139
CHAPTER 5
SARBANES-OXLEY, INTERNAL
CONTROL, AND CASH
CLASS DISCUSSION QUESTIONS
1. a. Congress passed the Sarbanes-Oxley
Act because of the Enron, WorldCom,
Tyco, Adelphia, and other financial scan–
dals that caused stockholders, creditors,
and other investors to lose millions and in
2. Internal control is broadly defined as the
procedures and processes used by a com-
pany to safeguard its assets, process infor-
mation accurately, and ensure compliance
with laws and regulations.
3. a. The five elements of internal control are
the control environment, risk assess-
ment, 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 various
b. No. One element of internal control is
not more important than another ele-
ment. All five elements are necessary
for effective internal control. The ac-
counting system is an information sys-
holders. It includes the entire network of
communications used by the business.
4. The knowledge that job rotation is practiced
and that one employee may perform
another’s job at a later date tends to dis-
cally checked by another employee in the
normal course of work. A system functioning
in this manner helps prevent errors and inef-
ficiency. Fraud is unlikely without collusion
between two or more employees.
6. To reduce the possibility of errors and em-
bezzlement, the functions of operations and
accounting should be separated. Thus, one
employee should not be responsible for
handling cash receipts (operations) and
maintaining the accounts receivable records
(accounting).
7. No. Combining the responsibility for related
sibility for a sequence of related operations
be divided among different persons is violat-
ed in this situation. This weakness in the in-
ternal control may permit irregularities. For
example, the ticket seller, while acting as
ticket taker, could admit friends without a
140
the responsibility for operations so that the
accounting records can serve as an inde-
pendent check on operations.
10. Controls that could have prevented or de-
tected the fraud include (1) requiring sup-
11. The three documents supporting the liability
are vendor’s invoice, purchase order, and
receiving report. The invoice should be
compared with the receiving report to de-
termine that the items billed have been re-
ceived and with the purchase order to verify
quantities, prices, and terms.
12. The prenumbering of checks and the paying
of obligations by check are desirable ele-
ments of internal control. The fundamental
weakness in internal control is the failure to
between the balance according to the
company’s records and the balance accord-
ing to the bank statement and to correct
those items representing errors in recording
that may have been made by the bank or by
account on the bank’s records.
16. a. Yes. Even though the petty cash fund is
only $2,500, if the fund is replenished
frequently, a significant amount of cash
could be stolen. For example, if the fund
is replenished weekly, then $130,000
($2,500 × 52 weeks) could be subject to
theft.
b. Controls for petty cash include (1) des–
ignating one person who is responsible
for the fund, (2) maintaining a written
141
EXERCISES
E5–1
Section 404 requires management’s internal control report to:
(1) state the responsibility of management for establishing and maintaining
an adequate internal control structure and procedures for financial report-
ing; and
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 re-
port,” which shall:
(1) state the responsibility of management for establishing and maintaining
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 with standards for attestation engagements issued or
adopted by the Board. An attestation engagement shall not be the subject of a
separate engagement.
142
E5–2
a. Disagree. It is commendable that Abby has given the employee a specific re-
sponsibility and is holding that employee accountable for it. However, after
the cashier has counted the cash, another employee (or perhaps Abby)
should remove the cash register tape and compare the amount on the tape
with the cash in the drawer. Also, Abby’s standard of no mistakes may en-
E5–3
a. The sales clerks could steal money by writing phony refunds and pocketing
the cash supposedly refunded to these fictitious customers.
b. Lili’s Creations suffers from inadequate separation of responsibilities for
related operations since the clerks issue refunds and restock all merchan-
dise. In addition, there is a lack of proofs and security measures since the
supervisors authorize returns two hours after they are issued.
c. A store credit for any merchandise returned without a receipt would reduce
the possibility of theft of cash. In this case, a clerk could only issue a phony
store credit rather than taking money from the cash register. A store credit is
not as tempting as cash. In addition, sales clerks could only use a few store
E5–3, 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
been tightened. After the holidays, customers wishing to return items for
cash refunds may be frustrated when they learn the store policy has changed.
purchases.
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 cash. The supervisor should only authorize the
refund after seeing both the customer and the merchandise that is being
returned.
E5–4
As an internal auditor, you would probably disagree with the change in policy.
Republic City Bank has some normal business risk associated with default on
bank loans. One way to help minimize this is to carefully evaluate loan applica-
144
E5–5
The Société Générale 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 too late. The loss could have been avoided with a
number of internal controls. First, the separation of duties control was overcome
by the trader’s intimate knowledge of the monitoring software. This knowledge of
the monitoring system allowed the trader to effectively hide trades. The design of
E5–6
This is an example of a fraud with significant collusion. Frauds that are perpetrat-
ed 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 sensitive position because his decisions
would initiate payments. However, claims would need to be authorized and veri-
fied before payment would be made. Knowing this, the employee made sure each
145
E5–7
Timeless 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 superior so that two people agree as to
what is being purchased. The requisition should initiate a purchase order to a
Note to Instructors: This exercise is based on an actual fraud.
