Chapter 6: Reporting and Analyzing Cash, Fraud, and Internal Control

Bank Balance Adjustments summary

- Add deposits in transit - Subtract outstanding checks - Add or subtract corrections of bank errors

Book Balance Adjustments summary

- Add interest earned and unrecorded cash receipts - Subtract bank fees and NSF checks - Add or subtract corrections of book errors

Over-the-Counter Cash Receipts in depth

- Custody over cash should be separate from recordkeeping. - Clerk who has access to cash in the register should not have access to its record. At the end of their work period, they should count the cash in the register, record the amount, and turn over the cash and record to the company cashier. - The cashier, like the clerk, has access to the cash but should not have access to accounting records (or the register tape or file). - A third employee, often a supervisor, compares the record of total register transactions with the cash receipts reported by the cashier. This record is used for a journal entry recording over-the-counter cash receipts. - The third employee have access to the records for cash but not to the actual cash. -The clerk and the cashier have access to cash but not to the accounting records. - None of them can make a mistake or steal cash without the difference being noticed

Bank Balance Adjustments

- Deposits in transit (or outstanding deposits) - Outstanding checks - Bank errors

Maintain Adequate Records (POIC)

- Helps protect assets and helps managers monitor company activities

Book Balance Adjustments

- Interest earned and unrecorded cash receipts - Bank fees and NSF checks - Book errors

Technological impacts we must be alert to:

- Reduced Processing Errors - More Extensive Testing of Records - New Evidence of Processing - Separation of Duties - Increased E-Commerce

Establish Responsibilities (POIC)

- Responsibility for a task should be clearly established and assigned to one person. - When a problem occurs in a company where responsibility is not established, determining who is at fault is difficult.

Over-the-Counter Cash Receipts

- Should be recorded on a cash register after each sale, and customers should get a receipt. - Cash registers should hold a permanent, locked-in record of each transaction. - The register is often linked with the accounting system. - Less advanced registers record each transaction on a paper tape or electronic file locked inside the register.

Why do managers use internal control systems?

- To prevent avoidable losses - Plan operations - Monitor company and employee performance

Cash Receipts by Mail

- Two people assigned to task of opening mail. (Theft requires collusion between these 2 employees) - Enters a list (in triplicate) of money received - each list has each sender's name, amount, and explanation of why money was sent. - First copy sent with money to cashier. - Second copy is sent to record keeper. - Third copy is kept by persons who opened mail. - Cashier deposits money in bank, and record keeper records amounts received. - Process is good internal control because the bank's record of cash deposited must agree with the records from each of the three. - System makes errors and fraud highly unlikely, with the exception of employee collusion.

Deposits in transit (or outstanding deposits) (BankBA)

- deposits made and recorded in the depositor's books but not yet listed on the bank statement. Ex: - companies can make deposits (in the night depository) after the bank is closed - If such deposit ocurred on a bank statement date, it would not appear on this period's statement. - The bank would record such a deposit on the next business day, and it would appear on the next period's bank statement. - Deposits mailed to the bank near the end of a period also can be in transit and not listed on the bank statement

Control of Cash Payments

- important as most large thefts occur from payment of fake invoices. Keys to controlling cash payments: - Require all payments to be made by check, with the exception of small payments from petty cash. - Deny access to accounting records to anyone other than the owner who has the authority to sign checks. A small-business owner often signs checks and knows that the items being paid for are actually received. (Large businesses cannot maintain personal supervision and must rely on internal controls described here, including the voucher system and petty cash system.)

Petty Cash Fund - payment received

- person receiving payment signs a renumbered petty cash receipt, also called petty cash ticket. - The petty cash receipt is then placed in the petty cashbox with the remaining money. Under this system, the total of all receipts plus the remaining cash equals the total fund amount.

Operating a Petty Cash Fund

- requires estimating the amount of small payments to be made during a short period such as a week or month - Check is then drawn by company cashier for an amount slightly in excess of this estimate. - Check is cashed and given to an employee called the petty cashier or petty cash custodian. - Petty cashier keeps cash safe, makes payments from the fund, and keeps records of it in a secure petty cashbox.

