CHAPTER 8

FRAUD, INTERNAL CONTROL, AND CASH

LEARNING OBJECTIVES

1. DISCUSS FRAUD AND THE PRINCIPLES OF

INTERNAL CONTROL.

2. APPLY INTERNAL CONTROL PRINCIPLES TO CASH.

3. IDENTIFY THE CONTROL FEATURES OF A BANK

ACCOUNT.

4. EXPLAIN THE REPORTING OF CASH.

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 CHAPTER REVIEW

Fraud and Internal Control

1. (L.O. 1) Fraud is a dishonest act by an employee that results in personal benefit to the employee
at a cost to the employer. The fraud triangle refers to the three factors that contribute to fraudulent
activity by employees: opportunity, financial pressure, and rationalization.

2. Internal control consists of all the related methods and measures adopted within an organization
to (a) safeguard assets, (b) enhance the reliability of accounting records, (c) increase efficiency of
operations, and (d) ensure compliance with laws and regulations.

3. An essential characteristic of internal control is the establishment of responsibility to specific

employees. Control is most effective when only one person is responsible for a given task.

4. The rationale for segregation of duties is this: The work of one employee should, without a
duplication of effort, provide a reliable basis for evaluating the work of another employee.

5. The responsibility for related transactions should be assigned to different individuals, and the respon-
sibility for establishing the accountability for an asset should be separate from the physical
custody of that asset.

6. Documentation procedures provide evidence that transactions and events have occurred.

7. Physical controls relate primarily to the safeguarding of assets and include such measures as
safes for the storage of cash prior to deposit, vaults for the deposit of cash, safety deposit boxes
for the storage of important business papers, and locked warehouses for inventories. These
controls also include alarms, television monitors, garment sensors and time clocks.

8. Most systems of internal control provide for independent internal verification. This principle
involves the review of data prepared by employees.

9. In large companies, independent internal verification is often assigned to internal auditors. Internal
auditors are company employees who continuously evaluate the effectiveness of the company’s
internal control systems.

10. Human resource control measures include bonding of employees who handle cash, rotating
employees’ duties and requiring employees to take vacations, and conducting thorough
background checks.

Limitations of Internal Control

11. The concept of reasonable assurance rests on the premise that the costs of establishing control
procedures should not exceed their expected benefits.

12. The human element is also an important factor in every system of internal control. A good system
can become ineffective through employee fatigue, carelessness, or indifference.

13. Collusion may result when two or more individuals work together to get around prescribed controls
and may significantly reduce the effectiveness of a system.

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Cash Controls

14. (L.O. 2) To safeguard cash and to assure the accuracy of the accounting records for cash,
effective internal control over cash is critical.

Cash Receipts Controls

15. The application of internal control principles to cash receipts transactions includes: (1) only
designated personnel should be authorized to handle or have access to cash receipts;
(2) different individuals should be assigned the duties of receiving cash, recording cash receipt
transactions, and having custody of cash; (3) documents should include remittance advices, cash
register tapes, and deposit slips; (4) cash should be stored in company safes and bank vaults,
access to storage areas should be limited to authorized personnel, and cash registers should be
used; (5) daily cash counts and daily comparisons of total receipts should be made; and (6) all
personnel who handle cash receipts should be bonded and required to take vacations.

16. Control of over-the-counter receipts is centered on cash registers that are visible to customers.

Cash Disbursements Controls

17. (L.O. 4) Generally, internal control over cash disbursements is more effective when companies
pay by check or electronic funds transfer (EFT), rather than by cash, except for incidental
amounts that are paid out of petty cash.

18. The application of internal control principles to cash disbursements transactions includes: (1) only
designated individuals should be authorized to sign checks; (2) different individuals should be
assigned the duties of approving an item for payment and paying it; (3) prenumbered checks
should be used and each check should be supported by an approved invoice or other document;
(4) blank checks should be stored in a safe and access should be restricted to authorized
personnel, and a machine should be used to imprint the amount on the check in indelible ink; (5)
each check should be compared with the approved invoice before it is issued; and (6) bonding
personnel who handle cash, requiring employees to take vacations, and conducting background
checks.

Voucher System

19. Companies use a voucher system to enhance the internal control over cash disbursements. A
voucher system is a network of approvals by authorized individuals, acting independently, to
ensure that all disbursements by check are proper. A voucher system includes the use of
authorization forms called vouchers which are recorded by the accounting department in the
voucher register.

Petty Cash Fund

20. A petty cash fund is a cash fund used to pay relatively small amounts.
a. The operation of the fund, often called an imprest system, involves (1) establishing the fund,
(2) making payments from the fund, and (3) replenishing the fund.
b. Accounting entries are required when (1) the fund is established, (2) the fund is replenished,
and (3) the amount of the fund is changed.

