CHAPTER FIVE

5. Fraud, Internal Control, and Cash

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Define fraud and internal control.
2. Identify the principles of internal control activities.
3. Explain the applications of internal control principles to cash receipts.
4. Explain the applications of internal control principles to cash disbursements.
5. Describe the operation of a petty cash fund.
6. Indicate the control features of a bank account.
7. Prepare a bank reconciliation.
8. Explain the reporting of cash.
5.1. Fraud and Internal Control.

An employee's dishonest act resulting in personal gain at the employer's expense is referred to as
fraud. Internal control measures are necessary to prevent such occurrences. Employee fraud is an
intentional act that deceives the employer for personal benefit. Two types of fraud are commonly
seen in business financial statements.
1. Employees of an entity commit asset misappropriation fraud by stealing money and
concealing it with incorrect book entries.
2. Fraudulent financial reporting occurs when company managers enter false and
misleading information in the books.

 The primary component of the fraud triangle is opportunity, which arises when the
workplace lacks adequate controls to prevent and detect fraudulent activities.
 Employees may engage in fraudulent activities due to personal financial issues or to
support a lifestyle beyond their means.
 They may also rationalize their actions by believing they deserve more pay.

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Managers of small businesses monitor the business operation and rely on internal controls. The
internal control system is used to protect assets, promote efficient operations, ensure reliable
accounting, and uphold company policies. Managers use internal control systems to prevent
avoidable losses, plan operations, and monitor company and employee performance.
Internal control is a process aimed at achieving objectives related to operations, reporting, and
compliance. It involves various measures adopted by organizations to safeguard assets, enhance
accounting record reliability, improve operational efficiency, and ensure regulatory compliance.
The five primary components of internal control systems are listed below.
o A control environment. -Top management is responsible for creating a control environment
that values integrity and prevents unethical activity.
o Risk assessment. - Companies must identify and analyze risk factors and develop strategies to
manage them.
o Control activities- Policies and procedures must be designed to address specific risks and
reduce fraud.
o Information and communication. - The internal control system must capture and
communicate pertinent information both internally and externally. management and/or
the board of directors
o Monitoring. - Regular monitoring of the internal control system is necessary, with significant
deficiencies reported to top
5.2. Principles of Internal Control Activities.

Each component of an internal control system is crucial. We will concentrate on control

activities since they are vital to the company's risk mitigation efforts. Control activities differ
depending on the risk assessment conducted by management. The size and nature of the
company have a significant impact on this evaluation.
1. Establishing responsibility is a crucial aspect of internal control, and it involves
assigning specific tasks to individual employees. The effectiveness of control is
maximized when only one person is responsible for a given task. To establish
responsibility, access must be limited to authorized personnel and their identification
must be identified. Many companies use automated systems with identifying passcodes to
track employee activity. This enables the company to identify the employee responsible
for the activity.

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2. Segregation of duties is crucial in internal control systems. It has two common
applications:

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 i. Related activities should have different responsible individuals.
ii. Recordkeeping responsibility for an asset should be separate from its
physical custody.
The rationale is to ensure efficient and reliable evaluations of employee work without
duplication. For example, those who design and program computerized systems should
not be involved in day-to-day use to prevent personal benefits and fraud concealment.

3. Documentation procedures are important as documents provide evidence of

transactions and events. Shipping documents and sales invoices are essential for other
businesses. Signatures on documents help identify responsible individuals. Companies
should document transactions and establish procedures for documents. Pre-numbering of
documents helps prevent errors. Control systems should require prompt forwarding of
source documents for accounting entries to ensure timely and accurate recording.

4. The implementation of physical controls is imperative in accounting. Such controls help

secure assets and improve the precision and dependability of financial records.

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5. Independent internal verification: most internal control systems prefer, which entails
reviewing data prepared by employees. To maximize its benefits, companies must verify
records periodically or on a surprise basis by an independent employee. Discrepancies
and exceptions must be reported to a management level that can take corrective action.
Independent internal verification is valuable for comparing accountability records with
assets. Examples include comparing a company's cash balance per books with the cash
balance per bank and verifying perpetual inventory records through physical inventory
count.

6. Human resource control activities involve bonding, rotating employees' duties,

requiring vacations, and conducting thorough background checks. Bonding provides
insurance protection and deters theft, while rotating duties and requiring vacations
prevent employees from concealing improper actions. Thorough background checks,
including verifying academic credentials and previous employment, are crucial in
reducing employee theft and fraud.

