Accounting, Fifth Edition 7 FRAUD, INTERNAL CONTROL, AND CASH Accounting, Fifth Edition

Learning Objectives After studying this chapter, you should be able to: Define fraud and internal control. Identify the principles of internal control activities. Explain the applications of internal control principles to cash receipts. Explain the applications of internal control principles to cash disbursements. Prepare a bank reconciliation. Explain the reporting of cash. Discuss the basic principles of cash management. Identify the primary elements of a cash budget.

Fraud and Internal Control Dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. Three factors that contribute to fraudulent activity. Illustration 7-1 LO 1 Define fraud and internal control.

Fraud and Internal Control The Sarbanes-Oxley Act Applies to publicly traded U.S. corporations. Required to maintain a system of internal control. Corporate executives and boards of directors must ensure that these controls are reliable and effective. Independent outside auditors must attest to the adequacy of the internal control system. SOX created the Public Company Accounting Oversight Board (PCAOB). LO 1 Define fraud and internal control.

Fraud and Internal Control Methods and measures adopted to: Safeguard assets. Enhance accuracy and reliability of accounting records. Increase efficiency of operations. Ensure compliance with laws and regulations. LO 1 Define fraud and internal control.

Designing an Internal Control System Control environment – does the corporate culture value integrity? Risk assessment – evaluate areas of risk and decide how to manage them. Control activities – design policies and procedures to address risks. Information and communication – capture and communicate pertinent information to all relevant internal and external parties. Monitoring – review and assess effectiveness of internal controls. Adjust internal controls as needed. LO 1 Define fraud and internal control.

The BACKBONE of Internal Controls Establishment of responsibility Separation of duties Documentation procedures Physical controls Independent internal verification Human resource controls LO 1 Define fraud and internal control.

The BACKBONE of Internal Controls Establish responsibilities Control is 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. Separation of duties 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. Principles of internal control include: Establish responsibilities. Maintain adequate records. Insure assets and bond key employees. Separate recordkeeping from custody of assets. Divide responsibility for related transactions. Apply technological controls. Perform regular and independent reviews. 6-8

The BACKBONE of Internal Controls Maintain adequate records & documents procedures Companies should use prenumbered documents, and all documents should be accounted for. Employees should promptly forward source documents for accounting entries to the accounting department. Physical Controls Illustration 7-2 Principles of internal control include: Establish responsibilities. Maintain adequate records. Insure assets and bond key employees. Separate recordkeeping from custody of assets. Divide responsibility for related transactions. Apply technological controls. Perform regular and independent reviews. 6-9

The BACKBONE of Internal Controls Independent internal verification Records periodically verified by an independent employee. Discrepancies reported to management. Internal Audit Human Resource Controls Bond employees who handle cash. Rotate employees’ duties and require vacations. Conduct background checks. Insure assets. Principles of internal control include: Establish responsibilities. Maintain adequate records. Insure assets and bond key employees. Separate recordkeeping from custody of assets. Divide responsibility for related transactions. Apply technological controls. Perform regular and independent reviews. 6-10

Limitations of Internal Control Costs should not exceed benefit. Human element. Human error – Negligence, Fatigue, Misjudgment, Confusion. Human Fraud – Intent to defeat internal controls for personal gain. Collusion Size of the business. Helpful Hint Controls may vary with the risk level of the activity. For example, management may consider cash to be high risk and maintaining inventories in the stockroom as lower risk. Thus, management would have stricter controls for cash. LO 2 Identify the principles of internal control activities.

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Control of Cash An effective system of internal control that protects cash and cash equivalents should meet three basic guidelines: Handling cash is separate from recordkeeping of cash. Cash receipts are promptly deposited in a bank. Control of cash focuses on three areas. One, those who handle cash should be separate from those who keep records of cash. Two, cash receipts should be deposited daily in the bank. Three, cash disbursements should be made by check. Cash disbursements are made by check. 6-13

Cash Receipt Controls (p. 347) Illustration 7-4 LO 3

Cash Controls Cash Receipt Controls Over-the-Counter Receipts Important internal control principle—segregation of record-keeping from physical custody. Illustration 7-5 LO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls Cash Receipt Controls Mail Receipts Mail receipts should be opened by two people, a list prepared, and each check endorsed “For Deposit Only.” Each mail clerk signs the list to establish responsibility for the data. Original copy of the list, along with the checks, is sent to the cashier’s department. Copy of the list is sent to the accounting department for recording. Clerks also keep a copy. LO 3 Explain the applications of internal control principles to cash receipts.

