Accounting Principles, Ninth Edition Chapter 8 Fraud, Internal Control and Cash Accounting Principles, Ninth Edition

Study Objectives Define fraud and internal control. Identify the principles of internal control. Explain the applications of internal control principles to cash receipts. Explain the applications of internal control principles to cash disbursements. Describe the operation of a petty cash fund. Indicate the control features of a bank account. Prepare a bank reconciliation. Explain the reporting of cash. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

Fraud, Internal Control, and Cash Fraud and Internal Control Cash Controls Control Features: Use of a Bank Reporting Cash Fraud The Sarbanes-Oxley Act Internal control Principles of internal control Limitations Cash receipts controls Cash disbursements controls Making deposits Writing checks Bank statements Reconciling the bank account Electronic funds transfer (EFT) system Cash equivalents Restricted cash Compensating balances Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation. Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt. Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets. Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees. Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss: difference between the actual return and the expected return on plan assets and, amortization of the unrecognized net gain or loss from previous periods

Fraud and Internal Control Dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. Illustration 8-1 Why does fraud occur? SO 1 Define fraud and internal control.

Fraud and Internal Control The Sarbanes-Oxley Act Companies must develop principles of control over financial reporting. continually verify that controls are working. Independent auditors must attest to the adequacy of internal control. SOX created the Public Company Accounting Oversight Board (PCAOB). SO 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, and Ensure compliance with laws and regulations. Under the Sarbanes-Oxley Act, all publicly traded U.S. corporations are required to maintain an adequate system of internal control. SO 1 Define fraud and internal control.

Fraud and Internal Control Internal control systems have five primary components A control environment Risk assessment Control activities Information and communication Monitoring See page 348 SO 1 Define fraud and internal control.

Fraud and Internal Control Principles of Internal Control Activities Measures vary with management’s assessment of the risks faced. size and nature of the company. Six principles of controls activities: Establishment of responsibility Segregation of duties Documentation procedures Physical controls Independent internal verification Human resource controls SO 2 Identify the principles of internal control.

Fraud and Internal Control Principles of Internal Control Activities ESTABLISHMENT OF RESPONSIBILITY Control is most effective when only one person is responsible for a given task. SEGREGATON OF DUTIES Related duties, including physical custody and record keeping, should be assigned to different individuals. DOCUMENTATION PROCEDURES Companies should use prenumbered documents for all documents should be accounted for. SO 2 Identify the principles of internal control.

Fraud and Internal Control Principles of Internal Control Activities PHYSICAL CONTROLS Illustration 8-2 SO 2 Identify the principles of internal control.

Fraud and Internal Control Principles of Internal Control Activities INDEPENDENT INTERNAL VERIFICATION Verify records periodically or on a surprise basis. Records verified by an employee who is independent. Discrepancies reported to management. Illustration 8-3 SO 2 Identify the principles of internal control.

Fraud and Internal Control Principles of Internal Control Activities HUMAN RESOURCE CONTROLS Bond employees. Rotate employees’ duties and require vacations. Conduct background checks. SO 2 Identify the principles of internal control.

Fraud and Internal Control Limitations of Internal Control Costs should not exceed benefit. Human element. Size of the business. SO 2 Identify the principles of internal control.

Do It Cash Controls See page 356 Question 8-8 (textbook) ( a ) The concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not exceed their expected benefit. (b) The human element is an important factor in a system of internal control. A good system can become ineffective through employee fatigue, carelessness, or in difference. Moreover, internal control may become ineffective as a result of collusion. SO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls Cash Receipts Controls Establishment of Responsibility Only designated personnel are authorized to handle cash receipts (cashiers) Documentation Procedures Use remittance advice (mail receipts), cash register tapes, and deposit slips Independent Internal Verification Supervisors count cash receipts daily; treasurer compares total receipts to bank deposits daily Segregation of Duties Different individuals receive cash, record cash receipts, and hold the cash Physical, Mechanical, and Electronic Controls Store cash in safes and bank vaults; limit access to storage areas; use cash registers Human Resource Controls Bond personnel who handle cash; require employees to take vacations; deposit all cash in bank daily Illustration 8-4 SO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls Discussion Question Q8-6. At the corner grocery store, all sales clerks make change out of one cash register drawer. Is this a violation of internal control? Why? See notes page for discussion Question 8-3 (textbook) This is a violation of the internal control principle of establishing responsibility. In this case, each sales clerk should have a separate cash register or cash register drawer. SO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls Discussion Question Q8-11. The management of Sewell Company asks you, as the company accountant, to explain (a) the concept of reasonable assurance in internal control and (b) the importance of the human factor in internal control. See notes page for discussion Question 8-8 (textbook) ( a ) The concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not exceed their expected benefit. (b) The human element is an important factor in a system of internal control. A good system can become ineffective through employee fatigue, carelessness, or in difference. Moreover, internal control may become ineffective as a result of collusion. SO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls Cash consists of coins, currency, checks, money orders, and money on hand or on deposit in a bank. Cash receipts come from: cash sales collections on account from customers receipt of interest, rent, and dividends investments by owners bank loans proceeds from the sale of noncurrent assets SO 3 Explain the applications of internal control principles to cash receipts.

