chapter
7
Sarbanes-Oxley, Internal
Control, and Cash
______________________________________________
OPENING COMMENTS
In recent years, events have occurred that have resulted in increased emphasis on proper financial
reporting and on ensuring that controls are in place to accomplish this. Chapter 7 introduces background
on the Sarbanes-Oxley Act of 2002, which has significantly increased the outside demand for assuring
After studying the chapter, your students should be able to:
2. Describe and illustrate the objectives and elements of internal control.
4. Describe the nature of a bank account and its use in controlling cash.
6. Describe the accounting for special-purpose cash funds.
8. Describe and illustrate the use of the ratio of cash to monthly cash expenses to assess the ability of a
company to continue in business.
126 Chapter 7 Sarbanes-Oxley, Internal Control, and Cash
KEY TERMS
bank reconciliation
bank statement
cash
cash equivalents
cash short and over account
compensating balance
control environment
electronic funds transfer (EFT)
elements of internal control
employee fraud
STUDENT FAQS
• Where do I go to get more information about working with Sarbanes-Oxley when I graduate? I also
need to make sure I take the correct courses in college.
• When a person doesn’t work all the hours they are supposed to during the day, are they defrauding
the company?
• Why must I learn to balance the cash account when I put the money in the bank to protect it?
• Do I have a legal obligation to give cash back to someone when I have no idea who that person is?
• Why do we spend so much time on internal control for cash receipts and disbursements? Shouldn’t
we be just as concerned over other assets? Expenses? Revenue? Liabilities?
Chapter 7 Sarbanes-Oxley, Internal Control, and Cash 127
OBJECTIVE 1
Describe the Sarbanes-Oxley Act and its impact on internal controls and financial
reporting.
SYNOPSIS
This chapter begins with the effects of the Sarbanes-Oxley Act. This act, passed by Congress, was to
strengthen the internal controls of publicly held companies. Internal control defines the processes meant
to safeguard assets, process information accurately, and ensure compliance with laws and regulations.
Key Terms and Definitions
• Internal Control – The policies and procedures used to safeguard assets, ensure accurate
business information, and ensure compliance with laws and regulations.
• Sarbanes-Oxley Act – Act passed by Congress to restore public confidence and trust in the
financial statements of companies.
Relevant Example Exercises and Exhibits
• Exhibit 1 – Effect of Sarbanes-Oxley
• Exhibit 2 – Sarbanes-Oxley Report of Nike
SUGGESTED APPROACH
Chapter 7 discusses the Sarbanes-Oxley Act of 2002 (the most important law affecting publicly held
companies in recent history). Although the law applies only to publicly traded companies, it really has
OBJECTIVE 2
Describe and illustrate the objectives and elements of internal control.
SYNOPSIS
The objectives of internal control are described in this section. As shown in Exhibit 3, internal control has
three objectives: making sure assets are safeguarded and used for business purposes, ensuring that all
accounting and business information is accurate, and making sure that employees and managers comply
with laws and regulations. The objectives can be achieved by using the five elements of internal control as
shown in Exhibit 4. The control environment is the overall attitude of the company, including
management, personnel policies, and organizational structure. Exhibit 5 shows how these interact to
128 Chapter 7 Sarbanes-Oxley, Internal Control, and Cash
complete the control environment. Risk is the second element: all risks should be identified, analyzed, and
assessed and actions taken to minimize their occurrence. Control procedures provide assurance that goals
will be met and include the prevention of fraud. Exhibit 6 shows how procedures protect the business.
Monitoring is the fourth element and is used to assess weaknesses and improve controls. Exhibit 7
Key Terms and Definitions
• Control Environment – The overall attitude of management and employees about the importance
of controls.
• Elements of Internal Control – The control environment, risk assessment, control activities,
information and communication, and monitoring.
• Employee Fraud – The intentional act of deceiving an employer for personal gain.