Voucher System in depth

- should be applied to all payments (except those using petty cash). - When a company received a monthly bill, it should review the charges, prepare a voucher (file), and insert the bill. - This transaction is then recorded. - If the amount is due, a check is issued. If not, the voucher is filed for payment on its due date. - Without records, an employee could collude with a supplier to get more than one payment, payment for excessive amounts, or payment for goods and services not received. A voucher system helps prevent such frauds.

ACFE estimates that employee fraud costs more than ...

... $150,000 per incident

Good control is to send a copy of the bank statement directly to ...

... a party without access to cash or recordkeeping.

Internal control varies from company to company, but internal control principles ...

... apply to all companies.

Blockchain technology has implications for ...

... auditors who test internal controls. Auditors focus more on testing the effectiveness of a company's blockchain processes and technology than verifying the accuracy of its output.

The Cash Over and Short account usually has a ...

... debit balance, because customers are more likely to dispute being shortchanged than being given too much change. A debit balance reflects an expense. It is reported on the income statement as part of selling, general, and administrative expenses. (Because the amount is usually small, it is often reported as part of miscellaneous expenses - or as part of miscellaneous revenues if it has a credit balance.)

Firms often have multiple bank accounts for ...

... different needs and for specific transactions such as payroll.

A control system is only as strong as ...

... its weakest link.

Sarbanes-Oxley Act requires...

... managers and auditors of companies whose stock is traded on an exchange (called public companies) to document and verify internal controls. Some of the requirements: - Company must have effective internal controls - Auditors must evaluate internal controls - Violators receive harsh penalties - up to 25 years in prison with fines - Auditors' work is overseen by the Public Company Accounting Oversight Board (PCAOB)

After the petty cash fund is established, the Petty Cash account is ...

... not debited or credited again unless the amount of the fund is changed.

The balance of a checking account on the bank statement ...

... rarely equals the depositor's book balance (from its records) - Due to info. that one party has that the other does not. - Verify the accuracy of both depositor and bank records by preparing a bank reconciliation.

COSO's five ingredients of internal control that add to the quality of accounting information:

1 ) Control environment - company structure, ethics, and integrity for internal control 2 ) Risk assessment - identify, analyze, and manage risk factors 3 ) Control activities - policies and procedures to reduce risk of loss 4 ) Information & communication - reports to internal and external parties 5 ) Monitoring - regular review of internal control effectiveness

Effective cash management involves applying the following cash management strategies:

1 ) Encourage collection of receivables 2 ) Delay payment of liabilities 3 ) Keep only necessary assets 4 ) Plan expenditures 5 ) Invest excess cash

Limitations of Internal Control

1 ) Human error or fraud - error occurs from carelessness, misjudgment, or confusion. Fraud is intentionally defeating internal controls, such as management override, for personal gain. 2 ) The cost-benefit constraint - The costs of internal controls must not exceed their benefits. Analysis of costs and benefits considers all factors, including morale..

Fraud triangle

1 ) Opportunity - Person must be able to commit fraud with a low risk of getting caught 2 ) Pressure, or incentive - Person must feel pressure or have incentive to commit fraud 3 ) Rationalization, or attitude - Person justifies fraud or does not see its criminal nature.

Two types of cash receipts:

1 ) Over-the-counter 2 ) By mail

Goals of cash management:

1 ) Plan cash receipts to meet cash payments when due 2 ) Keep a minimum level of cash necessary to operate

Other usual deductions on a bank statement include:

1 ) bank service fees 2 ) checks deposited that are uncollectible 3 ) corrections of previous errors 4 ) withdrawals through automated teller machines (ATMs) 5 ) payments arranged in advance by a depositor

Different banks use different formats for their bank statements, but all of them include the following:

1. Beginning-of-period account balance 2. Checks and other debits decreasing the account during the period. 3. Deposits and other credits increasing the account during the period. 4. End-of-period account balance.

Adjusting Entries from a Bank Reconciliation

A bank reconciliation often finds unrecorded items that need recording by the company.

Cash Management

A common reason companies fail is inability to manage cash. Companies must plan both cash receipts and cash payments. - Treasurer is responsible for cash management.

Bank fees and NSF checks (BookBA)

A company sometimes deposits another party's check that is uncollectible. This check is called a non sufficient funds (NSF) check. - The bank initially increases the depositor's account for the check. - When the check is uncollectible, the bank reduces the depositor's account for that check - The bank may charge the depositor a fee for processing an uncollectible check. - Other bank charges include printing new checks and service fees.

