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chapter

Sarbanes-Oxley, 8
Internal Control, and Cash
© KEMIE GUAIDA/ISTOCKPHOTO INC.

objectives
After studying this chapter, you should be able to:
4 Describe the nature of a bank account and its
1 Describe the Sarbanes-Oxley Act of 2002 and
use in controlling cash.
its impact on internal controls and financial
reporting. 5 Describe and illustrate the use of a bank recon-
ciliation in controlling cash.
2 Describe and illustrate the objectives and ele-
ments of internal control. 6 Describe the accounting for special-purpose
cash funds.
3 Describe and illustrate the application of inter-
nal controls to cash. 7 Describe and illustrate the reporting of cash and
cash equivalents in the financial statements.
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eBay Inc.

C
ontrols are a part of your everyday life. At of goods and services. Using eBay’s on-
one extreme, laws are used to limit your be- line platform, buyers and sellers can
havior. For example, the speed limit is a con- browse, buy, and sell a wide variety of
trol on your driving, designed for traffic items including antiques and used cars.
safety. In addition, you are also affected by many However, in order to maintain the in-
nonlegal controls. For example, you can keep credit tegrity and trust of its buyers and sellers, eBay must
card receipts in order to compare your transactions have controls to ensure that buyers pay for their
to the monthly credit card statement. Comparing re- items and sellers don’t misrepresent their items or
ceipts to the monthly statement is a control designed fail to deliver sales. One such control that eBay uses
to catch mistakes made by the credit card company. is the buyer’s or seller’s reputation based upon feed-
Likewise, recording checks in your checkbook is a back from past transactions of the member. A
control that you can use at the end of the month to prospective buyer or seller can view the member’s
verify the accuracy of your bank statement. In addi- reputation and feedback comments before complet-
tion, banks give you a personal identification num- ing a transaction. Dishonest or unfair trading can
ber (PIN) as a control against unauthorized access to lead to a negative reputation and even suspension
your cash if you lose your automated teller machine or cancellation of the member’s ability to trade on
(ATM) card. Dairies use freshness dating on their eBay.
milk containers as a control to prevent the purchase In this chapter, we will discuss controls that can
or sale of soured milk. As you can see, you use and be included in accounting systems to provide rea-
encounter controls every day. sonable assurance that the financial statements are
Just as there are many examples of controls reliable. We also discuss controls over cash that you
throughout society, businesses must also implement can use to determine whether your bank has made
controls to help guide the behavior of their managers, any errors in your account. We begin this chapter by
employees, and customers. For example, eBay Inc. discussing the Sarbanes-Oxley Act of 2002 and its
maintains an Internet-based marketplace for the sale impact on controls and financial reporting.

Sarbanes-Oxley Act of 2002

1 During the Enron, WorldCom, Tyco International, Ltd., Adelphia Communications,
objective and other financial scandals of the early 2000s, stockholders, creditors, and other in-
Describe the vestors lost millions and in some cases billions of dollars.1 The resulting public outcry
Sarbanes-Oxley
led Congress to pass the Sarbanes-Oxley Act of 2002. This act, referred to simply as
Act of 2002 and its
impact on internal Sarbanes-Oxley, is considered one of the most important and significant laws affecting
controls and publicly held companies in recent history. Although Sarbanes-Oxley applies only to
financial reporting. companies whose stock is traded on public exchanges, referred to as publicly held com-
panies, it has highlighted the need to assess the financial controls and reporting of all
companies.
Sarbanes-Oxley’s purpose is to restore public confidence and trust in the financial
statements of companies. In doing so, Sarbanes-Oxley emphasizes the importance of
effective internal control.2 Internal control is broadly defined as the procedures and
processes used by a company to safeguard its assets, process information accurately,
The ex-CEO of WorldCom, and ensure compliance with laws and regulations.
Bernard Ebbers, was sentenced
to 25 years in prison.

1 Exhibit 2 in Chapter 1 briefly summarizes these scandals.

2 Sarbanes-Oxley also has important implications for corporate governance and the regulation of the public
accounting profession. In this chapter, we focus on the internal control implications of Sarbanes-Oxley.

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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 349

Sarbanes-Oxley requires companies to maintain strong and effective internal con-

trols over the recording of transactions and the preparing of financial statements. Such
controls are important because they deter fraud and prevent misleading financial state-
ments as shown in the following illustration:

Sarbanes-Oxley not only requires companies to maintain strong and effective in-
ternal controls, but it also requires companies and their independent accountants to
report on the effectiveness of the company’s internal controls.3 These reports are re-
quired to be filed with the company’s annual 10-K report with the Securities and Ex-
It is estimated that companies
spend millions each year to
change Commission. The act also encourages companies to include these reports in
comply with the requirements their annual reports to stockholders. An example of such a report by the management
of Sarbanes-Oxley. of General Electric Company (GE) is shown in Exhibit 1.

EXHIBIT 1 Management’s Annual Report on Internal Control over Financial Reporting

Sarbanes-Oxley Report The management of General Electric Company is responsible for establishing and
General Electric maintaining adequate internal control over financial reporting for the company.
Company With the participation of the Chief Executive Officer and the Chief Financial Officer,
our management conducted an evaluation of the effectiveness of our internal con-
trol over financial reporting based on the framework and criteria established in
Internal Control—Integrated Framework, issued by the Committee of Sponsoring
Organizations. . . . Based on this evaluation . . . our management has concluded that
our internal control over financial reporting was effective. . . .
General Electric Company’s independent [accountant] auditor, KPMG LLP, a regis-
tered public accounting firm, has [also] issued an audit report on our management’s
assessment of our internal control over financial reporting.
JEFFREY R. IMMELT KEITH S. SHERIN
Chairman of the Board Senior Vice President, Finance
and Chief Executive Officer and Chief Financial Officer

3 These reporting requirements are required under Section 404 of the act. As a result, these requirements
and reports are often referred to as 404 requirements and 404 reports.
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350 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

GE based its assessment and evaluation of internal controls upon Internal Control—
Integrated Framework, which was issued by the Committee of Sponsoring Organizations
(COSO) of the Treadway Commission. This framework is the widely accepted stan-
dard by which companies design, analyze, and evaluate internal controls. For this rea-
son, we use this framework in the next section of this chapter as a basis for our
discussion of internal controls.

Internal Control
2 As indicated in the prior section, effective internal controls are required by Sarbanes-
objective Oxley. In addition, effective internal controls help businesses guide their operations
Describe and and prevent theft and other abuses. For example, assume that you own and manage a
illustrate the lawn care service. Your business uses several employee teams, and you provide each
objectives and
elements of team with vehicle and lawn equipment. What issues might you face as a manager in
internal control. controlling the operations of this business? Below are some examples.

■ Lawn care must be provided on time.

■ The quality of lawn care services must meet customer expectations.
■ Employees must provide work for the hours they are paid.
■ Lawn care equipment should be used for business purposes only.
■ Vehicles should be used for business purposes only.
■ Customers must be billed and payments collected for services rendered.

How would you address these issues? You could, for example, develop a sched-
ule at the beginning of each day and then inspect the work at the end of the day to
verify that it was completed according to quality standards. You could have “surprise”
inspections by arriving on site at random times to verify that the teams are working
according to schedule. You could require employees to “clock in” at the beginning of
the day and “clock out” at the end of the day to make sure that they are paid for hours
worked. You could require the work teams to return the vehicles and equipment to a
central location to prevent unauthorized use. You could keep a log of odometer read-
ings at the end of each day to verify that the vehicles have not been used for “joy rid-
ing.” You could bill customers after you have inspected the work and then monitor the
collection of all receivables. All of these are examples of internal control.
In this section, we describe and illustrate internal control using the framework
developed by the Committee of Sponsoring Organizations (COSO), which was formed
by five major business associations. The committee’s deliberations were published in
Internal Control—Integrated Framework.4 This framework, cited by GE in Exhibit 1, has
Information on Internal become the standard by which companies design, analyze, and evaluate internal con-
Control—Integrated Frame-
work can be found on
trol. We describe and illustrate the framework by first describing the objectives of
COSO’s Web site at internal control and then showing how these objectives can be achieved through the
[Link] five elements of internal control.

OBJECTIVES OF INTERNAL CONTROL

The objectives of internal control are to provide reasonable assurance that (1) assets are
safeguarded and used for business purposes, (2) business information is accurate, and
(3) employees comply with laws and regulations. These objectives are illustrated on
the following page.
Internal control can safeguard assets by preventing theft, fraud, misuse, or mis-
placement. One of the most serious breaches of internal control is employee fraud.
Employee fraud is the intentional act of deceiving an employer for personal gain.

4 Internal Control—Integrated Framework by the Committee of Sponsoring Organizations of the Treadway

Commission, 1992.
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 351

Such deception may range from purposely overstating expenses on a travel expense
report to embezzling millions of dollars through complex schemes.
Accurate information is necessary for operating a business successfully. The safe-
guarding of assets and accurate information often go hand-in-hand. The reason is that
The Association of Certified employees attempting to defraud a business will also need to adjust the accounting
Fraud Examiners has estimated records in order to hide the fraud.
that businesses will lose over
$660 billion, or around 6% of
Businesses must comply with applicable laws, regulations, and financial reporting
revenue, to employee fraud. standards. Examples of such standards and laws include environmental regulations, con-
tract terms, safety regulations, and generally accepted accounting principles (GAAP).
Source: 2004 Report to the
Nation: Occupational Fraud and
Abuse, Association of Certified
Fraud Examiners. ELEMENTS OF INTERNAL CONTROL
How does management achieve its internal control objectives? Management is responsi-
ble for designing and applying five elements of internal control to meet the three inter-
nal control objectives. These elements are (1) the control environment, (2) risk assessment,
(3) control procedures, (4) monitoring, and (5) information and communication.5
The elements of internal control are illustrated in Exhibit 2. In this exhibit, these
elements form an umbrella over the business to protect it from control threats. The

EXHIBIT 2 Elements of Internal Control

5 Ibid., 12–14.
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352 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

business’s control environment is represented by the size of the umbrella. Risk assess-
ment, control procedures, and monitoring are the fabric that keeps the umbrella from
leaking. Information and communication link the umbrella to management. In the fol-
lowing paragraphs, we discuss each of these elements.

CONTROL ENVIRONMENT
A business’s control environment is the overall attitude of management and employ-
ees about the importance of controls. One of the factors that influences the control
environment is management’s philosophy and operating style. A management that over-
emphasizes operating goals and deviates from control policies may indirectly encour-
age employees to ignore controls. For example, the pressure to achieve revenue targets
may encourage employees to fraudulently record sham sales. On the other hand, a
management that emphasizes the importance of controls and encourages adherence to
control policies will create an effective control environment.

The business’s organizational structure, which is the framework for planning and
controlling operations, also influences the control environment. For example, a de-
partment store chain might organize each of its stores as separate business units. Each
store manager has full authority over pricing and other operating activities. In such a
How do companies discover structure, each store manager has the responsibility for establishing an effective con-
fraud? Most fraud is discov- trol environment.
ered from tips by employees,
customers, suppliers, or anony-
Personnel policies also affect the control environment. Personnel policies involve the
mous sources. hiring, training, evaluation, compensation, and promotion of employees. In addition,
job descriptions, employee codes of ethics, and conflict-of-interest policies are part of
the personnel policies. Such policies can enhance the internal control environment if
they provide reasonable assurance that only competent, honest employees are hired
and retained.
To illustrate the importance of the control environment, consider the case where
the head of a bank’s loan department perpetrated a fraud by accepting bribes from cus-
tomers with poor credit ratings. As a result, the bank lost thousands of dollars from
bad loans. After discovering the fraud, the bank president improved the bank’s con-
trol environment by implementing a program that allowed employees to report sus-
picious conduct anonymously. In addition to encouraging employees to report
suspicious conduct, the employees were warned that employee fraud might occur any-
where and involve anyone.
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 353

RISK ASSESSMENT
All organizations face risks. Examples of risk include changes in customer require-
ments, competitive threats, regulatory changes, changes in economic factors such as in-
terest rates, and employee violations of company policies and procedures. Management
should assess these risks and take necessary actions to control them, so that the objec-
tives of internal control can be achieved.
Once risks are identified, they can be analyzed to estimate their significance, to as-
sess their likelihood of occurring, and to determine actions that will minimize them.
For example, the manager of a warehouse operation may analyze the risk of employee
back injuries, which might give rise to lawsuits. If the manager determines that the risk
is significant, the company may purchase back support braces for its warehouse em-
ployees and require them to wear the braces.

CONTROL PROCEDURES
Control procedures are established to provide reasonable assurance that business goals
will be achieved, including the prevention of fraud. In the following paragraphs, we
will briefly discuss control procedures that can be integrated throughout the account-
ing system. These procedures are listed in Exhibit 3.

EXHIBIT 3 Internal Control Procedures

Competent Personnel, Rotating Duties, and Mandatory Vacations The successful op-
eration of an accounting system requires procedures to ensure that people are able to
perform the duties to which they are assigned. Hence, it is necessary that all account-
ing employees be adequately trained and supervised in performing their jobs. It may
also be advisable to rotate duties of clerical personnel and mandate vacations for non-
clerical personnel. These policies encourage employees to adhere to prescribed proce-
dures. In addition, existing errors or fraud may be detected. For example, numerous
cases of employee fraud have been discovered after a long-term employee, who never
took vacations, missed work because of an illness or other unavoidable reasons.
To illustrate, consider the case where a bank officer who was not required to take
vacations stole approximately $5 million over 16 years by printing fake certificates of
deposit. The officer would then issue the fake certificate to the customer and pocket
the customer’s money. After discovering the theft, the bank began requiring all em-
ployees to take vacations.
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354 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

Integrity, Objectivity, and Ethics in Business

TIPS ON PREVENTING EMPLOYEE FRAUD IN SMALL COMPANIES

• Do not have the same employee write company checks • Require and monitor supporting documentation (such
and keep the books. Look for payments to vendors you as vendor invoices) before signing checks.
don’t know or payments to vendors whose names ap- • Track the number of credit card bills you sign monthly.
pear to be misspelled. • Limit and monitor access to important documents and
• If your business has a computer system, restrict access supplies, such as blank checks and signature stamps.
to accounting files as much as possible. Also, keep a • Check W-2 forms against your payroll annually to make
backup copy of your accounting files and store it at an sure you’re not carrying any fictitious employees.
off-site location. • Rely on yourself, not on your accountant, to spot fraud.
• Be wary of anybody working in finance that declines to Source: Steve Kaufman, “Embezzlement Common at Small Companies,”
take vacations. They may be afraid that a replacement Knight-Ridder Newspapers, reported in Athens Daily News/Athens
will uncover fraud. Banner-Herald, March 10, 1996, p. 4D.

