Chapter 7: Fraud, Internal Control, and Cash
Study Guide
Learning Objectives:
1. Define fraud and the principles of internal control.
2. Apply internal control principles to cash.
3. Identify the control features of a bank account.
4. Explain the reporting of cash and the basic principles of cash management.
Learning Objective 1: Define fraud and the principles of internal control.
Fraud and Internal Control
What is fraud? A dishonest act by an employee that results in personal benefit to
the employee at a cost to the employer
The three main factors that contribute to fraudulent activity are depicted by the
__fraud triangle___________.
The three elements of the fraud triangle are:
1) opportunity
2) financial pressure
3) rationalization
Which element of the fraud triangle is the most important? (It is the most
important because it is the element that the organization can control)
Opportunity
After numerous corporate scandals came to light in the early 2000s, Congress
addressed fraud by passing the ___Sarbanes Oxley Act ________ (SOX).
Under SOX, all publicly traded U.S. corporations are __required_____ to
maintain an adequate system of __internal controls___.
SOX also created the __Public Company Accounting Oversight Board
(PCAOB)____ to establish auditing standards and regulate auditor activity.
Internal controls are processes designed to safeguard __assets__, enhance the
reliability of ___accounting records_, increase _efficiency__ of operations, and
ensure compliance with _laws_ and __regulations__.
Internal control systems have five primary components:
ACCT 2001: Ch. 07 Page 1 of 11
Internal Control Definition
Component
Responsibility of top management to make it clear
Control Environment
that the organization values integrity and that
unethical activity will not be tolerated.
Companies must identify and analyze the various
Risk Assessment
factors that create risk for the business and
determine how to manage the risks
Management must design policies and procedures
Control Activities
to address the specific risks faced by the company.
Information and The internal control system must capture and
communicate all pertinent information both down
Communication
and up the organization, as well as to external
parties
Internal control systems must be monitored
Monitoring
periodically for their adequacy. Significant
deficiencies should be reported to top management
and board of directors.
Principles of Internal Controls
Control activities are the backbone of the company’s efforts to address the risks it
faces, such as __fraud__.
The specific control activities used by a company will vary, depending on
_management’s_ assessment of the risks faced. This assessment is heavily
influenced by the __size_ and __nature__ of the company.
What are the six principles of control activities?
1) Establishment of Responsibility:
When is control most effective?
When only one person is responsible for a given task.
Establishing responsibility often requires limiting access only to _authorized_
personnel, and then identifying those personnel.
Example: identifying passcodes
2) Segregation of Duties:
There are two common applications of this principle:
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Different individuals should be responsible for __related__ activities
The responsibility for record-keeping for an asset should be _separate___
from the physical custody of that asset.
Making one individual responsible for related activities __increases__ the
potential for errors and irregularities.
Companies should assign related __purchasing__ activities, or related sales
activities, to different individuals. This is because abuses are less likely to occur
when companies divide the purchasing, or sales, tasks.
The accountant should have neither physical _custody_ of the asset nor
__access_ to it.
The separation of accounting responsibility from the custody of assets is
especially important for _cash and inventories__ because these assets are very
vulnerable to fraud.
3) Documentation Procedures:
Whenever possible, companies should use __prenumbered__ documents, and
all documents should be accounted for.
The control system should require that employees promptly forward _source_
documents for accounting entries to the accounting department.
4) Physical Controls:
Physical Controls relate to the _safeguarding__ of assets and enhance the
accuracy and reliability of the accounting records. Examples: safes/vaults, locked
cabinets, alarms, monitors.
5) Independent Internal Verification:
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To obtain maximum benefit from independent internal verification:
Companies should verify records periodically or on a _surprise_ basis.
An employee who is _independent__ of the personnel responsible for
the information should make the verification.
Discrepancies and _exceptions__ should be reported to a
management level that can take appropriate corrective action.
Example: reconciliaitons, verifications of counts.
Who are internal auditors?
Company employees who continuously evaluate the effectiveness of the
company’s internal control systems.
They also __review_ the activities of departments and individuals to determine
whether prescribed internal controls are being followed and recommend
improvements when needed.
A growing field that has changed the aspects of internal auditing (and
accounting) is __Data Analytics___. Allows for continuous monitoring of
transactions. Transactions can be flagged by dollar amount, vendor, source.
6) Human Resource Controls
Bond employees who handle __cash_. What is bonding?
o Insurance protection against theft by employees.
Rotate employee’s _duties_ and require employees to take vacations.
Conduct thorough _background__ checks.
Some Limitations of Internal Control:
Human element and size of business
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Learning Objective 3: Identify the control features of a bank account.
Control Features: Use of a Bank
Contributes to good internal controls over cash.
