Accounting Ch 4

Fraud

A person intentionally deceives another person for personal gain or to damage that person -Occupational Fraud

Errors

Accidental errors in recording transactions or applying accounting principles

Separation of Duties

Activities such as authorizing transactions, recording transactions, and maintaining control of related assets should be prepared among employees. Ex: Employee selling movie tickets should not also account for cash at the theatre. (The guy just sells the tickets)

Audits

An expert auditor could be asked to access internal control procedures to detect any deficiencies or fraudulent behavior of employees. Ex: Hire an independent auditor to assess the theatre's internal control procedures to detect any deficiencies or fraudulent behavior of employees.

Physical Controls

Assets and accounting records must be kept safe and accessible only to authorized personnel Ex: Concession supplies should be kept in a locked room with access allowed only to authorized personnel.

Internal Controls

Attempt to eliminate opportunity element of fraud -Represent plans to... +Safeguard company's assets +Improve accuracy and reliability of accounting info

Hiring of auditor

Audit firms are hired by audit committee of the board of directors of the company, NOT by the company management.

Conflicts of Interest

Audit firms are not allowed to audit public companies whose chief executives worked for the audit firm and participated in that company's audit during the preceding year.

Retention of Work Papers

Auditors of public companies must retain all work papers for 7 years or face a prison term for willful violation

Enron

Avoided reporting billions in debt and losses

Corporate Executive Accountability

Corporate Executives must personally certify the company's financial statements and financial disclosures. Severe financial penalties and possibility of imprisonment are consequences of fraudulent misstatement

Responsibilities for internal control

CEO and CFO -both have accounting background -Sign a report each year certifying adequacy of internal controls Auditors -Provide an opinion on management's assessment of internal control over financial reporting -Provide their own opinion on company's internal control over financial reporting.

Reconcile Company's Cash Balance

Cash transactions recorded by bank but not company Common items that'll INCREASE company's cash balance -Collections made by the bank on company's behalf +Notes receivable -Interest earned on average daily balance DECREASE company's cash balance -NSF checks +Customer's checks written on "nonsufficient funds" or "bad" checks to the company -Debit card purchases -Electronic funds transfers (EFTs) -Bank Service fees

Reconcile Bank Cash Balance

Cash transactions recorded by company, but not yet recorded by its bank -Deposits outstanding +Cash receipts of company that have NOT been added to BANK'S record of company's balance +ADD deposits outstanding -Checks outstanding +Checks the company (Cash disbursements) has written that have NOT been subtracted from the bank's record of company's balance. +SUBTRACT checks outstanding

Components of Internal Control

Continual Monitoring Control Activities Risk Assessment Control Environment

Continual Monitoring

Continual Monitoring of internal activities are reporting of deficiencies is required. -Includes formal procedures for reporting control deficiencies

Company-issued debit/credit cards

Debit cards and checks captured in the bank reconciliation Credit card purchases need to be recorded

Controls over Cash Receipts

Each day: -Employees should open mail and list checks -A different employee should deposit cash and checks into company's bank account As soon as possible: -A separate employee should record cash receipts in the accounting records. Accept Credit/Debit cards to limit amount of cash handled

Employee Management

Employees should be trained to carry out their job and must be made aware of any internal control procedures, ethical responsibilities, and channels for reporting irregular activities

Performance Reviews

Employees' actual performance must be measured against their expected performance to detect unusual trends. Ex: The amount of concessions sold should be compared to the number of tickets sold over a period of time.

Risk Assessment

Identifies and analyzes internal and external risk factors that could prevent a company's objectives from being achieved.

Limitations of Internal Control

Internal control system can't turn a bad employee into a good one. Susceptible to collusion -Two or more people acting together to circumvent internal controls Top-level employees who can override internal control procedures have opportunity to commit fraud. -Take final responsibility Effective internal controls and ethical employees alone cannot ensure success or even survival

Nonaudit services

It's unlawful for auditors of public companies to also perform certain nonaudit services, such as investment advising, for their clients

Rationalizaiton

Justification for the deceptive act by the one committing the fraud.