Separating Responsibilities for Related Operations To decrease the possibility of inef-

ficiency, errors, and fraud, the responsibility for related operations should be divided
among two or more persons. For example, the responsibilities for purchasing, receiv-
ing, and paying for computer supplies should be divided among three persons or de-
partments. If the same person orders supplies, verifies the receipt of the supplies, and
pays the supplier, the following abuses are possible:
1. Orders may be placed on the basis of friendship with a supplier, rather than on
price, quality, and other objective factors.
2. The quantity and quality of supplies received may not be verified, thus causing
payment for supplies not received or poor-quality supplies.
Many companies have “fraud
hotlines” where employees can
3. Supplies may be stolen by the employee.
anonymously report suspicious 4. The validity and accuracy of invoices may be verified carelessly, thus causing the
or fraudulent activities. payment of false or inaccurate invoices.
The “checks and balances” provided by dividing responsibilities among various de-
partments requires no duplication of effort. The business documents prepared by one
department are designed to coordinate with and support those prepared by other
departments.
To illustrate, consider the case where an accounts payable clerk created false in-
voices and submitted them for payment. The clerk obtained the resulting checks,
opened a bank account, and cashed the checks under an assumed name. The clerk was
able to steal thousands of dollars because no one was required to approve the pay-
ments other than the accounts payable clerk.

Separating Operations, Custody of Assets, and Accounting Control policies should es-
tablish the responsibilities for various business activities. To reduce the possibility of
errors and fraud, the responsibilities for operations, custody of assets, and accounting
should be separated. The accounting records then serve as an independent check on
the individuals who have custody of the assets and who engage in the business oper-
An accounting clerk for the ations. For example, the employees entrusted with handling cash receipts from credit
Grant County (Washington)
Alcoholism Program was in
customers should not record cash receipts in the accounting records. To do so would
charge of collecting money, allow employees to borrow or steal cash and hide the theft in the records. Likewise, if
making deposits, and keeping those engaged in operating activities also record the results of operations, they could
the records. While the clerk distort the accounting reports to show favorable results. For example, a store manager
was away on maternity leave, whose year-end bonus is based upon operating profits might be tempted to record fic-
the replacement clerk discov-
ered a fraud: $17,800 in fees
titious sales in order to receive a larger bonus.
had been collected but had To illustrate, consider the case where a payroll clerk was responsible for prepar-
been hidden for personal gain. ing the payroll and distributing the payroll checks. The clerk stole almost $40,000 over
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 355

two months by preparing duplicate payroll checks and checks for fictitious part-time
employees. After the theft was detected, the duties of preparing payroll checks and dis-
tributing payroll checks were assigned to separate employees.

Proofs and Security Measures Proofs and security measures should be used to safe-
guard assets and ensure reliable accounting data. This control procedure applies to
many different techniques, such as authorization, approval, and reconciliation proce-
dures. For example, employees who travel on company business may be required to
obtain a department manager’s approval on a travel request form.
Other examples of control procedures include the use of bank accounts and other
measures to ensure the safety of cash and valuable documents. A cash register that dis-
plays the amount recorded for each sale and provides the customer a printed receipt
can be an effective part of the internal control structure. An all-night convenience store
could use the following security measures to deter robberies:
1. Locate the cash register near the door, so that it is fully visible from outside the
store; have two employees work late hours; employ a security guard.
2. Deposit cash in the bank daily, before 5 p.m.
3. Keep only small amounts of cash on hand after 5 p.m. by depositing excess cash
in a store safe that can’t be opened by employees on duty.
4. Install cameras and alarm systems.
To illustrate, consider the case where someone stole thousands of dollars in park-
ing fines from a small town. Citizens would pay their parking fines by placing money
in ticket envelopes and putting them in a locked box outside the town hall. The key to
the locked box was not safeguarded and was readily available to a variety of people.
As a result, the person who stole the money was never discovered. The town later gave
one person the responsibility of safeguarding the key and emptying the locked box.

MONITORING
Monitoring the internal control system locates weaknesses and improves control ef-
fectiveness. The internal control system can be monitored through either ongoing ef-
forts by management or by separate evaluations. Ongoing monitoring efforts may
include observing both employee behavior and warning signs from the accounting sys-
tem. The indicators shown in Exhibit 4 may be clues to internal control problems.6
Separate monitoring evaluations are generally performed when there are major
changes in strategy, senior management, business structure, or operations. In large busi-
nesses, internal auditors who are independent of operations normally are responsible
for monitoring the internal control system. Internal auditors can report issues and con-
cerns to an audit committee of the board of directors, who are independent of man-
agement. In addition, external auditors also evaluate internal control as a normal part
of their annual financial statement audit.

INFORMATION AND COMMUNICATION

Information and communication are essential elements of internal control. Information
about the control environment, risk assessment, control procedures, and monitoring is
needed by management to guide operations and ensure compliance with reporting,
legal, and regulatory requirements. Management can also use external information to
assess events and conditions that impact decision making and external reporting. For
example, management uses information from the Financial Accounting Standards
Board (FASB) to assess the impact of possible changes in reporting standards.

6 Edwin C. Bliss, “Employee Theft,” Boardroom Reports, July 15, 1994, pp. 5–6.
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356 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

EXHIBIT 4 Warning Signs of Internal Control Problems

Example Exercise 8-1 objective 2

Identify each of the following as relating to (a) the control environment, (b) risk assessment, or (c) control
procedures.
1. Mandatory vacations
2. Personnel policies
3. Report of outside consultants on future market changes

Follow My Example 8-1

1. (c) control procedures

2. (a) the control environment
3. (b) risk assessment

For Practice: PE 8-1A, PE 8-1B

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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 357

Cash Controls Over Receipts and Payments

3 Cash includes coins, currency (paper money), checks, money orders, and money on
objective deposit that is available for unrestricted withdrawal from banks and other financial in-
Describe and stitutions. Normally, you can think of cash as anything that a bank would accept for
illustrate the deposit in your account. For example, a check made payable to you could normally be
application of
internal controls deposited in a bank and thus is considered cash.
to cash. We will assume in this chapter that a business maintains only one bank account,
represented in the ledger as Cash. In practice, however, a business may have several
bank accounts, such as one for general cash payments and another for payroll. For each
of its bank accounts, the business will maintain a ledger account, one of which may be
called Cash in Bank—First Bank, for example. It will also maintain separate ledger ac-
counts for special-purpose cash funds, such as travel reimbursements. We will intro-
The Internet has given rise to duce some of these other cash accounts later in this chapter.
a form of cash called “cyber- Because of the ease with which money can be transferred, cash is the asset most
cash,” which is used for Inter- likely to be diverted and used improperly by employees. In addition, many trans-
net transactions, such as being
actions either directly or indirectly affect the receipt or the payment of cash. Busi-
used in conjunction with Pay-
Pal. nesses must therefore design and use controls that safeguard cash and control the
authorization of cash transactions. In the following paragraphs, we will discuss these
controls.

CONTROL OF CASH RECEIPTS

To protect cash from theft and misuse, a business must control cash from the time it is
received until it is deposited in a bank. Businesses normally receive cash from two main
sources: (1) customers purchasing products or services and (2) customers making pay-
ments on account. For example, fast-food restaurants, such as McDonald’s, Wendy’s
International Inc., and Burger King Corporation, receive cash primarily from over-
the-counter sales to customers. Mail-order and Internet retailers, such as Lands’ End
Inc., The Orvis Company, Inc., L.L. Bean, Inc., and [Link], receive cash pri-
marily through electronic funds transfers from credit card companies.

Cash Received from Cash Sales Regardless of the source of cash receipts, every busi-
ness must properly safeguard and record its cash receipts. One of the most important
controls to protect cash received in over-the-counter sales is a cash register. When a
clerk (cashier) enters the amount of a sale, the cash register normally displays the
amount. This is a control to ensure that the clerk has charged you the correct amount.
You also receive a receipt to verify the accuracy of the amount.
At the beginning of a work shift, each cash register clerk is given a cash drawer
that contains a predetermined amount of cash for making change for customers. The
amount in each drawer is sometimes called a change fund. At the end of the shift, the
clerk and the supervisor count the cash in that clerk’s cash drawer. The amount of cash
in each drawer should equal the beginning amount of cash plus the cash sales for the
day. However, errors in recording cash sales or errors in making change cause the
amount of cash on hand to differ from this amount. Such differences are recorded in
a cash short and over account.
At the end of the accounting period, a debit balance in the cash short and over ac-
count is included in Miscellaneous Expense in the income statement. A credit balance
is included in the Other Income section. If a clerk consistently has significant cash short
and over amounts, the supervisor may require the clerk to take additional training.
After a cash register clerk’s cash has been counted and recorded on a memoran-
dum form, the cash is then placed in a store safe in the Cashier’s Department until it
can be deposited in the bank. The supervisor forwards the clerk’s cash register receipts
to the Accounting Department, where they serve as the basis for recording the trans-
actions for the day as shown on the following page.
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358 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

Some retail companies use debit card systems to transfer and record the receipt of
cash. In a debit card system, a customer pays for goods at the time of purchase by pre-
senting a plastic card. The card authorizes the electronic transfer of cash from the cus-
tomer’s checking account to the retailer’s bank account.

Cash Received in the Mail Cash is received in the mail when customers pay their bills.
This cash is usually in the form of checks and money orders. Most companies’ invoices
are designed so that customers return a portion of the invoice, called a remittance ad-
vice, with their payment. The employee who opens the incoming mail should initially
compare the amount of cash received with the amount shown on the remittance ad-
vice. If a customer does not return a remittance advice, an employee prepares one. Like
the cash register, the remittance advice serves as a record of cash initially received. It
also helps ensure that the posting to the customer’s account is accurate. Finally, as a
control, the employee opening the mail normally also stamps checks and money or-
ders “For Deposit Only” in the bank account of the business.
All cash received in the mail is sent to the Cashier’s Department. An employee
there combines it with the receipts from cash sales and prepares a bank deposit ticket.
The remittance advices and their summary totals are delivered to the Accounting De-
partment. An accounting clerk then prepares the records of the transactions and posts
them to the customer accounts.
When cash is deposited in the bank, the bank normally stamps a duplicate copy of
the deposit ticket with the amount received. This bank receipt is returned to the Ac-
counting Department, where a clerk compares the receipt with the total amount that
should have been deposited. This control helps ensure that all the cash is deposited
and that no cash is lost or stolen on the way to the bank. Any shortages are thus
promptly detected.
Separating the duties of the Cashier’s Department, which handles cash, and the
Accounting Department, which records cash, is a control. If Accounting Department
employees both handle and record cash, an employee could steal cash and change the
accounting records to hide the theft.

Cash Received by EFT Cash may also be received from customers through electronic
funds transfers (EFT). For example, customers may authorize automatic electronic
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 359

transfers from their checking accounts to pay monthly bills for such items as cell phone,
cable, Internet, and electric services. In such cases, the company sends the customer’s
bank a signed form from the customer authorizing the monthly electronic transfers
from the customer’s checking account to the company’s bank account. Each month, the
company electronically notifies the customer’s bank of the amount of the transfer and
the date the transfer should take place. On the due date, the company records the elec-
tronic transfer as a receipt of cash to its bank account and posts the amount paid to the
customer’s account.
Most companies encourage automatic electronic transfers by customers for several
reasons. First, electronic transfers are less costly than receiving cash payments through
the mail since the employee handling of cash is eliminated. Second, electronic trans-
fers enhance internal controls over cash since the cash is received directly by the bank
without the handling of cash by employees. Thus, potential theft of cash is eliminated.
Finally, electronic transfers reduce late payments from customers and speed up the
processing of cash receipts.

CONTROL OF CASH PAYMENTS

The control of cash payments should provide reasonable assurance that payments are
made for only authorized transactions. In addition, controls should ensure that cash is
Howard Schultz & Associ- used efficiently. For example, controls should ensure that all available discounts, such
ates (HS&A) specializes in re- as purchase discounts, are taken.
viewing cash payments for its In a small business, an owner/manager may authorize payments based upon per-
clients. HS&A searches for er- sonal knowledge of goods and services purchased. In a large business, however, the
rors, such as duplicate pay-
ments, failures to take
duties of purchasing goods, inspecting the goods received, and verifying the invoices
discounts, and inaccurate com- are usually performed by different employees. These duties must be coordinated to en-
putations. Amounts recovered sure that checks for proper payments are made to creditors. One system used for this
for clients ranged from thou- purpose is the voucher system.
sands to millions of dollars.

Voucher System A voucher system is a set of procedures for authorizing and record-
ing liabilities and cash payments. A voucher is any document that serves as proof of
authority to pay cash or issue an electronic funds transfer. For example, an invoice
properly approved for payment could be considered a voucher. In many businesses,
however, a voucher is a special form for recording relevant data about a liability and
the details of its payment.
A voucher system may be either manual or computerized. In a manual system, a
voucher is normally prepared after all necessary supporting documents have been re-
ceived. For example, when a voucher is prepared for the purchase of goods, the voucher
should be supported by the supplier’s invoice, a purchase order, and a receiving re-
port. After a voucher is prepared, it is submitted to the proper manager for approval.
Once approved, the voucher is recorded in the accounts and filed by due date. Upon
payment, the voucher is recorded in the same manner as the payment of an account
payable.
In a computerized system, properly approved supporting documents (such as pur-
chase orders and receiving reports) would be entered directly into computer files. At
the due date, the checks would be automatically generated and mailed to creditors. At
that time, the voucher would be electronically transferred to a paid voucher file.

