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.
*5. COMPARE THE ACCOUNTING FOR FRAUD,
INTERNAL CONTROL, AND CASH UNDER GAAP AND
IFRS.
CHAPTER REVIEW
Fraud and Internal Control
1. (L.O. 1) Fraud is a dishonest act by an employee that results in personal benefit to the employee
at a cost to the employer. The fraud triangle refers to the three factors that contribute to fraudulent
activity by employees: opportunity, financial pressure, and rationalization.
2. Internal control consists of all the related methods and measures adopted within an organization
6. Documentation procedures provide evidence that transactions and events have occurred.
7. Physical controls relate to the safeguarding of assets and include such measures as safes for
the storage of cash prior to deposit, vaults for the deposit of cash, safety deposit boxes for the
storage of important business papers, and locked warehouses for inventories. These controls also
include alarms, television monitors, garment sensors and time clocks.
Limitations of Internal Control
11. The concept of reasonable assurance rests on the premise that the costs of establishing control
procedures should not exceed their expected benefit.
Cash Controls
14. (L.O. 2) To safeguard cash and to ensure the accuracy of the accounting records for cash,
effective internal control over cash is critical.
Cash Receipts Controls
15. The application of internal control principles to cash receipts transactions includes: (1) only
Cash Disbursements Controls
17. Generally, internal control over cash disbursements is more effective when companies pay by
check or electronic funds transfer (EFT), rather than by cash, except for incidental amounts that
are paid out of petty cash.
Voucher System
19. Companies use a voucher system to enhance the internal control over cash disbursements. A
Petty Cash Fund
20. A petty cash fund is a cash fund used to pay relatively small amounts.
a. The operation of the fund, often called an imprest system, involves (1) establishing the fund,
Control Features: Use of a Bank
21. (L.O. 3) The use of a bank minimizes the amount of currency that must be kept on hand and
therefore contributes significantly to good internal control over cash.
24. A bank debit memorandum is usually included with the bank statement to indicate charges
against the depositor’s account such as a bank service charge, cost of printing checks, issuing
traveler’s checks, and when a previously deposited customer’s check “bounces” because of
insufficient funds (NSF check).
Reconciling the Bank Account
26. A reconciliation of a bank account is necessary because the balance per bank and balance per
books are seldom in agreement. The need for agreement may be the result of time lags and
errors.
Reporting Cash
30. (L.O. 4) Cash on hand, cash in banks, and petty cash are often combined and reported simply
as Cash. Because it is the most liquid asset, cash is listed first in the current assets section of the
Compare the Accounting for Fraud, Internal Control, and Cash Under GAAP and IFRS
*32. (L.O. 5) The following are the key similarities and differences between GAAP and IFRS with
regard to fraud, internal control, and cash.
a. Similarities
(1) The fraud triangle is applicable to all international companies.
(2) Rising economic crime poses a growing threat to companies, with 34% of all
organizations world-wide being victims of fraud in a recent 12-month period.
b. Differences
The SOX internal control standards apply only to companies listed on U.S. exchanges.
There is continuing debate over whether foreign issuers should have to comply with this
extra layer of regulation.
LECTURE OUTLINE
A. Fraud.
1. A fraud is a dishonest act by an employee that results in personal benefit
to the employee at a cost to the employer.
2. The fraud triangle refers to the three main factors that contribute to
fraudulent activity by employees:
B. Internal Control.
1. Internal control consists of all the related methods and measures adopted
within an organization to:
C. Principles of Internal Control Activities.
1. Establishment of responsibility: control is most effective when only one
person is responsible for a given task, (i.e., cash register).
2. Segregation of duties: the work of one employee should, without a dupli–
cation of effort, provide a reliable basis for evaluating the work of another
employee.
a. Related activities: making one individual responsible for related
activities increases the potential for errors and irregularities.
3. Documentation procedures: documents provide evidence that transactions
and events have occurred.
4. Physical controls:
• Physical controls relate to the safeguarding of assets (safes, vaults,
5. Independent internal verification: the review of data prepared by
employees.
a. Maximum benefit from independent internal verification is obtained
when:
6. Human resource controls:
a. Bonding employees who handle cash involves obtaining insurance
protection against theft by employees.
ACCOUNTING ACROSS THE ORGANIZATION
To ensure proper employee supervision and proper separation of duties, companies
must develop and monitor an organizational chart. One corporation that did this
found that out of 17,000 employees, there were 400 people who did not report to
anyone, and 35 people who reported to each other.
Why would unsupervised employees or employees who report to each other
represent potential internal control threats?
D. Limitations of Internal Control.
1. The concept of reasonable assurance rests on the premise that the costs of
establishing control procedures should not exceed their expected benefit.
