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CHAPTER 7
Fraud, Internal Control, and Cash
Learning Objectives
1. Define 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 and the basic principles of cash management.
*5. Explain the operation of a petty cash fund.
Summary of Questions by Learning Objectives and Bloom’s Taxonomy
Item
LO
BT
Item
LO
BT
Item
LO
BT
Item
LO
BT
Item
LO
BT
Questions
1.
1
C
7.
1
C
13.
1
C
19.
2
C
25.
3
C
2.
1
C
8.
1
C
14.
4
AP
20.
2
K
26.
4
C
3.
1
C
9.
1
C
15.
2
C
21.
3
K
27.
4
C
4.
1
C
10.
1
C
16.
2
C
22.
3
C
28.
5*
C
5.
1
K
11.
1
C
17.
2
C
23.
3
C
6.
1
C
12.
1
C
18.
2
C
24.
4
C
Brief Exercises
1.
1
C
4.
2
C
7
3
C
10.
3
AP
13.
4
AP
2.
1
C
5.
2
AP
8.
3
C
11.
3
AP
14.
5*
AP
3.
1
C
6.
2
C
9.
3
C
12.
4
C
Do It Exercises
1.
1
C
2.
2
C
3.
3
K
4a.
4
AP
4b.
4
AP
Exercises
1.
1
C
5.
2
E
8.
3
AP
11.
3
AP
14.
4
AP
2.
1
C
6.
3
AP
9.
3
AP
12.
4
AP
15.
5*
AP
3.
2
E
7.
3
AP
10.
3
AP
13.
4
C
16.
5*
AP
4.
2
E
Problems: Set A
1.
2
C
3.
3
AP
5.
3
AP
7.
4
AP
8.
4
AP
2.
2
C
4.
3
AP
6.
1,2,3
E
*Continuing Cookie Solutions for this chapter are available online.
ASSIGNMENT CHARACTERISTICS TABLE
Problem
Number
Description
Difficulty
Level
Time
Allotted (min.)
1A
Identify internal control weaknesses for cash receipts.
Simple
20–30
2A
Identify internal control weaknesses in cash receipts and
cash disbursements.
Simple
20–30
3A
Prepare a bank reconciliation and adjusting entries.
Simple
20–30
4A
Prepare a bank reconciliation and adjusting entries from
detailed data.
Moderate
40–50
5A
Prepare a bank reconciliation and adjusting entries.
Moderate
30–40
6A
Prepare a comprehensive bank reconciliation with theft
and internal control deficiencies.
Complex
40–50
7A
Prepare a cash budget.
Moderate
30–40
8A
Prepare a cash budget.
Moderate
30–40
ANSWERS TO QUESTIONS
1. Fraud is a dishonest act by an employee that results in personal benefit to the employee at a cost
to the employer. An example of fraud that might occur at a bank would be a computer operator
embezzling funds by transferring a customer’s deposits into another account.
LO 1 BT: C Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting
2. The three main factors that contribute to employee fraud are opportunity, financial pressure, and
rationalization. Opportunities that an employee can take advantage of occur when the workplace
lacks sufficient controls to deter and detect fraud. Financial pressure occurs when employees want
to lead a lifestyle that they cannot afford on their current salary. Rationalization involves employees
justifying fraud because they believe they are underpaid while their employer is making lots of
money.
LO 1 BT: C Difficulty: Medium TOT: 4 min. AACSB: None AICPA FC: Reporting
3. The five components of a good internal control system are: (1) A control environment, (2) Risk
assessment, (3) Control activities, (4) Information and communication, and (5) Monitoring.
LO 1 BT: K Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting
4. Disagree. Internal control is also concerned with the safeguarding of company assets, increasing
efficiency of operations, and ensuring compliance with laws and regulations.
LO 1 BT: C Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting
5. The Sarbanes-Oxley Act requires that a company develop sound principles of internal control over
financial reporting and continually verify that these controls are working. The act specifically requires
top management to attest that the company’s internal controls are reliable and effective.
LO 1 BT: C Difficulty: Easy TOT: 3 min. AACSB: None AICPA FC: Reporting
6. The principles of internal control that apply to most businesses are: (a) establishment of
responsibility, (b) segregation of duties, (c) documentation procedures, (d) physical controls, (e)
independent internal verification, and (f) human resource controls.
LO 1 BT: C Difficulty: Easy TOT: 3 min. AACSB: None AICPA: Reporting
7. Yes, this is a violation of the internal control principle of establishing responsibility. In this case,
each sales clerk should have a separate cash register or cash register drawer.
