Chapter

Fraud, Internal
Control and Cash
Chapter
8-1

Accounting Principles, Ninth Edition

Study Objectives
1.

Define fraud and internal control.

2. Identify the principles of internal control.

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.
Chapter
8-2

Fraud, Internal Control, and Cash

Fraud and
Internal Control

Fraud

The SarbanesOxley Act

Internal control
Principles of
internal control

Limitations

Chapter
8-3

Cash Controls

Control
Features: Use of
a Bank

Reporting Cash

Cash receipts
controls

Making deposits

Cash equivalents

Writing checks

Restricted cash

Cash
disbursements
controls

Bank statements

Compensating
balances

Reconciling the
bank account
Electronic funds
transfer (EFT)
system

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 8-1

Why does
fraud occur?

Chapter
8-4

SO 1 Define fraud and internal control.

Chapter
8-5

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).
Chapter
8-6

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.
Under the Sarbanes-Oxley Act, all publicly traded U.S. corporations
are required to maintain an adequate system of internal control.
Chapter
8-7

SO 1 Define fraud and internal control.

Fraud and Internal Control

Internal Control
Internal control systems have five primary components
1. A control environment
2. Risk assessment

3. Control activities
4. Information and communication
5. Monitoring

Chapter
8-8

SO 1 Define fraud and internal control.

Fraud and Internal Control

Principles of Internal Control Activities
Measures vary with
managements assessment of the risks faced.
size and nature of the company.
Six principles of controls activities:

Chapter
8-9

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.
Chapter
8-10

SO 2 Identify the principles of internal control.

Fraud and Internal Control

Principles of Internal Control Activities
PHYSICAL CONTROLS

Chapter
8-11

Illustration 8-2

SO 2 Identify the principles of internal control.

Fraud and Internal Control

Principles of Internal Control Activities
INDEPENDENT INTERNAL
VERIFICATION

Illustration 8-3

1. Verify records
periodically or on a
surprise basis.
2. Records verified by an
employee who is
independent.
3. Discrepancies reported

to management.

Chapter
8-12

SO 2 Identify the principles of internal control.

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.

Chapter
8-13

SO 2 Identify the principles of internal control.

Chapter
8-14

Fraud and Internal Control

Limitations of Internal Control
Costs should not exceed benefit.

Human element.
Size of the business.

Chapter
8-15

SO 2 Identify the principles of internal control.

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

Human Resource
Controls

Illustration 8-4
Chapter
8-16

Store cash in safes

and bank vaults; limit
access to storage
areas; use cash
registers

Bond personnel who

handle cash; require
employees to take
vacations; deposit all
cash in bank daily

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

Chapter
8-17

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

Chapter
8-18

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
Chapter
8-19

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

Over-theCounter
Receipts

Illustration 8-4

Chapter
8-20

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

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 cashiers 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 treasurers office for
comparison with total shown on daily cash summary.
Chapter
8-21

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

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. Human resource controls.

Chapter
8-22

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

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

Chapter
8-23

SO 4 Explain the applications of internal

control principles to cash disbursements.

Cash Controls
Cash Disbursements Controls
Establishment of
Responsibility
Only designated
personnel are
authorized to sign
checks (treasurer) and
approve vendors
Segregation of Duties
Different individuals
approve and make
payments; check
signers do not record
disbursements
Chapter
8-24

Documentation
Procedures
Use prenumbered
checks; checks must
have an approved
invoice; require
employees to use
corporate credit cards
for reimbursable
expenses
Physical Controls

Store blank checks in

safes, with limited
access; print check
amounts by machine in
indelible ink

Illustration 8-6

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

Cash Controls
Discussion Question
Q8-17 Joe Griswold Companys 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

Chapter
8-25

SO 4 Explain the applications of internal

control principles to cash disbursements.

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.

Chapter
8-26

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.

Chapter
8-27

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:
1. establishing the fund,
2. making payments from the fund, and
3. replenishing the fund.

Chapter
8-28

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
Cash

Chapter
8-29

100
100

SO 5 Describe the operation of a petty cash fund.

Cash Controls
Illustration: Assume that on March 15 Lairds 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
Cash

Chapter
8-30

5
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 Lairds 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

Cash over and short

Cash
Chapter
8-31

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.

Chapter
8-32

SO 6 Indicate the control features of a bank account.

Control Features: Use of a Bank

Making Bank Deposits
Authorized employee
should make deposit.

Front Side
Chapter
8-33

Illustration 8-8

Bank Code
Numbers

Reverse Side
SO 6 Indicate the control features of a bank account.

Control Features: Use of a Bank

Writing Checks

Illustration 8-9

Written order signed by depositor directing bank to pay

a specified sum of money to a designated recipient.
Maker
Payee
Payer

Chapter
8-34

SO 6 Indicate the control features of a bank account.

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.
Chapter
8-35

SO 6 Indicate the control features of a bank account.

Control Features: Use of a Bank

Review Question
The control features of a bank account do not
include:
a. having bank auditors verify the correctness of
the bank balance per books.
b. minimizing the amount of cash that must be kept
on hand.
c. providing a double record of all bank
transactions.
d. safeguarding cash by using a bank as a
depository.
Chapter
8-36

SO 6 Indicate the control features of a bank account.

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.
Chapter
8-37

SO 7 Prepare a bank reconciliation.

Control Features: Use of a Bank

Reconciliation Procedures
Illustration 8-11

+ Deposit in Transit

+ Notes collected by bank

NSF (bounced) checks

Check printing or other

service charges

Outstanding Checks

+- Bank Errors

+- Company Errors
CORRECT BALANCE
Chapter
8-38

CORRECT BALANCE
SO 7 Prepare a bank reconciliation.

Control Features: Use of a Bank

Illustration: The bank statement for Laird Company (Illustration
8-10), shows a balance per bank of $15,907.45 on April 30, 2010.
On this date the balance of cash per books is $11,589.45. Using
the four reconciliation steps, Laird determines the following
reconciling items.

Chapter
8-39

Control Features: Use of a Bank

Illustration: a) Prepare a bank reconciliation at April 30.
Cash balance per bank statement
Add:

$15,907.45

Deposit in transit

2,201.40

Less:
Outstanding checks
Adjusted cash balance per bank

(5,904.00)
$12,204.85

Cash balance per books

$11,589.45

Add:

Error in recording check no. 443

Collection of notes + interest - fee

Less:

NSF check
Bank service charge

Adjusted cash balance per books

Chapter
8-40

Illustration 8-12

36.00
1,035.00

(425.60)
(30.00)
$12,204.85
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

Chapter
8-41

15.00

Notes receivable

1,000.00

Interest revenue

50.00

SO 5 Describe the operation of a petty cash fund.

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

Chapter
8-42

36.00

SO 5 Describe the operation of a petty cash fund.

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
Cash

Chapter
8-43

30.00
30.00

SO 5 Describe the operation of a petty cash fund.

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.

Chapter
8-44

SO 7 Prepare a bank reconciliation.

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.

Chapter
8-45

SO 7 Prepare a bank reconciliation.

Control Features: Use of a Bank

Discussion Question
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

Chapter
8-46

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 8-14

Cash equivalents
Restricted cash
Compensating balances
Chapter
8-47

SO 8 Explain the reporting of cash.

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.
Chapter
8-48

SO 8 Explain the reporting of cash.

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Chapter
8-49