7–1
CHAPTER 7
INTERNAL CONTROL AND CASH
DISCUSSION QUESTIONS
1. a. The five elements of internal control are the control environment, risk assessment, control procedures,
monitoring, and information and communication. The control environment is the overall attitude of
management and employees about the importance of controls. Risk assessment includes evaluating
2. To reduce the possibility of errors and embezzlement, the functions of operations and accounting should be
3. The control procedure requiring that responsibility for a sequence of related operations be divided among
4. The responsibility for maintaining the accounting records should be separated from the responsibility for
operations so that the accounting records can serve as an independent check on operations.
5. Controls that could have prevented or detected the fraud include: (1) requiring supporting documentation
6. The three documents supporting the liability are the vendor’s invoice, the purchase order, and the receiving
8. The purpose of a bank reconciliation is to determine the reasons for the difference between the balance
CHAPTER 7 Internal Control and Cash
7–2
DISCUSSION QUESTIONS (Concluded)
9. a. Yes. Even though the petty cash fund is only $750, if the fund is replenished frequently, a
10. a. Cash and cash equivalents are usually reported as one amount in the “Current assets” section of the
CHAPTER 7 Internal Control and Cash
7–3
BASIC EXERCISES
BE 7–1
BE 7–2
Item No.
Appears on the Bank
Statement as a Debit
or Credit Memo
Increases or Decreases
the Balance of the
Company’s Bank Account
1
credit memo
increases
2
credit memo
increases
3
credit memo
increases
4
debit memo
decreases
BE 7–3
a. $24,295 as shown below.
b.
Miscellaneous Expense
45
Cash
Cash
5,200
Notes Receivable
Interest Revenue
BE 7–4
a.
Petty Cash
500
Cash
b.
Store Supplies
360
Miscellaneous Selling Expense
40
Cash Short and Over
15
Cash
CHAPTER 7 Internal Control and Cash
7–4
BE 7–5
$33,710
$9,460 $24,250
Days 365 Expense) onDepreciati Expenses (Operating
sInvestment Term–Short Cash
Hand on Cash Days’
+
−
+
=
CHAPTER 7 Internal Control and Cash
7–5
EXERCISES
Ex. 7–1
Section 404 requires management’s internal control report to:
(2) contain an assessment, as of the end of the issuer’s fiscal year, of the effectiveness
of the internal control structure and procedures of the issuer for financial reporting.
The complete AICPA summary of Section 404 of Sarbanes-Oxley is as follows:
Section 404: Management Assessment of Internal Controls.
Requires each annual report of an issuer to contain an “internal control report,” which
shall:
Each issuer’s auditor shall attest to, and report on, the assessment made by the
management of the issuer. An attestation made under this section shall be in accordance
CHAPTER 7 Internal Control and Cash
7–6
Ex. 7–2
a. Disagree. Stealing is a serious issue. An employee who can justify taking a box of tea
bags can probably justify “borrowing” cash from the cash register.
b. Agree. Faith has made one employee responsible for the cash drawer in accordance with
Ex. 7–3
a. The sales clerks could steal money by writing phony refunds and pocketing the cash
supposedly refunded to these fictitious customers.
b. Ramona’s Clothing suffers from inadequate separation of responsibilities for related
CHAPTER 7 Internal Control and Cash
7–7
Ex. 7–3 (Concluded)
A disadvantage of issuing a store credit for returns without a receipt is that preholiday
sales might drop as gift-givers realize that the return policy has tightened. After the
d. The potential for abuse in the cash refund system could be eliminated if clerks were
required to get a supervisor’s authorization for a refund before giving the customer the
department.
Ex. 7–4
As an internal auditor, you would probably disagree with the change in policy. Pacific Bank
has some normal business risk associated with default on bank loans. One way to help
minimize this is to carefully evaluate loan applications. Large loans present greater risk in the
CHAPTER 7 Internal Control and Cash
7–8
Ex. 7–5
The Societe Generale trading losses show how small lapses in internal control can have large
consequences. When the losses became so large that they could no longer be hidden, it was
hidden losses once the trader was unable to attend to the trading positions.
Ex. 7–6
This is an example of a fraud with significant collusion. Frauds that are perpetrated with
multiple parties in different positions of control make detecting fraud more difficult. In this
case, the fraud began with an employee responsible for authorizing claim payments. This is a
CHAPTER 7 Internal Control and Cash
7–9
Ex. 7–7
All-Around Sound Co. should not have relied on the unusual nature of the vendors and
delivery frequency to uncover this fraud. The purchase and payment cycle is one of the most
critical business cycles to control because the potential for abuse is so great. Purchases
should be initiated by a requisition document. This document should be countersigned by a
Note to Instructors: This exercise is based on an actual fraud.
Ex. 7–8
a. The most difficult frauds to detect are those that involve the senior managers of a
company who are in a conspiracy to commit the fraud. The senior managers have the
CHAPTER 7 Internal Control and Cash
7–10
Ex. 7–9
a. The sales clerks should not have access to the cash register tapes.
b. The cash register tapes should be locked in the cash register and the key retained by
the cashier. An employee of the cashier’s office should remove the cash register
tape, record the total on the memo form, and note discrepancies.
