information in preparing its bank reconciliation on May 31: Cash balance per books, May 31, $3,500; deposits in transit, $1,150; note and interest collected by the bank, $850; bank service charge, $20; outstanding checks, $2,500; NSF check, $170. The adjusted cash balance per books at May 31 is A. $4,160. B $3,010. C $5,510. D $2,460.

Documentation Procedures

Documents provide evidence that transactions and events have occurred. For example, point-of-sale terminals are networked with a company's computing and accounting records, which results in direct documentation. Similarly, a shipping document indicates that the goods have been shipped, and a sales invoice indicates that the company has billed the customer for the goods. By requiring signatures (or initials) on the documents, the company can identify the individual(s) responsible for the transaction or event. Companies should document transactions when they occur. First, whenever possible, companies should use prenumbered documents, and all documents should be accounted for. Second, the control system should require that employees promptly forward source documents for accounting entries to the accounting department. This control measure helps to ensure timely recording of the transaction and contributes directly to the accuracy and reliability of the accounting records.

The financial secretary has custody of the cash, maintains church records, and prepares the bank reconciliation. [segregations of duties!]

Each month, the financial secretary reconciles the bank statement and submits a copy of the reconciliation to the board of trustees. The reconciliations have rarely contained any bank errors and have never shown any errors per books.

Financial Pressure

Employees sometimes commit fraud because of personal financial problems caused by too much debt Or, they might commit fraud because they want to lead a lifestyle that they cannot afford on their current salary.

Bank Charge Expense

Fees for processing debit and credit card transactions are normally debited to the Bank Charge Expense account, as are bank service charges. We have chosen to combine and record these in one journal entry, as shown below, although they also could be journalized separately. Bank Charge Exp: (debit) 200 Cash (credit): 200

D

Identify the example of poor internal control. A A salesperson makes the sale and a different person ships the goods. You got it wrong : B The custodian of an asset should not maintain or have access to the accounting records. C The accountant should not have physical custody of the asset nor access to it. D One person should be responsible for handling related transactions.

D

If a check written and paid by the bank for $638 is incorrectly recorded on the company's books at $683, the appropriate treatment on the bank reconciliation would be to A deduct $438 from the book balance. B add $45 to the bank balance. C deduct $45 from the bank balance. D add $45 to the book's balance.

Rationalization

In order to justify their fraud, employees______________________ their dishonest actions. For example, employees sometimes justify fraud because they believe they are underpaid while the employer is making lots of money. Employees feel justified in stealing because they believe they deserve to be paid more.

Opportunity

Most important element of the fraud triangle -the workplace environment must provide ____________________ that an employee can take advantage of -when the workplace lacks sufficient controls to deter and detect fraud For example, inadequate monitoring of employee actions can create opportunities for theft and can embolden employees because they believe they will not be caught.

D

Printing check amounts by machine in indelible ink is an example of A independent internal verification. B segregation of duties. C establishment of responsibility. D physical controls.

Reconciling the Bank Account

Reconcile balance per books and balance per bank to their "correct" or "true" balance. Items to reconcile: 1.Deposits in transit. 2.Outstanding checks. 3.Bank memorandum. 4.Errors by either party in recording transactions. -all time lags that prevent one of the parties from recording the transaction in the same period. For example, several days may elapse between the time a company pays by check and the date the bank pays the check. Similarly, when a company uses the bank's night depository to make its deposits, there will be a difference of one day between the time the company records the receipts and the time the bank does so. A time lag also occurs whenever the bank mails a debit or credit memorandum to the company.

Independent Internal Verification

Records periodically verified by an employee who is independent. 1.Companies should verify records periodically or on a surprise basis. 2.An employee who is independent of the personnel responsible for the information should make the verification. 3.Discrepancies and exceptions should be reported to a management level that can take appropriate corrective action.

Sarbanes-Oxley Act

Regulations passed by Congress to try to reduce unethical corporate behavior. -all publicly traded U.S. corporations are required to maintain an adequate system of internal control. -Corporate executives and boards of directors controls are reliable and effective - independent outside auditors must attest to the adequacy of the internal control system

Cash Equivalents

Short-term, highly liquid investments that can be converted to a specific amount of cash. 1.Readily convertible to known amounts of cash 2.So near their maturity that their market value is relatively insensitive to changes in interest rates. (Generally, only investments with maturities of three months or less qualify under this definition.)

