Chapter 7: Fraud, Internal Control, and Cash Accounting Principles of Cash Management

Fraud and the Sarbanes-Oxley Act

Fraud is defined as a dishonest act performed by an employee for personal gain at the expense of the employer. The Sarbanes-Oxley Act (SOX) addresses such activities by requiring publicly traded U.S. corporations to maintain effective internal control systems. Under SOX, corporate executives and boards must ensure these controls are reliable, while independent auditors must attest to their adequacy. The act also established the Public Company Accounting Oversight Board (PCAOB) to oversee auditing and related activities.

Components and Principles of Internal Control

An effective internal control system consists of five primary components: a control environment, risk assessment, control activities, information and communication, and monitoring. These systems are designed to safeguard assets, enhance accounting record reliability, increase operational efficiency, and ensure regulatory compliance.

Control activities follow six key principles. Establishment of responsibility determines that one person is accountable for a specific task. Segregation of duties ensures that different individuals are responsible for related activities and that record-keeping is separate from physical custody. Documentation procedures involve using prenumbered documents to account for all transactions. Physical controls include safes, alarms, and password-protected systems to deter theft. Independent internal verification involves periodic reviews of records by an independent employee. Human resource controls include bonding cash-handling employees, requiring mandatory vacations, and conducting background checks.

Internal Controls for Cash Transactions

Cash receipt controls focus on the segregation of record-keeping from physical custody. For over-the-counter receipts, cash registers are used to provide records. Mail receipts should be handled by two clerks who prepare and sign a list of checks endorsed "For Deposit Only." Internal controls for cash disbursements are most effective when payments are made via check or Electronic Funds Transfer (EFT). Voucher systems provide a network of independent approvals to ensure disbursements are proper. While most disbursements should avoid cash, petty cash funds may be used for incidental amounts.

Petty Cash and Bank Reconciliations

A petty cash fund is established by debiting Petty Cash and crediting Cash. For example, if a company establishes a fund for $100$, the account is debited by that amount. During replenishment, expenses such as Postage Expense, Freight-Out, or Miscellaneous Expense are debited based on receipts, and Cash is credited for the replenishment amount. If the physical cash plus receipts do not match the fund balance, a Cash Over and Short account is used to record the discrepancy, such as a debit of $1$ if the fund is short.

Bank reconciliations ensure that the balance per the bank statement matches the balance per the company's books. Reconciling items for the bank balance include adding deposits in transit and deducting outstanding checks. Reconciling items for the book balance include adding EFT collections and interest earned, while deducting bank service charges, NSF (bounced) checks, and debit/credit card fees. Adjusting journal entries must be made for all items affecting the book balance to reach the correct cash balance.

Reporting Cash and International Standards

Cash is listed first in the current assets section of the balance sheet. Cash equivalents are short-term, highly liquid investments readily convertible to cash, such as those that are near maturity and insensitive to interest rate changes. Restricted cash is money set aside for a specific purpose and not available for general use; it is reported as either a current or noncurrent asset depending on the restriction terms.

Under GAAP and IFRS, the accounting for cash is largely similar, including the definitions of cash and cash equivalents. However, the SOX internal control standards apply specifically to companies listed on U.S. exchanges. High-quality international financial reporting relies on the convergence of both accounting standards and auditing standards established by bodies like the International Auditing and Assurance Standards Board (IAASB).

Questions & Discussion

Question: Permitting only designated personnel to handle cash receipts is an application of which principle? Answer: Establishment of responsibility.

Question: The use of prenumbered checks in disbursing cash is an application of which principle? Answer: Documentation procedures.

Question: Which of the following is not a control feature of a bank account? Answer: Having bank auditors verify the correctness of the bank balance per books.

Question: Which reconciling item in a bank reconciliation results in an adjusting entry by the depositor? Answer: Bank service charges.

Question: Which statement correctly describes the reporting of cash? Answer: Cash is listed first in the current assets section.

Question: Do non-US companies that follow IFRS have to follow SOX? Answer: They are not required to follow SOX.

Question: To which entities does the Sarbanes-Oxley Act apply? Answer: All U.S. companies listed on U.S. exchanges.

Question: High-quality international accounting requires high-quality accounting standards and what else? Answer: High-quality auditing standards.