978-0078025914 Chapter 5 Lecture Note Part 1

CHAPTER 5

FRAUD, INTERNAL CONTROL, AND CASH

Student Learning Objectives and Related Assignment Materials

Student Learning

Objectives

Mini–

Exercises

Coached

Problems

(Groups

A & B)

Compre–

hensive

Problem

Skills

Develop–

ment

Cases

Continuing

Cases

LO 5-1 Define fraud

and internal

controls.

1

1, 2

4, 5, 6

2^£

LO 5-2 Explain

common principles

and limitations of

internal control.

2, 3*, 4

1, 2

1, 2, 3,

4, 6

LO 5-3 Apply internal

control principles

to cash receipts

and payments.

2, 3*, 4,

5, 6, 7,

10

3, 4

1

A1, B1

1†

LO 5-4 Perform the

key control of

reconciling cash to

bank statements.

8*, 9,

10, 11,

12, 13

5*, 6

2, 3

A2, A3,

B2, B3

1#

1†

LO 5-5 Explain the

reporting of cash.

14*

7, 8

2, 3, 4

A2, A3,

A4, B2,

B3, B4

1#

1, 2, 3, 5

1†

LO S-1 Describe the

operations of petty

cash systems.

15, 16*

9*, 10

4

A4, B4

* Animated solution included in the PowerPoint Slides.

^ Particularly challenging; requires students to combine multiple concepts in order to advance to the

next level of accounting knowledge.

# Comprehensive Problem 5-1 also covers LO 2-2, LO 2-4, LO 2-5, LO 3-3, LO 3-5, LO 4-2, LO 4-3,

and LO 4-4.

† Continuing Case 5-1 builds on the story of Nicole’s Getaway Spa, introduced in earlier chapters. This

case focuses on analyzing transactions from source documents, the preparation of a bank

reconciliation and resulting journal entries, and the determination of the amount of Cash and Cash

Equivalents reported on the company’s balance sheet. This case will be extended in future chapters.

£ Continuing Case 5-2 introduces the story of Wiki Art Gallery (WAG), an instructional case in

Connect. This case focuses on the fraud triangle and the risk of financial misreporting. The case will

be extended in future chapters.

Overview

Expanding from the key roles that accounting systems and financial statements play when establishing

and operating a small business (covered in Chapters 1 through 4), we explore another key part of an

accounting system: internal controls, which are the behind-the-scenes practices that help businesses

achieve their objectives.

Students learn how internal controls can improve operations when those controls are operating

effectively. They also learn what can happen when internal controls fail.

Synopsis of Chapter Revisions

• Substantially changed from 4e: removed discussion of press releases, illustration of European

financial statements, introduction of the basic business model, and repeated coverage of external

users, and inserted explanation and examples of internal control and cash reporting

• New focus company (Koss Corporation) to illustrate how internal control deficiencies allowed the

VP-Finance to steal $31.5 million to pay for extravagant credit card purchases

• New categorization of fraud types and new illustration of Fraud Triangle

• Expanded discussion of internal control to include new COSO cube

• New illustration of electronic documents used to process cash disbursements

• New discussion of petty cash transactions and p-cards in Spotlight on Controls

• New discussion and illustration of reporting restricted cash

• Reviewed, updated, and introduced new end-of-chapter material to support new topics and learning

objectives, including new problem that automatically posts to T-accounts and new continuing case

problem that includes cash disbursement documents

PowerPoint Slides

Student Learning Objective

PowerPoint® Slides

LO 5-1 Define fraud and internal controls.

5-2 through 5-8

LO 5-2 Explain common principles and limitations of internal control.

5-9 through 5-11

LO 5-3 Apply internal control principles to cash receipts and payments.

5-12 through 5-28

LO 5-4 Perform the key control of reconciling cash to bank statements.

5-29 through 5-35

LO 5-5 Explain the reporting of cash.

5-36 through 5-37

LO S-1 Describe the operations of petty cash systems.

5-38 through 5-42

Animated Builds and Animated Solutions

PowerPoint® Slides

Mini-Exercise 5-3

5-44

Mini-Exercise 5-8

5-45

Mini-Exercise 5-14

5-46

Mini-Exercise 5-16

5-47

Exercise 5-5

5-48 through 5-50

Exercise 5-9

5-51 through 5-52

Chapter Summary

LO 5-1 Define fraud and internal control.

• Fraud is an attempt to deceive others for personal gain. Employee fraud includes collusion, asset

misappropriation, and financial statement fraud.

• Internal control consists of the actions taken by people at every level of an organization to achieve

its objectives relating to operations, reporting, and compliance. The components of internal control

include the control environment, risk assessment, control activities, information and

communication, and monitoring activities.