E5–8
a. The most difficult frauds to detect are those that involve a company’s senior
management in a conspiracy to commit the fraud. The senior managers have
the power to access many parts of the accounting system, while the normal
separation of duties is subverted by involving many people in the fraud. In
addition, the authorization control is subverted because most of the authori-
zation power resides in the senior management.
E5–9
a. The sales clerks should not have access to the cash register tapes.
E5–10
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’
E5–11
a. The remittance advices should not be sent to the cashier.
b. The remittance advices should be sent directly to the Accounting Department
by the mailroom.
E5–12
a. $41,568
E5–13
a. $19,040
E5–14
The use of the voucher system is appropriate, the essentials of which are out-
lined below. (Although invoices could be used instead of vouchers, the latter
more satisfactorily provide for account distribution, signatures, and other signifi-
cant data.)
1. Each voucher should be approved for payment by a designated official only
after completion of the following verifications: (a) that prices, quantities,
2. The file for unpaid vouchers should be composed of 31 compartments, one
for each day of the month. Each voucher should be filed in the compartment
representing the last day of the discount period or the due date if the invoice
is not subject to a cash discount.
3. Each day, the vouchers should be removed from the appropriate section of
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
E5–15
To prevent the fraud scheme described, Torpedo must separate responsibilities
for related operations. As in the past, all service requisitions should be submitted
to the Purchasing Department. After receiving the service request, Purchasing
E5–16
a. Additions to the balance per bank: (3), (5)
E5–17
(1), (2), (4), (7)
The preceding additions to and deductions from the cash balance according to
149
E5–18
ROSS CO.
Bank Reconciliation
March 31, 20Y9
E5–19
Balance Sheet
Statement of
Assets
=
+
Stockholders’ Equity
Income
Cash Flows
Statement
Cash
=
July 31.
180
Statement of Cash Flows
July 31.
Operating
180
Balance Sheet
Statement of
Assets
=
+
Stockholders’ Equity
Income
Cash Flows
Retained
Statement
Cash
=
July 31.
Statement of Cash Flows
Income Statement
July 31.
Operating
July 31.
–125
150
E5–20
Balance Sheet
Statement of
Assets
=
Liabilities
+
Stockholders’ Equity
Income
Statement
=
E5–21
a.
WESTWIND CO.
Bank Reconciliation
August 31, 20Y6
Cash balance according to bank statement ……………….. $17,325
Add: Deposit in transit on August 31 …………………………. 2,175
$19,500
Deduct: Outstanding checks ……………………………………… 4,190
Adjusted balance………………………………………………………. $15,310
151
E5–22
1. The heading should be for June 30, 20Y3, and not For the Month Ended June
30, 20Y3.
2. The outstanding checks should be deducted from the balance per bank.
A correct bank reconciliation would be as follows:
DAKOTA CO.
Bank Reconciliation
June 30, 20Y3
Cash balance according to bank statement: $22,900
Add deposit of June 30, not recorded by bank 6,200
$29,100
Deduct outstanding checks:
No. 7715 …………………………………………… $1,450
7760 …………………………………………… 915
152
E5–23
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 $7,125, determined as shown below.
PALA CO.
Bank Reconciliation
April 30, 20Y1
Cash balance according to bank statement ………………………………….. $28,175
Deduct: Outstanding checks ………………………………………………………… 12,100
Adjusted balance…………………………………………………………………………. $16,075
b. The theft of the cash receipts might have been prevented by having more
than one person make the daily deposit. Collusion between two individuals
would then have been necessary to steal cash receipts. In addition, two
employees making the daily cash deposits would tend to discourage theft of
the cash receipts from the employees on the way to the bank.
153
E5–24
a.
Balance Sheet
Statement of
Assets
=
Liabilities
+
Stockholders’ Equity
Income
Cash Flows
Petty
Statement
Cash
+
Cash
–750
750
b.
Balance Sheet
Statement of
Assets
=
Liabilities
+
Stockholders’ Equity
Income
Cash Flows
Retained
Statement
Cash
Supplies
=
Earnings
–610
Income Statement
E5–25
a.
Balance Sheet
Statement of
Assets
=
Liabilities
+
Stockholders’ Equity
Income
Cash Flows
Statement
Cash
+
–500
b.
Balance Sheet
Statement of
Assets
=
Liabilities
+
Stockholders’ Equity
Income
Cash Flows
Office
Retained
Statement
Cash
+
Supplies
=
Earnings
–455
175
–280
Statement of Cash Flows
Income Statement
Operating
–455
Misc. selling
expense
–190
Misc. admin.
expense
–90
E5–26
Toy manufacturers and retailers experience a seasonal trend in cash flows from