chapter
8
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 8 introduces background
on the Sarbanes-Oxley Act of 2002, which has significantly increased the outside demand for assuring
proper financial reporting. The chapter also addresses the development of internal control frameworks for
a business and the financial accounting practices relating to recording cash transactions. Cash is
highlighted in this chapter because it is the asset most vulnerable to manipulation. The chapter ends with
an explanation of the ratio of cash to monthly cash expenses.
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 8 Sarbanes-Oxley, Internal Control, and Cash
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?
• Why don’t we make journal entries for bank errors?
• Why do we worry about deposits in transit and outstanding checks? Won’t they fiwork themselves
out” the following month?
• Why do we need a new asset account called petty cash? Can’t we use the cash account?
• If we use the account petty cash when we establish a petty cash fund, why don’t we use petty cash
when we replenish the fund?
• What is the normal balance of the ficash short and over” account? Why is this account treated as an
expense or revenue account on the income statement rather than an asset account on the balance
sheet? After all, isn’t it a cash account?
OBJECTIVE 1
Describe the Sarbanes-Oxley Act of 2002 and its impact on internal controls and financial
reporting.
KEY TERMS
Internal Control Sarbanes-Oxley Act of 2002
SUGGESTED APPROACH
Chapter 8 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
become the standard for assessing the financial controls and reporting of all companies. In essence, it
emphasizes the importance of effective internal control. Internal control procedures and processes have
been greatly emphasized and increased under Section 404 requirements. The Committee of Sponsoring
Organizations (COSO) is the widely accepted standard by which companies design, analyze, and evaluate
internal controls.
Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 127
OBJECTIVE 2
Describe and illustrate the objectives and elements of internal control.
KEY TERMS
Control Environment Employee Fraud
Elements 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] 8-1):
If you owned a business, would you expect your employees to:
1. Work to achieve the business goals and objectives you establish?
2. Use business assets (such as machinery or automobiles) only for legitimate business purposes
and avoid wasting business resources?
3. Record accurate data regarding business transactions so you could accurately judge how well
your business is doing?
4. Refrain from stealing your cash, supplies, inventory, or property, plant, and equipment?
TMs 8-2 through 8-4 include information to use in reviewing the elements of internal control.
Possible solution to TM 8-3: 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
128 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
and many donut shops would follow this model, a better model would be to separate the responsibilities
here, having one employee take the order, a second fill the order, and a third accept the payment. In all
three instances, separation of duties is the ultimate model whenever possible.
Possible response to TM 8-4: 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
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 8-5). 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.
Potential response to TM 8-5: Students might focus on the physical layout of the store. The doors
should be protected with scanning devices that detect removal of inventory that has not been security
deactivated. Security cameras, one-way mirrors, and limited access are also good ideas. Restricting
Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 129
OBJECTIVE 3
Describe and illustrate the application of internal controls to cash.
KEY TERMS
Cash Voucher
Cash Short and Over Account Voucher System
Electronic Funds Transfer (EFT)
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.
The topic of internal controls can be used to stimulate a lively class discussion. Suggestions for leading
that discussion follow.
The cash change fund and the cash short and over account are simple topics that can be covered
appropriately in a lecture format.
CLASS DISCUSSION—Internal Controls
Protecting business assets is an important concern for any manager or owner. TM 8-6 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.
The following lists some of the ways for the clerk in TM 8-6 to steal cash and some procedures to
prevent/detect this theft:
130 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
Means to Steal Cash
Ways to Prevent/Detect Theft
Offer customers a bonus if they are not handed a
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
Use cash registers that require a key to void a sale.
Require all voids to be documented and authorized
2. Enter the sale on the register, then
2. Only managers can ring voids.
pocket the cash.
Only managers can issue refunds.
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 8-7 presents procedures related to the receipt of cash through the mail. Use this illustration to point
out how good internal controls (mainly separation of accounting, custody of assets, and operations) will
reduce theft and errors. For example, pose the following questions to the class:
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 8-7 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 will institute nepotism policies, job rotation, and
mandatory vacations.
Point out to students that cash may also be received by EFT. Companies encourage customers to use EFT
because it is more cost efficient than processing payments received through the mail, it enhances internal
controls by avoiding the human factor of cash handling, it reduces late payments and it speeds up the
processing of cash receipts.
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.
As long as the cash short and over account shows only small discrepancies, management should not be
concerned. If the account shows large discrepancies or continuous shortages, however, management
should investigate these differences. Ask your students who have worked as cashiers to describe their
employers’ policies regarding cash overages and shortages. If a cashier consistently has large cash short
and over amounts, he or she probably needs additional training.