E. Cash Receipts Controls.
1. In retail businesses, control of over-the-counter receipts centers on cash
registers that are visible to customers.
F. Cash Disbursements Controls.
1. Generally, internal control over cash disbursements is more effective when
2. A voucher system is a network of approvals by authorized individuals,
acting independently, to ensure that all disbursements by check are
proper.
G. Petty Cash Fund.
1. Companies use a petty cash fund to pay relatively small amounts.
2. The operation of a petty cash fund, called an imprest system, involves:
ETHICS INSIGHT
A recent study by the Association of Certified Fraud Examiners found that two-
thirds of all employee thefts involved a fraudulent disbursement by an employee.
The most common form was fraudulent billing schemes.
How can companies reduce the likelihood of fraudulent disbursements?
H. Control Features: Use of a Bank.
1. The use of a bank contributes significantly to good internal control by:
a. Providing physical controls for the storage of cash.
4. A bank statement shows:
a. Checks paid and other debits (i.e. debit card transactions) that reduce
the balance in the depositor’s account.
I. Reconciling the Bank Account.
1. Deposits recorded by the depositor that have not been recorded by the
bank are deposits in transit and are added to the balance per bank.
J. Reporting Cash.
1. On the balance sheet, companies often combine cash on hand, cash in
bank, and petty cash and report the total as Cash.
A Look at IFRS
Fraud can occur anywhere. Because the three main factors that contribute to
fraud are universal in nature, the principles of internal control activities are used
KEY POINTS
SIMILARITIES
• The fraud triangle is applicable to all international companies.
• Rising economic crime poses a growing threat to companies, with nearly
one-third of all organizations worldwide being victims of fraud in a recent
12-month period.
• Companies find that internal control review is a costly process but badly
needed.
DIFFERENCES
• The SOX internal control standards apply only to companies listed on U.S.
exchanges. There is continuing debate over whether foreign issuers should
have to comply with this extra layer of regulation.
LOOKING TO THE FUTURE
Ethics has become a very important aspect of reporting. Different cultures have
different perspectives on bribery and other questionable activities, and
consequently penalties for engaging in such activities vary considerably across
countries.
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. An effective system of internal control will segregate functions between individuals to reduce
the potential for errors and fraud.
True False
2. When one individual is responsible for all of the related activities, the potential for errors and
fraud is increased.
True False
3. Independent internal verification should be made periodically and should be done by an
employee who is independent of the employee responsible for the information.
True False
4. The duties of receiving cash, recording cash receipts transactions, and having custody of
cash should be assigned to a single capable individual.
True False
5. At the end of an accounting period, a debit balance of $99.00 in the Cash Over and Short
account would be reported in the income statement as Miscellaneous Revenue.
True False
6. A check is a written order signed by the depositor directing the bank to pay a specified
sum of money to a designated recipient.
True False
7. Cash proceeds collected by the bank for a depositor would be identified in the bank
statement by a credit memorandum to explain the entry.
True False
8. The lack of agreement between the balance per books and the balance per bank is due
to time lags and errors by either party.
True False
9. An outstanding check that was also outstanding the previous month should not be included
in the reconciliation of the bank statement this month.
True False
10. A postage due expense of $4.75 would be paid out of petty cash and the entry to record
the transaction would reduce the balance of the Petty Cash account by that amount.
True False
Multiple Choice
1. Which of the following is a primary concern of internal control?
a. Promote training programs and control incentives
b. Enhancing the reliability of accounting data
c. Ensuring fairness of the financial statements
d. Encouraging adherence to prescribed managerial performance
2. Each of the following is an attribute of internal control except
a. segregation of duties.
b. establishment of responsibility.
c. independent internal verification.
d. a sound marketing plan.
3. A company issues a check for $75 but records it incorrectly as $57. On the bank recon-
ciliation, the $18 should be
a. deducted from the balance per bank.
b. added to the balance per bank.
c. deducted from the balance per books.
d. deducted from the balance per books and added to the balance per bank.
4. Irwin, Inc. has the following assets at the balance sheet date:
Cash in bank—savings account $4,000
Amounts due from customers 7,000
Post-dated checks 2,000
Checking account balance 6,000
Which amount should be reported as cash in the balance sheet?
a. $10,000
b. $6,000
c. $11,000
d. $13,000
5. A $100 petty cash fund has cash of $17 and valid receipts for $81. The journal entry upon
replenishment would include a
a. credit to Cash for $81.
b. credit to Cash Over and Short for $2.
c. debit to Cash for $81.
d. debit to Cash Over and Short for $2.
ANSWERS TO QUIZ
True/False
Multiple Choice