LO 5-2 Explain common principles and limitations of internal control.

• Most employees working within a company will encounter five basic principles: (1) establish

responsibility for each task; (2) segregate duties so that one employee cannot initiate, record,

approve, and handle a single transaction; (3) restrict access to those employees who have been

assigned responsibility; (4) document procedures performed; and (5) independently verify work

done by others inside and outside the business.

• Internal controls may be limited by cost, human error, and fraud.

LO 5-3 Apply internal control principles to cash receipts and payments.

• When applied to cash receipts, internal control principles require that (1) cashiers be held

individually responsible for the cash they receive; (2) different individuals be assigned to receive,

maintain custody of, and record cash; (3) cash be stored in a locked safe until it has been securely

deposited in a bank; (4) cash register receipts, cash count sheets, daily cash summary reports, and

bank deposit slips be prepared to document the cash received and deposited; and (5) cash register

receipts be matched to cash counts and deposit slips to independently verify that all cash was

received and deposited.

• When applied to cash payments, internal control principles require that (1) only certain individuals

or departments initiate purchase requests; (2) different individuals be assigned to order, receive,

and pay for purchases; (3) access to checks and valuable property be restricted; (4) purchase

requisitions, purchase orders, receiving reports, and prenumbered checks be used to document the

work done; and (5) each step in the payment process occurs only after the preceding step has been

independently verified using the documents listed in (4).

LO 5-4 Perform the key control of reconciling cash to bank statements.

• The bank reconciliation requires determining two categories of items: (1) those that have been

recorded in the company’s books but not in the bank’s statement of account and (2) those that

have been reported in the bank’s statement of account but not in the company’s books. The second

category of items provides the data needed to adjust the Cash account to the balance that will be

reported on the balance sheet.

LO 5-5 Explain the reporting of cash.

• Cash is combined with cash equivalents in current assets. Cash equivalents are highly liquid

investments purchased within three months of maturity.

• Restricted cash is reported separately, as a current asset if expected to be used up within one year

or, if not, as a noncurrent asset.

Chapter Outline

Teaching Notes

I. Fraud and Internal Control

A. Fraud

Illustrated in Exhibit 5.1

LO 5-1 Define fraud and internal controls.

1. Fraud––A fraud is an attempt to deceive others for

personal gain.

2. Employee fraud is often grouped into three categories:

Exhibit 5.1 illustrates

a. Corruption—Involves misusing one’s position for

inappropriate personal gain.

the frequency and median

loss of each type of fraud

b. Asset misappropriation—Quite simply, theft

(embezzlement); cash is usually the target, but other

assets can be misappropriated.

c. Financial statement fraud—Involves misreporting

amounts in the financial statements, usually to portray

more favorable financial results than what actually

exist.

3. Three factors exist when fraud occurs; these factors work

together as suggested by the fraud triangle:

Illustrated in margin

a. Incentive—The employee has a reason for committing

fraud.

i. Sometimes the reason is personal financial

pressure.

ii. Sometimes the incentive is to make the business

appear successful so as to attract investors, bring in

new business partners, or meet loan requirements.

• Loan covenants––Terms of a loan agreement

which, if broken, entitle the lender to

renegotiate loan terms or force repayment.

• If loan covenants are not met, the lender can

require the company to pay a higher interest

rate, repay its loan balance on demand, or put

up extra collateral to secure the loan.

The “Spotlight on Ethics”

feature addresses frauds

b. Opportunity—The employee has a means for

committing fraud.

that involve blatantly

unethical acts

c. Rationalization—The employee perceives the misdeed

as unavoidable or justified.

B. The Sarbanes-Oxley Act (SOX)

1. Sarbanes-Oxley (SOX) Act––A set of regulations passed

by Congress in 2002 in an attempt to improve financial

reporting and restore investor confidence.

Exhibit 5.2 sets forth the key

requirements of the Sarbanes-

Oxley Act (SOX)

a. Counteract incentives—Those who willfully

misrepresent financial results face:

i. Fines of up to $5 million plus repayment of any

fraud proceeds.

ii. Jail sentences of up to 20 years, which could add

up with consecutive terms for each violation.

Chapter Outline

Teaching Notes

b. Reduce opportunities—The part of the fraud triangle

most affected by SOX; it requires all public companies

to:

i. Establish an audit committee made up of

independent directors to ensure the company’s

accounting, internal controls, and audit functions

are effective.

ii. Evaluate and report on the effectiveness of internal

control over financial reporting; completed by

management and, for large public companies, by

external auditors as well.

iii. Encourage honesty in employees – Some

provisions of SOX should help employees of good

character confront those of poor character.

• Public companies must have tip lines.

