Assets, Fraud, and Internal Controls

Assets Overview

• FASB Definition of an Asset:

  • Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

  • Three key components:

    • Probable Future Economic Benefit: The item is likely to be worth something in the future.

    • Obtained or Controlled by a Particular Entity: The company owns or controls the item.

    • Result of Past Transactions or Events: A verifiable transaction exists for the asset's acquisition.

• Balance Sheet Reporting of Assets:

  • Current Assets: Converted to cash or used up within one year.

    • Examples: Cash, accounts receivable, inventory, supplies, prepaid expenses.

  • Long-Term Assets: Value expected to last beyond one year.

    • Categories: Long-term investments, plant assets, intangible assets, other long-term assets.

Specific Assets Covered

• Cash:

  • Includes currency, coins, checking accounts, and undeposited checks from customers.

  • Internal controls over cash are crucial.

• Inventory:

  • For merchandise firms: Current assets held for resale.

  • Manufacturing firms: Raw materials, work in process, finished goods.

• Receivables:

  • Money a company has the right to receive for goods or services.

  • Types: Accounts receivables and notes receivables.

  • Typically current assets, but long-term notes receivables are common.

Accounting Fraud

• Definition: Intentional misrepresentation of facts resulting in harm to others.

• Examples of Accounting Frauds:

  • Waste Management & HealthSouth: Reported fake revenues exceeding $1,500,000,000$.

  • Enron: Hid billions of dollars of liabilities, leading to shareholder losses over $74,000,000,000$.

  • Lehman Brothers: Recorded liabilities as revenues, totaling nearly $50,000,000,000$.

  • WorldCom: Recorded approximately $11,000,000,000$ in expenses as assets.

• Types of Accounting Fraud:

  • Misappropriation of Assets: Stealing (often smaller amounts).

  • Fraudulent Financial Reporting: Involves larger-scale manipulation of financial statements.

• Fraud Triangle:

  • Opportunity: Access to commit fraud.

  • Pressure: Financial or market pressures.

  • Rationalization: Justifying the fraudulent actions.

Sarbanes-Oxley Act of 2002 (SOX)

• Enacted in response to corporate accounting scandals (e.g., Enron, WorldCom).

• Applies to publicly traded U.S. companies.

• Key Requirements:

  • Maintain a system of internal controls.

  • Corporate executives and board of directors must ensure controls are reliable and effective.

  • Independent outside auditors must attest to the adequacy of internal control systems.

  • Creation of the Public Company Accounting Oversight Board (PCAOB).

  • Stiff penalties for violators (e.g., 20-25 years in prison).

• Public Company Accounting Oversight Board (PCAOB):

  • A private-sector, non-profit corporation overseeing audits of public companies.

  • Protects investors' interests and promotes accurate, independent audit reports.

Internal Controls

• Definition: Organizational plan and related measures to:

  • Safeguard assets.

  • Ensure accurate and reliable accounting records.

  • Promote operational efficiency.

  • Ensure compliance with laws and regulations.

• Objectives of Internal Controls in Detail:

  • Protect assets from theft, destruction, and misuse.

  • Ensure consistent task performance through policies.

  • Produce accurate, reliable accounting records.

  • Reduce expenses and increase profits through operational efficiency.

  • Ensure compliance with laws and regulations.

• Five Key Components of Internal Controls:

  • Control Environment: Overall attitude and awareness of management regarding internal control systems.

    • Expressed through management style, corporate culture, values, operating style, organizational structure, and HR policies.

  • Risk Assessment: Identifying potential exposures.

    • Control Risk: The risk that misstatements occur but are not detected or corrected by internal controls.

  • Information Systems: Ensuring adequate approvals for transactions and preventing unauthorized access.

    • Protects business and customer information.

    • Security measures include encryption and firewalls for e-commerce risks.

  • Monitoring: Oversight of internal control procedures, often through auditors.

    • Internal Auditors: Employees who check for company policy adherence and legal compliance.

    • External Auditors: Independent auditors who assess financial statement preparation controls and recommend improvements.

  • Control Procedures: Ensuring business goals are achieved.

    • Hiring competent, reliable, and ethical personnel.

    • Clearly assigned responsibilities for job accountability.

    • Separation of Duties: Dividing responsibilities to limit fraud and promote accuracy.

      • Separating operations from accounting.

      • Separating custody of assets from accounting.

    • Documents: Providing transaction details; should be pre-numbered to prevent theft.

• Limitations of Internal Controls:

  • Collusion: Circumvention through employee collaboration.

  • Cost-Benefit Relationship: Evaluating controls based on their financial sense.

  • Small Business Risk: Higher fraud risk due to limited resources for separation of duties and trained personnel.

Internal Controls Over Cash

• High inherent risk of theft; strong internal controls are essential.

• Controls Over Cash Receipts (Over the Counter):

  • Receipts issued for each transaction to create a paper trail.

  • Cash drawer opened only for transactions.

  • Actual cash on hand compared to register results at the end of the day.

  • Separation of duties: Someone prepares the deposit and another enters sales receipts into the accounting system.

• Controls Over Cash Receipts (By Mail):

  • Separation of duties: Person receiving cash is different from the one recording customer payments.