Minimizes the amount of cash on hand.
Creates a double record of bank transactions.
Bank reconciliation.
Many companies may use multiple bank accounts for different offices/branches
or even separate ones for _payroll___________.
Electronic Funds Transfer (EFT) allow the transfer of funds without paper
(deposit tickets, checks, etc). Include disbursement systems that use wires,
telephone and computers to transfer cash.
Many employers send payrolls through the EFT system.
Bank Statements
Bank statements are prepared from the bank’s perspective.
Deposits received by the bank increase a bank’s liability to the depositor (customer’s
money). Deposits and other amounts added to an account are recorded with credits.
Payments out of an account reduce a bank’s liability. Payments and other deductions
from an account are recorded with debits.
Credits
Debits
Electronic
Checks andand
other
paper
debits
deposits
(like debit card payments and EFT
Interest
payments)
earned
Bank service charges
NSF (not sufficient funds) withdrawals of previous deposits
(the “bouncing” of a deposit of a customer check)
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Reconciling a Bank Account
Reconcile balance per bank and balance per book to their adjusted (corrected)
true balances.
The need for a reconciliation has two causes
o Time Lags - which prevent one of the parties from recording the
transaction in the same period.
o Errors - can be made by either party (bank or company(books).
Reconciling Items:
Adjustments to the bank balance
1. Deposits in transit.
2. Outstanding checks.
3. Bank errors.
Adjustments to the book balance
1. Unrecorded receipts
2. Unrecorded payments
3. Company Errors
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Bank Reconciliation Illustrated
Illustration 7-7 presents the bank statement for Laird Company. It shows a balance per
bank of $15,907.45 on April 30, 2022. On this date the balance of cash per books is
$11,709.45. From the foregoing steps, Laird determines the following reconciling items.
Reconciling items for the bank
Step Deposits in Transit – April 30 deposit (received by bank on May $2,201.40
1 1st)
Step Outstanding checks – No. 453, $3,000.00; No. 457, $1,401.30; 5,904.00
2 No. 460, $1,502.70
Step Bank Errors (+/-) none 0.00
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Reconciling items per the books
Step Other deposits – Unrecorded receipts determined by a review of $1,035.00
1 bank statement is as follows:
Electronic receipt from customer on account on April 9th
Step Other payments – Unrecorded charges determined by a review 575.60
2 of bank statement are as follows:
Returned NSF check from JR Baron on April 29. $425.60
Debit and credit card fees on April 30. $120.00
Bank service charge on April 30. $30.00
Step Company Errors (+/-) 36.00
3 Check No. 443 was correctly written by Laird to a supplier
(Andrea Company) for $1,226 and was correctly paid by
the bank on April 12. However, it was recorded as $1,262
on Laird’s books.
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Illustration: Prepare a bank reconciliation at April 30.
Cash balance per bank statements $15,907.45
Add: Deposits in Transit 2,201.40
Less: Outstanding Checks 5,904.00
Adjusted cash balance per bank 12,204.85
Cash balance per books $11,709.45
Add:
Electronic receipt from customer 1,035.00
Company Error – Andrea Company 36.00
Less:
NSF Check – JR Baron 425.60
Bank Charges 150.00
Adjusted cash balance per books 12,204.85
Journalize the adjusting entries at April 30 on the books of Laird Company.
To record collection of electronic funds transfer:
Apr. 30
Cash 1,035
Accounts Receivable 1,035
To record NSF check
Apr. 30
Accounts Receivable 425.60
Cash 425.60
To record bank service charges
Apr. 30
Service Charge Expense 150
Cash 150
To correct error in recording check No. 443:
Apr. 30
Cash 36
Accounts Payable 36
Helpful Tip: In previous chapters, we considered Cash an account that never
needed adjustment. This was because we had not been introduced to the bank
reconciliation yet.
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Learning Objective 4: Explain the reporting of cash and the basic principles of
cash management. OMIT: “Managing and Monitoring Cash” section.
Reporting Cash
Cash consists of coins, currency (paper money), _checks_, money orders and
money _on hand__ or on __deposit___ in a bank or similar depository.
Companies report cash in two different statements:
The _Balance Sheet_ reports the amount of cash available at a given
point in time.
The _Statement of Cash Flows__ shows the sources and uses of cash
during a period of time.
Cash is the most _liquid_ asset owned by the company.
Many companies report __Cash__ and __Cash Equivalent__ together.
Cash equivalents are short-term _highly liquid___ investments. They must be
1. _readily convertible_ and
2. _near to maturity__ (generally with maturities of only 3 months or less).
_Restricted_ cash is cash that is not available for general purpose but is
restricted for a special purpose. Cash restricted must be reported
__separately___ on the balance sheet.
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