Cash Paid by EFT Cash can also be paid by electronic funds transfer systems by us-
ing computers rather than paper money or checks. For example, a company may pay
its employees by means of EFT. Under such a system, employees may authorize the
deposit of their payroll checks directly into checking accounts. Each pay period, the
business electronically transfers the employees’ net pay to their checking accounts
through the use of computer systems and networks. Likewise, many companies are us-
ing EFT systems to pay their suppliers and other vendors.
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360 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

Bank Accounts
4 Most of you are familiar with bank accounts. You probably have a checking account
objective at a local bank, credit union, savings and loan association, or other financial institu-
Describe the tion. In this section, we discuss the use of bank accounts by businesses. We then dis-
nature of a bank cuss the use of bank accounts as an additional control over cash.
account and its use
in controlling cash.

USE OF BANK ACCOUNTS

A business often maintains several bank accounts. For example, a business with sev-
eral branches or retail outlets such as Sears Holdings, Inc. or Gap Inc. will often main-
tain a bank account for each location. In addition, businesses usually maintain a separate
Many businesses and individu- bank account for payroll and other special purposes.
als are now using Internet A major reason that businesses use bank accounts is for control purposes. Use of
banking services, which pro- bank accounts reduces the amount of cash on hand at any one time. For example, many
vide for the payment of funds
electronically.
merchandise businesses deposit cash receipts twice daily to reduce the amount of cash
on hand that is susceptible to theft. Likewise, using a payroll account allows for pay-
ing employees by check or electronic funds transfer rather than by distributing a large
amount of cash each payroll period.
In addition to reducing the amount of cash on hand, bank accounts provide an in-
dependent recording of cash transactions that can be used as a verification of the busi-
ness’s recording of transactions. That is, the use of bank accounts provides a double
recording of cash transactions. The company’s cash account corresponds to the bank’s
liability (deposit) account for the company. As we will discuss and illustrate in the next
section, this double recording of cash transactions allows for a reconciliation of the cash
account on the company’s records with the cash balance recorded by the bank.
Finally, the use of bank accounts facilitates the transfer of funds. For example, elec-
tronic funds transfer systems require bank accounts for the transfer of funds between
companies. Within a company, cash can be transferred between bank accounts through
the use of wire transfers. In addition, online banking allows companies to transfer funds
and pay bills electronically as well as monitor their cash balances on a real-time basis.

BANK STATEMENT
Banks usually maintain a record of all checking account transactions. A summary of
all transactions, called a bank statement, is mailed to the depositor or made available
online, usually each month. Like any account with a customer or a creditor, the bank
statement shows the beginning balance, additions, deductions, and the balance at the
end of the period. A typical bank statement is shown in Exhibit 5.
The depositor’s checks or copies of the checks received by the bank during the pe-
riod may accompany the bank statement, arranged in order of payment. If paid checks
are returned, they are stamped “Paid,” together with the date of payment. Many banks
no longer return checks or check copies with bank statements. Instead, the check pay-
ment information is available online. Other entries that the bank has made in the de-
positor’s account are described as debit or credit memorandums on the statement.
The depositor’s checking account balance in the bank records is a liability; thus, in
the bank’s records, the depositor’s account has a credit balance. Since the bank state-
ment is prepared from the bank’s point of view, a credit memorandum entry on the
bank statement indicates an increase (a credit) in the depositor’s account. Likewise, a
debit memorandum entry on the bank statement indicates a decrease (a debit) in the
depositor’s account. This relationship is shown at the bottom of page 361.
A bank makes credit entries (issues credit memoranda) for deposits made by elec-
tronic funds transfer, for collections of note receivable for the depositor, for proceeds
for a loan to the depositor, for interest earned on the depositor’s account, and to cor-
rect bank errors. A bank makes debit entries (issues debit memoranda) for payments
made by electronic funds transfer, for service charges, for customers’ checks returned
for not sufficient funds, and to correct bank errors.
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 361

EXHIBIT 5 PAGE 1
MEMBER FDIC

Bank Statement VALLEY NATIONAL BANK ACCOUNT NUMBER 1627042

OF LOS ANGELES FROM 6/30/07 TO 7/31/07

LOS ANGELES, CA 90020-4253 (310)555-5151 BALANCE 4,218.60

22 DEPOSITS 13,749.75

52 WITHDRAWALS 14,698.57
POWER NETWORKING
1000 Belkin Street 3 OTHER DEBITS
Los Angeles, CA 90014 -1000 AND CREDITS 90.00CR

NEW BALANCE 3,359.78

* – – CHECKS AND OTHER DEBITS – – – * – – – DEPOSITS – – * – – DATE – – * – – BALANCE – – *

819.40 122.54 585.75 07/01 3,862.41
369.50 732.26 20.15 421.53 07/02 3,162.03
600.00 190.70 52.50 781.30 07/03 3,100.13
25.93 160.00 662.50 07/05 3,576.70
921.20 NSF 300.00 503.18 07/07 2,858.68

32.26 535.09 ACH 932.00 07/29 3,404.40

21.10 126.20 705.21 07/30 3,962.31
SC 18.00 MS 408.00 07/30 4,352.31
26.12 ACH 1,615.13 648.72 07/31 3,359.78

EC –– ERROR CORRECTION ACH –– AUTOMATED CLEARING HOUSE

MS –– MISCELLANEOUS
NSF –– NOT SUFFICIENT FUNDS SC –– SERVICE CHARGE
*** *** ***
THE RECONCILEMENT OF THIS STATEMENT WITH YOUR RECORDS IS ESSENTIAL.
ANY ERROR OR EXCEPTION SHOULD BE REPORTED IMMEDIATELY.

Customers’ checks returned for not sufficient funds, called NSF checks, are checks
that were initially deposited, but were not paid when they were presented to the cus-
tomer’s bank for payment. Since the bank initially credited the check to the depositor’s
account when it was deposited, the bank debits (issues a debit memorandum) when
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362 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

the check is returned without payment. We discuss the accounting for NSF checks later
in this chapter.
The reason for a credit or debit memorandum entry is indicated on the bank state-
ment. For example, Exhibit 5 identifies the following types of credit and debit memo-
randum entries:
EC: Error correction to correct bank error.
NSF: Not sufficient funds check.
SC: Service charge.
ACH: Automated Clearing House entry for electronic funds transfer.
MS: Miscellaneous item such as collection of a note receivable on behalf of
the depositor or receipt of loan proceeds by the depositor from the bank.
In the preceding list, we have included the notation “ACH” for electronic funds
transfers. ACH is a network for clearing electronic funds transfers among individuals,
companies, and banks.7 Because electronic funds transfers may be either deposits or
payments, ACH entries may indicate either a debit or credit entry to the depositor’s
account. Likewise, entries to correct bank errors and miscellaneous items may indicate
a debit or credit entry to the depositor’s account.

Example Exercise 8-2 objective 4

The following items may appear on a bank statement:

1. NSF check
2. EFT deposit
3. Service charge
4. Bank correction of an error from recording a $400 check as $40
Indicate whether the item would appear as a debit or credit memorandum on the bank statement and
whether the item would increase or decrease the balance of the depositor’s account.
Appears on the
Bank Statement as Increases or Decreases the
a Debit or Credit Balance of the Depositor's
Item No. Memorandum Bank Account

Follow My Example 8-2

Appears on the
Bank Statement as Increases or Decreases the
a Debit or Credit Balance of the Depositor's
Item No. Memorandum Bank Account
1 debit memorandum decreases
2 credit memorandum increases
3 debit memorandum decreases
4 debit memorandum decreases

For Practice: PE 8-2A, PE 8-2B

BANK ACCOUNTS AS A CONTROL OVER CASH

As we mentioned earlier, a bank account is one of the primary tools a company uses
to control cash. For example, companies often require that all cash receipts be initially
deposited in a bank account. Likewise, companies usually use checks or bank account

7 For further information on ACH, go to [Link] Click on “About Us,” and then click on
“What is ACH?”
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 363

transfers to make all cash payments, except for very small amounts.
When such a system is used, there is a double record of cash transac-
tions—one by the company and the other by the bank.
A bank and a business’s A company can use a bank statement to compare the cash transac-
records provide a double tions recorded in its accounting records to those recorded by the bank.
record of cash transactions The cash balance shown by a bank statement is usually different from
the cash balance shown in the accounting records of the company, as
shown in Exhibit 6.

EXHIBIT 6 Bank Statement

Beginning balance $ 4,218.60
Power Networking’s Additions:
Records and Bank Deposits $13,749.75
Statement Miscellaneous 408.00 14,157.75
Deductions:
Checks $14,698.57
NSF check 300.00
Service charge 18.00 15,016.57
Ending balance $ 3,359.78

Power Networking should deter-

Power Networking Records mine the reason for the difference
Beginning balance $ 4,227.60 in these two amounts.
Deposits 14,565.95
Checks 16,243.56
Ending balance $ 2,549.99

This difference may be the result of a delay by either party in recording transac-
tions. For example, there is a time lag of one day or more between the date a check is
written and the date that it is presented to the bank for payment. If the company mails
deposits to the bank or uses the night depository, a time lag between the date of the
deposit and the date that it is recorded by the bank is also probable. The bank may
also debit or credit the company’s account for transactions about which the company
will not be informed until later.
The difference may be the result of errors made by either the company or the bank
in recording transactions. For example, the company may incorrectly post to Cash a
check written for $4,500 as $450. Likewise, a bank may incorrectly record the amount
of a check.

Integrity, Objectivity, and Ethics in Business

CHECK FRAUD
Check fraud involves counterfeiting, altering, or otherwise inals perpetrate the fraud by taking blank checks from
manipulating the information on checks in order to fraud- your checkbook, finding a canceled check in the garbage,
ulently cash a check. According to the National Check or removing a check you have mailed to pay bills. Con-
Fraud Center, check fraud and counterfeiting are among sumers can prevent check fraud by carefully storing blank
the fastest growing problems affecting the financial sys- checks, placing outgoing mail in postal mailboxes, and
tem, generating over $10 billion in losses annually. Crim- shredding canceled checks.
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364 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

Bank Reconciliation
5 For effective control, the reasons for the difference between the cash balance on the
objective bank statement and the cash balance in the accounting records should be analyzed
Describe and by preparing a bank reconciliation. A bank reconciliation is an analysis of the items
illustrate the use and amounts that cause the cash balance reported in the bank statement to differ
of a bank
reconciliation in from the balance of the cash account in the ledger in order to determine the adjusted
controlling cash. cash balance.
A bank reconciliation is usually divided into two sections. The first section, referred
to as the bank section, begins with the cash balance according to the bank statement
and ends with the adjusted balance. The second section, referred to as the company
section, begins with the cash balance according to the company’s records and ends with
the adjusted balance. The two amounts designated as the adjusted balance must be
equal. The content of the bank reconciliation is shown below.

Cash balance according to bank $XXX

Add: Debits to cash not on bank statement
(deposits in transit, etc.) $XX
Deduct: Credits to cash not on bank statement
(outstanding checks, etc.) XX XXX
Adjusted balance $XXX

Must
Cash balance according to company $XXX be
Add: Unrecorded bank credits (notes collected equal
by bank) $XX
Deduct: Unrecorded bank debits (NSF checks,
service charges, etc.) XX XXX
Adjusted balance $XXX

The following steps are useful in finding the reconciling items and determining the
adjusted balance of Cash:
1. Compare each deposit listed on the bank statement with unrecorded deposits
appearing in the preceding period’s reconciliation and with the current period’s
deposits. Add deposits not recorded by the bank to the balance according to the bank
statement.
2. Compare paid checks with outstanding checks appearing on the preceding period’s
reconciliation and with recorded checks. Deduct checks outstanding that have not been
paid by the bank from the balance according to the bank statement.
3. Compare bank credit memorandums to entries in the journal. For example, a bank
would issue a credit memorandum for a note receivable and interest that it col-
lected for a company. Add credit memorandums that have not been recorded to the bal-
ance according to the company’s records.
4. Compare bank debit memorandums to entries recording cash payments. For ex-
ample, a bank normally issues debit memorandums for service charges and check
printing charges. A bank also issues debit memorandums for not sufficient funds
checks. NSF checks are normally charged back to the customer as an account re-
ceivable. Deduct debit memorandums that have not been recorded from the balance ac-
cording to the company’s records.
5. List any errors discovered during the preceding steps. For example, if an amount
has been recorded incorrectly by the company, the amount of the error should be
added to or deducted from the cash balance according to the company’s records.
Similarly, errors by the bank should be added to or deducted from the cash bal-
ance according to the bank statement.
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 365

To illustrate a bank reconciliation, we will use the bank statement for Power Net-
working in Exhibit 5. This bank statement shows a balance of $3,359.78 as of July 31.
The cash balance in Power Networking’s ledger as of the same date is $2,549.99. The
following reconciling items are revealed by using the steps outlined above:

Deposit of July 31, not recorded on bank statement . . . . . . . . . . . . . . . . . . . . . $ 816.20

Checks outstanding: No. 812, $1,061.00; No. 878, $435.39;
No. 883, $48.60 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,544.99
Note plus interest of $8 collected by bank (credit memorandum), not
recorded in the journal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408.00
Check from customer (Thomas Ivey) returned by bank because of
insufficient funds (NSF) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300.00
Bank service charges (debit memorandum), not recorded in the journal . . . . 18.00
Check No. 879 for $732.26 to Taylor Co. on account, recorded
in the journal as $723.26 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.00

The bank reconciliation, based on the bank statement and the reconciling items, is
shown in Exhibit 7.