Limitations of Internal Control

 Companies aim to ensure protection of assets and reliability of accounting
records through internal control systems. The concept of reasonable assurance is
based on
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 balancing control procedure costs with expected benefits. Retail stores control
shoplifting losses using less expensive methods such as hidden cameras, signs and
sensor equipment.
 Human factors such as fatigue and collusion can render good systems ineffective.
 No internal control system is perfect and small companies may face limitations.
 Control of Cash
Cash can be hidden and moved easily, but internal controls protect it by following three
guidelines. The first guideline separates handling cash from recordkeeping to minimize errors
and fraud. The second guideline requires prompt deposit of cash receipts to create an
independent record and reduce theft or loss. The third guideline uses check or electronic funds
transfer for payments to develop an independent record and reduce risk of theft or loss.
 Cash, Cash Equivalents, and Liquidity
Liquidity pertains to a company's capability to pay for its current liabilities. Cash and similar
assets are referred to as liquid assets because they can be easily used to pay for liabilities. Cash
encompasses currency, coins, and bank deposits, along with items that can be deposited in these
accounts. Cash equivalents are short-term, highly liquid investment assets meeting two criteria.
These investments are typically within three months of their due date. Most companies combine
cash equivalents with cash on the balance sheet.
 Cash Management
Companies often fail due to poor cash management. To succeed, companies must plan for both
inflows and outflows of cash. The goals of cash management are to ensure timely payment of
debts and maintain a minimum level of operating cash. The treasurer is responsible for effective
cash management, which involves strategies such as encouraging timely customer payments,
delaying payment of liabilities, minimizing unnecessary assets, planning expenditures, and
investing excess cash in productive assets. Excess cash from seasonal cycles can be invested in
short-term options for additional returns.

5.3. Applications of Internal Control Principles to Cash Receipts.

The implementation of internal control for cash receipts guarantees accurate recording and
deposition. Cash receipts can come from various transactions such as cash sales, customer
account collections, interest receipts, bank loans, asset sales, and owner investments. The
following section outlines internal control for two types of cash receipts: in-person and by mail.
1) Over-the-counter cash sales require recording on a cash register and providing a receipt. The
register should hold a permanent record and be separate from the custody of cash. At the end
of the work period, the clerk should count the cash and record the amount, which is turned
over to the company cashier. A supervisor compares the record of register transactions with
the cashier's reported cash receipts for journal entry purposes. Employees have limited access
to either cash or accounting records to prevent mistakes or theft.

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 During transactions, customers may receive incorrect change leading to discrepancies
between the cash in a register and the recorded receipts. These differences are
documented in the Cash Over and Short account, which records the income impact of any
overages or shortages. An example entry would be if cash register sales were recorded at
$550, but the cash count in the register was $555.
Cash..................................................................................................555
Cash Over and Short..................................................................5
Sales.......................................................................................550
Record cash sales and a cash overage
Alternatively, if a cash register’s record shows $625 but the count of cash in the register is
$621, the entry to record cash sales and its shortage is
cash..................................................................................................621
Cash Over and Short............................................................................4
Sales........................................................................................625
Record cash sales and a cash shortage.
Customers tend to dispute being shortchanged more than being given too much change. Hence,
the Cash Over and Short account usually has a debit balance. A debit balance indicates an
expense which is reported on the income statement as part of selling, general, and administrative
expenses. If the amount is small, it is often reported as part of miscellaneous expenses or as part
of miscellaneous revenues if it has a credit balance.
2) Cash Receipts by Mail: Two individuals are responsible for opening cash receipts by mail.
For theft to occur, these employees must collude. Upon opening the mail, a list of received
money is entered (in triplicate), including the sender's name, amount, and reason for sending.
One copy is sent with the money to the cashier, another to the record-keeper, and the third is
kept by the mail opener(s). The cashier deposits the money in a bank, while the record-
keeper records the sums received.
This procedure is an effective internal control, as the bank's cash deposit records must match
those of all three. If the mail opener(s) fail to report all receipts accurately, customers will
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 question their account balances. If the cashier does not deposit all the cash, the bank balance
will not match the record-keeper's cash balance. The record-keeper does not have access to
cash and cannot steal it. This setup makes errors and fraud highly improbable, with the
exception of employee collusion.
5.4. Applications of Internal Control Principles to Cash Disbursements.
Control of cash payments is crucial in preventing theft from fictitious invoices. The use of checks for all
payments, except for small payments from petty cash, and limiting access to accounting records to
authorized personnel are effective methods of control.

