Cash, Fraud, and Internal Control: Chapter 6

Cash, Fraud, and Internal Control - Chapter 6 Study Notes

Review Before Class

  • Preview the slides before each class to familiarize yourself with key concepts and terms.
  • Take Notes: Focus on new vocabulary words by jotting down definitions and examples to strengthen your understanding of key terms.
  • Work Through Examples: Actively work through each example provided on the slides to ensure you understand the application of concepts.
  • Revisit Slides Weekly: After each class, revisit the slides as part of your weekly review to reinforce your learning and identify areas needing clarification.
  • Utilize for Exam Prep: Use the slides as a study tool when preparing for exams, focusing on key points and summary sections for efficient review.

Chapter 6 Learning Objectives

  • Conceptual Learning Objectives:
    • C1: Define internal control and identify its purpose and principles.
    • C2: Define cash and cash equivalents and explain how to report them.
  • Analytical Learning Objective:
    • A1: Compute the days’ sales uncollected ratio and use it to assess liquidity.
  • Procedural Learning Objectives:
    • P1: Apply internal control to cash receipts and payments.
    • P2: Explain and record petty cash fund transactions.
    • P3: Prepare a bank reconciliation.
    • P4 (Appendix 6A): Describe the use of documentation and verification to control cash payments.

Learning Objective C1: Define Internal Control

Internal Control System
  • Definition: An internal control system is utilized to monitor and control business activities.
  • Purpose: Includes the policies and procedures used to:
    • Protect assets.
    • Ensure reliable accounting.
    • Uphold company policies.
    • Promote efficient operations.
Sarbanes-Oxley Act (SOX)
  • Overview: The Sarbanes-Oxley Act mandates that managers and auditors of public companies document and certify their systems of internal controls.
  • Key Requirements:
    • Companies must maintain effective internal controls.
    • Auditors are required to evaluate internal controls.
    • Violations can lead to severe penalties including a maximum of 25 years in prison and significant fines.
    • The Public Company Accounting Oversight Board (PCAOB) oversees auditors’ work.
Committee of Sponsoring Organizations (COSO)
  • Five Ingredients of Internal Control:
    1. Control environment
    2. Risk assessment
    3. Control activities
    4. Information & communication
    5. Monitoring
Principles of Internal Control
  • Common Principles:
    • Establish responsibilities.
    • Maintain adequate records.
    • Insure assets and bond key employees.
    • Separate recordkeeping from custody of assets.
    • Divide responsibility for related transactions.
    • Apply technological controls.
    • Perform regular and independent reviews.
Detailed Explanation of Internal Control Principles
Establish Responsibilities
  • Tasks must be clearly defined and assigned to specific individuals to enable accountability.
Maintain Adequate Records
  • Purpose: Protects assets and helps managers monitor activities.
  • Includes:
    • Detailed records.
    • Use of a chart of accounts.
    • Preprinted forms.
    • Prenumbered sales slips.
    • Computerized point-of-sale systems.
Insure Assets and Bond Key Employees
  • All assets should be insured against potential losses.
  • Employees handling significant cash or assets should be bonded, meaning the company purchases an insurance policy to protect against theft by said employees.
Separate Recordkeeping from Custody of Assets
  • The individual managing an asset should not have access to the accounting records for that asset to prevent unauthorized actions.
  • This setup necessitates collusion for fraud to occur, as two individuals would need to agree secretly.
Divide Responsibility for Related Transactions
  • Transaction responsibilities should be distributed to multiple people. This is necessary to ensure peer checks and minimize fraud or errors, known as the separation of duties.
Apply Technological Controls
  • Use of modern technologies such as electronic cash registers to ensure accurate transaction records and limit unauthorized access using ID scanners.
Perform Regular and Independent Reviews
  • Regular reviews are essential to ensure compliance with internal procedures. Typically, these reviews should be conducted by external auditors to evaluate the effectiveness of internal controls.
Limitations of Internal Control
  • Human Error: Can include mistakes due to carelessness, misjudgment, or confusion.
  • Human Fraud: Deliberate attempts to violate controls for personal gain.
  • The Fraud Triangle: Consists of three elements: Opportunity, Pressure, and Rationalization.
  • Cost-Benefit Constraint: The costs associated with internal controls should not exceed their expected benefits.