You may want to review the journal entry illustrated on page 369 of the text with your class and remind
them that a debit balance in the cash short and over account is treated as a miscellaneous administrative
expense. A credit balance is included in the Other Income section of the income statement.
INTERNET ACTIVITY — Internal Controls over Cash
Instruct your students to search the Web using fiinternal controls” and ficash management” as their search
criteria. At the time this manual was written, the following sites offered some interesting information:
132 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
These sites discuss the importance of establishing internal controls over petty cash and many other areas.
The voucher system will require a detailed explanation in lecture format. TM 8-8 will help you present
this topic. After discussing the voucher system, use the Writing Exercise shown below to test your
students’ comprehension of the system.
Objective 3 also addresses electronic funds transfers. Most students will be familiar with electronic funds
transfers (EFT) through direct experience with automated teller machines (ATMs), payroll direct deposit,
or point-of-sale systems. Use this opportunity to point out the control risks of EFTs and make students
aware of the internal control procedures that must be implemented when EFTs are used. To achieve this
goal, stimulate a Class Discussion on control issues related to point-of-sale systems. Next, assign a Group
Learning Activity that requires your students to implement EFT control procedures.
LECTURE AID — The Voucher System
TM 8-8 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 8-9):
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?
Possible response: There are two possible ways to verify payment. Cancelled checks will show
Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 133
CLASS DISCUSSION — Control of Point-of-Sale Systems
The following two scenarios (TM 8-10) 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
could allow friends and family to leave the store without paying for their merchandise and claim they paid
with an EFT. In addition, a customer might mistakenly (or intentionally) authorize the wrong payment
amount when using the point-of-sale device.
Solution: A receipt from the point-of-sale device must be placed in the cash register drawer as evidence
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.
Control Risk: Whenever a customer puts gasoline in the car and drives off, the clerk will assume that the
customer paid with the point-of-sale device. In reality, the customer may not have paid at all.
Solution: The clerk must have a device that clearly indicates which customers have chosen to pay with
GROUP LEARNING ACTIVITY — Electronic Funds Transfers
TM 8-11 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 8-12 presents a suggested solution.
OBJECTIVE 4
Describe the nature of a bank account and its use in controlling cash.
134 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
KEY TERM
Bank Statement
SUGGESTED APPROACH
Objective 4 explains the use of the bank account and the associated bank statement as a tool for internal
control over cash. The bank statement provides an independent report of deposits and withdrawals of the
company cash. This independent report provides an important tool for safeguarding cash. Debit and credit
memos are explained. This provides an important foundation for Objective 5, completing the bank
reconciliation. See TM 8-13 for a summary of possible debit and credit memos in preparation of the bank
reconciliation.
OBJECTIVE 5
Describe and illustrate the use of a bank reconciliation in controlling cash.
KEY TERM
Bank Reconciliation
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.
Begin this topic with a Class Discussion that establishes the relevance of the bank reconciliation. Next,
give your students the opportunity to practice a bank reconciliation using the Group Learning Activity.
Finally, demonstrate the journal entries required by a bank reconciliation.
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
bank’s error and the wrong they suffered. After listening to these details, ask your students how they
discovered the bank’s error. The usual responses are either through a bank reconciliation or notification
that they were bouncing checks. If the response is bouncing checks, pose this question: What if you had
an extra $1,000 (or more) in your account so that your checks would not have bounced as a result of the
error? How could you have discovered the error in this case? Now the answer must be through some sort
of reconciliation process.
Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 135
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 direct your students to the form and content of the bank reconciliation on page 374 of the
text and discuss the contents of that illustration. Another approach is to ask your class to use
brainstorming to determine the items that must be included on the bank reconciliation, thereby allowing
GROUP LEARNING ACTIVITY — Preparing a Bank Reconciliation
TM 8-15 presents the information for a bank reconciliation. Ask your students to work in small groups to
prepare that bank reconciliation. TM 8-16 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 8-16, 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
136 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
Cash…………………. 27
OBJECTIVE 6
Describe the accounting for special-purpose cash funds.
KEY TERMS
Petty Cash Fund Special-Purpose Funds
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
expenses. When discussing petty cash in class, you will want to address both the journal entries and the
internal controls related to the fund.
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 Federal Express to send an urgent letter, $10.
Entry to establish the petty cash fund:
Jan. 1 Petty Cash………………… 150
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
Chapter 8 Sarbanes-Oxley, Internal Control, and Cash 137
2. Guidelines should be established for the types of expenses that may be paid from petty cash. In
3. Whenever a disbursement is made from the fund, the custodian records the details on a petty cash
receipts form.
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)
OBJECTIVE 7
Describe and illustrate the reporting of cash and cash equivalents in the financial
statements.