Sales Activities

Similarly, companies should assign related sales activities to different individuals. Related selling activities include making a sale, shipping (or delivering) the goods to the customer, billing the customer, and receiving payment. Various frauds are possible when one person handles related sales activities: •If a salesperson can make a sale without obtaining supervisory approval, he or she might make sales at unauthorized prices to increase sales commissions. •A shipping clerk who also has access to accounting records could ship goods to himself. •A billing clerk who handles billing and receipt could understate the amount billed for sales made to friends and relatives.

segregation of record keeping from physical custody

The accountant should have neither physical custody of the asset nor access to it. Likewise, the custodian of the asset should not maintain or have access to the accounting records. The custodian of the asset is not likely to convert the asset to personal use when one employee maintains the record of the asset, and a different employee has physical custody of the asset.

Human Resource Control

The church's board of trustees has delegated responsibility for the financial management and audit of the financial records to the finance committee. This group prepares the annual budget and approves major disbursements. It is not involved in collections or recordkeeping. No audit has been made in recent years because the same trusted employee has kept church records and served as financial secretary for 15 years. The church does not carry any fidelity insurance.

Physical Controls (money is kept overnight in safe) and segregation of duties (each usher could take money from collection plates) Segregation of duties and independent verification (head usher counts money alone)

The collection at the weekly service is taken by a team of ushers who volunteer to serve one month. The ushers take the collection plates to a basement office at the rear of the church. They hand their plates to the head usher and return to the church service. After all plates have been turned in, the head usher counts the cash received. The head usher then places the cash in the church safe along with a notation of the amount counted. The head usher volunteers to serve for 3 months.

Entries from Bank Reconciliation

The depositor (that is, the company) next must record each reconciling item used to determine the adjusted cash balance per books. If the company does not journalize and post these items, the Cash account will not show the correct balance.

Segregation of duties and human resource control (financial secretary is counting cash alone; this should be combined with head usher for observation)

The next morning, the financial secretary opens the safe and recounts the collection.

Bank Reconciliation

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

The financial secretary withholds $150 to $200 per week. [segregation of duties: the person with accounting responsibilities should not also handle cash] Checks are made payable to "cash." [Terrible idea! This creates the 'Opportunity' element of the Fraud Triangle. Documentation procedure failure. All checks should be made payable to the organization; otherwise it's the same as actual cash.]

The secretary withholds $150-$200 in cash, depending on the cash expenditures expected for the week, and deposits the remainder of the collections in the bank. To facilitate the deposit, church members who contribute by check are asked to make their checks payable to "Cash."

Fraud Triangle

The three factors that contribute to fraudulent activity by employees: opportunity, financial pressure, and rationalization.

Using Bank as a Control Feature

The use of a bank contributes significantly to good internal control over cash. A company safeguards its cash by using a bank as a depository and clearinghouse for checks received and checks written. The use of a bank checking account minimizes the amount of currency that must be kept on hand. It also facilitates control of cash because a double record is maintained of all bank transactions—one by the business and the other by the bank Bank reconciliation

RECONCILIATION PROCEDURE

To obtain maximum benefit from a bank reconciliation, an employee who has no other responsibilities related to cash should prepare the reconciliation. Reconciling Items Per Bank and Reconciling Items Per Books

B

Tonya A. is responsible for posting entries to the company's accounts receivable subsidiary ledger. Her colleague, Joshua P. posts to the Accounts Receivable Control account in the general ledger. This is an example of A inadequate internal control. B segregation of duties. C duplication of effort. D external verification.

B

What does the term "bonding" mean when it refers to employees? A It is impossible for them to steal from the company. B They have been insured against misappropriation of assets. C They have worked for the company for at least 10 years. D They are allowed to handle cash.

A

When a company allows only designated personnel to handle cash receipts, it is applying the internal control principle of This is correct answer : A establishment of responsibility. B segregation of duties. C documentation procedures. D independent internal verification.

C

Which of the following is an example of an electronic funds transfer? A Paying regular monthly bills by check. B Sending stock reports to shareholders electronically. C Sending payroll data directly to banks for direct deposit to employee accounts. D Issuing formal payroll checks to employees.