Separation of Duties

A company with few employees risks losing separation of duties. EX: The person who designs the information system should not operate it. The company also must separate control over programs and files from the activities related to cash receipts and payments. EX: A computer operator should not control check-writing activities.

Separate Recordkeeping from Custody of Assets (POIC)

A person who controls or has access to an asset must not have access to that asset's accounting records. - This principle reduces the risk of theft or waste of an asset because the person with control over it knows that another person keeps its records. - A record keeper who does not have access to the asset has no reason to falsify records. That means to steal an asset and hide the theft from the records, two or more people must collude - or agree in secret to commit the fraud.

Voucher system

A set of procedures and approvals designed to control cash payments and the acceptance of liabilities that consist of: - verifying, approving, and recording liabilities for cash payment - Issuing checks for payment of verified, approved, and recorded liabilities.

3 ) Keep only necessary assets (CMS)

Acquiring expensive and rarely used assets can cause cash shortages. Some companies lease warehouses or rent equipment to avoid large up-front payments.

Increased E-Commerce

All e-commerce transactions involve at least three risks: 1 ) credit card number theft 2 ) computer viruses 3 ) impersonation or identify theft Companies use technological internal controls to combat these risks.

Internal control System

All policies and procedures used to: - Protect assets - Ensure reliable accounting - Promote efficient operations - Uphold company policies

Bonded

An employee is bonded when a company purchases an insurance policy, or a bond, against theft by that employee. - Bonding discourages theft because bonded employees know the bonding company will pursue reported theft.

What do managers use to monitor and control business activities?

An internal control system

Bank errors (BankBA)

Any errors made by the bank are accounted for in the reconciliation. To find errors: a ) compare deposits on the bank statement with deposits in the accounting records b ) compare canceled checks on the bank statement with checks recorded in the accounting records

Book errors (BookBA)

Any errors made by the depositor in the company books are accounted for in the reconciliation. - To find errors, we use the same procedures described in the "Bank errors".

Insure Assets and Bond Key Employees (POIC)

Assets should be insured against losses, and employees handling lots of cash and easily transferable assets should be bonded.

Liquidity

Availability of resources to meet short-term cash requirements. - Refers to a company's ability to pay for its current liabilities.

Bank statement

Bank report on the depositor's beginning and ending cash balances, and a listing of its changes, for a period - Usually once a month, the bank sends a bank statement showing the account activity.

Basic Bank Services

Banks safeguard cash and provide detailed records of cash transactions. They provide services and documents that help control cash, which is the focus of this section.

Interest earned and unrecorded cash receipts (BookBA)

Banks sometimes collect notes for depositors. Banks also receive electronic funds transfers to the depositor's account. - When a bank collects an item, it is added to the depositor's account, less any service fee. - The bank statement also includes any interest earned

Your checking account is a liability from the bank's perspective:

But an asset from yours. - When you make a deposit, they "credit your account." - Credits increase the bank's liability to you. - When you write a check or use your debit card, the bank decreases its liability to you; they "debit your account." - Debits decrease the bank's liability to you.

Vendee

Buyer of goods or services

Internal controls protect cash and meet three guidelines:

Cash is easily hidden and moved. Internal controls: 1 ) Handling cash is separate from recordkeeping of cash - applies separation of duties to minimize errors and fraud. When duties are separated, two or more people must collude to steal cash and hide this action. 2 ) Cash receipts are promptly deposited in a bank. - Uses immediate deposits of all cash receipts to produce an independent record of the cash received. It also reduces the chance of cash theft (or loss). 3 ) Cash payments are made by check or electronic funds transfer (EFT). - Uses payments by check to develop an independent record of cash payments. It also reduces the risk of cash theft (or loss)

Canceled checks

Checks the bank has paid and deducted from the customer's (depositor's) account. - such checks "cleared the bank".

Committee of Sponsoring Organizations (COSO)

Committee of Sponsoring Organizations of the Treadway Commission (or COSO) is a joint initiative of five private sector organizations and is dedicated to providing thought leadership through the development of frameworks and guidance on enterprise risk management, internal control, and fraud deterrence.