a) The voucher system is a set of procedures and approvals used to control cash payments and
liabilities. It only allows authorized departments and individuals to incur liabilities and limits the
type of liabilities. A company uses several different business documents to coordinate and control
responsibilities of various departments. A voucher system should be applied to all payments, except
for those using petty cash. It helps prevent fraud by ensuring proper recording of transactions and
preventing collusion between employees and suppliers. Cash budgeting is important for companies to
minimize the cash they hold and manage risk.
b) Petty Cash System of Control: To avoid writing checks for small amounts, a company sets up a
petty cash system. Petty cash payments are small payments for items such as shipping fees,
minor repairs, and low-cost supplies.

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5.5. Operation of A Petty Cash Fund.
To manage small payments over a short period, a petty cash fund is estimated and a check is
issued. The petty cashier is responsible for safekeeping the cash and recording payments in a
secure petty cashbox. A pre-numbered petty cash receipt is signed by the person receiving
payment and placed in the petty cashbox. The total of receipts plus remaining cash equals the
total fund amount, which is reimbursed when nearing zero or at the end of an accounting period.
The paid receipts are sorted and totaled by the petty cashier, who then gives them to the company
cashier for recordkeeping and a check is issued to the petty cashier to restore the original amount
of cash in the box. The fund is now ready for a new cycle of payments.
Illustration: If Zhu Ltd. decides to establish a NT$3,000 fund on March 1, the journal entry
is: Mar. 1 Petty Cash 3,000
Cash 3,000
 Management usually limits the size of expenditures.
 Does not permit use of the fund for certain types of transactions.
 Payments are documented on a pre-numbered receipt.
 Signatures of both the custodian and the individual receiving payment are required on the
receipt.
 Supporting documents should be attached to the receipt.
 Custodian keeps the receipts in the petty cash box until the fund is replenished.
 Sum of the receipts and money in the fund should equal the established total at all times.
Illustration: Assume that on March 15 Zhu’s petty cash custodian requests a check for
NT$2,610. The fund contains NT$390 cash and petty cash receipts for postage NT$1,320,
freight-out NT$1,140, and miscellaneous expenses NT$150. The general journal entry to record
the check is:

Illustration: Occasionally, the company may need to recognize a cash shortage or overage.
Assume that Zhu’s petty cash custodian has only NT$360 in cash in the fund plus the receipts as
listed. The request for reimbursement would, therefore, be for NT$2,640, and Zhu would make
the following entry:

Petty cashiers may fail to receive receipts or overpay. If the fund is reimbursed later, the
payments report and cash remaining may not match the fund balance. This error leads to a fund
shortage, which is recorded as an expense with a debit to Cash Over and Short. An overage is
recorded with a credit to the same account.
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Ex- Bateer SA established a R$50 petty cash fund on July 1. On July 30, the fund had R$12 cash
remaining and petty cash receipts for postage R$14, office supplies R$10, and delivery expense
R$15. Prepare journal entries to establish the fund on July 1 and to replenish the fund on July 30.

5.6. Control Features of a Bank Account.

Banks safeguard cash and provide detailed records of cash transactions. They provide services
and documents that help control cash, which is the focus of this section.
Bank Account, Deposit, and Check
A bank account is used to deposit money for safekeeping and helps control withdrawals. Persons
authorized to write checks on the account must sign a signature card, which the bank uses to
verify signatures. Each bank deposit has a deposit ticket, which lists items such as currency,
coins, and checks deposited along with amounts. The bank gives the customer a receipt as proof
of the deposit.

A check is a document used by a depositor to withdraw money. It involves a maker, a payee, and
a bank. The bank provides the checks and may include a remittance advice and a memo line for
explanation.