KEY TERMS
Cash Equivalents Compensating Balance
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.
138 Chapter 8 Sarbanes-Oxley, Internal Control, and Cash
Readers of the financial statements normally assume that a company may use its cash at any time for any
purpose. If this is not true, the amount of funds not available for withdrawal must be disclosed in the
notes to the financial statements. For example, any compensating balance required by a bank as part of a
loan agreement or line of credit must be disclosed.
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.
KEY TERMS
Ratio of Cash to Monthly Cash Expenses
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.
Ask students to suggest ways for companies to raise cash (loans, owner investment, sell unnecessary
assets, offer incentives to customers to make purchases).
Learning
Objective
Spread–
sheet
expenses
expenses
report
HOMEWORK CHART WITH LEARNING OUTCOMES TAGGING
DIFFICULTY BUSPROG AICPA AICPA ACBSP ACBSP BLOOM’S TIME
Problem
Learning
Objective
Description Primary Broad Business Functional Primary Secondary
Spread-
sheet
GL
Ex8-15 8-2, 8-3 Internal control of cash payments Easy Analytic Measurement Internal Controls Knowledge 10 min.
Ex8-16 8-5 Bank reconciliation Easy Analytic Measurement Bank Reconciliation Application 10 min.
Ex8-17 8-5 Entries based on bank reconciliation Easy Analytic Measurement Bank Reconciliation
Application 5 min.
Ex8-18 8-5 Bank reconciliation Easy Analytic Measurement Bank Reconciliation Application 15 min.
Ex8-19 8-5 Entries for bank reconciliation Easy Analytic Measurement Bank Reconciliation
Application 10 min.
Ex8-20 8-5 Entries for note collected by bank Easy Analytic Measurement Bank Reconciliation Application 5 min.
Ex8-21 8-5 Bank reconciliation Moderate Analytic Measurement Bank Reconciliation Application 15 min.
Ex8-23
5
determine cash receipts stolen
Moderate Analytic Measurement Bank Reconciliation
Controls
Application 10 min.
Ex8-24 8-6 Petty cash fund entries Easy Analytic Measurement Current Assets Application 10 min.
Ex8-25 8-7 Variation in cash flows Easy Analytic Measurement Statement of Cash Flows Application 10 min.
Ex8-26 8-8
Cash to monthly cash expenses
ratio
Moderate Analytic Measurement Financial Statement Analysis Application 10 min.
Ex8-27 8-8
ratio
Moderate Analytic Measurement Financial Statement Analysis Application 10 min.
Ex8-28 8-8
Cash to monthly cash expenses
ratio
Moderate Analytic Measurement Financial Statement Analysis Application 10 min.
Pr8-1A 8-2, 8-3 Evaluating internal control of cash Moderate Analytic Measurement Internal Controls Application 30 min.
Pr8-2A 8-3, 8-6
short and over
Pr8-3A 8-5 Bank reconciliation and entries Moderate Analytic Measurement Bank Reconciliation Application 45 min. X X
Pr8-4A 8-5 Bank reconciliation and entries Moderate Analytic Measurement Bank Reconciliation Application 45 min. X X
Pr8-1B 8-2, 8-3 Evaluate internal control of cash Moderate Analytic Measurement Internal Controls Application 30 min.
Pr8-2B 8-3, 8-6
Transactions for petty cash, cash
short and over
Pr8-3B 8-5 Bank reconciliation and entries Moderate Analytic Measurement Bank Reconciliation Application 45 min. X X
Pr8-4B 8-5 Bank reconciliation and entries Moderate Analytic Measurement Bank Reconciliation Application 45 min. X X
Pr8-5B 8-5 Bank reconciliation and entries Challenging Analytic Measurement Bank Reconciliation Application
1.5
hours
X
CP8-1 8-2, 8-4
Ethics and professional conduct in
business
Easy Ethics Industry Internal Controls Comprehension 5 min.
CP8-2 8-2, 8-3 Internal controls Moderate Analytic Measurement Internal Controls Comprehension 15 min.
CP8-3 8-2, 8-4 Internal controls Moderate Analytic Measurement Internal Controls Analysis 15 min.
DIFFICULTY BUSPROG AICPA AICPA ACBSP ACBSP BLOOM’S TIME
Problem
Learning
Objective
Description Primary Broad Business Functional Primary Secondary
Spread-
sheet
GL
CP8-4 8-2, 8-3
Ethics and professional conduct in
business
Moderate Ethics Industry Internal Controls Analysis 10 min.
CP8-5 8-3, 8-5
control
Reconciliation
CP8-6 8-3 Observe internal controls over cash Challenging
Thinking
Critical Thinking Internal Controls Knowledge 1 hour