Learning Objective C2: Define Cash and Cash Equivalents

Control of Cash
  • An effective internal control system for cash should meet three basic guidelines:
    • Handling of cash should be separate from recordkeeping.
    • Payments should be made by check or electronic funds transfer (EFT).
    • Cash receipts should be deposited promptly in a bank.
Definition of Cash and Cash Equivalents
  • Cash: Includes currency, coins, and deposits held in bank accounts, as well as items such as customer checks, cashier checks, certified checks, and money orders.
  • Cash Equivalents: Defined as short-term, highly liquid investments that are:
    1. Readily convertible to a known cash amount.
    2. Close to their maturity date and not sensitive to market changes.
  • Liquidity: Cash and cash equivalents are considered liquid assets, available for paying liabilities immediately.
Cash Management Goals
  • The dual goals of cash management are:
    1. Plan cash receipts to ensure they cover cash payments when due.
    2. Maintain a minimum level of cash necessary for operations.
  • Cash Management Strategies:
    • Encourage prompt collection of receivables.
    • Delay payment of liabilities where feasible.
    • Maintain only the necessary level of cash and invest excess cash when possible.

Learning Objective P1: Apply Internal Control to Cash Receipts and Payments

Over-the-Counter Cash Receipts
  • Illustrates an internal control system where no individuals can mismanage cash without the discrepancy becoming apparent.
Cash Over and Short
  • Overages: If cash register records indicate $550 while the count reveals $555, a journal entry is required to reflect this surplus.
  • Shortages: Conversely, if a register shows $625 but the actual count is $621, a corresponding entry would track this deficit in cash records.
Control of Cash Payments
  • Crucial to control cash payments to prevent theft due to fictitious invoices.
  • Key Strategies for Control:
    • All payments should be executed via check.
    • Access to accounting records should be restricted to authorized personnel.
  • Cash Budget: Must encompass projected receipts and payments.
Voucher System of Control
  • A voucher system formalizes procedures for:
    • Verifying, approving, and recording liabilities before cash payments.
    • Issuing checks for payment of verified obligations.

Learning Objective P2: Explain and Record Petty Cash Fund Transactions

Petty Cash System of Control
  • Intended for small payments (e.g., shipping fees, minor repairs).
Establishing a Petty Cash Fund
  • Accounting Treatment: Debit Petty Cash account to establish the fund, crediting Cash to decrease total cash.
Operating a Petty Cash Fund
  • Summarizing petty cash receipts is crucial for effective tracking and control.
Reimbursement of Petty Cash Fund
  • Upon reimbursement, the petty cash report is vital for journal entries; debit expenses incurred and credit Cash.
Adjusting Petty Cash Fund Size
  • Increasing Fund: Debit Petty Cash and credit Cash.
  • Decreasing Fund: Debit Cash and credit Petty Cash.
Cash Over and Short in Petty Cash
  • Shortages lead to a debit in Cash Over and Short; overages are credited accordingly.

Learning Objective P3: Prepare a Bank Reconciliation

Bank Reconciliation Overview
  • Definition: A reconciliation routinely prepared to explain discrepancies between bank statement cash and company cash records.
Purpose of Bank Reconciliation
  • Reconciliation Formula:
    • Cash Balance per Bank + Deposits in Transit - Outstanding Checks +/- Bank Errors = Adjusted Cash Balance
    • Cash Balance per Book + Collections & Interest - Bank fees and NSF Checks +/- Book Errors = Adjusted Cash Balance
    • Adjusting entries needed only for items reconciling the book balance.
Steps for Bank Reconciliation
  • Demonstration: Specific steps for reconciling three kinds of financial adjustments will be conducted to ensure accuracy.

Learning Objective A1: Compute the Days’ Sales Uncollected Ratio

Days’ Sales Uncollected Formula
  • Formula:
    racextAccountsReceivableextNetSalesimes365rac{ ext{Accounts Receivable}}{ ext{Net Sales}} imes 365
  • Purpose: Indicates the average time until cash is received from credit sales.

Appendix 6A: Documentation and Verification to Control Cash Payments

Key Documents Involved in Payment Control
  • Documentation: Receives report, purchase requisition, purchase order, and invoice are essential for verifying and approving payments.
  • Invoice Approval Process: Critical for ensuring that all documents align before payment is authorized, hence termed check authorization.
  • Creation of Voucher: A voucher is finalized after all verifications are completed, used to log and authorize recording obligations.