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Electronic funds transfer (EFT) is an electronic method for transferring cash between parties,
which is gaining popularity due to its convenience and affordability. EFT is commonly used for
payroll, rent, utilities, insurance, and interest payments. Withdrawals and receipts via EFT are
recorded on bank statements alongside checks and deposits.
Bank Statement: Usually once a month, the bank sends a bank statement showing the account
activity. Different banks use different formats for their bank statements, but all of them include
the following.
a. Beginning-of-period account balance.
b. Checks and other debits decreasing the account during the period.
c. Deposits and other credits increasing the account during the period.
d. End-of-period account balance.
Exhibit shows one type of bank statement. Part A of Exhibit summarizes changes in the account.
B lists paid checks along with other debits. C lists deposits and credits to the account. Canceled
checks are checks the bank has paid and deducted from the customer’s account. We say such
checks cleared the bank. Other usual deductions on a bank statement include (1) bank service
fees,

(2) checks deposited that are uncollectible, (3) corrections of previous errors, (4) withdrawals
through automated teller machines (ATMs), and (5) payments arranged in advance by a
depositor. A debit memorandum notifies a depositor of a deduction. Increases to the depositor’s
account include amounts the bank collects on behalf of the depositor and the corrections of
previous errors. A credit memorandum notifies the depositor of all increases. Banks that pay
interest on checking accounts credit interest earned to the depositor’s account each period. In the
bank credits $8 of interest to the account

5.7. Bank Reconciliation.

The checking account balance on the bank statement may differ from the depositor's book balance. This

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is because of missing information. It is important to verify both the depositor's records and the bank's

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records for accuracy. A bank reconciliation is prepared to explain differences between the two balances.
Bank and book adjustments are used for this purpose.

Bank Balance Adjustments

+ Deposits in transit (or outstanding deposits). Deposits that are made and recorded in the
depositor's books but not yet listed on the bank statement are known as deposits in transit. These
can include deposits made after the bank is closed, such as through a night depository. If a
deposit occurred on a bank statement date, it would not appear on that statement but instead on
the next period's statement. Deposits mailed to the bank near the end of a period can also be in
transit and not listed on the bank statement.
– Outstanding checks. Outstanding checks are payments written by the depositor that have not
been turned in for payment at the bank statement date.
± Bank errors. The bank's errors are included in the reconciliation process. Two methods are
used to identify errors: comparing bank statement deposits with accounting records and
comparing canceled checks with recorded checks.
Book Balance Adjustments

+ Interest earned and unrecorded cash receipts. Banks collect notes and electronic transfers
for depositors and add them to their accounts, less any service fee. The bank statement reports
earned interest.
− Bank fees and NSF checks. A company may deposit an uncollectible check from another
party, known as a nonsufficient funds (NSF) check. The bank will initially increase the
depositor's account for the check, but will later reduce it when the check proves uncollectible. A
fee may be charged by the bank for processing an uncollectible check, as well as for printing new
checks and service fees.
± Book errors. Errors made in company books are reconciled and identified using procedures
described in the “Bank errors” section.

The bank statement for Laird Company, in Illustration 7-10, shows a balance per bank of
£15,907.45 on April 30, 2017. On this date the balance of cash per books is £11,589.45. Using the
four reconciliation steps, Laird determines the following reconciling items.
Step 1. Deposits in transit:
April 30 deposit (received by bank on May 1). £2,201.40

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Step 2. Outstanding checks: No. 453, £3,000.00; no. 457, £1,401.30; no. 460, £1,502.70.
5,904.00
Step 3. Errors: Laird wrote check no. 443 for £1,226.00 and the bank correctly paid that
amount. However, Laird recorded the check as £1,262.00. 36.00
Step 4. Bank memoranda:
a. Debit—NSF check from J. R. Baron for £425.60 425.60
b. Debit—Charge for printing company checks £30.00 30.00
c. Credit—Collection of note receivable for £1,000 plus interest earned £50, less
bank collection fee £15.00 1,035.00
AIRD COMPANY plc
Bank Reconciliation
April 30, 2017

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
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
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
5.8. Reporting of Cash.
Companies report cash in two statements: statement of financial position & statement of cash
flows. Statement of financial position reports cash at a point in time, while statement of cash
flows shows sources/uses of cash over time. Cash is presented in the financial position statement
as a combination of cash on hand, in banks, and petty cash. It is listed last in the current assets

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section

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because it is the most liquid asset owned by the company. The presentation of cash in the
statement of financial position is discussed in this section.
Restricted Cash: A company may possess restricted cash, which cannot be utilized for general
purposes and is reserved for a specific intention. Such restricted cash must be stated separately in
the financial position statement. If it is expected to be used within a year, it is recorded as a
current asset; otherwise, it is reported as a non-current asset.

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