Financial Accounting- Ch 5: Fraud, Internal Control, and Cash

Sarbanes-Oxley (SOX) Act

a set of regulations passed by Congress in 2002 in an attempt to improve financial reporting and restore investor confidence; increased regulations for internal controls, corporate executives, and auditors

information and communication

about activities affecting the organization to support sound decision making

restrict access

access to assets and records should be provided on an as-needed basis

cash shortage/overage

account reported on income statement as miscellaneous expense/revenue

internal control

actions taken to promote efficient and effective operations, protect assets, enhance accounting information, and adhere to laws and regulations

fraud

an attempt to deceive others for personal gain

segregation of duties

designed to prevent an employee from making a mistake or committing a dishonest act as part of one assigned duty, and then also covering it up through another assigned duty; one employee should not initiate, approve, record, and have access to items involved in a transaction

petty cash is not held at the bank

difference between imprest payroll account and petty cash

- some items are recorded that the bank doesn't know about at the time - bank recorded items that the company doesn't know about at the time

differences in the company's records

- checks cleared - deposits made - other transactions

differences with the bank statement

increases the risk that others will commit fraud in the future

effect of firing employees who don't meet certain performance targets on risk of future fraud

monitoring activities

evaluated often to determine whether it is working as intended

compliance objectives

focus on adhering to laws and regulations

operational objectives

focus on completing work efficiently, and effectively, and protecting assets by reducing the risk of fraud

independently verify

hire someone (an internal auditor) to check the work done by others; comparing the company's accounting information to information kept by an independent third party

- identify the deposits in transit - identify the outstanding checks - record other transactions on the bank statement and correct your errors (when in doubt, look at balance after each transaction to check direction)

in preparing the bank reconciliation, the entries in the cash account are compared to the bank statement with the following goals:

reporting objectives

include producing reliable and timely accounting information for use by people internal and external to the organization

control activities

include various work responsibilities and duties completed by employees to reduce risks to an acceptable level

- voucher system -- employee responsibilities are limited to specific tasks with proper authorization -- segregated duties between purchasing, receiving, and bill payment ensure that the company obtains and pays only for the goods and services that have been authorized

internal controls for cash paid by check for purchases on account

- company initiates EFT by instructing bank to transfer net pay to each employee's checking account - convenient and efficient for employer and employee - risk is that the bank might accidentally over/underpay an employee-- reduced by imprest system

internal controls for cash paid to employees via Electronic Funds Transfer

- petty cash fund acts as a control by establishing a limited amount of cash to use for specific types of expenses -- rather than transfer funds from a general bank account to another account, the company removes cash from its bank account to hold at its premises in a locked cash box - company's petty cash custodian is responsible for operating the petty cash fund; should be supervised and the fund is subject to surprise audits

internal controls for cash paid to reimburse employees

- businesses receive checks when customers pay on account - mail clerk lists all amounts received - remittance advice: customer includes with payment, explains the purpose of the payment - mail clerk has a supervisor to make sure they don't take any cash receipts for personal use - stamp each check "For Deposit Only" to ensure no one diverts the checks for personal use - cash is separated from the record of cash received

internal controls for cash received by mail

- EFTs speed up collections - EFTs eliminate the need for some internal controls because the payments are deposited directly - accounting department records journal entries to debit cash and credit each customer's account receivable

internal controls for cash received electronically

- segregation of duties - use of a cash register and its accompanying point-of-sale accounting system (restrict access to cash, document the amount charged for each item sold, summarize the total cash sales) - use of a cash count sheet documents the amount of cash the cashier received and determines any cash short/over that occurred during the shift (supervisor independently verifies each count sheet and prepares a daily cash receipts summary of all cashier's count sheets, places cash in locked vault until it's taken to the bank) - use of a deposit slip that lists the amounts included in the bank deposit which is verified and stamped by bank teller (independent verification between accounting department, cashier, supervisor and bank records, journal entry is prepared to record Sales Revenue at the amount rung up by the register and Cash at the amount deposited in the bank (difference is cash shortage or overage))

internal controls for cash received in person

financial statement fraud

involves misreporting amounts in the financial statements, usually to portray more favorable financial results than what actually exists; overstate assets, understate liabilities

corruption

involves misusing one's position for inappropriate personal gain

- entries on the bank statement will be corrected by the bank - items on the company's books side of bank reconciliation need to be recorded in the company's records

journal entries recorded to balance the cash account after bank reconciliation

- internal controls should be implemented only to the extent that their benefits exceed their costs - people can make mistakes when performing control procedures, override internal controls, or collude to get around them