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Control Features: Use of a Bank

21. (L.O. 3) The use of a bank minimizes the amount of currency that must be kept on hand and
therefore contributes significantly to good internal control over cash.

22. A check is a written order signed by the depositor directing the bank to pay a specified sum of
money to a designated recipient. The three parties to a check are as follows:
a. The maker (or drawer) who issues the check.
b. The bank (or payer) on which the check is drawn.
c. The payee to whom the check is payable.

23. A bank statement shows (a) checks paid and other debits charged against the account, (b) deposits
and other credits made to the account, and (c) the account balance after each day’s transactions.

24. A bank debit memorandum is usually included with the bank statement to indicate charges
against the depositor’s account such as a bank service charge, cost of printing checks, issuing
traveler’s checks, and when a previously deposited customer’s check “bounces” because of
insufficient funds (NSF check).

25. A bank credit memorandum shows such items as the collection of a note receivable for the
depositor by the bank.

Reconciling the Bank Account

26. A reconciliation of a bank account is necessary because the balance per bank and balance per
books are seldom in agreement. The need for agreement may be the result of time lags and
errors.

27. To obtain maximum benefit from a bank reconciliation, the reconciliation should be prepared by
an employee who has no other responsibilities pertaining to cash.

28. In reconciling the bank statement, it is customary to reconcile the balance per books and balance
per bank to their adjusted cash balances. The reconciliation schedule consists of two sections.
The steps in preparing a bank reconciliation are:
a. Determine deposits in transit.
b. Determine outstanding checks.
c. Note any errors discovered.
d. Trace bank memoranda to the depositor’s records.

29. Each reconciling item used in determining the adjusted cash balance per books should be re-
corded by the depositor.

Reporting Cash

30. (L.O. 4) Cash on hand, cash in banks, and petty cash are often combined and reported simply
as Cash. Because it is the most liquid asset, cash is listed first in the current assets section of the
balance sheet under the title “Cash and cash equivalents.” Cash equivalents are short-term
highly liquid investments that are both readily convertible to known amounts of cash, and so near
their maturity that their market value is relatively insensitive to changes in interest rates. They
include Treasury bills, Commercial paper, and money market funds.

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 LECTURE OUTLINE

A. Fraud.

1. A fraud is a dishonest act by an employee that results in personal benefit

to the employee at a cost to the employer.

2. The fraud triangle refers to the three factors that contribute to fraudulent
activity by employees:

a. Opportunity—occurs when the workplace lacks sufficient controls to

deter and detect fraud.

b. Financial pressure—employees sometimes commit fraud because

they want to lead a lifestyle that they cannot afford on their current
salary.

c. Rationalization—employees sometimes justify fraud because they

believe they are underpaid and the employer is making lots of
money.

B. Internal Control.

1. Internal control consists of all the related methods and measures adopted
within an organization to:

a. Safeguard assets, enhance the reliability of accounting records,

increase efficiency of operations, and ensure compliance with laws
and regulations.

2. Internal control systems have five primary components: a control environ-

ment, risk assessment, control activities, information and communication,
and monitoring.

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C. Principles of Internal Control Activities.

1. Establishment of responsibility: control is most effective when only one

person is responsible for a given task, (i.e., cash register).

2. Segregation of duties: the work of one employee should, without a dupli-

cation of effort, provide a reliable basis for evaluating the work of another
employee.

a. Related activities: making one individual responsible for related

activities increases the potential for errors and irregularities.

(1) Activities related to purchasing (ordering, receiving, and authorizing

payment).

(2) Activities related to sales (selling, shipping, and billing).

b. Record keeping separate from physical custody: The custodian of

the asset is not likely to convert the asset to personal use when one
employee maintains the record of the asset, and a different employee
has physical custody of the asset.

3. Documentation procedures: documents provide evidence that transactions

and events have occurred.

a. Prenumbering documents helps to prevent a transaction from being

recorded more than once, or conversely, from not being recorded at
all.

b. Companies should require that employees promptly forward source

documents for accounting entries to the accounting department.

4. Physical controls:

a. Physical controls relate to the safeguarding of assets (safes, vaults,

safety deposit boxes, and locked warehouses), and enhance the
accuracy and reliability of the accounting records (alarms, television
monitors, garment sensors, and time clocks).

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 5. Independent internal verification: the review of data prepared by
employees.

a. Maximum benefit from independent internal verification is obtained

when:

(1) Companies verify records periodically or on a surprise basis.

(2) An independent employee makes the verification.

(3) Discrepancies and exceptions are reported and corrected.

b. Internal auditors review the activities of departments and individuals

to determine whether prescribed internal controls are being followed
and recommend improvements when needed.