LO 1 BT: C Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting
8. The two applications of segregation of duties are:
(1) The responsibility for related activities should be assigned to different individuals.
(2) The responsibility for record keeping for an asset should be separate from the physical
custody of that asset.
LO 1 BT: C Difficulty: Easy TOT: 3 min. AACSB: None AICPA FC: Reporting
9. Documentation procedures contribute to good internal control by providing evidence of the occur-
rence of transactions and events and, when signatures (or initials) are added, the documents
establish responsibility for the transactions. The prompt transmittal of documents to accounting
contributes to recording transactions in the proper period, and the prenumbering of documents
helps to ensure that a transaction is not recorded more than once or not at all.
LO 1 BT: C Difficulty: Medium TOT: 4 min. AACSB: None AICPA FC: Reporting
10. Safes, vaults, and locked warehouses contribute to the safeguarding of company assets. Cash
registers and computerized accounting equipment contribute to the accuracy and reliability of the
accounting records, and electronic burglary systems and sensors help to safeguard assets.
LO 1 BT: C Difficulty: Easy TOT: 3 min. AACSB: None AICPA FC: Reporting
11. (a) Independent internal verification involves the review, comparison, and reconciliation of data
prepared by employees.
(b) Maximum benefit is obtained from independent internal verification when:
(1) The verification is made periodically or on a surprise basis.
(2) The verification is done by an employee who is independent of the personnel respon-
sible for the information.
(3) Discrepancies and exceptions are reported to a management level that can take appro-
priate corrective action.
LO 1 BT: C Difficulty: Medium TOT: 5 min. AACSB: None AICPA FC: Reporting
12. (a) The concept of reasonable assurance means that the costs of establishing control procedures
should not exceed their expected benefit. Ordinarily, a system of internal control provides
reasonable but not absolute assurance, since absolute assurance would be too costly.
(b) The human element is an important factor in a system of internal control. A good system
may become ineffective as the result of employee fatigue, carelessness, or indifference.
Moreover, internal control may become ineffective as a result of collusion.
LO 1 BT: C Difficulty: Medium TOT: 5 min. AACSB: None AICPA FC: Reporting
13. The human resources department plays an important role in internal control by
(a) bonding employees who handle cash,
(b) rotating employees’ duties and requiring employees to take vacations,
(c) conducting thorough background checks.
LO 1 BT: C Difficulty: Easy TOT: 3 min. AACSB: None AICPA FC: Reporting
14. Cash should be reported at $21,100 ($8,000 + $1,100 + $12,000).
LO 4 BT: AP Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA FC: Reporting
15. Daily cash counts pertain primarily to the principles of segregation of duties, documentation procedures,
and independent internal verification. Daily cash counts also involve the establishment of responsi-
bility for performing the counts.
LO 2 BT: C Difficluty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting
16. Cash registers are readily visible to the customer. Thus, they prevent the sales clerk from ringing
up a lower amount and pocketing the difference. In addition, the customer receives an itemized
receipt, and the cash register tape is locked into the register for further verification, providing
documentation and enabling independent internal verification.
LO 2 BT: C Difficulty: Medium TOT: 3 min. AACSB: None AICPA FC: Reporting
17. Two mail clerks contribute to a more accurate listing of mail receipts and to the endorsement of
all checks “For Deposit Only.” In addition, two clerks reduce the likelihood of mail receipts being
diverted to personal use.
LO 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting
18. True. Payment by check contributes to effective internal control over cash disbursements.
However, effective control is also possible when small payments are made from petty cash.
LO 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting
19. The procedure and related principle are:
Procedure Principle
(1) Treasurer signs checks. • Establishment of responsibility.
(2) Checks imprinted by a checkwriter. • Physical controls.
(3) Comparing check with approved • Independent internal verification.
invoice before signing.
LO 2 BT: C Difficulty: Medium TOT: 4 min. AACSB: None AICPA FC: Reporting
20. (a) Physical controls apply to cash disbursements when blank checks are stored in a safe, and
access to the safe is restricted to authorized personnel, and a check-writing machine is used
to print amounts on checks with indelible ink.
(b) Human resource controls apply when the company bonds personnel who handle cash,
requires employees to take vacations, and conducts background checks.
LO 2 BT: C Difficulty: Easy TOT: 3 min. AACSB: None AICPA FC: Reporting
21. Electronic funds transfer is a cash disbursement system that uses wire, telephone, or computers
to transfer cash balances from one location to another.