  • Cash goes to a separate department or person than the remittance advice.

  • Bank reconciliation performed to match deposited amounts with the cash ledger.

  • Remittance advice included with payments to ensure proper posting.

• Internal Controls Over Payments:

  • Separation of duties between operations and check writing.

  • Payment by check provides a record.

  • Checks must be signed by authorized personnel.

  • Invoice and supporting documentation reviewed before signing checks.

• Steps for Proper Purchases and Payments:

  • Buyer orders products and provides a purchase order number.

  • A copy of the purchase order goes to the accounting department.

  • The seller ships goods and sends an invoice to the accounting department of the buying company.

  • A receiving report is prepared detailing the items received and quantities.

  • Accounting compares purchase order, invoice, and receiving report before authorizing payment.

Bank Reconciliation

• Keeping cash in a bank account helps control cash.

• Documents Used to Control a Bank Account:

  • Signature card: Authorizes account access.

  • Deposit tickets: Summarize deposits.

  • Checks: Provide a paper trail of spending.

  • Electronic Funds Transfers (EFTs): Transfer money directly between accounts without paper.

• Two Records of a Business's Cash:

  • Cash account in the company's general ledger (the book).

  • Bank statement.

• Bank Reconciliation Process:

  • Explaining differences between cash account and bank statement balance due to time lags.

  • Done at the end of the accounting period.

  • Adjusting entries are part of step five in the accounting cycle, adjusting entries.

  • Result is adjusted cash balance for the balance sheet and statement of cash flows.

• Reconciling Items (Bank Side): It is stuff the book knows about, but the bank does not.

  • Deposits in Transit: Receipts recorded by the company but not yet by the bank (added to the bank statement balance).

  • Outstanding Checks: Checks written but not yet cleared (deducted from the bank statement balance).

  • Bank Errors: Can either add or subtract from the bank statement balance.

• Reconciling Items (Book Side): It is stuff the bank knows about, but the book does not.

  • Bank Collections: Customer payments sent directly to the bank (added to the book balance).

  • Interest Revenue: Interest earned on the bank account (added to the book balance).

  • Bank Service Charges and Fees: (Deducted from the book balance).

  • EFT Payments: Electronic payments (deducted from the book balance).

  • NSF Checks: Non-sufficient funds checks (deducted from the book balance).

  • Book Errors: Can either add or subtract from the cash balance.

• Steps in the Bank Reconciliation Process:

  • Reconcile the bank statement balance.

  • Reconcile the book balance.

  • Compare the bank's adjusted cash balance to the book's adjusted cash balance to ensure that they are the same.

  • Make adjusting entries for items that reconcile the book side.

Bank Reconciliation Example

• Bank statement balance: $42,006.25$

• Unadjusted cash account balance: $37,007.25$

• The focus of the video will be how to reconcile the bank statement balance.

• Book Knows but Bank Doesn't:

  • Deposits in transit.

    • A $36,500$ deposit recorded on November 30 but not on the bank statement.

  • Outstanding checks

    • Checks number 207 and 208, with a toal of $32,000$ not yet cleared by the bank.

  • Bank error

    • A $8,000$ should have been deducted but instead only deducted $800$, resulting in an error correction deduction of $7,200$.

• Reconciling formula: Bank

  • Bank statement balance plus deposits in transit minus outstanding checks plus or minus any bank errors to arrive at the adjusted cash balance.

• The focus of the video will be how to reconcile the book balance.

• Bank Knows but Book Doesn't:

  • Bank collections:

    • Collection of $18,250$ relating to a notes receivable.

  • Interest revenue:

    • $150$ in interest earned.

  • Service charges:

    • $200$ in surface charges.

  • EFT Payments:

    • $12,500$ EFT payment for rent expense for a warehouse.

  • NSF Checks

    • NSF checks totaling $4,000$.

  • Book Errors

    • Check 202 was incorrectly recorded by the accountant for $1,500$ instead of $1,000$, resulting in an book error addition of $500$.

• Reconciling formula: Book

  • Cash balance plus bank collections plus interest revenue minus service charges minus EFT payments minus NSF checks and plus or minus any book errors to arrive at the adjusted cash balance.

Adjusting Entries

• Complete the bank reconciliation to calculate adjusted cash balance.

• Determine that adjusted cash balance should be $39,925$. However, cash ledger still shows the unadjusted balance of $37,725$.

• Items that are added in the reconciliation process mean a debit to cash and a credit to whatever account the item relates to.

• Items that are deducted in the reconciliation means a credit to cash and the debit to, again, whatever the item relates to.

• Make adjusting entries (examples)

  • Debit cash and credit notes receivable for $18,250$ (collection).

  • Debit cash and credit interest revenue for $150$ (interest).

  • Debit bank service charge expense and credit cash for $200$ (service charge).

  • Debit rent expense and credit cash for $12,500$ (EFT payment).

  • Debit accounts receivable and credit cash for $4,000$ (NSF checks).

  • Debit cash and credit accounts payable for $500$ (book error).

• Do not make adjusting entries for the items that reconcile the bank side because we've already recorded these items on our books.