Relevant Example Exercises and Exhibits
• Example Exercise 7-1 Internal Control Elements
• Exhibit 3 – Objectives of Internal Control
SUGGESTED APPROACH
The text lists the three objectives of internal control as reasonable assurance that (1) assets are
safeguarded and used for business purposes, (2) business information is accurate, and (3) employees and
managers comply with laws and regulations. The five elements of internal control are (1) control
environment, (2) risk assessment, (3) control procedures, (4) monitoring, and (5) information and
communication. To stimulate interest in these topics, use the following Lecture Aid.
LECTURE AID—Internal Control
Ask the following questions (also shown on Transparency Master [TM] 7-1):
4. Refrain from stealing your cash, supplies, inventory, or property, plant, and equipment?
TMs 7-2 through 7-4 include information to use in reviewing the elements of internal control.
Possible solution to TM 7-3: 1) Salespersons on commission also approved to grant credit represent a
conflict of interest. Denial of credit to a potential sale would take money out of the pocket of the
salesperson, creating an opportunity to grant credit to customers not worthy of credit in order to make a
sale. Separation of duties to have a non-commissioned individual to approve credit would be the preferred
method. 2) Having a single individual responsible for all of these duties creates an opportunity to easily
order goods, check them in, approve payment, and allow that individual to carry the inventory away.
Possible response to TM 7-4: Allowing the clerk to accept cash and update customer account records
gives a single individual an opportunity to accept the cash, pocket it, and provide the customer record
with the credit. Requiring a second individual to balance the bank deposit against the customer account
credits could make this model workable, but separation of duties would be a preferred model. 2) Allowing
a single individual to approve invoices, prepare checks, mail them, and update hospital records provides
an opportunity to create fictitious vendors and to prepare checks to these fictitious vendors that can then
be cashed by the employee for personal use. In both scenarios, separation of duties would have made the
potential fraud more difficult to execute.
130 Chapter 7 Sarbanes-Oxley, Internal Control, and Cash
GROUP LEARNING ACTIVITY—Internal Control Structure
Ask your students to assume that they have decided to open a bookstore that sells textbooks and competes
with the campus bookstore (TM 7-5). With students in small groups, instruct them to list the internal
control procedures they would implement in their store. After giving the groups a few minutes to work,
ask each group to share a couple of their ideas.
OBJECTIVE 3
Describe and illustrate the application of internal controls to cash.
SYNOPSIS
The control of cash is important to a business because it is the asset most likely to be stolen or used
improperly. To protect cash from being stolen or misused, a business must record cash from the time it is
received until its deposit in a bank account. Cash received from cash sales must be safeguarded by cash
register controls. There are nine steps in the cash register control, which appear in the text along with a
related exhibit (Exhibit 8). Differences in the cash sales process are accounted by using the cash short and
Key Terms and Definitions
• Cash – Coins, currency (paper money), checks, money orders, and money on deposit that is
available for unrestricted withdrawal from banks and other financial institutions.
• Cash Short and Over Account – An account which has recorded errors in cash sales or errors in
making change causing the amount of actual cash on hand to differ from the beginning amount of
cash plus the cash sales for the day.
Chapter 7 Sarbanes-Oxley, Internal Control, and Cash 131
Relevant Example Exercises and Exhibits
• Exhibit 8 – Cash Register as a Control
SUGGESTED APPROACH
Remind your students that cash includes anything a bank would accept for deposit in your account. This
includes coins, currency, checks, and money orders. A good system of internal controls is necessary to
protect all of these forms of cash.
CLASS DISCUSSION—Internal Controls
Protecting business assets is an important concern for any manager or owner. TM 7-6 reviews the typical
controls for protecting cash received at the cash register. Review these controls with your class. Point out
how the principle of separation of accounting, custody of assets, and operations is applied in this scenario.
Next, ask your class to identify the people who have the opportunity to steal cash. The candidates are the
clerk and the cashier, because they are the only ones who actually handle cash. Ask your students to
identify ways in which these individuals can steal cash and, more importantly, what procedures can be
instituted to prevent theft by these means.
132 Chapter 7 Sarbanes-Oxley, Internal Control, and Cash
Means to Steal Cash
Ways to Prevent/Detect Theft
Have one employee ring up customer orders and
Proper supervision—watch for employees who do
1. Don’t ring the sale on the cash
register, and pocket the cash.