6. Human resource controls:

a. Bonding employees who handle cash involves obtaining insurance

protection against theft by employees.

b. Rotating employees’ duties and requiring employees to take vaca-

tions deters employees from attempting thefts since they will not be
able to permanently conceal their improper actions.

c. Conducting thorough background checks is considered by many to

be the most important and inexpensive measure any business can
take to reduce employee theft and fraud.

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ACCOUNTING ACROSS THE ORGANIZATION

To ensure proper employee supervision and proper separation of duties, companies

must develop and monitor an organizational chart. One corporation that did this
found that out of 17,000 employees, there were 400 people who did not report to
anyone, and 35 people who reported to each other.

Why would unsupervised employees or employees who report to each other

represent potential internal control threats?

Answer: An unsupervised employee may have a fraudulent job (or may even be
a fictitious person—e.g., a person drawing a paycheck without working).
Or, if two employees supervise each other, there is no real separation
of duties, and they can conspire to defraud the company.

D. Limitations of Internal Control.

1. The concept of reasonable assurance rests on the premise that the costs of
establishing control procedures should not exceed their expected benefit.

2. It should also be recognized that the human element (employee fatigue,

carelessness, or indifference) is an important factor as is collusion between
two or more individuals to get around prescribed controls.

E. Cash Receipts Controls.

1. In retail businesses, control of over-the-counter receipts centers on cash

registers that are visible to customers.

2. All mail receipts should be opened in the presence of at least two mail
clerks and one of the clerks should endorse each check “For Deposit Only.”

3. By employing two clerks, the chance of fraud is reduced since they would
have to collude to engage in fraud.

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F. Cash Disbursements Controls.

1. Generally, internal control over cash disbursements is more effective when

companies pay by check or electronic funds transfer (EFT), except for
incidental amounts that are paid out of petty cash.

2. A voucher system is a network of approvals by authorized individuals,

acting independently, to ensure that all disbursements by check are
proper.

3. The use of a voucher system, whether done manually or electronically,

improves internal control over cash disbursements and keeps track of the
documents that back up each transaction.

G. Petty Cash Fund.

1. Companies use a petty cash fund to pay relatively small amounts.

2. The operation of a petty cash fund, called an imprest system, involves:

a. Establishing the fund: debit Petty Cash and credit Cash.
b. Making payments from the fund: payments must be documented by a
prenumbered petty cash receipt.
c. Replenishing the fund: debit appropriate expense accounts and
credit Cash.

ETHICS INSIGHT

A recent study by the Association of Certified Fraud Examiners found that two-
thirds of all employee thefts involved a fraudulent disbursement by an employee.
The most common form was fraudulent billing schemes.

How can companies reduce the likelihood of fraudulent disbursements?

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Answer: Some common-sense approaches are to make sure only certain desig-
nated individuals can sign checks. In addition, make sure that different
personnel approve payments and make payments. The next chapter
will provide even more sophisticated approaches to reduce fraudulent
disbursements.

H. Control Features: Use of a Bank.

1. The use of a bank contributes significantly to good internal control by:

a. Providing physical controls for the storage of cash.

b. Minimizing the amount of currency that a company must keep on

hand.

c. Creating a double record of a depositor’s bank transactions.

2. An authorized employee (i.e., head cashier) should make a company’s bank

deposits, documented by a deposit slip (ticket).

3. A check is a written order signed by the depositor directing the bank to

pay a specified sum of money to a designated recipient.

4. A bank statement shows:

a. Checks paid and other debits (i.e. debit card transactions) that reduce
the balance in the depositor’s account.

b. Deposits and other credits that increase the balance in the depositor’s
account.

c. The account balance after each day’s transactions.

5. A debit memorandum may identify a bank’s monthly service charge (SC)

or a non-sufficient funds check (NSF).

6. A credit memorandum may identify notes receivable collected by the bank

for the depositor and interest paid on checking account.

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I. Reconciling the Bank Account.

1. Deposits recorded by the depositor that have not been recorded by the
bank are deposits in transit and are added to the balance per bank.

2. Issued checks recorded by the company but that have not yet been paid
by the bank are outstanding checks and are deducted from the balance
per bank.

3. List any errors by the depositor or bank in the appropriate section of the
reconciliation schedule.

4. List any unrecorded bank memoranda in the appropriate section of the

reconciliation schedule.

J. Reporting Cash.

1. On the balance sheet, companies often combine cash on hand, cash in

banks, and petty cash and report the total as Cash.

2. Cash equivalents are short-term, highly liquid investments that are both:

a. Readily convertible to known amounts of cash, and

b. So near their maturity that their market value is relatively insensitive

to changes in interest rate.

3. Restricted cash is cash that is not available for general use but is
restricted for a special purpose. It should be reported separately on the
balance sheet as either a current or noncurrent asset.

