Slide 7 1 Chapter 7 Fraud Internal Control

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Chapter 7 Fraud, Internal Control, and Cash Financial Accounting, IFRS Edition Weygandt Kimmel Kieso Slide 7 -2

Study Objectives Slide 7 -3 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.

Fraud, Internal Control, and Cash Fraud and Internal Control Fraud Internal control Principles of internal control activities Limitations Slide 7 -4 Cash Receipts Controls Over-thecounter receipts Mail receipts Cash Disbursement Controls Voucher system controls Petty cash fund controls Control Features: Use of a Bank Making deposits Writing checks Bank statements Reconciling the bank account Electronic funds transfer (EFT) system Reporting Cash equivalents Restricted cash Compensating balances

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? Slide 7 -5 SO 1 Define fraud and internal control.

Answer on notes page Slide 7 -6

Fraud and 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 and 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 and Internal Control Principles of Internal Control Activities The spesific control activities, measures vary depend on management’s assessment of the risks faced. Influence by size and nature of the company. Six principles of controls activities: Ø Ø Ø Slide 7 -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 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. Slide 7 -10 SO 2 Identify the principles of internal control activities.

Fraud and Internal Control Slide 7 -11 SO 2

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

Fraud and Internal Control Slide 7 -13 SO 2

Fraud and Internal Control Principles of Internal Control Activities PHYSICAL CONTROLS Slide 7 -14 Illustration 7 -2 SO 2 Identify the principles of internal control activities.

Fraud and Internal Control Principles of Internal Control Activities INDEPENDENT INTERNAL VERIFICATION Illustration 7 -3 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 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. Slide 7 -16 SO 2 Identify the principles of internal control activities.

Fraud and Internal Control Slide 7 -17 SO 2

Fraud and Internal Control Slide 7 -18 SO 2

Fraud and Internal Control Slide 7 -19 SO 2

Slide 7 -20 Answer on notes page

Fraud and Internal 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 Receipts Controls Over-the-Counter Receipts Slide 7 -22 Illustration 7 -4 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 Controls Store cash in safes and bank vaults; limit access to storage areas; use cash registers Human Resource Controls 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 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 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 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. Slide 7 -25 SO 3 Explain the applications of internal control principles to cash receipts.

Cash Receipts 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 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 7 -27 SO 4 Explain the applications of internal control principles to cash disbursements.

Cash Disbursement Controls Illustration 7 -6 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 Slide 7 -28 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 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 Disbursement 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 7 -29 SO 4 Explain the applications of internal control principles to cash disbursements.

Cash Disbursement 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 7 -30 SO 4 Explain the applications of internal control principles to cash disbursements.

Cash Disbursement 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 Disbursement Controls Illustration: If Laird Company decides to establish a $100 fund on March 1, the journal entry is: Mar. 1 Petty cash Cash Slide 7 -32 100 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: (Pengisian kembali kas) Mar. 15 Postage expense 44 Freight-out 38 Miscellaneous expense Cash Slide 7 -33 5 87 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 Slide 7 -34 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. Slide 7 -35 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 Slide 7 -36 Illustration 7 -8 Bank Code Numbers Reverse Side 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 Slide 7 -37 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. Slide 7 -38 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. Slide 7 -39 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. Slide 7 -40 SO 7 Prepare a bank reconciliation.

Control Features: Use of a Bank Reconciliation Procedures Illustration 7 -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 Slide 7 -41 CORRECT BALANCE SO 7 Prepare a bank reconciliation.

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. Slide 7 -42

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 Slide 7 -43 Illustration 7 -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 Miscellaneous expense Slide 7 -44 1, 035. 00 15. 00 Notes receivable 1, 000. 00 Interest revenue 50. 00 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 Accounts payable Slide 7 -45 36. 00 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 Cash Slide 7 -46 30. 00 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. Slide 7 -47 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. Slide 7 -48 SO 7 Prepare a bank reconciliation.

Reporting 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 Restricted cash Compensating balances Slide 7 -49 SO 8 Explain the reporting of cash. While cash equivalents are now frequently reported with cash, it appears likely that the IASB will end this practice in the future. Instead, items now referred to as cash equivalents will be reported as short-term investments.

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. Slide 7 -50 SO 8 Explain the reporting of cash.

Understanding U. S. GAAP Key Differences Fraud, Internal Control, 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. Slide 7 -51 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.

Understanding U. S. GAAP Key Differences Fraud, Internal Control, 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 (Pricewaterhouse. Coopers’ Global Economic Crime Survey, 2005). Slide 7 -52

Understanding U. S. GAAP Key Differences Fraud, Internal Control, 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 U. S. GAAP Looking to the Future Fraud, Internal Control, 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 highquality 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

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