Cash Disbursement Controls (p. 350) Illustration 7-6 LO 4

Cash Disbursement Controls Generally, internal control over cash disbursements is more effective when companies pay by check or electronic funds transfer (EFT) rather than by cash since no cash or checks are handled by employees. EFTs use wire, telephone, or computers to transfer cash balances between locations. Voucher System -- A voucher is an authorization form prepared for each expenditure in a voucher system. A string of approvals that verifies, approves and records disbursements to ensure all payments by check are proper. Requires a paper trail for payment of verified, approved & recorded obligations. Petty Cash Fund (Appendix 7A) LO 4 Explain the applications of internal control principles to cash disbursements.

Control Features: Use of a Bank The use of a bank contributes significantly to good internal control over cash. Minimizes the amount of currency on hand. Creates a double record of bank transactions. Bank reconciliation. Helpful Hint Essentially, the bank statement is a copy of the bank’s records sent to the customer or made available online for review. LO 5 Prepare a bank reconciliation.

Control Features: Use of a Bank Bank Statements Illustration 7-7 Debit Memorandum (a MINUS to cash) Bank service charge. NSF (not sufficient funds). Credit Memorandum (a PLUS to cash) Collect notes receivable. Interest earned. LO 5 Prepare a bank reconciliation.

Control Features: Use of a Bank Reconciling the Bank Account Reconcile balance per books and balance per bank to their “correct or true” balance. Reconciling Items: Deposits in transit. Outstanding checks. Bank memoranda. Errors. Time Lags LO 5 Prepare a bank reconciliation.

Control Features: Use of a Bank Reconciliation Procedures Illustration 7-8 + Deposit in Transit - Outstanding Checks +/- Bank Errors + Notes collected by bank - NSF (bounced) checks - Check printing or other service charges +/- Company Errors CORRECT BALANCE CORRECT BALANCE LO 5 Prepare a bank reconciliation.

Control Features: Use of a Bank LO 5 Prepare a bank reconciliation.

Control Features: Use of a Bank Illustration: Prepare a bank reconciliation at April 30. Cash balance per bank statement $15,907.45 Deposit in transit 2,201.40 Outstanding checks (5,904.00) Adjusted cash balance per bank $12,204.85 Cash balance per books $11,589.45 Error in check No. 443 36.00 NSF check (425.60) Bank service charge (30.00) Collection of notes receivable 1,035.00 Adjusted cash balance per books $12,204.85 LO 5 Prepare a bank reconciliation.

Sally Kist owns Linen Kist Fabrics Sally Kist owns Linen Kist Fabrics. Sally asks you to explain how she should treat the following reconciling items when reconciling the company’s bank account: (1) a debit memorandum for an NSF check, (2) a credit memorandum for a note collected by the bank, (3) outstanding checks, and (4) a deposit in transit. Solution Sally should treat the reconciling items as follows. (1) NSF check: Deduct from balance per books. (2) Collection of note: Add to balance per books. (3) Outstanding checks: Deduct from balance per bank. (4) Deposit in transit: Add to balance per bank. LO 5

Bank Reconciliation Practice Problem E7-8 (a), p. 376 Find the opening BANK balance & BOOK balance. In your textbook, using slide 20, write next to each item what type of reconciling item it is (only pick one): Book + Book – Bank + Bank – Using Slide 20, complete the bank reconciliation. The Adjusted Balances should EQUAL one another.

Bank Reconciliation Journal Entries Practice Problem E7-8 (b), p. 376 Using the bank reconciliation just completed, determine what is MISSING from the business’ accounting records. Choose only ONE side (right or left). Create journal entries to correct the business’ cash balance. Check that every entry includes either a Debit OR Credit to Cash.

Reporting Cash Cash Equivalents Restricted Cash Cash equivalents are short-term, highly liquid investments that are both: Readily convertible to known amounts of cash, and So near their maturity that their market value is relatively insensitive to changes in interest rates. Restricted Cash Cash that is not available for general use but rather is restricted for a special purpose. LO 6 Explain the reporting of cash.

Reporting Cash Illustration 7-11 LO 6 Explain the reporting of cash.

Collect Quick. Pay Slow! Cash Management Principles When companies fail, one of the most common causes is their inability to manage cash. The goals of cash management are: Plan cash receipts to meet cash payments when due. Keep the minimum level of cash necessary to operate. Collect Quick. Pay Slow! 6-30

Managing and Monitoring Cash Operating Cycle of a Merchandising Company Illustration 7-12 LO 7 Discuss the basic principles of cash management.

Managing and Monitoring Cash Basic Principles of Cash Management Illustration 7-13 LO 7

Managing and Monitoring Cash Cash Budget Shows anticipated cash flows, usually over a one- to two- year period. Contributes to more effective cash management. LO 8 Identify the primary elements of a cash budget.