Update Company's Cash Account

Look up items used to reconcile COMPANY'S cash balance DEBIT cash for items that ADD to balance *Record items that increase cash* -Debit cash -Credit Notes Receivable, Interest Receivable (from note), and Interest Revenue (from bank account) CREDIT cash for items that SUBTRACT from the balance *Record items that decrease cash* -Debit accounts receivable, equipment, advertising expense, service fee expense, rent expense -Credit cash DON'T UPDATE CASH ACCOUNT FOR, -DEPOSITS OUTSTANDING -CHECKS OUTSTANDING -BANK ERROR

Bank Reconciliation

Matches balance of cash in bank account with the balance of cash in the company's own records -Bank fixes its mistakes Timing Differences occur when company records transactions either before/after the bank records the same transactions Errors can be made by either bank or company. Step 1 -Reconcile Bank's Cash Balance Step 2 -Reconcile Company's Cash Balance Step 3 -Update Company's Cash Account

WorldCom

Misclassified expenditures to overstate assets and profitability -Turned expenses to assets and overstated net income

Cash

Most susceptible to employee fraud Cash equivalents are defined as investments that mature within THREE MONTHS from date of purchase Includes... -Coins and currency -Checks Received -Savings Accounts -Checking Accounts -Credit Card Sales -Debit Card Sales -Cash Equivalents -Money orders received from customers ALL forms of cash and cash equivalents are usually combined and reported as a single asset. -Referred as "cash" or "cash and cash equivalents"

E-commerce Controls

Only authorized personnel should have passwords to conduct electronic business transactions; firewalls are maintained to prevent unauthorized access; and the system's antivirus software should be regularly updated. Ex: The theatre should maintain and systematically check the firewall settings to prevent unauthorized access to accounts and credit card numbers

Proper Authorization

Only personnel with authorization should be allowed to collect money, process transactions, or make purchases. Ex: Only theatre management should be authorized to make purchases over a certain amount.

Fraud Triangle

Opportunity Motivation Rationalization

Sarbanes - Oxley Act of 2002 (SOX)

Passed by Congress (Also known as Public Company Accounting Reform and Investor Protection Act of 2002) Applies to all companies that are required to file financial statements with the SEC -NOT ALL COMPANIES IN THE U.S. Establish guidelines related to: -Internal control procedures -Auditor-client relations Major provisions of the SOX -Oversight board -Corporate Executive Accountability -Nonaudit Services -Retention of Work Papers -Auditor Rotation -Conflicts of Interest -Hiring of Auditor -Internal Control

Reconciliations

Physical assets must be verified periodically to see if they match with the accounting records. Ex: Management should periodically determine whether the amount of physical assets of the company (cash, concession items, movie t-shirts, etc.) agree with the accounting records.

Control Activities

Policies and procedures that help ensure that management's directives are being carried out. These activities include authorizations, reconciliations, and separations of duties. -Preventive controls -Detective controls

Detective Controls for Control Activites

Reconciliations Performance Reviews Audits

Internal Control

Section 404 of act requires... A. that company management document and assess the effectiveness of all internal control processes that could affect financial reporting B. That company auditors express an opinion on whether management's assessment of the effectiveness of internal control is fairly stated. +Smaller companies are exempt from requirement B Requires company management and auditors to document and assess the effectiveness of company's internal controls.

Preventative Controls for Control Activities

Separation of Duties Physical Controls Proper Authorization Employee mangement E-commerce controls

Control Environment

Sets overall ethical tone of company with respect to internal control. Includes formal policies related to management's philosophy, assignment of responsibilities, and organizational structure.

Controls over Cash Disbursements

Should be made by check, credit/debit card Authorize all expenditures -Authorizing employee should NOT also prepare the check Checks should be serially numbered and should require two signatures for large amounts Periodically agree debit/credit card statements to purchase receipts Set max purchase limits Separate cash disbursement and cash receipt duties

Opportunity

Situation allows fraud to occur

Petty Cash fund

Small amount of cash kept on hand to pay for minor purchases Accounting for petty cash fund involves... -Establishing fund -Recognizing expenditures from fund -Replenishing the fund DEBIT Petty cash CREDIT Cash

Motivation

Someone feels the need to commit fraud, such as need for money

Managers act as ________ or __________ of the company's assets.

Stewards; Caretakers Managers are entrusted with resources of both company's lenders and owners Some mangers shirked their ethical responsibilities -Top executives misused or misreported the company's funds.

Oversight Board

The Public Company Accounting Oversight Board (PCAOB) has authority to establish standards dealing with auditing, quality control, ethics, independence, and other activities relating to the preparation of audited financial reports.

Auditor Rotation

The lead auditor in charge of auditing a particular company (referred to as the audit partner) must rotate off that company within five years and allow a new audit partner to take the lead.

Occupational Fraud

Use of one's occupation for personal enrichment through the deliberate misuse or misapplication of the employer's resources. First source: Misuse of company's resources Second source: Financial statement manipulation