EXHIBIT 7 Power Networking

Bank Reconciliation
Bank Reconciliation
July 31, 2007
for Power Networking
Cash balance according to bank statement $3 3 5 9 78
Add deposit of July 31, not recorded by bank 8 1 6 20
$4 1 7 5 98
Deduct outstanding checks:
No. 812 $1 0 6 1 00
No. 878 4 3 5 39
No. 883 4 8 60 1 5 4 4 99
Adjusted balance $2 6 3 0 99

Cash balance according to Power Networking records $2 5 4 9 99

Add note and interest collected by bank 4 0 8 00
$2 9 5 7 99
Deduct: Check returned because of insufficient funds $ 3 0 0 00
Bank service charge 1 8 00
Error in recording Check No. 879 9 00 3 2 7 00
Adjusted balance $2 6 3 0 99

No entries are necessary on the company’s records as a result of the information

included in the bank section of the reconciliation. This section begins with the cash
balance according to the bank statement. However, the bank should be notified of any
errors that need to be corrected on its records.
Any items in the company’s section of the bank reconciliation must be recorded in
the company’s accounts. For example, journal entries should be made for any un-
recorded bank memorandums and any company errors. The journal entries for Power
Networking, based on the preceding bank reconciliation, are as follows:
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366 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

July 31 Cash 4 0 8 00
Notes Receivable 4 0 0 00
Interest Revenue 8 00

31 Accounts Receivable—Thomas Ivey 3 0 0 00

Miscellaneous Expense 1 8 00
Accounts Payable—Taylor Co. 9 00
Cash 3 2 7 00

After the entries above have been posted, the cash account will have a debit bal-
ance of $2,630.99. This balance agrees with the adjusted cash balance shown on the
bank reconciliation. This is the amount of cash available as of July 31 and the amount
that would be reported on Power Networking’s July 31 balance sheet.
Although businesses may reconcile their bank accounts in a slightly different for-
mat from what we described above, the objective is the same: to control cash by rec-
onciling the company’s records to the records of an independent outside source, the
bank. In doing so, any errors or misuse of cash may be detected.
For effective control, the bank reconciliation should be prepared by an employee
who does not take part in or record cash transactions. When these duties are not prop-
erly separated, mistakes are likely to occur, and it is more likely that cash will be stolen
or otherwise misapplied. For example, an employee who takes part in all of these
duties could prepare and cash an unauthorized check, omit it from the accounts, and
omit it from the reconciliation.
A bank reconciliation is also appropriate in a computerized environment where
the deposits and checks are stored in electronic files and records. In some systems, the
computer determines the difference between the ending bank balance and the balance
per the company’s records and then adjusts for deposits in transit and outstanding
checks. Any remaining differences are reported for further analysis.

Example Exercise 8-3 objective 5

The following data were gathered to use in reconciling the bank account of Photo Op.
Balance per bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,500
Balance per company records . . . . . . . . . . . . . . . . . . . 13,875
Bank service charges . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Deposit in transit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,750
NSF check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Outstanding checks . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,250
a. What is the adjusted balance on the bank reconciliation?
b. Journalize any necessary entries for Photo Op based upon the bank reconciliation.

Follow My Example 8-3

a. $13,000, as shown below.
Bank section of reconciliation: $14,500
$3,750  $5,250  $13,000
Company section of reconciliation: $13,875  $75  $800  $13,000
b. Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Miscellaneous Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 875

For Practice: PE 8-3A, PE 8-3B

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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 367

Integrity, Objectivity, and Ethics in Business

BANK ERROR IN YOUR FAVOR

You may sometime have a bank error in your favor, such trol systems quickly discover most errors and make auto-
as a misposted deposit. Such errors are not a case of matic adjustments. Even so, you have a legal responsibil-
“found money,” as in the Monopoly® game. Bank con- ity to report the error and return the money to the bank.

Special-Purpose Cash Funds

6 It is usually not practical for a business to write checks to pay small amounts, such as
objective postage. Yet, these small payments may occur often enough to add up to a significant
Describe the total amount. Thus, it is desirable to control such payments. For this purpose, a spe-
accounting for
cial cash fund, called a petty cash fund, is used.
special-purpose
cash funds. A petty cash fund is established by first estimating the amount of cash needed for
payments from the fund during a period, such as a week or a month. After necessary
approvals, a check is written and cashed for this amount. The money obtained from
cashing the check is then given to an employee, called the petty cash custodian, who
is authorized to disburse monies from the fund. For control purposes, the company
may place restrictions on the maximum amount and the types of payments that can be
made from the fund. Each time monies are paid from petty cash, the custodian records
the details of the payment on a petty cash receipt form.
The petty cash fund is normally replenished at periodic intervals or when it is
depleted or reaches a minimum amount. When a petty cash fund is replenished, the
accounts debited are determined by summarizing the petty cash receipts. A check is
then written for this amount, payable to petty cash.
To illustrate normal petty cash fund entries, assume that a petty cash fund of $500
is established on August 1. The entry to record this transaction is as follows:

Aug. 1 Petty Cash 5 0 0 00

Cash 5 0 0 00

At the end of August, the petty cash receipts indicate expenditures for the follow-
ing items: office supplies, $380; postage (office supplies), $22; store supplies, $35; and
miscellaneous administrative expense, $30. The entry to replenish the petty cash fund
on August 31 is as follows:

Aug. 31 Office Supplies 4 0 2 00

Store Supplies 3 5 00
Miscellaneous Administrative Expense 3 0 00
Cash 4 6 7 00

Replenishing the petty cash fund restores it to its original amount of $500. You
should note that there is no entry in Petty Cash when the fund is replenished. Petty
Cash is debited only when the fund is initially set up or when the amount of the fund
is increased at a later time. Petty Cash is credited if it is being decreased.
In addition, businesses often use other cash funds to meet special needs, such as
payroll or travel expenses for salespersons. Such funds are called special-purpose
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368 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

funds. For example, each salesperson might be given $200 for travel-related expenses.
Periodically, the salesperson submits a detailed expense report and the travel funds are
replenished. Also, as we discussed earlier in this chapter, retail businesses use change
funds for making change for customers. Finally, most businesses use a payroll bank
account to pay employees.
A special-purpose cash fund is initially established by first estimating the amount
of cash needed for payments from the fund during a period, such as a week or a
month. After necessary approvals, cash is transferred to the special-purpose fund.
The employee responsible for disbursing monies from the fund, called the custodian,
approves all dibursements from the fund. For control purposes, the company may
place restrictions on the maximum amount and types of payments that can be made
from the fund. Periodically, an independent employee reviews disbursements from
the fund, the disbursements are recorded, and the fund is replenished.

Example Exercise 8-4 objective 6

Prepare journal entries for each of the following:

a. Issued a check to establish a petty cash fund of $500.
b. The amount of cash in the petty cash fund is $120. Issued a check to replenish the fund, based on the
following summary of petty cash receipts: office supplies, $300 and miscellaneous administrative
expense, $75. Record any missing funds in the cash short and over account.

Follow My Example 8-4

a. Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
b. Office Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Miscellaneous Administrative Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Cash Short and Over . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380

For Practice: PE 8-4A, PE 8-4B

Financial Statement Reporting of Cash

7 Cash is the most liquid asset, and therefore it is listed as the first asset in the Current
objective Assets section of the balance sheet. Most companies present only a single cash amount
Describe and on the balance sheet by combining all their bank and cash fund accounts.
illustrate the
A company may have cash in excess of its operating needs. In such cases, the
reporting of cash
and cash company normally invests in highly liquid investments in order to earn interest. These
equivalents in the investments are called cash equivalents.8 Examples of cash equivalents include U.S.
financial Treasury Bills, notes issued by major corporations (referred to as commercial paper),
statements. and money market funds. Companies that have invested excess cash in cash equiv-
alents usually report Cash and cash equivalents as one amount on
the balance sheet.
Banks may require depositors to maintain minimum cash
balances in their bank accounts. Such a balance is called a com-
pensating balance. This requirement is often imposed by the
In the United Kingdom, the statement of cash flows is
prepared using a narrower definition of “cash” than in
the United States. Specifically, the United Kingdom does
not include cash equivalents, such as certificates of de- 8 To be classified a cash equivalent, according to FASB Statement 95, the invest-
posit, in its definition of cash as does the United States. ment is expected to be converted to cash within 90 days.
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 369

bank as a part of a loan agreement or line of credit. A line of credit is a preapproved

amount the bank is willing to lend to a customer upon request. Compensating bal-
ance requirements should be disclosed in notes to the financial statements.

Business Connections

MICROSOFT CORPORATION
Microsoft Corporation develops, manufactures, licenses, volved in the video game market through its Xbox and is
and supports software products for computing devices. also involved in online products and services.
Microsoft software products include computer operating Microsoft is known for its strong cash position. Micro-
systems, such as Windows, and application software, such soft’s June 30, 2005 balance sheet reported almost $38 bil-
as Microsoft Word™ and Excel.™ Microsoft is actively in- lion of cash and short-term investments, as shown below.

Balance Sheet
June 30, 2005
(In millions)
Assets

Current assets:
Cash and equivalents $ 4,851
Short-term investments 32,900
Total cash and short-term investments $37,751

© RENE MACURO/ASSOCIATED PRESS

The cash and cash equivalents of $4,851 million are
further described in the notes to the financial statements,
as shown below.

Cash and equivalents:

Cash $1,911
Commercial paper 1,570
Certificates of deposit 453
Money market mutual funds 817
Corporate notes and bonds 80
Municipal securities 20
Total cash and equivalents $4,851
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370 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

Financial Analysis and Interpretation

For companies that are either starting up or in financial distress, cash is critical for their survival. In
their first few years of operations, startup companies often report losses and negative net cash flows.
In these cases, the ratio of cash to monthly cash expenses (negative cash flow for operating activities) is
useful for assessing how long a company can continue to operate without additional financing or with-
out generating positive cash flows from operations. Likewise, this ratio can be used to assess how long
a business may continue to operate when experiencing financial distress. In computing cash to monthly
cash expenses, the amount of cash on hand can be taken from the balance sheet, while the monthly
cash expenses can be estimated from the operating activities section of the statement of cash flows.
The ratio of cash to monthly cash expenses is computed by first determining the monthly cash ex-
penses. The monthly cash expenses are determined as follows:
Negative Cash Flows from Operations
Monthly Cash Expenses  
12

The ratio of cash to monthly cash expenses can then be computed as follows:
Cash and Cash Equivalents as of Year-End
Ratio of Cash to Monthly Cash Expenses  
Monthly Cash Expenses

To illustrate these ratios, we use Northwest Airlines Corporation, a major carrier of passengers
and cargo with service to approximately 900 cities in 160 countries. For the year ending December 31,
2005, Northwest Airlines reported the following data (in millions):

Negative cash flows from operations $ (436)

Cash and cash equivalents as of December 31, 2005 1,284)

Based upon the preceding data, the monthly cash expenses, sometimes referred to as cash burn, were
$36.3 million per month ($436/12). Thus, as of December 31, 2005, the cash to monthly cash expenses
ratio was 35.4 ($1,284/$36.3). That is, as of December 31, 2005, Northwest would run out of cash in less
than three years unless it changes its operations, sells investments, or raises additional financing. In
September 2005, Northwest Airlines filed for voluntary reorganization under Chapter 11 of the U.S.
Bankruptcy Code.

At a Glance

1. Describe the Sarbanes-Oxley Act of 2002 and its impact on internal controls and financial reporting.

Example Practice
Key Points Key Learning Outcomes Exercises Exercises

The purpose of the Sarbanes-Oxley Act of • Describe why Congress passed

2002 is to restore public confidence and trust Sarbanes-Oxley.
in the financial statements of companies. • Describe the purpose of
Sarbanes-Oxley requires companies to main- Sarbanes-Oxley.
tain strong and effective internal controls • Define internal control.
and to report on the effectiveness of the
internal controls.
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 371

2. Describe and illustrate the objectives and elements of internal control.

Example Practice
Key Points Key Learning Outcomes Exercises Exercises

The objectives of internal control are to pro- • List the objectives of internal
vide reasonable assurance that (1) assets are control.
safeguarded and used for business purposes, • List the elements of internal
(2) business information is accurate, and control.
(3) laws and regulations are complied with. • Describe each element of 8-1 8-1A, 8-1B
The elements of internal control are the con- internal control and factors
trol environment, risk assessment, control influencing each element.
procedures, monitoring, and information and
communication.

3. Describe and illustrate the application of internal controls to cash.

Example Practice
Key Points Key Learning Outcomes Exercises Exercises

A cash register is one of the most important • Describe and give examples
controls to protect cash received in over-the- of controls for cash received
counter sales. A remittance advice is a control from cash sales, cash received
for cash received through the mail. in the mail, and cash received
Separating the duties of handling cash and by EFT.
recording cash is also a control. A voucher • Describe and give examples
system is a control system for cash payments of controls for cash payments
that uses a set of procedures for authorizing made using a voucher system
and recording liabilities and cash payments. and cash payments made by
Many companies use electronic funds transfers EFT.
to enhance their control over cash receipts
and cash payments.

4. Describe the nature of a bank account and its use in controlling cash.

Example Practice
Key Points Key Learning Outcomes Exercises Exercises

Bank accounts help control cash by reducing • Describe how the use of bank
the amount of cash on hand and facilitating accounts helps control cash.
the transfer of cash between businesses and • Describe a bank statement 8-2 8-2A, 8-2B
locations. In addition, the bank statement and provide examples of
allows a business to reconcile the cash trans- items that appear on a bank
actions recorded in the accounting records to statement as debit and credit
those recorded by the bank. memoranda.

