Accounting 101: Fraud, Internal Controls, and Cash

Accounting 101 - Chapter 7: Fraud, Internal Controls, and Cash

1. Fraud

  • Definition: A dishonest act by an employee that results in personal benefit to the employee at a cost to the employer.

    • Example 1: A shipping clerk with 28 years of service shipped $125,000 of merchandise to himself.

    • Example 2: A church treasurer “borrowed” $150,000 of church funds to finance a friend’s business dealings.

    • Example 3: A student aide clocks out before his or her shift is up and gets paid for the whole shift.

2. Fraud Triangle

  • Components of the Fraud Triangle:

    • Opportunity: Occurs when the workplace lacks sufficient controls to deter and detect fraud.

    • Financial Pressure: Employees may experience too much debt or be unable to maintain their lifestyle on their current salary.

    • Rationalization: Employees justify their fraudulent actions by believing they are underpaid.

3. Internal Controls

  • Definition: Processes designed to provide reasonable assurance regarding the achievement of company objectives related to:

    • Operations

    • Reporting

    • Compliance

  • Purpose: To safeguard assets, enhance the reliability of accounting records, increase efficiency of operations, and ensure compliance with laws and regulations.

4. Components of Internal Control

  • Control Environment

  • Risk Assessment

  • Control Activities

  • Information and Communication

  • Monitoring

4.1 Control Environment

  • Management's Role:

    • Management must stress the organization's values of integrity.

    • Unethical behavior must not be tolerated.

    • Known as the “Tone at the Top.”

4.2 Risk Assessment

  • Risk Management: Organizations must identify and analyze various factors that create risk and assess how these risks are managed.

4.3 Control Activities

  • Purpose: Designed to reduce the occurrence of fraud.

  • Design Considerations: Must establish policies and procedures to address specific risks faced by the company.

4.4 Information and Communication

  • System Requirements:

    • Should capture and communicate all pertinent information both downward and upward within the organization.

    • Communications must extend to appropriate external parties.

4.5 Monitoring

  • Monitoring Systems:

    • Systems should be periodically monitored for adequacy.

    • Any deficiencies need to be reported to top management and/or the board of directors.

5. Principles of Internal Control Activities

  • Establishment of Responsibility:

    • Control is most effective when one person is responsible for a given task.

    • Limit access to authorized personnel.

    • Examples:

    • Automated systems using identifying passcodes.

    • Cash drawers at stores.

  • Segregation of Duties:

    • Different individuals should be responsible for related activities.

    • The responsibility for recordkeeping of an asset is separate from the physical custody of that asset.

    • The work of one employee should provide a reliable basis for evaluating another employee's work without duplication of effort.

5.1 Segregation of Duties (Continued)

  • Segregation of Related Activities:

    • Making one individual responsible for related activities increases the potential for errors or irregularities.

  • Segregation of Recordkeeping from Physical Custody:

    • When one employee maintains records and another has physical custody of the asset, the custodian is less likely to convert the asset for personal use.

5.2 Documentation Procedures

  • Best Practices:

    • Use prenumbered documents, ensuring all documents are accounted for.

    • Source documents must be forwarded to the accounting department promptly.

    • Transactions should be recorded in a timely manner.

5.3 Physical Controls

  • Safeguarding Assets:

    • Physical controls include various means to safeguard assets and enhance accounting accuracy and reliability.

    • Examples include:

    • Safes, vaults

    • Computers with passkey access

    • Alarms

    • Time clocks

    • Garment sensors.

  • Control Measures: Physical access should be restricted to authorized personnel and secured through technology.

5.4 Independent Internal Verification

  • Verification Practices:

    • Companies should verify records periodically or on a surprise basis.

    • The verification should be executed by an employee independent of personnel responsible for the records.

    • Discrepancies and exceptions should be communicated to management for corrective action.

    • Example: Internal Auditors conduct these verifications.

5.5 Human Resource Controls

  • Employee Management Practices:

    • Bond employees who handle cash through insurance against employee theft.

    • Rotate employee duties and require vacations to mitigate risks.

    • Conduct thorough background checks before hiring.

6. Limitations of Internal Control

  • Reasonable Assurance: Internal controls are designed to provide reasonable assurance of proper safeguarding of assets.

  • Cost-Benefit Analysis: The costs associated with internal control measures should not exceed the benefits provided by those controls.

  • Human Element: Acknowledges the potential for collusion, where two or more individuals may work together to bypass prescribed controls.

  • Business Size Limitations: The size of a business can impose inherent limitations on internal control measures, making implementation more challenging.