What do companies invest to increase income?

Companies invest idle cash in cash equivalents to increase income.

4 ) Plan expenditures (CMS)

Companies must look at seasonal and business cycles to plan expenditures when money is available

Outstanding checks are identified by:

Comparing canceled checks on the bank statement with checks recorded. This includes identifying any outstanding checks listed on the previous period's bank reconciliation.

Purchase requisition

Document listing merchandise needed by a department and requesting it be purchased. - Two copies are sent to the purchasing department, which then sends one copy to the accounting department. When the accounting department receives a purchase requisition, it creates and maintains a voucher for this transaction. The requesting department keeps a third copy.

Purchase order

Document used by the purchasing department to place an order with a seller or supplier (vendor). - authorizes a vendor to ship merchandise at the stated price and terms

Deposit ticket

Each bank deposit has a deposit ticket, which lists items such as currency, coins, and checks deposited along with amounts. The bank gives the customer a receipt as proof of the deposit.

Apply Technological Controls (POIC)

Examples of devices that can improve internal control: 1 ) Cash registers - with a locked-in tape or electronic file makes a record of each cash sale. 2 ) Time clock - records the exact hours worked by an employee 3 ) ID scanners - limit access to authorized individuals

5 ) Invest excess cash (CMS)

Excess cash earns no return and should be invested in productive assets like factories. Excess cash from seasonal cycles can be placed in a short-term investment for interest.

Receiving report

Form used to report that ordered goods were received and to describe their quantity and condition.

Signature card

Includes the signature of each person authorized to sign checks on the bank account.

Cash Over and Short

Income statement account used to record cash overages and cash shortages arising from errors in cash receipts or payments. - One or more customers can be given too much or little change. At the end of a work period, the cash in the register might not equal the record of cash receipts. The difference is reported in the Cash Over and Short account, or (Cash short and over).

Voucher

Internal file used to store documents and information to control cash disbursements and to ensure that a transaction is properly authorized and recorded.

Sarbanes-Oxley Act (SOX)

Legislation that created the Public Company Accounting Oversight Board, regulates analyst conflicts, imposes corporate governance requirements, enhances accounting and control disclosures, impacts insider transactions and executive loans, establishes new types of criminal conduct, and expands penalties for violations of federal securities laws.

Establish Responsibilities point

Many companies have a mandatory vacation policy for employees who handle cash. When another employee must cover for the one on vacation, it is more difficult to hide cash frauds.

Days' sales uncollected

Measure of the liquidity of receivables, computed by dividing the current balance of receivables by the annual credit (or net) sales and then multiplying by 365; also called days' sales in receivables.

Credit memorandum

Notification that the issuer (sender) has credited the recipient's account in the sender's records. *Notifies the depositor of all increases.

Principles of internal control

Principles prescribing management to: - establish responsibility - maintain records - insure assets - separate record keeping from custody of assets - divide responsibility for related transactions - apply technological controls - perform regular and independent reviews

Cash budget

Projected cash receipts and cash payments are summarized in a cash budget. If there is enough cash for operations, companies wish to minimize the cash they hold because of its risk of theft and its low return versus other assets.

Liquid assets

Resources such as cash that are easily converted into other assets or used to pay for goods, services, or liabilities. - Cash and similar assets that can be readily used to pay for liabilities. - The most liquid assets are usually reported first on a balance sheet; the least liquid assets are reported last.

Divid Responsibility for Related Transactions (POIC)

Responsibility for a transaction should be divided between two or more individuals or departments. - This ensures the work of one person acts as a check on the other to prevent fraud and errors. - This principle, called separation of duties, does not mean duplication of work.

Cash equivalents

Short-term investment assets that are readily convertible to a known cash amount or sufficiently close to their maturity date (usually within 90 days) so that market value is not sensitive to interest rate changes. Only investments within three months of their due date usually meet these criteria. Cash equivalents are short-term investments such as U.S. Treasury bills. Most companies combine cash equivalents with cash on the balance sheet.

Petty cash

Small amount of cash in a fund to pay minor expenses; accounted for using an impress system.

New Evidence of Processing

Technology makes it possible to record additional transaction details not possible with manual systems. EX: A system can record who made the entry, the data and time, the source of the entry, and so on. This means that internal control depends more on the design and operation of the information system and less on the analysis of its resulting documents.