Ex. 7–10
Big & Bad Burgers suffers from a failure to separate responsibilities for related operations.
Big & Bad Burgers could stop this theft by limiting the drive-through clerk to taking customer
orders, entering them on the cash register, accepting the customers’ payments, returning
customers’ change, and handing customers their orders that another employee has
Ex. 7–11
CHAPTER 7 Internal Control and Cash
7–11
Ex. 7–12
Cash
83,452
Cash Short and Over
28
Sales
Ex. 7–13
Cash
315,280
Sales
Cash Short and Over
Ex. 7–14
The use of the voucher system is appropriate, the essentials of which are outlined
below. (Although invoices could be used instead of vouchers, the latter more
satisfactorily provide for account distribution, signatures, and other significant data.)
1. Each voucher should be approved for payment by a designated official only after
completion of the following verifications: (a) that prices, quantities, terms, etc., on
2. The file for unpaid vouchers should be composed of 31 compartments, one for each
3. Each day, the vouchers should be removed from the appropriate section of the file
4. At the time of payment, all vouchers and supporting documents should be stamped
or perforated “Paid” to prevent their resubmission for payment. They should then
be filed in numerical sequence for future reference. The implementation and use of
CHAPTER 7 Internal Control and Cash
7–12
Ex. 7–15
To prevent the fraud scheme described, Paragon Tech must separate responsibilities for
related operations. As in the past, all service requisitions should be submitted to the
Ex. 7–16
Ex. 7–17
CHAPTER 7 Internal Control and Cash
7–13
Ex. 7–18
a.
Creative Design Co.
Bank Reconciliation
August 31, 20Y6
Cash balance according to bank statement
$ 56,300
Add: Deposit in transit on August 31
13,325
Deduct: Outstanding checks
(25,390)
Adjusted balance
$ 44,235
Cash balance according to company’s records
$ 42,920
Add: Error in recording check as $1,500 instead of $150
1,350
Deduct: Bank service charge
(35)
Adjusted balance
$ 44,235
balance.
Ex. 7–19
20Y6
Aug.
31
Cash
1,350
Accounts Payable
1,350
31
Miscellaneous Expense
35
Cash
35
Ex. 7–20
Cash
21,200
Notes Receivable
20,000
Interest Revenue
1,200
CHAPTER 7 Internal Control and Cash
7–14
Ex. 7–21
a.
Chesner Co.
Bank Reconciliation
July 31, 20Y4
Cash balance according to bank statement
$ 27,645
Add: Deposit in transit on July 31
11,300
Deduct: Outstanding checks
(4,780)
Adjusted balance
$ 34,165
Cash balance according to company’s records
$ 18,520
Add: Error in recording Check No. 1056 as $875
instead of $785
$ 90
Note for $15,000 collected by bank, including interest
15,600
Total additions
15,690
Deduct: Bank service charges
(45)
Adjusted balance
$34,165
Ex. 7–22
a. 1. The heading should be “June 30, 20Y7,” and not “For the Month Ended June 30, 20Y7.”
CHAPTER 7 Internal Control and Cash
7–15
Ex. 7–22 (Concluded)
b. A correct bank reconciliation would be as follows:
Poway Co.
Bank Reconciliation
June 30, 20Y7
Cash balance according to bank statement
$ 16,185
Add: Deposit in transit on June 30
6,600
Deduct: Outstanding Check No. 1067
$ 575
Outstanding Check No. 1106
470
Outstanding Check No. 1110
1,050
Outstanding Check No. 1113
910
Total deductions
(3,005)
Adjusted balance
$ 19,780
Cash balance according to company’s records
$ 8,985
Add: Note collected by bank, including $300 interest
$6,300
Error in recording June 17 deposit as $1,750
instead of $7,150
5,400
Total additions
11,700
Deduct: Check returned because of insufficient funds
$ 890
Bank service charges
15
Total deductions
(905)
Adjusted balance
$ 19,780
CHAPTER 7 Internal Control and Cash
7–16
Ex. 7–23
a. The amount of cash receipts stolen by the sales clerk can be determined by attempting to
reconcile the bank account. The bank reconciliation will not reconcile by the amount of
cash receipts stolen. The amount stolen by the sales clerk is $4,135, determined as shown
below.
Alaska Impressions Co.
Bank Reconciliation
October 31, 20Y3
Cash balance according to bank statement
$13,275
Deduct: Outstanding checks
(3,670)
Adjusted balance
$ 9,605
Cash balance according to company’s records
$11,680
Add: Note collected by bank, including interest
2,100
Deduct: Bank service charges
(40)
Adjusted balance
$13,740
b. The theft of the cash receipts might have been prevented by having more than one
person make the daily deposits. Collusion between two individuals would then
CHAPTER 7 Internal Control and Cash
Ex. 7–24
a.
Petty Cash
500
Cash
500
b.
Office Supplies
212
Miscellaneous Selling Expense
156
Miscellaneous Administrative Expense
61
Cash Short and Over
31
Cash
460