1. Odd pricing—clerk must make change.
Require receipts for refunds.
Put coupons on backs of receipts so the customer
2. Enter the sale on the register, then
2. Only managers can ring voids.
pocket the cash.
3. Enter a cash refund on the register and
3. Require a manager to authorize all refunds in the
else will be blamed.
4. If more than one clerk uses the
4. Have a separate register for each clerk.
TM 7-7 presents procedures related to the receipt of cash through the mail. Use this illustration to point
1. Assume that the employee who opens the mail steals a customer payment. How will this theft be
detected?
2. Assume that the accounting clerk posts the payment to the wrong customer’s account. How will
this error be detected?
3. Assume that the accounting clerk posts a customer’s payment for the wrong amount, giving the
customer credit for less than he or she actually paid. How will this error be detected?
4. Assume that an employee in the cashier’s department loses a check. (Maybe it was placed in the
customer’s file rather than deposited in the bank.) How will this error be detected?
TM 7-7 can also be used to explain collusion. Collusion occurs when two or more employees work
together to embezzle cash or conceal errors. For example, if the accounting clerk and the employee who
opens the mail decide to work together, one can steal customer payments and the other can fidoctor” the
accounting records. To prevent collusion, companies institute nepotism policies, job rotation, and
mandatory vacations.
LECTURE AID—Cash Change Fund and Cash Short and Over Account
Objective 3 also presents the cash change fund and the cash short and over account. Ask students who
have worked as cashiers to share what amount of cash was in their cash register at the beginning and end
of the day. This represents a cash change fund.
Remind students that a cash change fund is required for any business that receives cash from its
customers. Someone must be accountable for that change fund at all times. It should be locked in a
company vault when not in use.
The cash short and over account is used when the cash on hand at the end of the day does not equal the
amount in the beginning cash change fund plus the day’s cash sales. It is used to record discrepancies due
to errors in recording sales or making change. The cash short and over account is needed because
employees will not be accurate 100 percent of the time.
INTERNET ACTIVITY—Internal Controls over Cash
Instruct your students to search the Web using fiinternal controls” and ficash management” as their search
134 Chapter 7 Sarbanes-Oxley, Internal Control, and Cash
http://www.coso.org/IC-IntegratedFramework-summary.htm
http://www.securitymanagement.com/library/000304.html
LECTURE AID—The Voucher System
TM 7-8 is a flowchart-style illustration of the voucher system, putting the textbook description in picture
format. Review this exhibit with your class, stressing the control aspects of the voucher system. A
Writing Exercise to reinforce your coverage of this topic follows.
WRITING EXERCISE—The Voucher System
After reviewing the voucher system, ask your class to write answers to the following questions (TM 7-9):
1. How does the voucher system ensure that management is paying only valid obligations?
2. How does the voucher system help a company maintain a favorable credit standing by aiding
management in paying all invoices on time?
3. How would a company using a voucher system investigate a supplier’s complaint that an invoice
has not been paid?
Chapter 7 Sarbanes-Oxley, Internal Control, and Cash 135
CLASS DISCUSSION—Control of Point-of-Sale Systems
The following two scenarios (TM 7-10) relate to point–of-sale systems. In a classroom discussion, ask
your students to identify the control risk associated with each system and name procedures that can be
implemented to counterbalance the risk.
1. A grocery store decides to install a point-of-sale system that will allow the customer to use his or her
ATM card to pay for merchandise at the checkout line. Previously, the grocery store has accepted
only cash and checks as payment.
Control Risk: In the past, the clerks would have reconciled their cash registers by comparing the sales on
the register tape to the total of the cash and checks in the register drawer. Under the new system, a clerk
could steal the cash taken for a customer’s order and claim that the customer paid by EFT. The clerk also
2. A self-service gas station decides to install a point-of-sale device at the gasoline pump. This will
speed the time it takes a customer to fill his or her gas tank, since payment can be made right at the
pump, eliminating the time spent waiting in line for a clerk to accept payment.