LO 3 BT: C Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting
22. True. A bank contributes significantly to internal control over cash because it: (1) safeguards cash
on deposit, (2) minimizes the amount of cash that must be kept on hand, and (3) provides a double
record of all bank transactions.
LO 3 BT: C Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting
23. The lack of agreement between the balances may be due to either:
(1) Time lags—a check written in July does not clear the bank until August.
(2) Errors—a check for $110 is recorded by the depositor as $101.
LO 3 BT: C Difficulty: Easy TOT: 3 min. AACSB: None AICPA FC: Reporting
24. The basic principles of cash management are: (1) increase the speed of receivables collection,
(2) keep inventory low, (3) monitor payment of liabilities, (4) plan timing of major expenditures,
and (5) invest idle cash.
LO 4 BT: K Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting
25. (a) An NSF check occurs when the checkwriter’s bank balance is less than the amount of the
check.
(b) In a bank reconciliation, a customer’s NSF check is deducted from the balance per books.
(c) An NSF check results in an adjusting entry in the company’s books, as a debit to Accounts
Receivable and a credit to Cash.
LO 3 BT: C Difficulty: Medium TOT: 4 min. AACSB: None AICPA FC: Reporting
26. (a) Cash equivalents are short-term highly liquid investments that may be converted to a specific
amount of cash. Cash equivalents may be reported with cash in the current assets section
of the balance sheet.
(b) Cash restricted for a special purpose should be reported separately as a current or noncurrent
asset depending on when the cash is expected to be used.
LO 4 BT: C Difficulty: Medium TOT: 4 min. AACSB: None AICPA FC: Reporting
27. At September 27, 2014, Apple reported cash and cash equivalents of $13,844 (millions). It reported
no restricted cash. In Note 1 to its financial statements it defines cash equivalents as “All highly
liquid investments with maturities of three months or less at the date of purchase.”
LO 4 BT: AN Difficulty: Medium TOT: 4 min. AACSB: Analytic AICPA FC: Reporting
*28. The activities in a petty cash system and the related principles are:
(a) (1) Establishing the fund. • Establishment of responsibility for custody of the
fund.
(2) Making payments from the fund. • Documentation procedures because the custodian
must use a prenumbered petty cash receipt.
(3) Replenishing the fund. • Independent internal verification because the
request for replenishment must be approved before
the check is written.
(b) Journal entries are required for a petty cash fund when it is established and replenished.
Entries are also required when the size of the fund is increased or decreased.
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 7-1
(a) Financial Pressure
BRIEF EXERCISE 7-2
The purposes of internal control are to:
1. Safeguard a company’s assets from employee theft, robbery, and unau-
2. Enhance the accuracy and reliability of a company’s accounting records
4. Ensure compliance with laws and regulations. An application is use of
BRIEF EXERCISE 7-3
(a) Segregation of duties.
BRIEF EXERCISE 7-4
(a) Physical controls.
BRIEF EXERCISE 7-5
Cash ($1,125.74 – $150.00) ...................................... 975.74
BRIEF EXERCISE 7-6
(a) Documentation procedures.
BRIEF EXERCISE 7-7
(a) The use of a checking account minimizes the amount of currency that
(b) A bank statement provides a double record of a depositor’s bank
LO 3 BT: C Difficulty: Medium TOT: 4 min. AACSB: None AICPA FC: Measurement
BRIEF EXERCISE 7-8
(a) Outstanding checks—deducted from cash balance per bank.
(b) Bank debit memorandum for service charge—deducted from cash
BRIEF EXERCISE 7-9
(a) The reconciling items per the books, items (b) and (c) above, will
require adjustment on the books of the depositor.
BRIEF EXERCISE 7-10
Cash balance per bank statement ................................................. $7,291
BRIEF EXERCISE 7-11
Checks written in November ......................................................... $ 9,750
BRIEF EXERCISE 7-12
Spahn Company should report cash in bank and payroll bank account as
BRIEF EXERCISE 7-13
BONKERS COMPANY
Cash Budget
For the Month of January
Beginning cash balance ................................................................ $12,000
Add: Cash receipts ...................................................................... 59,000
Total available cash ....................................................................... 71,000
*BRIEF EXERCISE 7-14
Mar. 20 Postage Expense .......................................................... 40
SOLUTIONS TO DO IT! EXERCISES
DO IT! 7-1
1. Violates the control activity of documentation procedures. Source docu-
ments should be promptly forwarded to the accounting department so
2. Violates the control activity of segregation of duties. Different individuals
should be responsible for related activities, such as these three
3. Violates the control activity of establishment of responsibility. Guillen’s
would be unable to determine who was responsible for a cash shortage;
DO IT! 7-2
All mail receipts should be opened in the presence of two mail clerks.
