2. CHAPTER8
Fraud, Internal Control, and Cash

3. PreviewofCHAPTER8

4. Three factors that contribute to fraudulent activity.
Fraud and Internal Control
Fraud
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 8-1
SO 1 Define fraud and internal control.

5. 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).
SO 1 Define fraud and internal control.

6. 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.
SO 1 Define fraud and internal control.

7. Fraud and Internal Control
Five Primary Components:
Control environment.
Risk assessment.
Control activities.
Information and communication.
Monitoring.
SO 1 Define fraud and internal control.

8. 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.
Segregation of Duties
Related duties should be assigned to different individuals.
Documentation Procedures
Companies should use prenumbered documents and all documents should be accounted for.
SO 2 Identify the principles of internal control activities.

9. Fraud and Internal Control
Principles of Internal Control Activities
Illustration 8-2
Physical Controls
SO 2 Identify the principles of internal control activities.

10. Fraud and Internal Control
Principles of Internal Control Activities
Independent Internal Verification
Illustration 8-3
Records periodically verified by an employee who is independent.
Discrepancies reported to management.
SO 2 Identify the principles of internal control activities.

11. 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 activities.

17. 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 activities.

18. Cash Controls
Cash Receipts Controls
Illustration 8-4
SO 3

19. Cash Controls
Cash Receipts Controls
Illustration 8-4
SO 3

20. Cash Controls Cash Receipts Controls Over-the-Counter Receipts
Important internal control principle—segregation of record-keeping from physical custody.
Illustration 8-5
SO 3

21. Cash Controls Cash Receipts Controls Mail Receipts
Mail receipts should be opened by two people, a list prepared, and each check endorsed.
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.
SO 3 Explain the applications of internal control principles to cash receipts.

22. Cash Controls Review Question
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. other controls.
SO 3 Explain the applications of internal control principles to cash receipts.

23. 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.

24. Cash Controls
Cash Disbursements Controls
Illustration 8-6
SO 4

25. Cash Controls
Cash Disbursements Controls
Illustration 8-6
SO 4

26. Cash Controls Review Question
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.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

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

34. 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.

35. Control Features: Use of a Bank
Bank Statements
Illustration 8-10
Debit Memorandum
Bank service charge.
NSF (not sufficient funds).
Credit Memorandum
Collect notes receivable.
Interest earned.

36. Control Features: Use of a Bank
Reconciling the Bank Account
Reconcile balance per books and balance per bank to their adjusted (corrected) cash balances.
Reconciling Items:
Deposits in transit.
Outstanding checks.
Bank memoranda.
Errors.
Time Lags
SO 7 Prepare a bank reconciliation.

37. Control Features: Use of a Bank
Reconciliation Procedures
Illustration 8-11
+ Deposit in Transit
- Outstanding Checks
+/- Bank Errors
+ Notes collected by bank
- NSF (bounced) checks
- Check printing or other service charges
+/- Book Errors
CORRECT BALANCE
CORRECT BALANCE
SO 7 Prepare a bank reconciliation.

38. Control Features: Use of a Bank
SO 7 Prepare a bank reconciliation.

39. 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
NSF check (425.60)
Bank service charge (30.00)
Collection of notes receivable 1,035.00
Adjusted cash balance per books $12,204.85
SO 7 Prepare a bank reconciliation.

40. Control Features: Use of a Bank
Company records each reconciling item used to determine the adjusted cash balance per books.
Collection of Note Receivable: Assuming interest of $50 has not been accrued and collection fee is charged to Miscellaneous Expense, the entry is:
Apr. 30
Cash 1,035.00
Miscellaneous expense 15.00
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.
Notes receivable 1,000.00
Interest revenue
SO 7 Prepare a bank reconciliation.