limitations to internal controls- impossible for internal controls to prevent and detect all errors and fraud for two reasons:

risk assessment

managers continuously assess the potential for fraud and other risks that could prevent the company from achieving its objectives

cash

money or any instrument that banks will accept for deposit and immediate credit to a company's account, such as a check, money order, or bank draft

restricted cash

not available for general use but rather restricted for a specific purpose; must be reported separately on the balance sheet

operations reporting compliance

objectives of internal controls

electronic funds transfer (EFT)

occurs when a customer electronically transfers funds from its bank account to the company's bank account

controls for cash receipts

primary internal control goal is to ensure that the business receives the appropriate amount of cash and safely deposits it in the bank

controls for cash payments

primary internal control is to ensure that the business pays only for properly authorized transactions

establish responsibility segregation of duties restrict access document procedures independently verify

principles of control activities

asset misappropriation

quite simply, theft (embezzlement); usually of cash

control environment

refers to the attitude that people in the organization hold regarding internal control

cash equivalents

short-term, highly liquid investments purchased within three months of maturity; equivalent to cash because they are both readily convertible to known amounts of cash and so near to maturity that there is little risk their value will change

encourage honesty in employees

some provisions of SOX should help employees of good character confront those of poor character: public companies must have tip lines whistle blowers have legal protection code of ethics required for senior financial officers

voucher

a collection of the documents prepared at each step in the system

voucher system

a process for approving and documenting all purchases and payments made on account; system of controls surrounding the purchase of goods or services on account

imprest system

a process that controls the amount paid to others by limiting the total amount of money available for making payments to others; no error = special payroll account equals zero after all employees have been paid

- putting money into petty cash to establish a fund (debit petty cash, credit cash) - paying money out to reimburse others (following established policies; not recorded until fund is replenished) - putting money back into petty cash to replenish the fund (credit petty cash, and debit the amounts that were paid)

3 steps of a petty cash system

bank reconciliation

an internal report prepared to verify the accuracy of both the bank statement and the cash accounts of a business or individual

counteract incentives reduce opportunities encourage honesty in employees

aspects of SOX act

establish responsibility

assign each task to only one employee; doing so allows you to determine who caused any errors or thefts that occur

- cash deposited with banks - petty cash on hand - cash equivalents

cash reported on the balance sheet includes:

- the bank doesn't know about: -- bank errors -- time lags (deposit in transit or outstanding checks - the company doesn't know about: -- interest deposited -- electronic funds transfer -- service charges -- not sufficient funds checks -- your errors

causes of differences between bank statement and company books

- expected to be used up within a year is a current asset - not expected to be used up within a year is a noncurrent asset

classification of restricted cash on balance sheet

control environment risk assessment control activities information and communication monitoring activities

components of internal control

- restricting access - documenting procedures - independent verification -- bank reconciliation

controls for bank procedures

- purchase requisition is prepared and approved by supervisor; send copy to purchasing agent - purchasing agent completes purchase order; copies to supplier and accounting department - receiving report is prepared when goods are received; copy to accounting department for use in preparing journal entry for purchase on account - when invoice is received from supplier, accounting department matches to purchase order and receiving report and prepares voucher package, which contains these supporting documents - check of EFT is prepared to pay for items purchased and received; voucher is then marked "paid" so that it cannot be resubmitted for duplicate payment

steps in the voucher system

loan covenants

terms of a loan agreement which, if broken, entitle the lender to renegotiate loan terms or force repayment

opportunity

the employee has a means for committing fraud

incentive

the employee has a reason for committing fraud; sometimes the reason is personal financial pressure; sometimes its to make the business appear successful so as to attract investors, bring in new business partners, or meet loan requirements

rationalization

the employee perceives the misdeed as unavoidable or justified

reduce opportunities

the part of the fraud triangle most affected by SOX; it requires all public companies to: establish an audit committee made up of independent directors to ensure the company's accounting, internal controls, and audit functions are effective evaluate and report on the effectiveness of internal control over financial reporting; completed by management and, for large public companies, by external auditors as well

counteract incentives

those who willfully misrepresent financial results face: fines of up to $5 million plus repayment of any fraud proceeds jail sentences of up to 20 years, which could add up with consecutive terms for each violation

corruption asset misappropriation financial statement fraud

three categories of employee fraud

incentive opportunity rationalization

three factors that exist when fraud occurs-- the fraud triangle

document procedures

without documents, a company wouldn't know what transactions have already been or still need to be entered into its accounting system; assign a sequential number to each document which only corresponds with one entry