A

Which of the following statements regarding external auditors is true? A They are hired by CPA firms to audit business firms. B They evaluate the system of internal controls for the companies that employ them. C They are employees of the IRS who evaluate the internal controls of companies filing tax returns. D They cannot evaluate the system of internal controls of the company that employs them because they are not independent.

B

Which of the following would be the appropriate treatment on a bank reconciliation if a check correctly written and paid by the bank for $734 is incorrectly recorded on the company's books for $743? A deduct $734 from the book's balance B add $9 to the book's balance C subtract $9 from the book's balance D deduct $11 from the bank's balance

Segregation of Related Activities

making one individual responsible for related activities increases the potential for errors and irregularities

Reconciling Items Per Books

relate to amounts not yet recorded on the company's books and include adjustments from deposits and other amounts added, payments and other amounts deducted, and company errors (if any). Step 1.Other deposits (+). Compare the other deposits on the bank statement with the company records. Any unrecorded amounts should be added to the balance per books. For example, if the bank statement shows electronic funds transfers from customers paying their accounts online, these amounts should be added to the balance per books on the bank reconciliation to update the company's records unless they had previously been recorded by the company. Step 2.Other payments (−). Similarly, any unrecorded other payments should be deducted from the balance per books. For example, if the bank statement shows service charges (such as debit and credit card fees and other bank service charges), this amount is deducted from the balance per books on the bank reconciliation to make the company's records agree with the bank's records. Normally, the company will already have recorded electronic payments. However, if this has not been the case then these payments must be deducted from the balance per books on the bank reconciliation to make the company's records agree with the bank's records. Step 3.Book errors (+/−). Note any errors made by the depositor that have been discovered in the previous steps. For example, say a company wrote check No. 493 to a supplier in the amount of $1,226 on April 12, but the accounting clerk recorded the check amount as $1,262. The error of $36 ($1,262 − $1,226) is added to the balance per books because the company reduced the balance per books by $36 too much when it recorded the check as $1,262 instead of $1,226. Only errors made by the company, not the bank, are included as reconciling items in determining the adjusted cash balance per books.

Physical Controls

relate to the safeguarding of assets and enhance the accuracy and reliability of the accounting records EX: -safe, vault, safety deposit boxes for cash and business docs -locked warehouse and storage cabinets for inventories and records -computer facilities with passkey access or fingerprint or eyeball scans -alarms to prevent breakins -television monitors and sensors -time clocks for recording time worked

RECONCILING ITEMS PER BANK

the items to reconcile are deposits in transit (amounts added), outstanding checks (amounts deducted), and bank errors (if any). By adjusting the bank balance for these items, a company brings that balance up to date. Step 1.Deposits in transit (+). Compare the individual deposits on the bank statement with the deposits in transit from the preceding bank reconciliation and with the deposits per company records or copies of duplicate deposit slips. Add these deposits to the balance per bank Step 2.Outstanding checks (−). Compare the paid checks shown on the bank statement or the paid checks returned with the bank statement with (a) checks outstanding from the preceding bank reconciliation, and (b) checks issued by the company recorded as cash payments. Issued checks recorded by the company that have not been paid by the bank represent outstanding checks. Deduct outstanding checks from the balance per bank. Step 3.Bank errors (+/−). Note any errors made by the bank that were discovered in the previous steps. For example, if the bank processed a deposit of $1,693 as $1,639 in error, the difference of $54 ($1,693 − $1,639) is added to the balance per bank on the bank reconciliation. All errors made by the bank are reconciling items in determining the adjusted cash balance per the bank.

Components of Internal Controls

1. Control Environment 2. Risk Assessment 3. Control Activities 4. Information and Communication 5. Monitoring

Limitations of Internal Control

1. Human Element--A good system can become ineffective as a result of employee fatigue, carelessness, or indifference; two or more individuals may work together to get around prescribed controls. Such collusion can significantly reduce the effectiveness of a system, eliminating the protection offered by segregation of duties. No system of internal control is perfect. 2. size of the business--Small companies often find it difficult to segregate duties or to provide for independent internal verification Costs should not exceed benefit. 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.