(continued)
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372 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

5. Describe and illustrate the use of a bank reconciliation in controlling cash.

Example Practice
Key Points Key Learning Outcomes Exercises Exercises

The bank reconciliation begins with the cash • Describe a bank reconciliation. 8-3 8-3A, 8-3B
balance according to the bank statement. • Prepare a bank reconciliation. 8-3 8-3A, 8-3B
This balance is adjusted for the company’s • Journalize any necessary 8-3 8-3A, 8-3B
changes in cash that do not appear on the entries on the company’s
bank statement and for any bank errors. The records based upon the bank
second section begins with the cash balance reconciliation.
according to the company’s records. This bal-
ance is adjusted for the bank’s changes in
cash that do not appear on the company’s
records and for any company errors. The ad-
justed balances for the two sections must be
equal. The items in the company section must
be journalized on the company’s records.

6. Describe the accounting for special-purpose cash funds.

Example Practice
Key Points Key Learning Outcomes Exercises Exercises

Special-purpose cash funds, such as a petty • Describe the use of special-

cash fund or travel funds, are used by busi- purpose cash funds.
nesses to meet specific needs. Each fund is • Journalize the entry to estab- 8-4 8-4A, 8-4B
established by cashing a check for the amount lish a petty cash fund.
of cash needed. At periodic intervals, the • Journalize the entry to 8-4 8-4A, 8-4B
fund is replenished and the disbursements replenish a petty cash fund.
recorded.

7. Describe and illustrate the reporting of cash and cash equivalents in the financial statements.

Example Practice
Key Points Key Learning Outcomes Exercises Exercises

Cash is listed as the first asset in the Current • Describe the reporting of cash
Assets section of the balance sheet. Companies and cash equivalents in the
that have invested excess cash in highly liquid financial statements.
investments usually report Cash and cash • Illustrate the reporting of
equivalents on the balance sheet. cash and cash equivalents in
the financial statements.

Key Terms
Bank reconciliation (364) Electronic funds transfer (EFT) Sarbanes-Oxley Act of 2002 (348)
Bank statement (360) (358) Special-purpose fund (367)
Cash (357) Elements of internal control (351) Voucher (359)
Cash equivalents (368) Employee fraud (350) Voucher system (359)
Cash short and over account (357) Internal controls (348)
Compensating balance (368) Petty cash fund (367)
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 373

Illustrative Problem
The bank statement for Urethane Company for June 30, 2007, indicates a balance of
$9,143.11. All cash receipts are deposited each evening in a night depository, after
banking hours. The accounting records indicate the following summary data for cash
receipts and payments for June:

Cash balance as of June 1 $ 3,943.50

Total cash receipts for June 28,971.60
Total amount of checks issued in June 28,388.85

Comparing the bank statement and the accompanying canceled checks and memoranda
with the records reveals the following reconciling items:
a. The bank had collected for Urethane Company $1,030 on a note left for collection.
The face amount of the note was $1,000.
b. A deposit of $1,852.21, representing receipts of June 30, had been made too late to
appear on the bank statement.
c. Checks outstanding totaled $5,265.27.
d. A check drawn for $139 had been incorrectly charged by the bank as $157.
e. A check for $30 returned with the statement had been recorded in the company’s
records as $240. The check was for the payment of an obligation to Avery Equip-
ment Company for the purchase of office supplies on account.
f. Bank service charges for June amounted to $18.20.
Instructions
1. Prepare a bank reconciliation for June.
2. Journalize the entries that should be made by Urethane Company.
Solution
1.

Urethane Company
Bank Reconciliation
June 30, 2007
Cash balance according to bank statement $ 9 1 4 3 11
Add: Deposit of June 30 not recorded by bank $1 8 5 2 21
Bank error in charging check as $157
instead of $139 1 8 00 1 8 7 0 21
$11 0 1 3 32
Deduct: Outstanding checks 5 2 6 5 27
Adjusted balance $ 5 7 4 8 05

Cash balance according to company’s records $ 4 5 2 6 25 *

Add: Proceeds of note collected by bank,
including $30 interest $1 0 3 0 00
Error in recording check 2 1 0 00 1 2 4 0 00
$ 5 7 6 6 25
Deduct: Bank service charges 1 8 20
Adjusted balance $ 5 7 4 8 05
*$3,943.50
$28,971.60  $28,388.85

(continued)
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374 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

2.
June 30 Cash 1 2 4 0 00
Notes Receivable 1 0 0 0 00
Interest Revenue 3 0 00
Accounts Payable—Avery Equipment Company 2 1 0 00

30 Miscellaneous Administrative Expense 1 8 20

Cash 1 8 20

Self-Examination Questions (Answers at End of Chapter)

1. Which of the following is not an element of internal B. deducted from the cash balance according to the
control? bank statement.
A. Control environment C. added to the cash balance according to the com-
B. Monitoring pany’s records.
C. Compliance with laws and regulations D. deducted from the cash balance according to the
D. Control procedures company’s records.
2. The bank erroneously charged Tropical Services’ ac- 4. Journal entries based on the bank reconciliation are
count for $450.50 for a check that was correctly writ- required for:
ten and recorded by Tropical Services as $540.50. To A. additions to the cash balance according to the com-
reconcile the bank account of Tropical Services at the pany’s records.
end of the month, you would: B. deductions from the cash balance according to the
A. add $90 to the cash balance according to the bank company’s records.
statement. C. both A and B.
B. add $90 to the cash balance according to Tropical D. neither A nor B.
Services’ records.
5. A petty cash fund is:
C. deduct $90 from the cash balance according to the
A. used to pay relatively small amounts.
bank statement.
B. established by estimating the amount of cash needed
D. deduct $90 from the cash balance according to
for disbursements of relatively small amounts dur-
Tropical Services’ records.
ing a specified period.
3. In preparing a bank reconciliation, the amount of C. reimbursed when the amount of money in the fund
checks outstanding would be: is reduced to a predetermined minimum amount.
A. added to the cash balance according to the bank D. all of the above.
statement.

Eye Openers
1. (a) Why did Congress pass the Sarbanes-Oxley Act of 2002? (b) What was the purpose
of the Sarbanes-Oxley Act of 2002?
2. Define internal control.
3. (a) Name and describe the five elements of internal control. (b) Is any one element of
internal control more important than another?
4. How does a policy of rotating clerical employees from job to job aid in strengthening
the control procedures within the control environment? Explain.
5. Why should the responsibility for a sequence of related operations be divided among
different persons? Explain.
6. Why should the employee who handles cash receipts not have the responsibility for
maintaining the accounts receivable records? Explain.
7. In an attempt to improve operating efficiency, one employee was made responsible for
all purchasing, receiving, and storing of supplies. Is this organizational change wise
from an internal control standpoint? Explain.
8. The ticket seller at a movie theater doubles as a ticket taker for a few minutes each day
while the ticket taker is on a break. Which control procedure of a business’s system of
internal control is violated in this situation?
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 375

9. Why should the responsibility for maintaining the accounting records be separated from
the responsibility for operations? Explain.
10. Assume that Julee Shiver, accounts payable clerk for Galaxy Inc., stole $110,000 by
paying fictitious invoices for goods that were never received. The clerk set up accounts
in the names of the fictitious companies and cashed the checks at a local bank. Describe
a control procedure that would have prevented or detected the fraud.
11. Before a voucher for the purchase of merchandise is approved for payment, support-
ing documents should be compared to verify the accuracy of the liability. Give an
example of supporting documents for the purchase of merchandise.
12. The accounting clerk pays all obligations by prenumbered checks. What are the
strengths and weaknesses in the internal control over cash payments in this situation?
13. The balance of Cash is likely to differ from the bank statement balance. What two fac-
tors are likely to be responsible for the difference?
14. What is the purpose of preparing a bank reconciliation?
15. Do items reported as credits on the bank statement represent (a) additions made by the
bank to the company’s balance or (b) deductions made by the bank from the company’s
balance? Explain.
16. Spectacle Inc. has a petty cash fund of $2,000. (a) Since the petty cash fund is only $2,000,
should Spectacle Inc. implement controls over petty cash? (b) What controls, if any,
could be used for the petty cash fund?
17. (a) How are cash equivalents reported in the financial statements? (b) What are some
examples of cash equivalents?

Practice Exercises
PE 8-1A Identify each of the following as relating to (a) the control environment, (b) control proce-
Internal control elements dures, or (c) information and communication.
obj. 2 1. Separating related operations
2. Report of internal auditors
3. Management’s philosophy and operating style

PE 8-1B Identify each of the following as relating to (a) the control environment, (b) control proce-
Internal control elements dures, or (c) monitoring.
obj. 2 1. Personnel policies
2. Safeguarding inventory in a locked warehouse
3. Hiring of external auditors to review the adequacy of controls

PE 8-2A The following items may appear on a bank statement:

Effect of items on
depositor’s bank account 1. Service charge
2. Note collected for depositor
obj. 4 3. Bank correction of an error from recording a $2,100 deposit as $1,200
4. EFT payment
Using the format shown below, indicate whether each item would appear as a debit or
credit memorandum on the bank statement and whether the item would increase or de-
crease the balance of your account.
Appears on the
Bank Statement as Increases or Decreases the
a Debit or Credit Balance of the Depositor’s
Item No. Memorandum Bank Account

PE 8-2B The following items may appear on a bank statement:

Effect of items on
depositor’s bank account 1. Bank correction of an error from posting another customer’s check to your account
2. Loan proceeds
obj. 4 3. NSF check
4. EFT deposit
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376 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

Using the format shown below, indicate whether each item would appear as a debit or
credit memorandum on the bank statement and whether the item would increase or de-
crease the balance of your account.
Appears on the
Bank Statement as Increases or Decreases the
a Debit or Credit Balance of the Depositor’s
Item No. Memorandum Bank Account

PE 8-3A The following data were gathered to use in reconciling the bank account of Cards Company.
Adjusted balance and
entries from bank Balance per bank $9,200
account reconciliation Balance per company records 9,335
Bank service charges 40
obj. 5
Deposit in transit 2,800
NSF check 475
Outstanding checks 3,180

a. What is the adjusted balance on the bank reconciliation?

b. Journalize any necessary entries for Cards Company based upon the bank reconciliation.

PE 8-3B The following data were gathered to use in reconciling the bank account of DRW Company.
Adjusted balance and
entries from bank Balance per bank $28,100
account reconciliation Balance per company records 9,155
Bank service charges 80
obj. 5 Deposit in transit 3,100
Note collected by bank with $225 interest 15,225
Outstanding checks 6,900

a. What is the adjusted balance on the bank reconciliation?

b. Journalize any necessary entries for DRW Company based upon the bank reconciliation.

PE 8-4A Prepare journal entries for each of the following:

Entries for petty cash
fund a. Issued a check to establish a petty cash fund of $600.
b. The amount of cash in the petty cash fund is $175. Issued a check to replenish the fund,
obj. 6
based on the following summary of petty cash receipts: repair expense, $350 and mis-
cellaneous selling expense, $55. Record any missing funds in the cash short and over
account.

PE 8-4B Prepare journal entries for each of the following:

Entries for petty cash
fund a. Issued a check to establish a petty cash fund of $400.
b. The amount of cash in the petty cash fund is $85. Issued a check to replenish the fund,
obj. 6
based on the following summary of petty cash receipts: store supplies, $180 and miscel-
laneous selling expense, $110. Record any missing funds in the cash short and over
account.

Exercises
EX 8-1 Using the [Link] Advanced Search feature, enter “Sarbanes-Oxley” and
Sarbanes-Oxley internal click on Google Search. Click on “Summary of Sarbanes-Oxley Act of 2002” that appears as
control report part of the [Link] Web site. Scan the summary of the act and read Section 404.
obj. 1 What does Section 404 require of management’s internal control report?
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 377

EX 8-2 Tyler Kirsch has recently been hired as the manager of Dark Canyon Coffee. Dark Canyon
Internal controls Coffee is a national chain of franchised coffee shops. During his first month as store man-
objs. 2, 3 ager, Tyler encountered the following internal control situations:
a. Dark Canyon Coffee has one cash register. Prior to Tyler’s joining the coffee shop, each
employee working on a shift would take a customer order, accept payment, and then
prepare the order. Tyler made one employee on each shift responsible for taking orders
and accepting the customer’s payment. Other employees prepare the orders.
b. Since only one employee uses the cash register, that employee is responsible for count-
ing the cash at the end of the shift and verifying that the cash in the drawer matches the
amount of cash sales recorded by the cash register. Tyler expects each cashier to balance
the drawer to the penny every time—no exceptions.
c. Tyler caught an employee putting a box of 100 single-serving tea bags in his car. Not
wanting to create a scene, Tyler smiled and said, “I don’t think you’re putting those
tea bags on the right shelf. Don’t they belong inside the coffee shop?” The employee
returned the tea bags to the stockroom.
State whether you agree or disagree with Tyler’s method of handling each situa-
tion and explain your answer.

EX 8-3 Rare Earth Clothing is a retail store specializing in women’s clothing. The store has estab-
Internal controls lished a liberal return policy for the holiday season in order to encourage gift purchases.
objs. 2, 3 Any item purchased during November and December may be returned through January
31, with a receipt, for cash or exchange. If the customer does not have a receipt, cash will
still be refunded for any item under $100. If the item is more than $100, a check is mailed
to the customer.
Whenever an item is returned, a store clerk completes a return slip, which the customer
signs. The return slip is placed in a special box. The store manager visits the return counter
approximately once every two hours to authorize the return slips. Clerks are instructed to
place the returned merchandise on the proper rack on the selling floor as soon as possible.
This year, returns at Rare Earth Clothing have reached an all-time high. There are a
large number of returns under $100 without receipts.
a. How can sales clerks employed at Rare Earth Clothing use the store’s return pol-
icy to steal money from the cash register?
b. What internal control weaknesses do you see in the return policy that make cash
thefts easier?
c. Would issuing a store credit in place of a cash refund for all merchandise re-
turned without a receipt reduce the possibility of theft? List some advantages and dis-
advantages of issuing a store credit in place of a cash refund.
d. Assume that Rare Earth Clothing is committed to the current policy of issuing
cash refunds without a receipt. What changes could be made in the store’s procedures
regarding customer refunds in order to improve internal control?

