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 Chapter 7

Fraud, Internal
Control, and Cash

Financial Accounting, IFRS Edition

Weygandt Kimmel Kieso
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 Fraud, Internal Control, and Cash

Fraud and Cash Control

Cash Receipts Reporting
Internal Disbursement Features: Use
Controls Cash
Control Controls of a Bank

Fraud Over-the- Voucher Making Cash

Internal control counter system deposits equivalents
receipts controls Writing checks Restricted
Principles of
internal control Mail receipts Petty cash Bank cash
activities fund controls statements Compensating
Limitations Reconciling balances
the bank
account
Electronic
funds transfer
(EFT) system

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 Fraud and Internal Control

Fraud
Dishonest act by an employee that results in personal
benefit to the employee at a cost to the employer.

Illustration 7-1

Why does
fraud occur?

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SO 1 Define fraud and internal control.
 Fraud and Internal Control

Internal Control
Methods and measures adopted to:
1. Safeguard assets.

2. Enhance accuracy and reliability of accounting records.

3. Increase efficiency of operations, and

4. Ensure compliance with laws and regulations.

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SO 1 Define fraud and internal control.
 Fraud and Internal Control

Internal Control
Internal control systems have five primary components
A control environment
Risk assessment
Control activities
Information and communication
Monitoring

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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
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SO 2 Identify the principles of internal control activities.
 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 and all
documents should be accounted for.

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SO 2 Identify the principles of internal control activities.
 Fraud and Internal Control

Principles of Internal Control Activities

PHYSICAL CONTROLS Illustration 7-2

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SO 2 Identify the principles of internal control activities.
 Fraud and Internal Control

Principles of Internal Control Activities

Illustration 7-3
INDEPENDENT INTERNAL
VERIFICATION
1. Verify records periodically
or on a surprise basis.
2. Verify records by an
employee who is
independent.
3. Discrepancies reported
to management.

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SO 2 Identify the principles of internal control activities.
 Fraud and Internal Control

Principles of Internal Control Activities

HUMAN RESOURCE CONTROLS
1. Bond employees.
2. Rotate employees’ duties and
require vacations.
3. Conduct background checks.

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SO 2 Identify the principles of internal control activities.
 Answer on
Slide notes page
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 Fraud and Internal Control

Limitations of Internal Control

Costs should not exceed benefit.
Human element.
Size of the business.

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SO 2 Identify the principles of internal control activities.
 Cash Receipts Controls

Over-the-Counter Receipts
Illustration 7-4

Establishment of Documentation Independent Internal

Responsibility Procedures Verification
Only designated Use remittance advice Supervisors count cash
personnel are authorized (mail receipts), cash receipts daily; treasurer
to handle cash receipts register tapes, and compares total receipts
(cashiers) deposit slips to bank deposits daily

Segregation of Duties Physical Controls Human Resource

Different individuals Store cash in safes Controls
receive cash, record and bank vaults; limit Bond personnel who
cash receipts, and hold access to storage handle cash; require
the cash areas; use cash employees to take
registers vacations; deposit all
cash in bank daily
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SO 3 Explain the applications of internal control principles to cash receipts.
 Cash Receipts 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

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

Illustration 7-5

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SO 3 Explain the applications of internal control principles to cash receipts.
 Cash Receipts Controls

Mail Receipts
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,

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.

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

Slide SO 4 Explain the applications of internal control

7-18 principles to cash disbursements.
 Cash Disbursement Controls
Illustration 7-6

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

Voucher System 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.

Slide SO 4 Explain the applications of internal control

7-20 principles to cash disbursements.
 Cash Disbursement Controls

Petty Cash Fund Controls

Petty Cash Fund - Used to pay small amounts.
Involves:
1. establishing the fund,

2. making payments from the fund, and

3. replenishing the fund.

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SO 5 Describe the operation of a petty cash fund.
 Cash Disbursement 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

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SO 5 Describe the operation of a petty cash fund.
 Cash Disbursement 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
Miscellaneous expense 5
Cash 87

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SO 5 Describe the operation of a petty cash fund.
 Cash Disbursement 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
Miscellaneous expense 5
Cash over and short 1
Cash 88

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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.

