Slide

7-1
 Chapter 7

Fraud, Internal
Control, and Cash

Financial Accounting, IFRS Edition

Weygandt Kimmel Kieso
Slide
7-2
 Study
Study Objectives
Objectives
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.
Slide
7-3
 Fraud,
Fraud, Internal
Internal Control,
Control, and
and Cash
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

Slide
7-4
 Fraud
Fraud and
and Internal
Internal Control
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?

Slide
7-5
SO 1 Define fraud and internal control.
Answer on
notes page

Slide
7-6
 Fraud
Fraud and
and Internal
Internal Control
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.

Slide
7-7
SO 1 Define fraud and internal control.
 Fraud
Fraud and
and Internal
Internal Control
Control

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

Slide
7-8
SO 1 Define fraud and internal control.
 Fraud
Fraud and
and Internal
Internal Control
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:
Establishment of responsibility
Segregation of duties
Documentation procedures
Physical controls
Independent internal verification
Human resource controls
Slide
7-9
SO 2 Identify the principles of internal control activities.
 Fraud
Fraud and
and Internal
Internal Control
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.

Slide
7-10
SO 2 Identify the principles of internal control activities.
 Fraud
Fraud and
and Internal
Internal Control
Control

Slide
7-11 SO 2
 Fraud
Fraud and
and Internal
Internal Control
Control

Slide
7-12
SO 2 Identify the principles of internal control activities.
 Fraud
Fraud and
and Internal
Internal Control
Control

Slide
7-13 SO 2
 Fraud
Fraud and
and Internal
Internal Control
Control

Principles of Internal Control Activities

PHYSICAL CONTROLS Illustration 7-2

Slide
7-14
SO 2 Identify the principles of internal control activities.
 Fraud
Fraud and
and Internal
Internal Control
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.
Slide
7-15
SO 2 Identify the principles of internal control activities.
 Fraud
Fraud and
and Internal
Internal Control
Control

Principles of Internal Control Activities

HUMAN RESOURCE CONTROLS

1. Bond employees.
2. Rotate employees duties and
require vacations.
3. Conduct background checks.

Slide
7-16
SO 2 Identify the principles of internal control activities.
 Fraud
Fraud
and
and
Internal
Internal
Control
Control

Slide
7-17 SO 2
 Fraud
Fraud and
and Internal
Internal Control
Control

Slide
7-18 SO 2
 Fraud
Fraud and
and Internal
Internal Control
Control

Slide
7-19 SO 2
 Answer on
Slide notes page
7-20
 Fraud
Fraud and
and Internal
Internal Control
Control

Limitations of Internal Control

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

Slide
7-21
SO 2 Identify the principles of internal control activities.
 Cash
Cash Receipts
Receipts Controls
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
Slide
7-22
SO 3 Explain the applications of internal control principles to cash receipts.
 Cash
Cash Receipts
Receipts Controls
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

Slide
7-23
SO 3 Explain the applications of internal control principles to cash receipts.
 Over-the-
Counter
Receipts

Illustration 7-5

Slide
7-24
SO 3 Explain the applications of internal control principles to cash receipts.
 Cash
Cash Receipts
Receipts Controls
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 cashiers 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 treasurers office for comparison with

total shown on daily cash summary.

Slide
7-25
SO 3 Explain the applications of internal control principles to cash receipts.
 Cash
Cash Receipts
Receipts Controls
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.

Slide
7-26
SO 3 Explain the applications of internal control principles to cash receipts.
 Cash
Cash Disbursement
Disbursement Controls
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

7-27 principles to cash disbursements.
 Cash
Cash Disbursement
Disbursement Controls
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;
Physical Controls require employees
approve and make
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
Slide
7-28
 Cash
Cash Disbursement
Disbursement Controls
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.

Slide SO 4 Explain the applications of internal control

7-29 principles to cash disbursements.
 Cash
Cash Disbursement
Disbursement Controls
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

7-30 principles to cash disbursements.
 Cash
Cash Disbursement
Disbursement Controls
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.

Slide
7-31
SO 5 Describe the operation of a petty cash fund.
 Cash
Cash Disbursement
Disbursement Controls
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

Slide
7-32
SO 5 Describe the operation of a petty cash fund.
 Cash
Cash Disbursement
Disbursement Controls
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 5
Cash 87

Slide
7-33
SO 5 Describe the operation of a petty cash fund.
 Cash
Cash Disbursement
Disbursement Controls
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 5
Cash over and short 1
Cash 88

Slide
7-34
SO 5 Describe the operation of a petty cash fund.
 Control
Control Features:
Features: Use
Use of
of aa Bank
Bank

Contributes to good internal control over cash.

Minimizes the amount of currency on hand.

Creates a double record of bank transactions.

Bank reconciliation.

Slide
7-35
SO 6 Indicate the control features of a bank account.
 Control
Control Features:
Features: Use
Use of
of aa Bank
Bank
Illustration 7-8
Making Bank Deposits
Bank Code
Authorized employee should
Numbers
make deposit.

Reverse Side
Front Side
Slide
7-36
SO 6 Indicate the control features of a bank account.
 Control
Control Features:
Features: Use
Use of
of aa Bank
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

Slide
7-37
SO 6 Indicate the control features of a bank account.
 Control
Control Features:
Features: Use
Use of
of aa Bank
Bank
Illustration 7-10

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

Credit Memorandum
Collect notes
receivable.
Interest earned.

Slide
7-38 SO 6 Indicate the control features of a bank account.
 Control
Control Features:
Features: Use
Use of
of aa Bank
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.

Slide
7-39
SO 6 Indicate the control features of a bank account.
 Control
Control Features:
Features: Use
Use of
of aa Bank
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.

Slide
7-40
SO 7 Prepare a bank reconciliation.
 Control
Control Features:
Features: Use
Use of
of aa Bank
Bank
Reconciliation Procedures Illustration 7-11

+ Deposit in Transit + Notes collected by bank

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

Slide
7-41
SO 7 Prepare a bank reconciliation.
 Control
Control Features:
Features: Use
Use of
of aa Bank
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.

Slide
7-42
 Control
Control Features:
Features: Use
Use of
of aa Bank
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

7-43
SO 7 Prepare a bank reconciliation.
 Control
Control Features:
Features: Use
Use of
of aa Bank
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

Slide
7-44
SO 7 Prepare a bank reconciliation.
 Control
Control Features:
Features: Use
Use of
of aa Bank
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

Slide
7-45
SO 7 Prepare a bank reconciliation.
 Control
Control Features:
Features: Use
Use of
of aa Bank
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
Slide
7-46
SO 7 Prepare a bank reconciliation.
 Control
Control Features:
Features: Use
Use of
of aa Bank
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.

Slide
7-47
SO 7 Prepare a bank reconciliation.
 Control
Control Features:
Features: Use
Use of
of aa Bank
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.

Slide
7-48
SO 7 Prepare a bank reconciliation.
 Reporting
Reporting Cash
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 the
Restricted cash 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.
Slide
7-49 SO 8 Explain the reporting of cash.
 Reporting
Reporting Cash
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.

Slide
7-50
SO 8 Explain the reporting of cash.
 Understanding
Understanding U.S.
U.S. GAAP
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.
Slide
7-51
 Understanding
Understanding U.S.
U.S. GAAP
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).

Slide
7-52
 Understanding
Understanding U.S.
U.S. GAAP
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.

Slide
7-53
 Understanding
Understanding U.S.
U.S. GAAP
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.

Slide
7-54
 Copyright
Copyright

Copyright 2011 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser
may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility for
errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.

Slide
7-55