EX 8-4 First Capone Bank provides loans to businesses in the community through its Commercial
Internal controls for Lending Department. Small loans (less than $125,000) may be approved by an individual
bank lending loan officer, while larger loans (greater than $125,000) must be approved by a board of loan
objs. 2, 3 officers. Once a loan is approved, the funds are made available to the loan applicant under
agreed-upon terms. The president of First Capone Bank has instituted a policy whereby she
has the individual authority to approve loans up to $4,000,000. The president believes that
this policy will allow flexibility to approve loans to valued clients much quicker than un-
der the previous policy.
As an internal auditor of First Capone Bank, how would you respond to this change
in policy?

EX 8-5 One of the largest fraud losses in history involved a securities trader for the Singapore
Internal controls office of Barings Bank, a British merchant bank. The trader established an unauthorized
objs. 2, 3 account number that was used to hide $1.4 billion in losses. Even after Barings’ internal
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378 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

auditors noted that the trader both executed trades and recorded them, management did
not take action. As a result, a lone individual in a remote office bankrupted an interna-
tionally recognized firm overnight.
What general weaknesses in Barings’ internal controls contributed to the occur-
rence and size of the fraud?

EX 8-6 An employee of JHT Holdings, Inc., a trucking company, was responsible for resolving road-
Internal controls way accident claims under $25,000. The employee created fake accident claims and wrote
objs. 2, 3 settlement checks of between $5,000 and $25,000 to friends or acquaintances acting as phony
“victims.” One friend recruited subordinates at his place of work to cash some of the checks.
Beyond this, the JHT employee also recruited lawyers, who he paid to represent both the
trucking company and the fake victims in the bogus accident settlements. When the lawyers
cashed the checks, they allegedly split the money with the corrupt JHT employee. This fraud
went undetected for two years.
Why would it take so long to discover such a fraud?

EX 8-7 Quality Sound Co. discovered a fraud whereby one of its front office administrative em-
Internal controls ployees used company funds to purchase goods, such as computers, digital cameras, com-
objs. 2, 3 pact disk players, and other electronic items for her own use. The fraud was discovered
when employees noticed an increase in delivery frequency from vendors and the use of un-
usual vendors. After some investigation, it was discovered that the employee would alter
the description or change the quantity on an invoice in order to explain the cost on the bill.
What general internal control weaknesses contributed to this fraud?

EX 8-8 A former chairman, CFO, and controller of Donnkenny, Inc., an apparel company that makes
Financial statement fraud sportswear for Pierre Cardin and Victoria Jones, pleaded guilty to financial statement fraud.
objs. 2, 3 These managers used false journal entries to record fictitious sales, hid inventory in public
warehouses so that it could be recorded as “sold,” and required sales orders to be back-
dated so that the sale could be moved back to an earlier period. The combined effect of
these actions caused $25 million out of $40 million in quarterly sales to be phony.
a. Why might control procedures listed in this chapter be insufficient in stopping
this type of fraud?
b. How could this type of fraud be stopped?

EX 8-9 The procedures used for over-the-counter receipts are as follows. At the close of each day’s
Internal control of cash business, the sales clerks count the cash in their respective cash drawers, after which they
receipts determine the amount recorded by the cash register and prepare the memorandum cash
objs. 2, 3 form, noting any discrepancies. An employee from the cashier’s office counts the cash, com-
pares the total with the memorandum, and takes the cash to the cashier’s office.
a. Indicate the weak link in internal control.
b. How can the weakness be corrected?

EX 8-10 Amber Meehan works at the drive-through window of Jackpot Burgers. Occasionally, when
Internal control of cash a drive-through customer orders, Amber fills the order and pockets the customer’s money.
receipts She does not ring up the order on the cash register.
objs. 2, 3 Identify the internal control weaknesses that exist at Jackpot Burgers, and discuss
what can be done to prevent this theft.

EX 8-11 The mailroom employees send all remittances and remittance advices to the cashier. The
Internal control of cash cashier deposits the cash in the bank and forwards the remittance advices and duplicate
receipts deposit slips to the Accounting Department.
objs. 2, 3
a. Indicate the weak link in internal control in the handling of cash receipts.
b. How can the weakness be corrected?
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 379

EX 8-12 The actual cash received from cash sales was $21,099.75, and the amount indicated by the
Entry for cash sales; cash cash register total was $21,114.26. Journalize the entry to record the cash receipts and cash
short sales.
objs. 2, 3

EX 8-13 The actual cash received from cash sales was $8,374.58, and the amount indicated by the
Entry for cash sales; cash cash register total was $8,351.14. Journalize the entry to record the cash receipts and cash
over sales.
objs. 2, 3

EX 8-14 Paul’s Rama Co. is a medium-size merchandising company. An investigation revealed that
Internal control of cash in spite of a sufficient bank balance, a significant amount of available cash discounts had
payments been lost because of failure to make timely payments. In addition, it was discovered that
objs. 2, 3 the invoices for several purchases had been paid twice.
Outline procedures for the payment of vendors’ invoices, so that the possibilities
of losing available cash discounts and of paying an invoice a second time will be minimized.

EX 8-15 Clear Voice Company, a communications equipment manufacturer, recently fell victim to
Internal control of cash a fraud scheme developed by one of its employees. To understand the scheme, it is neces-
payments sary to review Clear Voice’s procedures for the purchase of services.
objs. 2, 3 The purchasing agent is responsible for ordering services (such as repairs to a photo-
copy machine or office cleaning) after receiving a service requisition from an authorized
manager. However, since no tangible goods are delivered, a receiving report is not pre-
pared. When the Accounting Department receives an invoice billing Clear Voice for a ser-
vice call, the accounts payable clerk calls the manager who requested the service in order
to verify that it was performed.
The fraud scheme involves Dana Foley, the manager of plant and facilities. Dana
arranged for her uncle’s company, Foley Industrial Supply and Service, to be placed on
Clear Voice’s approved vendor list. Dana did not disclose the family relationship.
On several occasions, Dana would submit a requisition for services to be provided by
Foley Industrial Supply and Service. However, the service requested was really not needed,
and it was never performed. Foley would bill Clear Voice for the service and then split the
cash payment with Dana.
Explain what changes should be made to Clear Voice’s procedures for ordering
and paying for services in order to prevent such occurrences in the future.

EX 8-16 Identify each of the following reconciling items as: (a) an addition to the cash balance ac-
Bank reconciliation cording to the bank statement, (b) a deduction from the cash balance according to the bank
obj. 5 statement, (c) an addition to the cash balance according to the company’s records, or (d) a
deduction from the cash balance according to the company’s records. (None of the trans-
actions reported by bank debit and credit memoranda have been recorded by the company.)
1. Bank service charges, $48.
2. Outstanding checks, $8,125.50.
3. Deposit in transit, $12,200.
4. Note collected by bank, $8,750.
5. Check drawn by company for $150 but incorrectly recorded as $510.
6. Check for $200 incorrectly charged by bank as $2,000.
7. Check of a customer returned by bank to company because of insufficient funds, $1,200.

EX 8-17 Which of the reconciling items listed in Exercise 8-16 require an entry in the company’s
Entries based on bank accounts?
reconciliation
obj. 5
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380 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

EX 8-18 The following data were accumulated for use in reconciling the bank account of Spectrum
Bank reconciliation Co. for July:
obj. 5 a. Cash balance according to the company’s records at July 31, $8,346.50.
Adjusted balance: b. Cash balance according to the bank statement at July 31, $9,066.35.
$8,506.50 c. Checks outstanding, $3,175.25.
d. Deposit in transit, not recorded by bank, $2,615.40.
e. A check for $240 in payment of an account was erroneously recorded in the check reg-
ister as $420.
f. Bank debit memorandum for service charges, $20.00.
Prepare a bank reconciliation, using the format shown in Exhibit 7.

EX 8-19 Using the data presented in Exercise 8-18, journalize the entry or entries that should be
Entries for bank made by the company.
reconciliation
obj. 5

EX 8-20 Accompanying a bank statement for Bionics Company is a credit memorandum for $17,750,
Entries for note collected representing the principal ($15,000) and interest ($2,750) on a note that had been collected
by bank by the bank. The depositor had been notified by the bank at the time of the collection, but
obj. 5 had made no entries. Journalize the entry that should be made by the depositor to bring
the accounting records up to date.

EX 8-21 An accounting clerk for Lock-It Co. prepared the following bank reconciliation:
Bank reconciliation
Lock-It Co.
obj. 5 Bank Reconciliation
Adjusted balance: October 31, 2008
$15,175.60 Cash balance according to company’s records . . . . . . . . . . . . . . . . . . $ 9,305.60
Add: Outstanding checks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,115.35
Error by Lock-It Co. in recording Check
No. 1007 as $4,715 instead of $4,175 . . . . . . . . . . . . . . . . . . . 540.00
Note for $5,000 collected by bank, including interest . . . . . . . 5,375.00 13,030.35
$22,335.95
Deduct: Deposit in transit on October 31 . . . . . . . . . . . . . . . . . . . . . . $13,690.45
Bank service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45.00 13,735.45
Cash balance according to bank statement . . . . . . . . . . . . . . . . . . . . $ 8,600.50

a. From the data in the above bank reconciliation, prepare a new bank reconciliation for
Lock-It Co., using the format shown in the illustrative problem.
b. If a balance sheet were prepared for Lock-It Co. on October 31, 2008, what amount should
be reported for cash?

EX 8-22 Identify the errors in the following bank reconciliation:

Bank reconciliation
Mkabe Co.
obj. 5 Bank Reconciliation
Corrected adjusted For the Month Ended June 30, 2008
balance: $9,000.00 Cash balance according to bank statement . . . . . . . . . . . $ 7,560.14
Add outstanding checks:
No. 315 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 717.42
360 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617.11
364 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 906.15
365 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,501.50 3,742.18
$11,302.32
Deduct deposit of June 30, not recorded by bank . . . . . 5,182.04
Adjusted balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,120.28

(continued)
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 381

Cash balance according to company’s records . . . . . . . . $ 3,735.70

Add: Proceeds of note collected by bank:
Principal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000.00
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180.00 $6,180.00
Service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27.00 6,207.00
$ 9,942.70
Deduct: Check returned because of
insufficient funds . . . . . . . . . . . . . . . . . . . . . . . $1,158.70
Error in recording June 15
deposit of $3,960 as $3,690 . . . . . . . . . . . . . . . 270.00 1,428.70
Adjusted balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,514.00

EX 8-23 Argonaut Co. records all cash receipts on the basis of its cash register tapes. Argonaut Co.
Using bank reconciliation discovered during November 2008 that one of its sales clerks had stolen an undetermined
to determine cash amount of cash receipts when she took the daily deposits to the bank. The following data
receipts stolen have been gathered for November:
obj. 5
Cash in bank according to the general ledger $12,510.45
Cash according to the November 30, 2008 bank statement 22,060.65
Outstanding checks as of November 30, 2008 6,381.42
Bank service charge for November 35.00
Note receivable, including interest collected by bank in November 7,140.00

No deposits were in transit on November 30, which fell on a Sunday.

a. Determine the amount of cash receipts stolen by the sales clerk.
b. What accounting controls would have prevented or detected this theft?

EX 8-24 Journalize the entries to record the following:

Petty cash fund entries
a. Check No. 6172 is issued to establish a petty cash fund of $1,000.
obj. 6 b. The amount of cash in the petty cash fund is now $239.16. Check No. 6319 is issued to
replenish the fund, based on the following summary of petty cash receipts: office sup-
plies, $379.10; miscellaneous selling expense, $216.25; miscellaneous administrative ex-
pense, $143.06. (Since the amount of the check to replenish the fund plus the balance in
the fund do not equal $1,000, record the discrepancy in the cash short and over account.)

EX 8-25 Mattel, Inc. designs, manufactures, and markets toy products worldwide. Mattel’s toys
Variation in cash flows include Barbie™ fashion dolls and accessories, Hot Wheels™, and Fisher-Price brands. For
obj. 7 a recent year, Mattel reported the following net cash flows from operating activities (in
thousands):
First quarter ending March 31, 2005 $(374,933)
Second quarter ending June 30, 2005 (551,080)
Third quarter ending September 30, 2005 (629,006)
Year ending December 31, 2005 466,677

Explain how Mattel can report negative net cash flows from operating activities
during the first three quarters yet report net positive cash flows on December 31.

EX 8-26 During 2007, Kinetic Inc. has monthly cash expenses of $175,000. On December 31, 2007,
Cash to monthly cash the cash balance is $1,575,000.
expenses ratio
a. Compute the ratio of cash to monthly cash expenses.
b. Based upon (a), what are the implications for Kinetic Inc.?

EX 8-27 Delta Air Lines is one of the major airlines in the United States and the world. It provides
Cash to monthly cash passengers and cargo services for over 200 domestic U.S. cities as well as 70 international
expenses ratio cities. It operates a fleet of over 800 aircraft and is headquartered in Atlanta, Georgia.
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382 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

Delta reported the following financial data (in millions) for the year ended December 31,
2004:
Net cash flows from operating activities $(1,123)
Cash, December 31, 2004 1,811

a. Determine the monthly cash expenses. Round to one decimal place.

b. Determine the ratio of cash to monthly expenses. Round to one decimal place.
c. Based upon your analysis, do you believe that Delta will remain in business?

EX 8-28 Hyperspace Communications, Inc., engages in the development, manufacture, and market-
Cash to monthly cash ing of network acceleration and data compression software worldwide. Its software prod-
expenses ratio ucts speed up the delivery of information over computer networks, including the Internet,
wireless, broadband, private, and dial-up networks. Hyperspace reported the following data
(in thousands) for the years ending December 31:
2005 2004

Net cash flows from operating activities $(7,827) $(2,558)

Cash, December 31 3,897 5,875

a. Determine the monthly cash expenses for 2005 and 2004. Round to one decimal place.
b. Determine the ratio of cash to monthly expenses for December 31, 2005 and 2004. Round
to one decimal place.
c. Based upon (a) and (b), what are the implications for Hyperspace?