Reduced Processing Errors

Technology reduces, but does not eliminate, errors in processing information. - Less human involvement can cause data entry errors to go undiscovered. - Errors in software can produce consistent but inaccurate processing of transactions.

Blockchain

Technology used to create a secure ledger of transactions. - viewed as a new, more secure type of accounting ledger. - A blockchain ledger is continuously and simultaneously updated and verified. - Blockchain technology makes it difficult for the ledger to be modified without a detailed record of changes. - Records cannot be destroyed or hidden as the record is shared and stored by multiple users.

Electronic funds transfer (EFT)

The electronic transfer of cash from one party to another. - Companies are increasingly using EFT because of its convenience and low cost. - Payroll, rent, utilities, insurance, and interest payments are usually done by EFT. - Bank statement lists cash withdrawals by EFT with the checks and other deductions. - Cash receipts by EFT are listed with deposits and other additions.

2 ) Delay payment of liabilities (CMS)

The more delayed a company is in paying others, the more time it has to use the money. Companies regularly wait to pay bills until the last day allowed.

1 ) Encourage collection of receivables (CMS)

The quicker customers and others pay the company, the quicker it can use the money. Some companies offer discounts for quicker payments.

Petty Cash System of Control

To avoid writing checks for small amounts, a company sets up a petty cash system. Petty cash payments are small payments for items such as shipping fees, minor repairs, and low-cost supplies.

Check

To withdraw money, the depositor can use a check, which is a document telling the bank to pay a specified amount to a designated recipient. Check involves 3 parties: - Maker who signs the check - Payee who is the recipient - Bank (or payer) on which the check is drawn The bank provides the depositor the checks. It has an optional remittance advice explaining the payment. The memo line is used for an explanation.

Bank account

Used to deposit money for safekeeping and helps control withdrawals. Persons authorized to write checks on the account must sign a signature card, which the bank uses to verify signatures.

When does a voucher system's control over cash payments begin?

When a company incurs a liability that will result in cash payment. The system only allows authorized departments and individuals to incur liabilities and limits the type of liabilities. To coordinate and control responsibilities of these departments, a company uses several different business documents.

More Extensive Testing of Records

When accounting records are kept manually, only small samples of data are usually checked for accuracy. - When data are accessible using technology, large samples or even the entire database can be tested quickly.

Increases to the depositor's account include:

amounts the bank collects on behalf of the depositor and the corrections of previous errors.

Outstanding checks (BankBA)

checks written by the depositor, subtracted on the depositor's books, and sent to the payees but not yet turned in for payment at the bank statement date

Banks that pay interest on checking accounts:

credit interest earned to the depositor's account each period.

One measure of how quickly a company can convert its accounts receivable into cash is:

days' sales uncollected, also called days' sales in receivables. - We use days' sales uncollected to estimate how much time is likely to pass before the current amount of accounts receivable is received in cash. It is used to determine if cash is being collected quickly enough to pay upcoming obligations. The less time money is tied up in receivables, the better.

Internal control of cash receipts

ensures that cash received is properly recorded and deposited. - Cash receipts commonly arise from transactions such as cash sales and collections of customer accounts.

Cash

includes currency, coins, and amounts on deposit in bank checking or savings accounts. - Cash also includes items that can be deposited in these accounts such as customer checks, cashier's checks, certified checks, and money orders.

Invoice

itemized record of goods prepared by the vendor that lists the customer's name, items sold, sales prices, and terms of sale. - also a bill sent to the buyer from the supplier. - From the vendor's point of view, it is a sales invoice. - The buyer, or vendee, treats it as a purchase invoice. - The invoice is sent to the buyer's accounting department, where it is placed in the voucher.

Debit memorandum

notification that the issuer (sender) has debited the recipient's account in the sender's records. *notifies a depositor of a deduction.

Books

refer to accounting records

Bank reconciliation

report that explains the difference between the book (company) balance of cash and the cash balance reported on the bank statement, for purposes of computing the adjusted cash balance. - Person preparing the bank reconciliation should not be responsible for processing cash receipts, managing checks, or maintaining cash records.

Vendor

seller of goods and services