GROUP LEARNING ACTIVITY—Electronic Funds Transfers
TM 7-11 presents information regarding a company that has decided to use EFT to pay vendor invoices.
Divide the class into small groups and ask them to define procedures for paying vendor invoices via EFT.
Their procedures should include any documentation, authorization, or reconciliation required and who
should be made responsible for those tasks. TM 7-12 presents a suggested solution.
136 Chapter 7 Sarbanes-Oxley, Internal Control, and Cash
OBJECTIVE 4
Describe the nature of a bank account and its use in controlling cash.
SYNOPSIS
Using a bank account is another way to enhance internal control. Bank accounts reduce cash on hand,
provide an independent recording of cash, and can be used to transfer funds electronically. Banks
maintain a record of all checking account transactions and provide a bank statement on a monthly basis.
with the business’s books is an important part of cash control.
Key Terms and Definitions
• Bank Statement – A summary of all transactions mailed to the depositor or made available
online by the bank each month.
Relevant Example Exercises and Exhibits
• Example Exercise 7-2 Items on Company’s Bank Statement
• Exhibit 9 – Bank Statement
• Exhibit 10 – Checking Account: Company and Bank Perspectives
• Exhibit 11 – Power Networking’s Records and Bank Statement
SUGGESTED APPROACH
OBJECTIVE 5
Describe and illustrate the use of a bank reconciliation in controlling cash.
SYNOPSIS
Reconciling the amounts in the business’s cash account with the amount in the bank account is called
bank reconciliation. The bank reconciliation is divided into two parts. They are the bank section and the
company section. The adjusted balances from these two sections must equal. Exhibit 12 lists the steps
Chapter 7 Sarbanes-Oxley, Internal Control, and Cash 137
involved in preparing a bank reconciliation. Exhibit 13 presents a bank reconciliation for Power
Networking. Outstanding checks and deposits have to be accounted for in the bank balance. The
reconciliation process then checks the balance in the company’s cash account, adds any amounts that need
to be added, such as interest or notes collected, and deducts NSF checks and bank services charges, and
Key Terms and Definitions
• Bank Reconciliation – The analysis that details the items responsible for the difference between
the cash balance reported in the bank statement and the balance of the cash account in the ledger.
Relevant Example Exercises and Exhibits
• Example Exercise 7-3 Bank Reconciliation
• Exhibit 12 – How to Prepare a Bank Reconciliation
• Exhibit 13 – Bank Reconciliation for Power Networking
SUGGESTED APPROACH
The bank reconciliation is usually an easy task for students who have their own checking accounts.
Depending on your student body, you may discover that many of your students do not have a checking
account.
CLASS DISCUSSION—Establishing Relevance of the Bank Reconciliation
An interesting way to begin your coverage of the bank reconciliation is to ask your students to indicate
(by a show of hands) whether they have a checking account. Next, ask if their bank has ever made an
error in their checking account. You will probably find that your students will volunteer to describe the
138 Chapter 7 Sarbanes-Oxley, Internal Control, and Cash
BRAINSTORMING ACTIVITY—Developing the Format for a Bank
Reconciliation
After establishing the relevance of a bank reconciliation, you can discuss how one is prepared. One
approach is to discuss with your students the form and content of the bank reconciliation as illustrated in
the text. Another approach is to ask your class to use brainstorming to determine the items that must be
included on the bank reconciliation, thereby allowing them to discover how to prepare a reconciliation.
Write fiCash Balance on Bank Statement” and fiCash Balance on Depositor’s Records” on opposing sides
GROUP LEARNING ACTIVITY—Preparing a Bank Reconciliation
TM 7-15 presents the information for a bank reconciliation. Ask your students to work in small groups to
prepare that bank reconciliation. TM 7-16 is the solution, which you can share after the groups have
finished. Emphasize that the adjusted balance on the bank reconciliation is the amount that is reported on
the balance sheet.
DEMONSTRATION PROBLEM—Journal Entries Required by a Bank
Reconciliation
Using TM 7-16, demonstrate the following journal entries required as a result of the bank reconciliation.