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SO 6 Indicate the control features of a bank account.
 Control Features: Use of a Bank
Illustration 7-8
Making Bank Deposits
Bank Code
Authorized employee should Numbers
make deposit.

Reverse Side
Front Side
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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 7-9

Maker

Payee

Payer

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SO 6 Indicate the control features of a bank account.
 Control Features: Use of a Bank
Illustration 7-10

Bank Statements
Debit Memorandum
Bank service charge
NSF (not sufficient
funds)

Credit Memorandum
Collect notes
receivable.
Interest earned.

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 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:
1. Deposits in transit.

2. Outstanding checks.

3. Errors.

4. Bank memoranda.

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

+ Deposit in Transit + Notes collected by bank

- Outstanding Checks - NSF (bounced) checks
+- Bank Errors - Check printing or other
service charges
+- Company Errors
CORRECT BALANCE CORRECT BALANCE

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 Control Features: Use of a Bank

Illustration: The bank statement for Laird Company (Illustration 7-12),

shows a balance per bank of $15,907.45 on April 30, 2011. On this
date the balance of cash per books is $11,589.45. Using the four
reconciliation steps, Laird determines the following reconciling items.

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 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. 443 36.00
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

Slide Illustration 7-12

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SO 7 Prepare a bank reconciliation.
 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
Notes receivable 1,000.00
Interest revenue 50.00

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SO 7 Prepare a bank reconciliation.
 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 36.00

Accounts payable 36.00

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SO 7 Prepare a bank reconciliation.
 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 425.60

Cash 425.60

Bank Service Charges: Depositors debit check printing

charges (DM) and other bank service charges (SC) to
Miscellaneous Expense. The entry is:

Apr. 30 Miscellaneous expense 30.00

Cash 30.00
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SO 7 Prepare a bank reconciliation.
 Control Features: Use of a Bank

Review Question
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.

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

Electronic Funds Transfers (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.

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SO 7 Prepare a bank reconciliation.
 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 7-14

Cash equivalents While cash equivalents are now frequently

reported with cash, it appears likely that
Restricted cash the IASB will end this practice in the future.
Compensating balances Instead, items now referred to as cash
equivalents will be reported as short-term
investments.
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 Reporting Cash

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

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SO 8 Explain the reporting of cash.
 Understanding U.S. GAAP
Fraud, Internal Control,
Key Differences and Cash
The fraud triangle discussed in this chapter is applicable to U.S.
companies as well. Some of the most infamous U.S. fraud scandals
are Enron, Worldcom, and, more recently, the Bernie Madoff ponzi
scheme.

After numerous corporate scandals, the U.S. Congress passed the

Sarbanes-Oxley Act of 2002 (SOX). Under SOX, all publicly traded
U.S. corporations are required to maintain an adequate system of
internal control.

As a result of SOX, corporate executives and boards of directors

must ensure that internal controls are reliable and effective. In
addition, independent outside auditors must attest to the adequacy
of the internal control system.
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 Understanding U.S. GAAP
Fraud, Internal Control,
Key Differences and Cash
SOX created the Public Company Oversight Board (PCAOB), to
establish auditing standards and regulate auditor activity.

One study estimates the cost of 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. One
study of first compliance with the internal-control testing
provisions documented material weaknesses for about 13% of
companies reporting in 2004 and 2005 (PricewaterhouseCoopers’
Global Economic Crime Survey, 2005).

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 Understanding U.S. GAAP
Fraud, Internal Control,
Key Differences and Cash
The enhanced internal control standards apply only to large public
companies listed on U.S. exchanges. There is continuing debate
over whether foreign issuers should have to comply with this extra
layer of regulation.

Most companies report cash and cash equivalents together under

IFRS and GAAP, as shown in this textbook. In addition, GAAP
follows the same accounting policies related to the reporting of
restricted cash.

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 Understanding U.S. GAAP
Fraud, Internal Control,
Looking to the Future and Cash
High-quality international accounting requires both high-quality
accounting standards and high-quality auditing. Similar to the
convergence of GAAP and IFRS, there is a movement to improve
both U.S. and 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. Also, under
proposed new standards being developed jointly by the FASB and
IASB for financial statement presentation, cash equivalents cannot
be combined with cash.

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 Copyright

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