Over-the-Counter Receipts Illustration 8-4 SO 3 Explain the applications of internal control principles to cash receipts.

Review Question Cash Controls Permitting only designated personnel to handle cash receipts is an application of the principle of: a. segregation of duties. b. establishment of responsibility. c. independent check. d. Human resource controls. See Page 358

Cash Controls Cash Disbursements Controls Generally, internal control over cash disbursements is more effective when companies pay by check, rather than by cash. Applications: Voucher system Petty cash fund SO 4 Explain the applications of internal control principles to cash disbursements.

Cash Controls Cash Disbursements Controls Documentation Procedures Illustration 8-6 Documentation Procedures Use prenumbered checks; checks must have an approved invoice; require employees to use corporate credit cards for reimbursable expenses Establishment of Responsibility Only designated personnel are authorized to sign checks (treasurer) and approve vendors Independent Internal Verification Compare checks to invoices; reconcile bank statement monthly Human Resource Controls Bond personnel who handle cash; require employees to take vacations; conduct background checks Segregation of Duties Different individuals approve and make payments; check signers do not record disbursements Physical Controls Store blank checks in safes, with limited access; print check amounts by machine in indelible ink

Discussion Question Cash Controls Q8-17 Joe Griswold Company’s internal controls over cash disbursements provide for the treasurer to sign checks imprinted by a checkwriting machine in indelible ink after comparing the check with the approved invoice. Identify the internal control principles that are present in these controls. See notes page for discussion Question 8-14 (textbook) SO 4 Explain the applications of internal control principles to cash disbursements.

Review Question Cash Controls The use of prenumbered checks in disbursing cash is an application of the principle of: a. establishment of responsibility. b. segregation of duties. c. physical, mechanical, and electronic controls. d. documentation procedures. SO 4 Explain the applications of internal control principles to cash disbursements.

Cash Controls Cash Disbursements Controls Voucher System Network of approvals, by authorized individuals, to ensure all disbursements by check are proper. A voucher is an authorization form prepared for each expenditure. SO 4 Explain the applications of internal control principles to cash disbursements.

Cash Controls Cash Disbursements Controls Petty Cash Fund - Used to pay small amounts. Involves: establishing the fund, making payments from the fund, and replenishing the fund. SO 5 Describe the operation of a petty cash fund.

Cash Controls Illustration: If Laird Company decides to establish a $100 fund on March 1, the journal entry is: Mar. 1 Petty cash 100 Cash 100 Question 2-19 (textbook) No, Jim is not correct . The proper sequence is as follows : ( b ) Business transaction occurs. ( c ) Information entered in the journal. ( a ) Debits and credits are posted to the ledger. ( e ) Trial balance is prepared. ( d ) Financial statements are prepared. SO 5 Describe the operation of a petty cash fund.

Cash Controls Illustration: Assume that on March 15 Laird’s petty cash custodian requests a check for $87. The fund contains $13 cash and petty cash receipts for postage $44, freight-out $38, and miscellaneous expenses $5. The general journal entry to record the check is: Mar. 15 Postage expense 44 Freight-out 38 Question 2-19 (textbook) No, Jim is not correct . The proper sequence is as follows : ( b ) Business transaction occurs. ( c ) Information entered in the journal. ( a ) Debits and credits are posted to the ledger. ( e ) Trial balance is prepared. ( d ) Financial statements are prepared. Miscellaneous expense 5 Cash 87 SO 5 Describe the operation of a petty cash fund.

Cash Controls Illustration: Occasionally, the company may need to recognize a cash shortage or overage. Assume that Laird’s petty cash custodian has only $12 in cash in the fund plus the receipts as listed. The request for reimbursement would, therefore, be for $88, and Laird would make the following entry: Mar. 15 Postage expense 44 Freight-out 38 Question 2-19 (textbook) No, Jim is not correct . The proper sequence is as follows : ( b ) Business transaction occurs. ( c ) Information entered in the journal. ( a ) Debits and credits are posted to the ledger. ( e ) Trial balance is prepared. ( d ) Financial statements are prepared. Miscellaneous expense 5 Cash over and short 1 Cash 88 SO 5 Describe the operation of a petty cash fund.

Control Features: Use of a Bank Contributes to good internal control over cash. Minimizes the amount of currency on hand. Creates a double record of bank transactions. Bank reconciliation. SO 6 Indicate the control features of a bank account.

Control Features: Use of a Bank Illustration 8-8 Making Bank Deposits Authorized employee should make deposit. Bank Code Numbers Reverse Side Front Side SO 6 Indicate the control features of a bank account.

Control Features: Use of a Bank Writing Checks Written order signed by depositor directing bank to pay a specified sum of money to a designated recipient. Illustration 8-9 Maker Payee Payer SO 6 Indicate the control features of a bank account.