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

3. 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)

4. 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

5. 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.

7. 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.

8. 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.

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

10. 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.

11. 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.

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

13. 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.

14. 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.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

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

22. Mail Receipts Control Procedures:
Mail receipts should be opened by two people, a list prepared, and each check endorsed.
Copy of the list, along with the checks and remittance advices, sent to cashier’s department.
Cashier adds the checks to the over-the-counter receipts and prepares a daily cash summary and makes the daily bank deposit.
Copy of list sent to treasurer’s office for comparison with total shown on daily cash summary.
SO 3 Explain the applications of internal control principles to cash receipts.

23. 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.
SO 3 Explain the applications of internal control principles to cash receipts.

24. 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.

25. 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

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. 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.

34. 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.

35. 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.

36. Control Features: Use of a Bank
Illustration 8-10
Bank Statements
Debit Memorandum
Bank service charge
NSF (not sufficient funds)
Credit Memorandum
Collect notes receivable.
Interest earned.
SO 6 Indicate the control features of a bank account.

37. Review Question Control Features: Use of a Bank
The control features of a bank account do not include:
having bank auditors verify the correctness of the bank balance per books.
minimizing the amount of cash that must be kept on hand.
providing a double record of all bank transactions.
safeguarding cash by using a bank as a depository.
SO 6 Indicate the control features of a bank account.

38. 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.
Errors.
Bank memoranda.
SO 7 Prepare a bank reconciliation.

39. 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
+- Company Errors
CORRECT BALANCE
CORRECT BALANCE
SO 7 Prepare a bank reconciliation.

40. Control Features: Use of a Bank
Illustration: The bank statement for Laird Company (Illustration 8-10), shows a balance per bank of $15, on April 30, On this date the balance of cash per books is $11, Using the four reconciliation steps, Laird determines the following reconciling items.

41. Control Features: Use of a Bank
Illustration: a) Prepare a bank reconciliation at April 30.
Cash balance per bank statement $15,907.45
Add: Deposit in transit 2,201.40
Less: Outstanding checks (5,904.00)
Adjusted cash balance per bank $12,204.85
Cash balance per books $11,589.45
Add: Error in recording check no
Collection of notes + interest - fee 1,035.00
Less: NSF check (425.60)
Bank service charge (30.00)
Adjusted cash balance per books $12,204.85
Illustration 8-12
SO 7 Prepare a bank reconciliation.

42. Control Features: Use of a Bank
The 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 5 Describe the operation of a petty cash fund.

43. 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
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.

44. Control Features: Use of a Bank
NSF Check: As indicated earlier, an NSF check becomes an account receivable to the depositor. The entry is:
Apr. 30
Accounts receivable
Cash
Bank Service Charges: Depositors debit check printing charges (DM) and other bank service charges (SC) to Miscellaneous Expense. 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
Miscellaneous 30.00
Cash
SO 5 Describe the operation of a petty cash fund.

45. Review Question Control Features: Use of a Bank
The reconciling item in a bank reconciliation that will result in an adjusting entry by the depositor is:
a. outstanding checks.
b. deposit in transit.
c. a bank error.
d. bank service charges.
SO 7 Prepare a bank reconciliation.

46. Control Features: Use of a Bank
Electronic Funds Transfers (EFT)
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.

47. Discussion Question Control Features: Use of a Bank
Q8-23. Lori Figgs is confused about the lack of agreement between the cash balance per books and the balance per the bank. Explain the causes for the lack of agreement to Lori, and give an example of each cause.
See notes page for discussion
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.

48. 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.
Illustration 8-14
Cash equivalents
Restricted cash
Compensating balances
SO 8 Explain the reporting of cash.

49. Review Question Reporting Cash
Which of the following statements correctly describes the reporting of cash?
Cash cannot be combined with cash equivalents.
Restricted cash funds may be combined with Cash.
Cash is listed first in the current assets section.
Restricted cash funds cannot be reported as a current asset.
SO 8 Explain the reporting of cash.

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