• Whistle blowers have legal protection.

• Code of ethics required for senior financial

officers.

C. Internal Control

1. Internal control––Actions taken to promote efficient and

effective operations, protect assets, enhance accounting

information, and adhere to laws and regulations.

2. Objectives—Internal control consists of actions taken

throughout the organization to achieve its objectives

relating to:

a. Operations—Operational objectives focus on

completing work efficiently, and effectively, and

protecting assets by reducing the risk of fraud.

b. Reporting—Reporting objectives include producing

reliable and timely accounting information for use by

people internal and external to the organization.

c. Compliance—Compliance objectives focus on

adhering to laws and regulations.

3. Components—An internal control system should include:

a. Control environment—The control environment refers

to the attitude that people in the organization hold

regarding internal control.

Exhibit 5.3 illustrates the

relationship of control

objectives and components to

b. Risk assessment—Managers continuously assess the

potential for fraud and other risks that could prevent

the company from achieving its objectives.

organizational levels

c. Control activities—Control activities include various

work responsibilities and duties completed by

employees to reduce risks to an acceptable level.

d. Information and communication—An effective

internal control system generates and communicates

information about activities affecting the organization

to support sound decision making.

Chapter Outline

Teaching Notes

e. Monitoring activities—The internal control system is

evaluated often to determine whether it is working as

intended

LO5-2 Explain common principles and limitations of internal control.

4. Principles of Control Activities

Summarized in Exhibit 5.4

a. Establish responsibility—Assign each task to only one

employee; doing so allows you to determine who

caused any errors or thefts that occur.

b. Segregation of duties––An internal control designed

into the accounting system to prevent an employee

from making a mistake or committing a dishonest act

as part of one assigned duty, and then also covering it

up through another assigned duty.

i. Most effective when responsibilities for related

activities are assigned to two or more people and

when responsibilities for record keeping are

assigned to people who do not also handle the

assets that they are accounting for.

ii. One employee should not initiate, approve, record,

and have access to items involved in a transaction.

c. Restrict access—Access to assets and records should

be provided on an as-needed basis. If it’s not needed

to fulfill an employee’s assigned responsibilities, the

employee should be denied access to it.

d. Document procedures—Without documents, a

company wouldn’t know what transactions have

already been or still need to be entered into its

accounting system. To enhance this control further,

most companies:

i. Assign a sequential number to each document

ii. Check at the end of every accounting period that

each document number corresponds to one, and

only one, entry in the accounting system

e. Independently verify—Independent verification can

occur in various ways:

i. The most obvious is to hire someone (an internal

auditor) to check that the work done by others

within the company is appropriate and supported

by documentation. Independent verification also

can be made part of a person’s job.

ii. A final form of independent verification involves

comparing the company’s accounting information

to information kept by an independent third party.

Chapter Outline

Teaching Notes

5. Control Limitations—It is impossible for internal controls

to prevent and detect all errors and fraud for two reasons:

a. Internal controls should be implemented only to extent

that their benefits exceed their costs.

The “Spotlight on Controls”

feature addresses other

b. People can make mistakes when performing control

procedures, override (disarm) internal controls, or

collude (work together) to get around them.

control procedures.

II. Internal Control for Cash

LO 5-3 Apply internal control principles to cash receipts and payments.

A. Controls for Cash Receipts

Primary internal control goal is to ensure that the business

receives the appropriate amount of cash and safely deposits it

in the bank.

Internal controls for

processing cash received in

person are illustrated in

exhibit 5.5

1. Cash Received in Person

a. Segregation of duties—Ensures that those who handle

the cash (cashiers and supervisors) do not have access

to those who record it (the accounting staff); if this

segregation of duties did not exist, employees could

steal the cash and cover up the theft by changing the

accounting records.

i. A cashier is responsible for collecting cash and

issuing a receipt at the point of sale

ii. A supervisor is responsible for taking custody of

the cash at the end of each cashier’s shift and

depositing it in the bank.

iii. Members of the accounting staff are responsible for

ensuring that the receipts from cash sales are

properly recorded in the accounting system.

b. Use of a cash register and its accompanying point-of–

sale accounting system performs three functions:

i. Restrict access to cash (to reduce the risk of cash

being lost or stolen).

ii. Document the amount charged for each item sold

(to reduce errors by allowing customers to dispute

overcharges should they occur).

iii. Summarize the total cash sales (to provide an

independent record of the amount of cash the

cashier should have collected and passed on for

deposit at the bank).

c. Use of a cash count sheet documents the amount of

cash the cashier received and determines any cash

short or over that occurred during the shift.

i. Supervisor independently verifies each count sheet

and prepares a daily cash receipts summary that

summarizes all cashiers’ count sheets.

ii. Places the cash in a locked vault until it is taken to

the bank.