Problems Series A
PR 8-1A The following procedures were recently installed by Sacha’s Company:
Evaluating internal
control of cash a. The accounts payable clerk prepares a voucher for each disbursement. The voucher
along with the supporting documentation is forwarded to the treasurer’s office for
objs. 2, 3 approval.
b. After necessary approvals have been obtained for the payment of a voucher, the trea-
surer signs and mails the check. The treasurer then stamps the voucher and supporting
documentation as paid and returns the voucher and supporting documentation to the
accounts payable clerk for filing.
c. Along with petty cash expense receipts for postage, office supplies, etc., several post-
dated employee checks are in the petty cash fund.
d. At the end of the day, cash register clerks are required to use their own funds to make
up any cash shortages in their registers.
e. All mail is opened by the mail clerk, who forwards all cash remittances to the cashier.
The cashier prepares a listing of the cash receipts and forwards a copy of the list to the
accounts receivable clerk for recording in the accounts.
f. At the end of each day, any deposited cash receipts are placed in the bank’s night
depository.
g. At the end of each day, an accounting clerk compares the duplicate copy of the daily
cash deposit slip with the deposit receipt obtained from the bank.
h. The bank reconciliation is prepared by the cashier, who works under the supervision of
the treasurer.
Instructions
Indicate whether each of the procedures of internal control over cash represents
(1) a strength or (2) a weakness. For each weakness, indicate why it exists.
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 383

PR 8-2A Ivan’s Restoration Company completed the following selected transactions during October
Transactions for petty 2008:
cash, cash short and over
Oct. 1. Established a petty cash fund of $750.
objs. 3, 6
15. The cash sales for the day, according to the cash register records, totaled
$9,702.38. The actual cash received from cash sales was $9,752.38.
31. Petty cash on hand was $40.75. Replenished the petty cash fund for the follow-
ing disbursements, each evidenced by a petty cash receipt:
Oct. 4. Store supplies, $217.30.
8. Express charges on merchandise sold, $150 (Delivery Expense).
9. Office supplies, $13.75.
18. Office supplies, $27.80.
19. Postage stamps, $11.70 (Office Supplies).
21. Repair to office file cabinet lock, $50.00 (Miscellaneous Administrative
Expense).
23. Postage due on special delivery letter, $21.95 (Miscellaneous Admin-
istrative Expense).
24. Express charges on merchandise sold, $165 (Delivery Expense).
29. Office supplies, $26.85.
31. The cash sales for the day, according to the cash register records, totaled
$10,125.95. The actual cash received from cash sales was $10,123.05.
31. Increased the petty cash fund by $150.
Instructions
Journalize the transactions.

PR 8-3A The cash account for Bonita Medical Co. at September 30, 2008, indicated a balance of
Bank reconciliation and $5,335.30. The bank statement indicated a balance of $5,604.60 on September 30, 2008. Com-
entries paring the bank statement and the accompanying canceled checks and memoranda with
obj. 5 the records revealed the following reconciling items:
a. Checks outstanding totaled $4,790.45.
b. A deposit of $9,226.15, representing receipts of September 30, had been made too late to
appear on the bank statement.
1. Adjusted balance: c. The bank had collected $7,725 on a note left for collection. The face of the note was $7,500.
$12,110.30 d. A check for $4,315 returned with the statement had been incorrectly recorded by Bonita
Medical Co. as $3,415. The check was for the payment of an obligation to Rowe Co. for
the purchase of office equipment on account.
e. A check drawn for $230 had been erroneously charged by the bank as $2,300.
f. Bank service charges for September amounted to $50.
Instructions
1. Prepare a bank reconciliation.
2. Journalize the necessary entries. The accounts have not been closed.

PR 8-4A The cash account for Cabrillo Co. at March 1, 2008, indicated a balance of $10,676.67. Dur-
Bank reconciliation and ing March, the total cash deposited was $39,146.38, and checks written totaled $42,918.40.
entries The bank statement indicated a balance of $10,960.06 on March 31. Comparing the bank
obj. 5 statement, the canceled checks, and the accompanying memoranda with the records re-
vealed the following reconciling items:
a. Checks outstanding totaled $11,008.25.
b. A deposit of $8,773.34, representing receipts of March 31, had been made too late to
1. Adjusted balance: appear on the bank statement.
$9,175.15 c. The bank had collected for Cabrillo Co. $3,710 on a note left for collection. The face of
the note was $3,500.
d. A check for $380 returned with the statement had been incorrectly charged by the bank
as $830.
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384 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

e. A check for $419 returned with the statement had been recorded by Cabrillo Co. as $149.
The check was for the payment of an obligation to Graven Co. on account.
f. Bank service charges for March amounted to $40.
g. A check for $1,129.50 from Kane-Miller Co. was returned by the bank because of insuf-
ficient funds.
Instructions
1. Prepare a bank reconciliation as of March 31.
2. Journalize the necessary entries. The accounts have not been closed.

PR 8-5A Pacific Furniture Company deposits all cash receipts each Wednesday and Friday in a
Bank reconciliation and night depository, after banking hours. The data required to reconcile the bank statement
entries as of June 30 have been taken from various documents and records and are reproduced
obj. 5 as follows. The sources of the data are printed in capital letters. All checks were written
for payments on account.

JUNE BANK STATEMENT:

1. Adjusted balance:
$12,822.02
MEMBER FDIC PAGE 1
ACCOUNT NUMBER
AMERICAN NATIONAL BANK
OF DETROIT FROM 6/01/20– TO 6/30/20–

DETROIT, MI 48201-2500 (313)933-8547 BALANCE 9,447.20

9 DEPOSITS 8,691.77

20 WITHDRAWALS 7,345.91
PACIFIC FURNITURE COMPANY
4 OTHER DEBITS
AND CREDITS 2,298.70CR

NEW BALANCE 13,091.76

* – – – CHECKS AND OTHER DEBITS – – – * – – DEPOSITS – – * – DATE – * – – BALANCE– – *

No.731 162.15 No.738 251.40 690.25 6/01 9,723.90
No.739 60.55 No.740 237.50 1,080.50 6/02 10,506.35
No.741 495.15 No.742 501.90 854.17 6/04 10,363.47
No.743 671.30 No.744 506.88 840.50 6/09 10,025.79
No.745 117.25 No.746 298.66 MS 2,500.00 6/09 12,109.88
No.748 450.90 No.749 640.13 MS 125.00 6/09 11,143.85
No.750 276.77 No.751 299.37 896.61 6/11 11,464.32
No.752 537.01 No.753 380.95 882.95 6/16 11,429.31
No.754 449.75 No.756 113.95 1,606.74 6/18 12,472.35
No.757 407.95 No.760 486.39 897.34 6/23 12,475.35
942.71 6/25 13,418.06
NSF 291.90 6/28 13,126.16
SC 34.40 6/30 13,091.76

EC –– ERROR CORRECTION OD –– OVERDRAFT

MS –– MISCELLANEOUS PS –– PAYMENT STOPPED
NSF –– NOT SUFFICIENT FUNDS SC –– SERVICE CHARGE
*** *** ***
THE RECONCILEMENT OF THIS STATEMENT WITH YOUR RECORDS IS ESSENTIAL.
ANY ERROR OR EXCEPTION SHOULD BE REPORTED IMMEDIATELY.

CASH ACCOUNT:
Balance as of June 1 $9,317.40

CASH RECEIPTS FOR MONTH OF JUNE $9,565.31

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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 385

DUPLICATE DEPOSIT TICKETS:

Date and amount of each deposit in June:

Date Amount Date Amount Date Amount

June 1 $1,080.50 June 10 $ 896.61 June 22 $ 897.34

3 854.17 15 882.95 24 942.71
8 840.50 17 1,660.47 30 1,510.06

CHECKS WRITTEN:
Number and amount of each check issued in June:

Check No. Amount Check No. Amount Check No. Amount

740 $237.50 747 Void 754 $ 449.75

741 495.15 748 $450.90 755 272.75
742 501.90 749 640.31 756 113.95
743 671.30 750 276.77 757 407.95
744 506.88 751 299.37 758 259.60
745 117.25 752 537.01 759 901.50
746 298.66 753 380.95 760 486.39

Total amount of checks issued in June $8,305.84

BANK RECONCILIATION FOR PRECEDING MONTH:

Pacific Furniture Company

Bank Reconciliation
May 31, 20—

Cash balance according to bank statement . . . . . . . . . . . . . . . . . . . . . . . $ 9,447.20

Add deposit for May 31, not recorded by bank . . . . . . . . . . . . . . . . . . . 690.25
$10,137.45
Deduct outstanding checks:
No. 731 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $162.15
736 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345.95
738 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251.40
739 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60.55 820.05
Adjusted balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,317.40
Cash balance according to depositor’s records . . . . . . . . . . . . . . . . . . . . $ 9,352.50
Deduct service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35.10
Adjusted balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,317.40

Instructions
1. Prepare a bank reconciliation as of June 30. If errors in recording deposits or checks are
discovered, assume that the errors were made by the company. Assume that all deposits
are from cash sales. All checks are written to satisfy accounts payable.
2. Journalize the necessary entries. The accounts have not been closed.
3. What is the amount of Cash that should appear on the balance sheet as of June 30?
4. Assume that a canceled check for $390 has been incorrectly recorded by the bank
as $930. Briefly explain how the error would be included in a bank reconciliation and
how it should be corrected.

Problems Series B
PR 8-1B The following procedures were recently installed by The Insideout Company:
Evaluate internal control
of cash a. All sales are rung up on the cash register, and a receipt is given to the customer. All sales
are recorded on a record locked inside the cash register.
objs. 2, 3 b. Vouchers and all supporting documents are perforated with a PAID designation after
being paid by the treasurer.
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386 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

c. Checks received through the mail are given daily to the accounts receivable clerk for
recording collections on account and for depositing in the bank.
d. At the end of a shift, each cashier counts the cash in his or her cash register, unlocks the
cash register record, and compares the amount of cash with the amount on the record
to determine cash shortages and overages.
e. Each cashier is assigned a separate cash register drawer to which no other cashier has
access.
f. Disbursements are made from the petty cash fund only after a petty cash receipt has
been completed and signed by the payee.
g. The bank reconciliation is prepared by the accountant.
Instructions
Indicate whether each of the procedures of internal control over cash represents (1)
a strength or (2) a weakness. For each weakness, indicate why it exists.

PR 8-2B Avalanche Company completed the following selected transactions during April 2008:
Transactions for petty
cash, cash short and over Apr. 1. Established a petty cash fund of $900.
4. The cash sales for the day, according to the cash register records, totaled
objs. 3, 6
$12,099.69. The actual cash received from cash sales was $12,115.42.
30. Petty cash on hand was $118.40. Replenished the petty cash fund for the fol-
lowing disbursements, each evidenced by a petty cash receipt:
April 4. Store supplies, $62.18.
9. Express charges on merchandise purchased, $116.30 (Merchandise
Inventory).
12. Office supplies, $42.80.
15. Office supplies, $119.82.
19. Postage stamps, $78.00 (Office Supplies).
20. Repair to fax, $205.00 (Miscellaneous Administrative Expense).
21. Repair to office door lock, $51.50 (Miscellaneous Administrative
Expense).
22. Postage due on special delivery letter, $24.10 (Miscellaneous Adminis-
trative Expense).
27. Express charges on merchandise purchased, $75.40 (Merchandise
Inventory).
30. The cash sales for the day, according to the cash register records, totaled
$13,800.60. The actual cash received from cash sales was $13,774.90.
30. Decreased the petty cash fund by $100.
Instructions
Journalize the transactions.

PR 8-3B The cash account for Turbocharged Systems at February 29, 2008, indicated a balance of
Bank reconciliation and $8,608.13. The bank statement indicated a balance of $17,877.63 on February 29, 2008. Com-
entries paring the bank statement and the accompanying canceled checks and memoranda with
obj. 5 the records reveals the following reconciling items:
a. Checks outstanding totaled $9,652.40.
b. A deposit of $11,322.90, representing receipts of February 29, had been made too late to
appear on the bank statement.
1. Adjusted balance: c. The bank had collected $10,250 on a note left for collection. The face of the note was
$19,278.13 $10,000.
d. A check for $2,380 returned with the statement had been incorrectly recorded by Turbo-
charged Systems as $2,830. The check was for the payment of an obligation to Yanni Co.
for the purchase of office supplies on account.
e. A check drawn for $960 had been incorrectly charged by the bank as $690.
f. Bank service charges for February amounted to $30.
Instructions
1. Prepare a bank reconciliation.
2. Journalize the necessary entries. The accounts have not been closed.
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 387

PR 8-4B The cash account for Black Diamond Sports Co. on November 1, 2008, indicated a balance
Bank reconciliation and of $23,326.69. During November, the total cash deposited was $118,125.41, and checks writ-
entries ten totaled $115,650.10. The bank statement indicated a balance of $24,226.75 on November
obj. 5 30, 2008. Comparing the bank statement, the canceled checks, and the accompanying mem-
oranda with the records revealed the following reconciling items:
a. Checks outstanding totaled $12,673.40.
b. A deposit of $18,332.15, representing receipts of November 30, had been made too late
1. Adjusted balance: to appear on the bank statement.
$29,615.50 c. A check for $850 had been incorrectly charged by the bank as $580.
d. A check for $39.30 returned with the statement had been recorded by Black Diamond
Sports Co. as $393.00. The check was for the payment of an obligation to Locke & Son
on account.
e. The bank had collected for Black Diamond Sports Co. $4,590 on a note left for collection.
The face of the note was $4,500.
f. Bank service charges for November amounted to $50.
g. A check for $1,080.20 from Kalina Co. was returned by the bank because of insufficient
funds.
Instructions
1. Prepare a bank reconciliation as of November 30.
2. Journalize the necessary entries. The accounts have not been closed.