Those mail clerks should immediately stamp each check “For Deposit Only.”
DO IT! 7-3
Ned should treat the reconciling items as follows:
1. Outstanding checks: Deduct from balance per bank.
3. The bank charged to our account a check written by another company:
4. A debit memorandum for a bank service charge: Deduct from balance
DO IT! 7-4a
2. False. A company that has received NSF checks should report these
checks as a current asset (accounts receivable) on the balance sheet.
4. True.
LO 4 BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA FC: Reporting
DO IT! 7-4b
Beginning cash balance ................................................ $ 12,270
Add: Cash receipts for September .............................. 97,200
Total available cash ....................................................... 109,470
SOLUTIONS TO EXERCISES
EXERCISE 7-1
The principles of internal control inherent in the “maker-checker” proce-
dure are:
2. Physical controls. Access to the computer system is password-
EXERCISE 7-2
2. Segregation of duties. Employees who make the pizzas do not handle
3. Documentation procedures. The counter clerk uses your order invoice
5. Independent internal verification. The counter clerk, in handling the
pizza, compares the size of the pizza with the size indicated on the order.
EXERCISE 7-3
(a)
(b)
Procedure
Weakness
Principle
Violated
Recommended
Change
1.
Cashiers are
not bonded and
Human resource
controls.
Cashiers should be
bonded and
2.
Inability to
establish
Establishment
of responsibility.
There should be
separate cash
3.
Cash is not
Physical controls.
Cash should be
4.
Cash is not
independently
Independent
internal
A cashier office
supervisor should
5.
The accountant
Segregation
The cashier’s
EXERCISE 7-4
(a)
(b)
Procedure
Weakness
Principle
Violated
Recommended
Change
1.
Checks are
Physical controls.
Checks should be
2.
The approval
and payment
Segregation
of duties.
The store manager
should approve bills
3.
Unauthorized
employees
making
Establishment of
responsibility.
Only employees
granted authority
should make purchases
4.
Filing does
not prevent a
Documentation
procedures.
Bills should be
stamped PAID after
5.
The bank
reconciliation
Independent
internal
Someone with no other
responsibilities relating
EXERCISE 7-5
(a) Weaknesses
(b) Suggested Improvement
1. Checks are not prenumbered.
Use prenumbered checks.
(Documentation procedures)
2. The purchasing agent signs
Only the treasurer’s department
3. Unissued checks are stored in
Unissued checks should be stored
4. Purchasing agent approves
Purchasing should approve bills
5. After payment, the invoice is
The invoice should be stamped
6. The purchasing agent records
Only accounting department
7. The treasurer records the checks
Same as answer to No. 6 above.
8. The treasurer reconciles the
An internal auditor should
EXERCISE 7-6
(a) Cash balance per bank statement ................... $3,677.20
Add: Deposits in transit ................................. 590.00
(b) Cash balance per books .................................. $3,975.20
EXERCISE 7-7
The outstanding checks are as follows:
No.
Amount
255
$ 700
EXERCISE 7-8
(a) LANCE COMPANY
Bank Reconciliation
July 31, 2017
Cash balance per bank statement ................................. $7,328
Add: Deposits in transit ............................................... 2,700
10,028
(b) July 31 Cash ................................................................ 2,016
Accounts Receivable ............................. 2,016
EXERCISE 7-9
(a) HOWARD COMPANY
Bank Reconciliation
September 30, 2017
Cash balance per bank statement .......................... $16,500
Add: Deposits in transit ........................................ 4,738
21,238
Less: Outstanding checks ..................................... 2,383
Adjusted cash balance per bank ............................ $18,855
(b) Sept. 30 Cash ....................................................... 1,830
Accounts Receivable .................... 1,830
30 Cash ....................................................... 45
Interest Revenue ........................... 45
EXERCISE 7-10
(a) Deposits in transit:
Deposits per books in July ........................... $16,900
Less: Deposits per bank in July .................. $15,600
(b) Outstanding checks:
Checks per books in July ............................. $17,500
(c) Deposits in transit:
Deposits per bank statement in
September .................................................. $25,900
Add: Deposits in transit, September 30 .... 2,200
(d) Outstanding checks:
Checks clearing bank in September ............ $24,000
Add: Outstanding checks,