41. Control Features: Use of a Bank
Book Error: The cash disbursements journal shows that check no. 443 was a payment on account to Andrea Company, a supplier. The correcting entry is:
Apr. 30
Cash
Accounts payable
NSF Check: As indicated earlier, an NSF check becomes an account receivable to the depositor. The entry is:
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.
Apr. 30
Accounts receivable
Cash
SO 7 Prepare a bank reconciliation.

42. Control Features: Use of a Bank
Bank Service Charges: Depositors debit check printing charges (DM) and other bank service charges (SC) to Miscellaneous Expense. The entry is:
Apr. 30
Miscellaneous 30.00
Cash
Illustration 8-13
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 7 Prepare a bank reconciliation.

43. Control Features: Use of a Bank
Electronic Funds Transfer (EFT) System
Disbursement systems that uses wire, telephone, or computers to transfer cash balances between locations.
EFT transfers normally result in better internal control since no cash or checks are handled by company employees.
SO 7 Prepare a bank reconciliation.

45. Reporting Cash Cash Equivalents Restricted Cash
Cash equivalents are short-term, highly liquid investments that are both:
Readily convertible to cash, and
So near their maturity that their market value is relatively insensitive to changes in interest rates.
Restricted Cash
Should be reported separately on the balance sheet as restricted cash.
SO 8 Explain the reporting of cash.

46. Reporting Cash
Illustration 8-14
SO 8 Explain the reporting of cash.

47. Key Points
The fraud triangle discussed in this chapter is applicable to all international companies. Some of the major frauds on an international basis are Parmalat (Italy), Royal Ahold (the Netherlands), and Satyam Computer Services (India).
Rising economic crime poses a growing threat to companies, with nearly half of all organizations worldwide being victims of fraud in a recent two-year period (PricewaterhouseCoopers’ Global Economic Crime Survey, 2005). Specifically, 44% of Romanian companies surveyed experienced fraud in the past two years.

48. Key Points
Globally, the number of companies reporting fraud increased from 37% to 45% since 2003, a 22% increase. The cost to companies was an average US$1.7 million in losses from “tangible frauds,” that is, those that result in an immediate and direct financial loss.
Accounting scandals both in the United States and internationally have re-ignited the debate over the relative merits of GAAP, which takes a “rules-based” approach to accounting, versus IFRS, which takes a “principles-based” approach. The FASB announced that it intends to introduce more principles-based standards.

49. Key Points
On a lighter note, at one time Ig Nobel Prize in Economics went to the CEOs of those companies involved in the corporate accounting scandals of that year for “adapting the mathematical concept of imaginary numbers for use in the business world.” The Ig Nobel Prizes (read Ignoble, as not noble) are a parody of the Nobel Prizes and are given each year in early October for 10 achievements that “first make people laugh, and then make them think.”
While most companies have internal control systems in place, many have never completely documented them, nor had an independent auditor attest to their effectiveness. Both of these actions are required under SOX.

50. Key Points
One study estimates the cost of SOX compliance for U.S. companies at over $35 billion, with audit fees doubling in the first year of compliance. At the same time, examination of internal controls indicates lingering problems in the way companies operate.
The SOX internal control standards apply only to companies listed on U.S. exchanges. There is continuing debate over whether foreign issuers should have to comply.
The accounting and internal control procedures related to cash is essentially the same under both IFRS and this textbook. In addition, the definition used for cash equivalents is the same.

51. Key Points
Most companies report cash and cash equivalents together under IFRS, as shown in this textbook. In addition, IFRS follows the same accounting policies related to the reporting of restricted cash.
IFRS defines both cash and cash equivalents as follows.
Cash is comprised of cash on hand and demand deposits.
Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

52. Looking to the Future
High-quality international accounting requires both high-quality accounting standards and high-quality auditing. Similar to the convergence of GAAP and IFRS, there is movement to improve international auditing standards. The International Auditing and Assurance Standards Board (IAASB) functions as an independent standard-setting body. It works to establish high-quality auditing and assurance and quality-control standards throughout the world. Whether the IAASB adopts internal control provisions similar to those in SOX remains to be seen.