Remind your students that any adjustments made to the depositor’s records must be journalized.
To record the note collected by bank:
Cash…………………………. 1,260
Notes Receivable…… 1,200
Chapter 7 Sarbanes-Oxley, Internal Control, and Cash 139
OBJECTIVE 6
Describe the accounting for special-purpose cash funds.
SYNOPSIS
Small sums of money often need to be paid out in the course of doing business. It is inconvenient to write
a check for numerous small sums. Postage, minor repairs, and office supplies are some of these minor
expenses. Most businesses establish a petty cash fund to account for these expenses. The fund is
Key Terms and Definitions
• Petty Cash Fund – A special cash fund to pay relatively small amounts.
• Special-Purpose Funds – Cash funds used for a special business need.
Relevant Example Exercises and Exhibits
• Example Exercise 7-4 Petty Cash Fund
DEMONSTRATION PROBLEM—Petty Cash
In some cases, it is impractical to pay an expense by check, either because the expense is very small or
payment is required sooner than a check can be processed. Petty cash is used to cover these types of
Allied Plumbing Supply decides to establish a petty cash fund of $150 on January 1. The petty cash fund
will be replenished whenever the fund reaches a balance of $20 or less. On February 10, the fund is
replenished and the following receipts for items paid out of the petty cash fund are recorded: office
supplies, $34; postage, $28; store supplies, $12; a minor repair on office equipment, $52; and the cost
paid to FedEx to send an urgent letter, $10.
140 Chapter 7 Sarbanes-Oxley, Internal Control, and Cash
Entry to replenish the petty cash fund:
In reviewing the internal controls related to petty cash, you will want to mention the following:
1. A trusted employee must be named custodian of the petty cash fund. That employee is responsible
for disbursements from the fund.
2. Guidelines should be established for the types of expenses that may be paid from petty cash. In
4. The fund custodian should submit receipts documenting all fund expenditures before receiving
money to replenish the fund.
CLASS DISCUSSION—Internal Controls over Petty Cash
Ask your students how the custodian of a petty cash fund could steal cash. (Answer: by forging a
signature on a petty cash receipt)
Next, ask them how this theft could be detected. Your students’ ideas may include the following: (1) a
periodic audit of the petty cash fund, (2) randomly checking signatures on receipts, or (3) comparing petty
cash expenditures with normal or expected amounts. Point out that the small amounts of cash in a petty
cash fund normally do not justify elaborate control procedures.
OBJECTIVE 7
Describe and illustrate the reporting of cash and cash equivalents in the financial
statements.
SYNOPSIS
Chapter 7 Sarbanes-Oxley, Internal Control, and Cash 141
Key Terms and Definitions
SUGGESTED APPROACH
This topic can be covered quickly, but thoroughly, through a brief lecture.
LECTURE AID—Cash on the Balance Sheet
To cover this objective, you need only remind students of the following points:
1. Cash is the first asset listed on the balance sheet because it is the most liquid.
2. Funds placed in highly liquid investments such as Treasury bills, money market funds, and
commercial paper, are called cash equivalents. Since these investments can be sold quickly and
easily, funds in these investments can be accessed as easily as cash held in a bank. Therefore, they
are considered fiequivalent” to cash.
OBJECTIVE 8
Describe and illustrate the use of the ratio of cash to monthly cash expenses to assess the
ability of a company to continue in business.
SYNOPSIS
This chapter establishes how important cash and control of cash is to the successful operation of a
business. The ratio of cash to monthly cash expenses is useful is assessing how long a business can pay its
142 Chapter 7 Sarbanes-Oxley, Internal Control, and Cash
Key Terms and Definitions
• Ratio of Cash to Monthly Cash Expenses – Ratio that helps assess how long a company can
continue to operate without additional financing or generating positive cash flows from
operations.
SUGGESTED APPROACH
Explain to students that this computation is most critical for companies in financial distress and quite
often startup companies that haven’t had enough operating time to generate positive cash flows. It can be
used as a measure of when a company may need additional financing.
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