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A Look at IFRS

Fraud can occur anywhere. Because the three main factors that contribute to
fraud are universal in nature, the principles of internal control activities are used
globally by companies. While Sarbanes-Oxley (SOX) does not apply to interna-
tional companies, most large international companies have internal controls
similar to those indicated in the chapter. IFRS and GAAP are also very similar in
accounting for cash. IAS No. 1 (revised). “Presentation of Financial Statements,”
is the only standard that discusses issues specifically related to cash.

Relevant Facts

Following are the key similarities and differences between GAAP and IFRS
related to fraud, internal control, and cash.

 The fraud triangle discussed in this chapter is applicable to all international

companies. Some of the major frauds on an international basis are
Parmalat (Italy), Royal Ahold (the Netherlands), and Satyam Computer
Services (India).

 Rising economic crime poses a growing threat to companies, with nearly

one-third of all organizations worldwide being victims of fraud in a recent
12-month period.

 Accounting scandals both in the United States and internationally have re-
ignited the debate over the relative merits of GAAP, which takes a “rules-
based” approach to accounting, versus IFRS, which takes a “principles-
based” approach. The FASB announced that it intends to introduce more
principles-based standards.

 On a lighter note, at one time the Ig Nobel Prize in Economics went to the
CEOs of those companies involved in the corporate accounting scandals of
that year for “adapting the mathematical concept of imaginary numbers for
use in the business world.”

 The accounting and internal control procedures related to cash are

essentially the same under both IFRS and this textbook. In addition, the
definition used for cash equivalents is the same.

 Most companies report cash and cash equivalents together under IFRS, as
shown in this textbook. In addition, IFRS follows the same accounting
policies related to the reporting of restricted cash.
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  The SOX internal control standards apply only to companies listed on U.S.
exchanges. There is continuing debate over whether foreign issuers should
have to comply with this extra layer of regulation.

LOOKING TO THE FUTURE

Ethics has become a very important aspect of reporting. Different cultures have
different perspectives on bribery and other questionable activities, and
consequently penalties for engaging in such activities vary considerably across
countries.

High-quality international accounting requires both high-quality accounting

standards and high-quality auditing. Similar to the convergence of GAAP and
IFRS, there is movement to improve 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.

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 20 MINUTE QUIZ

Circle the correct answer.

True/False

1. An effective system of internal control will segregate functions between individuals to reduce
the potential for errors and fraud.
True False

2. When one individual is responsible for all of the related activities, the potential for errors and
fraud is increased.
True False

3. Independent internal verification should be made periodically and should be done by an

employee who is independent of the employee responsible for the information.
True False

4. The duties of receiving cash, recording cash receipts transactions, and having custody of
cash should be assigned to a single capable individual.
True False

5. At the end of an accounting period, a debit balance of $99.00 in the Cash Over and Short
account would be reported in the income statement as Miscellaneous Revenue.
True False

6. A check is a written order signed by the depositor directing the bank to pay a specified
sum of money to a designated recipient.
True False

7. Cash proceeds collected by the bank for a depositor would be identified in the bank
statement by a credit memorandum to explain the entry.
True False

8. The lack of agreement between the balance per books and the balance per bank is due
to time lags and errors by either party.
True False

9. An outstanding check that was also outstanding the previous month should not be included
in the reconciliation of the bank statement this month.
True False

10. A postage due expense of $4.75 would be paid out of petty cash and the entry to record
the transaction would reduce the balance of the Petty Cash account by that amount.
True False

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Multiple Choice

1. Which of the following is a primary concern of internal control?

a. Promote training programs and control incentives
b. Enhancing the reliability of accounting data
c. Ensuring fairness of the financial statements
d. Encouraging adherence to prescribed managerial performance

2. Each of the following is an attribute of internal control except

a. segregation of duties.
b. establishment of responsibility.
c. independent internal verification.
d. a sound marketing plan.

3. A company issues a check for $75 but records it incorrectly as $57. On the bank recon-
ciliation, the $18 should be
a. deducted from the balance per bank.
b. added to the balance per bank.
c. deducted from the balance per books.
d. deducted from the balance per books and added to the balance per bank.

4. Irwin, Inc. has the following assets at the balance sheet date:
Cash in bank—savings account $4,000
Amounts due from customers 7,000
Post-dated checks 2,000
Checking account balance 6,000

Which amount should be reported as cash in the balance sheet?

a. $10,000
b. $6,000
c. $11,000
d. $13,000

5. A $100 petty cash fund has cash of $17 and valid receipts for $81. The journal entry upon
replenishment would include a
a. credit to Cash for $81.
b. credit to Cash Over and Short for $2.
c. debit to Cash for $81.
d. debit to Cash Over and Short for $2.

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 ANSWERS TO QUIZ

True/False

1. True 6. True
2. True 7. True
3. True 8. True
4. False 9. False
5. False 10. False

Multiple Choice

1. b.
2. d.
3. c.
4. a.
5. d.

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