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

Human Resource Controls

1.Bond employees who handle cash. Bonding involves obtaining insurance protection against theft by employees. It contributes to the safeguarding of cash in two ways. First, the insurance company carefully screens all individuals before adding them to the policy and may reject risky applicants. Second, bonded employees know that the insurance company will vigorously prosecute all offenders. 2. Rotate employees' duties and require employees to take vacations. These measures deter employees from attempting thefts since they will not be able to permanently conceal their improper actions. 3.Conduct thorough background checks

Segregation of Duties

1.Different individuals should be responsible for related activities. 2.The responsibility for record keeping for an asset should be separate from the physical custody of that asset. The work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of another employee. EX: or example, the personnel that design and program computerized systems should not be assigned duties related to day-to-day use of the system. Otherwise, they could design the system to benefit them personally and conceal the fraud through day-to-day use.

NSP Checks

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

Electronic Funds Transfer

A disbursement system that uses wire, telephone, or computers to transfer funds from one location to another instead of using paper Normally result in better internal control since no cash or checks are handled by company employees. This does not mean that opportunities for fraud are eliminated. In fact, the same basic principles related to internal control apply to these transactions. For example, without proper segregation of duties and authorizations, an employee might be able to redirect electronic payments into a personal bank account and conceal the theft with fraudulent accounting entries.

Fraud

A dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. EX: -A bookkeeper in a small company diverted $750,000 of bill payments to a personal bank account over a three-year period. -A shipping clerk with 28 years of service shipped $125,000 of merchandise to himself. -A computer operator embezzled $21 million from Wells Fargo Bank over a two-year period.

C

A month-end bank statement shows a balance of $52,000, outstanding checks are $8,000, a deposit of $3,500 was in transit at month end, and a deduction error of $25 made by the bank against the account. What is the correct balance in the bank account at month end? A $44,000 B $47,500 C $47,525 D $60,525

Bank Statements

A monthly statement from the bank that shows the depositor's bank transactions and balances. Prepared from the bank's perspective. Every deposit the bank receives is an increase in the bank's liabilities (an account payable to the depositor). Lists in numerical sequence all paid checks along with the date the check was paid and its amount. Bank includes with the bank statement memoranda explaining other debits and credits it made to the depositor's account. A check that is not paid by a bank because of insufficient funds in a bank account is called an NSF check (not sufficient funds).

Collection of electronic funds transfer

A payment of an account by a customer is recorded in the same way, whether the cash is received through the mail or electronically. The entry is as follows. Cash (debit): 1,035 Accounts Rec. (credit): 1,035

Internal Control

A process designed to provide reasonable assurance regarding the achievement of company objectives related to operations, reporting, and compliance. -to safeguard assets, enhance the reliability of accounting records, increase efficiency of operations, and ensure compliance with laws and regulations.

B

A small business owner has two employees but each employee has a separate cash register draw. This situation can be viewed as A violating segregation of duties. : B supporting establishment of responsibility. C supporting internal independent verification. D violating establishment of responsibility.

B

A supervisor counting cash receipts daily is an example of which of the following? A human resource controls B independent internal verification C establishment of responsibility D segregation of duties

Writing Checks

A written order signed by a bank depositor, directing the bank to pay a specified sum of money to a designated recipient. There are three parties to a check: (1) the maker (or drawer) who issues the check, (2) the bank (or payer) on which the check is drawn, and (3) the payee to whom the check is payable. A check is a negotiable instrument that one party can transfer to another party by endorsement.

Credit Memo

Amounts added to the account like interest

Establishment of Responsibility

An essential principle of internal control is to assign responsibility to specific employees. Control is most effective when only one person is responsible for a given task. EX: Cash on hand at the end of the day in a supermarket is $10 short of the cash entered in the cash register. If only one person has operated the register, the shift manager can quickly determine responsibility for the shortage. If two or more individuals have worked the register, it may be impossible to determine who is responsible for the error. Many retailers solve this problem by having registers with multiple drawers. This makes it possible for more than one person to operate a register but still allows identification of a particular employee with a specific drawer. Only the signed-in cashier has access to his or her drawer. Establishing responsibility often requires limiting access only to authorized personnel, and then identifying those personnel through passcodes

Book Error

An examination of the cash disbursements journal shows that check No. 443 was a payment on account to Andrea Company, a supplier. The correcting entry is as follows. Cash (debit): 36 Accounts Pay (credit): 36

Debit Memo

An item that the bank deducts from the account