Chapter Outline

Teaching Notes

d. Use of a deposit slip that lists the amounts included in

the deposit is prepared and presented to the bank –

The bank teller verifies the deposit and stamps the

deposit slip, which is then forwarded to the accounting

department.

i. Independent verification:

• The accounting department compares the

record of cash sales maintained by the cash

register with the count sheet prepared by the

cashier, the daily cash receipts summary

prepared by the supervisor, and the stamped

bank deposit slip.

• Ensures that the amount of cash rung up at the

time of sale was deposited.

ii. A journal entry is prepared to record Sales

Revenue at the amount rung up by the cash register

and Cash at the amount deposited in the bank.

• Any difference is recorded in a Cash Shortage

(or Overage) account.

• The Cash Shortage (or Overage) account is

reported on the income statement as a

miscellaneous expense (or revenue).

2. Cash Received from a Remote Source

a. Cash Received by Mail

To help students visualize,

i. Businesses receive checks in the mail when

customers pay on account. The clerk who opens the

mail performs the functions of the cash register.

Have them go back to Exhibit

5.5 and replace the cash

register with a mail clerk and

ii. The mail clerk lists all amounts received on the

cash receipt list with customers’ names and

purpose of each payment.

remove Step 1

iii. Remittance advice—The customer includes with

the payment; it explains the purpose of the

payment.

iv. Ideally, someone supervises the mail clerk to

ensure that he or she takes no cash receipts for

personal use; the mail clerk and supervisor sign the

completed cash receipts list to evidence.

v. The mail clerk stamps each check “For Deposit

Only” (to ensure that no one diverts the checks for

personal use).

Chapter Outline

Teaching Notes

vi. The cash received is separated from the record of

cash received.

• Checks and money orders are given to the

person who prepares the bank deposit whereas

the cash receipts list and remittance advices are

sent to the accounting department.

• The accounting department then compares the

total on the cash receipts list with the stamped

deposit slip received from the bank; this

comparison serves to independently verify that

all cash received by mail was deposited in the

bank

• The accounting department then uses the cash

receipts list to record the journal entries that

debit Cash and credit Accounts Receivable

from each customer

b. Cash Received Electronically.

i. Electronic funds transfer (EFT) – Occurs when a

customer electronically transfers funds from its

bank account to the company’s bank account; EFTs

speed up collections.

ii. Because these payments are deposited directly into

the company’s bank account, EFTs eliminate the

need for some internal controls.

iii. The accounting department merely records journal

entries to debit Cash and credit each customer’s

account receivable.

B. Controls for Cash Payments

Primary internal control is to ensure that the business pays

only for properly authorized transactions.

1. Cash Paid by Check for Purchases on Account

a. Businesses usually purchase goods and services on

account and pay later by check.

b. Voucher system––A process for approving and

documenting all purchases and payments made on

account; a voucher is a collection of the documents

prepared at each step in the system.

Steps, documentation, and

controls in a voucher system

are set forth in exhibit 5.6

i. At each step, employee responsibilities are limited

to specific tasks that occur only after obtaining and

documenting proper authorization in the prior step.

ii. Purchasing, receiving, and bill payment duties are

segregated to ensure that the company obtains and

pays only for the goods or services that have been

properly authorized.

Chapter Outline

Teaching Notes

c. Steps:

i. Purchase requisition prepared and approved by

supervisor; copy to purchasing agent.

ii. Purchasing agent completes purchase order; copies

to supplier (who is on preapproved list) and

accounting department.

iii. Receiving report prepared when goods are

received; copy to accounting department for use in

preparing journal entry for purchase on account.

iv. When invoice is received from supplier,

accounting department matches to purchase order

and receiving report and prepares voucher

package, which contains these supporting

documents.

v. Check of EFT is prepared to pay for items

purchased and received; voucher is then marked

“paid” so that it cannot be resubmitted for

duplicate payment.

2. Cash Paid to Employees via Electronic Funds Transfer

a. Most companies pay cash to their employees through

EFTs, which are known by employees as direct

deposits.

i. Company initiates EFT by instructing bank to

transfer the net pay due each employee directly

from the company’s bank account to each

employee’s checking account.

ii. Convenient and efficient for both the employer and

employee.

iii. Risk is that the bank might accidentally overpay or

underpay an employee by transferring the wrong

amount of money; imprest system reduces risk.

b. Imprest system––A process that controls the amount

paid to others by limiting the total amount of money

available for making payments to others.

i. If the transfers occur without error, the special

payroll account equals zero after all employees

have been paid.

ii. If the account is overdrawn or a balance remains,

the company knows an error has occurred.