PR 8-5B Vintage Interiors deposits all cash receipts each Wednesday and Friday in a night deposi-
Bank reconciliation and tory, after banking hours. The data required to reconcile the bank statement as of July 31
entries have been taken from various documents and records and are reproduced as follows. The
obj. 5 sources of the data are printed in capital letters. All checks were written for payments on
account.

BANK RECONCILIATION FOR PRECEDING MONTH (DATED JUNE 30):

1. Adjusted balance: Cash balance according to bank statement . . . . . . . . . . . . . . . . . . . . . . $ 9,422.80
$12,644.09 Add deposit of June 30, not recorded by bank . . . . . . . . . . . . . . . . . . . 780.80
$10,203.60
Deduct outstanding checks:
No. 580 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $310.10
No. 602 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85.50
No. 612 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92.50
No. 613 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137.50 625.60
Adjusted balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,578.00
Cash balance according to company’s records . . . . . . . . . . . . . . . . . . . . $ 9,605.70
Deduct service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27.70
Adjusted balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,578.00

CASH ACCOUNT:
Balance as of July 1 $9,578.00

CHECKS WRITTEN:
Number and amount of each check issued in July:

Check No. Amount Check No. Amount Check No. Amount

614 $243.50 621 $309.50 628 $ 837.70

615 350.10 622 Void 629 329.90
616 279.90 623 Void 630 882.80
617 395.50 624 707.01 631 1,081.56
618 435.40 625 518.63 632 62.40
619 320.10 626 550.03 633 310.08
620 238.87 627 318.73 634 503.30

Total amount of checks issued in July $8,675.01

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388 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

JULY BANK STATEMENT:

MEMBER FDIC PAGE 1

ACCOUNT NUMBER
AMERICAN NATIONAL BANK
OF DETROIT FROM 7/01/20– TO 7/31/20–

DETROIT, MI 48201-2500 (313)933-8547 BALANCE 9,422.80

9 DEPOSITS 6,086.35

20 WITHDRAWALS 7,514.11
VINTAGE INTERIORS
4 OTHER DEBITS
AND CREDITS 5,150.50CR

NEW BALANCE 13,145.54

* – – – – – CHECKS AND OTHER DEBITS – – – – – * – DEPOSITS – * – DATE – * – BALANCE– *

No.580 310.10 No.612 92.50 780.80 07/01 9,801.00
No.613 137.50 No.614 243.50 569.50 07/03 9,989.50
No.615 350.10 No.616 279.90 701.80 07/06 10,061.30
No.617 395.50 No.618 435.40 819.24 07/11 10,049.64
No.619 320.10 No.620 238.87 580.70 07/13 10,071.37
No.621 309.50 No.624 707.01 MS 5,000.00 07/14 14,054.86
No.625 158.63 No.626 550.03 MS 400.00 07/14 13,746.20
No.627 318.73 No.629 329.90 600.10 07/17 13,697.67
No.630 882.80 No.631 1,081.56 NSF 225.40 07/20 11,507.91
No.632 62.40 No.633 310.08 701.26 07/21 11,836.69
731.45 07/24 12,568.14
601.50 07/28 13,169.64
SC 24.10 07/31 13,145.54

EC –– ERROR CORRECTION OD –– OVERDRAFT

MS –– MISCELLANEOUS PS –– PAYMENT STOPPED
NSF –– NOT SUFFICIENT FUNDS SC –– SERVICE CHARGE
*** *** ***
THE RECONCILEMENT OF THIS STATEMENT WITH YOUR RECORDS IS ESSENTIAL.
ANY ERROR OR EXCEPTION SHOULD BE REPORTED IMMEDIATELY.

CASH RECEIPTS FOR MONTH OF JULY 6,230.10

DUPLICATE DEPOSIT TICKETS:

Date and amount of each deposit in July:

Date Amount Date Amount Date Amount

July 2 $569.50 July 12 $580.70 July 23 $731.45

5 701.80 16 600.10 26 601.00
9 819.24 19 701.26 31 925.05

Instructions
1. Prepare a bank reconciliation as of July 31. If errors in recording deposits or checks are
discovered, assume that the errors were made by the company. Assume that all deposits
are from cash sales. All checks are written to satisfy accounts payable.
2. Journalize the necessary entries. The accounts have not been closed.
3. What is the amount of Cash that should appear on the balance sheet as of July 31?
4. Assume that a canceled check for $2,680 has been incorrectly recorded by the
bank as $6,280. Briefly explain how the error would be included in a bank reconciliation
and how it should be corrected.
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 389

Special Activities
SA 8-1 During the preparation of the bank reconciliation for Colonial Co., Javier Frailey, the as-
Ethics and professional sistant controller, discovered that El Camino National Bank incorrectly recorded an $819
conduct in business check written by Colonial Co. as $189. Javier has decided not to notify the bank but wait
for the bank to detect the error. Javier plans to record the $630 error as Other Income if the
bank fails to detect the error within the next three months.
Discuss whether Javier is behaving in a professional manner.

SA 8-2 The following is an excerpt from a conversation between two sales clerks, Fred Loya and
Internal controls Steph Gillespie. Both Fred and Steph are employed by Wireless Electronics, a locally owned
and operated electronics retail store.
Fred: Did you hear the news?
Steph: What news?
Fred: Alice and John were both arrested this morning.
Steph: What? Arrested? You’re putting me on!
Fred: No, really! The police arrested them first thing this morning. Put them in handcuffs,
read them their rights—the whole works. It was unreal!
Steph: What did they do?
Fred: Well, apparently they were filling out merchandise refund forms for fictitious cus-
tomers and then taking the cash.
Steph: I guess I never thought of that. How did they catch them?
Fred: The store manager noticed that returns were twice that of last year and seemed to be
increasing. When he confronted Alice, she became flustered and admitted to taking the
cash, apparently over $5,000 in just three months. They’re going over the last six months’
transactions to try to determine how much John stole. He apparently started stealing
first.
Suggest appropriate control procedures that would have prevented or detected the
theft of cash.

SA 8-3 The following is an excerpt from a conversation between the store manager of Trader Sam’s
Internal controls Grocery Stores, Jennings Maloy, and Sam Burley, president of Trader Sam’s Grocery Stores.
Sam: Jennings, I’m concerned about this new scanning system.
Jennings: What’s the problem?
Sam: Well, how do we know the clerks are ringing up all the merchandise?
Jennings: That’s one of the strong points about the system. The scanner automatically rings
up each item, based on its bar code. We update the prices daily, so we’re sure that the
sale is rung up for the right price.
Sam: That’s not my concern. What keeps a clerk from pretending to scan items and then
simply not charging his friends? If his friends were buying 10-15 items, it would be easy
for the clerk to pass through several items with his finger over the bar code or just pass
the merchandise through the scanner with the wrong side showing. It would look nor-
mal for anyone observing. In the old days, we at least could hear the cash register ring-
ing up each sale.
Jennings: I see your point.
Suggest ways that Trader Sam’s Grocery Stores could prevent or detect the theft
of merchandise as described.

SA 8-4 Pete Harsh and Sara Alper are both cash register clerks for Farmers’ Markets. Gina Majed
Ethics and professional is the store manager for Farmers’ Markets. The following is an excerpt of a conversation
conduct in business between Pete and Sara:
Pete: Sara, how long have you been working for Farmers’ Markets?
Sara: Almost five years this July. You just started two weeks ago . . . right?
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390 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

Pete: Yes. Do you mind if I ask you a question?

Sara: No, go ahead.
Pete: What I want to know is, have they always had this rule that if your cash register is
short at the end of the day, you have to make up the shortage out of your own pocket?
Sara: Yes, as long as I’ve been working here.
Pete: Well, it’s the pits. Last week I had to pay in almost $50.
Sara: It’s not that big a deal. I just make sure that I’m not short at the end of the day.
Pete: How do you do that?
Sara: I just short-change a few customers early in the day. There are a few jerks that de-
serve it anyway. Most of the time, their attention is elsewhere and they don’t think to
check their change.
Pete: What happens if you’re over at the end of the day?
Sara: Majed lets me keep it as long as it doesn’t get to be too large. I’ve not been short in
over a year. I usually clear about $50 to $80 extra per day.
Discuss this case from the viewpoint of proper controls and professional behavior.

SA 8-5 The records of Filippi’s Company indicate a March 31 cash balance of $10,806.05, which in-
Bank reconciliation and cludes undeposited receipts for March 30 and 31. The cash balance on the bank statement
internal control as of March 31 is $7,004.95. This balance includes a note of $3,000 plus $120 interest col-
lected by the bank but not recorded in the journal. Checks outstanding on March 31 were
as follows: No. 670, $1,129.16; No. 679, $830; No. 690, $525.90; No. 2148, $127.40; No. 2149,
$520; and No. 2151, $851.50.
On March 3, the cashier resigned, effective at the end of the month. Before leaving on
March 31, the cashier prepared the following bank reconciliation:

Cash balance per books, March 31 . . . . . . . . . . . $10,806.05

Add outstanding checks:
No. 2148 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $127.40
2149 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520.00
2151 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 851.50 1,198.90
$12,004.95
Less undeposited receipts . . . . . . . . . . . . . . . . . . . 5,000.00
Cash balance per bank, March 31 . . . . . . . . . . . . $ 7,004.95
Deduct unrecorded note with interest . . . . . . . . 3,120.00
True cash, March 31 . . . . . . . . . . . . . . . . . . . . . . . $ 3,884.95

Calculator Tape of Outstanding Checks:

0.00 *
127.40

520.00

851.50

1,198.90 *

Subsequently, the owner of Filippi’s Company discovered that the cashier had stolen an
unknown amount of undeposited receipts, leaving only $5,000 to be deposited on March
31. The owner, a close family friend, has asked your help in determining the amount that
the former cashier has stolen.
1. Determine the amount the cashier stole from Filippi’s. Show your computations in good
form.
2. How did the cashier attempt to conceal the theft?
3. a. Identify two major weaknesses in internal controls, which allowed the cashier to steal
the undeposited cash receipts.
b. Recommend improvements in internal controls, so that similar types of thefts
of undeposited cash receipts can be prevented.
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Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 391

SA 8-6 Select a business in your community and observe its internal controls over cash receipts
Observe internal controls and cash payments. The business could be a bank or a bookstore, restaurant, department
over cash store, or other retailer. In groups of three or four, identify and discuss the similarities and
Group Project differences in each business’s cash internal controls.

SA 8-7 OccuLogix, Inc., provides treatments for eye diseases, including age-related macular de-
Cash to monthly cash generation (AMD). The company’s treatment system, called the RHEO system, consists of
expenses ratio an Octonova pump and disposable treatment sets that improve microcirculation in the eye
by filtering high molecular weight proteins and other macromolecules from the patient’s
plasma. OccuLogix reported the following data (in thousands) for the years ending De-
cember 31, 2005, 2004, and 2003:

2005 2004 2003

Cash as of December 31* $41,268 $60,040 $ 1,239

Net cash flows from operating activities (18,710) (5,382) (2,375)
*Includes cash equivalents and short-term investments.

1. Determine the monthly cash expenses for 2005, 2004, and 2003. Round to one decimal
place.
2. Determine the ratio of cash to monthly expenses as of December 31, 2005, 2004, and 2003.
Round to one decimal place.
3. Based upon (1) and (2), comment on OccuLogix’s ratio of cash to monthly oper-
ating expenses for 2005, 2004, and 2003.

SA 8-8 Acusphere, Inc., is a specialty pharmaceutical company that develops new drugs and im-
Cash to monthly cash proved formulations of existing drugs using its proprietary microparticle technology.
expenses ratio Currently, the company has three products in development in the areas of cardiology, on-
cology, and asthma. Acusphere reported the following data (in thousands) for the years
ending December 31, 2005, 2004, and 2003.

2005 2004 2003

Cash as of December 31* $ 51,112 $ 45,180 $ 54,562

Net cash flows from operating activities (30,683) (19,319) (15,507)
*Includes cash equivalents and short-term investments.

1. Determine the monthly cash expenses for 2005, 2004, and 2003. Round to one decimal
place.
2. Determine the ratio of cash to monthly expenses as of December 31, 2005, 2004, and 2003.
Round to one decimal place.
3. Based upon (1) and (2), comment on Acusphere’s ratio of cash to monthly oper-
ating expenses for 2005, 2004, and 2003.

Answers to Self-Examination Questions

1. C Compliance with laws and regulations (answer C) Since the bank deducted $90 ($540.50
$450.50) too
is an objective, not an element, of internal control. The little, the error of $90 should be deducted from the cash
control environment (answer A), monitoring (answer balance according to the bank statement (answer C).
B), control procedures (answer D), risk assessment, 3. B On any specific date, the cash account in a com-
and information and communication are the five ele- pany’s ledger may not agree with the account in the
ments of internal control. bank’s ledger because of delays and/or errors by either
2. C The error was made by the bank, so the cash balance party in recording transactions. The purpose of a bank
according to the bank statement needs to be adjusted. reconciliation, therefore, is to determine the reasons for
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392 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash

any differences between the two account balances. All bring the cash account up to date for delays in record-
errors should then be corrected by the company or the ing transactions.
bank, as appropriate. In arriving at the adjusted cash 5. D To avoid the delay, annoyance, and expense that
balance according to the bank statement, outstanding is associated with paying all obligations by check, rel-
checks must be deducted (answer B) to adjust for atively small amounts (answer A) are paid from a
checks that have been written by the company but that petty cash fund. The fund is established by estimat-
have not yet been presented to the bank for payment. ing the amount of cash needed to pay these small
4. C All reconciling items that are added to and de- amounts during a specified period (answer B), and it
ducted from the cash balance according to the com- is then reimbursed when the amount of money in the
pany’s records on the bank reconciliation (answer C) fund is reduced to a predetermined minimum amount
require that journal entries be made by the company (answer C).
to correct errors made in recording transactions or to