Accounting Principles Thirteenth Edition

Authors: Weygandt, Kimmel, Kieso

Chapter 8: Fraud, Internal Control, and Cash

Prepared by: Coby HarmonUniversity of California, Santa Barbara, Westmont College

Chapter Outline

Learning Objectives

• LO 1: Define fraud and the principles of internal control.

• LO 2: Apply internal control principles to cash.

• LO 3: Identify the control features of a bank account.

• LO 4: Explain the reporting of cash.

Definition of Fraud

• Fraud: A dishonest act by an employee resulting in personal gain at the employer's expense.

• Fraud Triangle:

  • Opportunity: Circumstances that make committing fraud easier, including weak internal controls.

  • Financial Pressure: Motivation stemming from personal financial problems, such as debt or lifestyle choices.

  • Rationalization: Justifying dishonest actions often by altering one's perception of the morality of the act or believing it to be harmless.

The Sarbanes-Oxley Act (SOX)

Key Elements:

• Applies to publicly traded U.S. corporations, ensuring transparency and ethical standards in financial reporting.

• Mandates a reliable internal control system that must be regularly assessed.

• Corporate executives and boards must ensure the effectiveness of these controls or face penalties.

• Requires independent auditors to attest to internal control adequacy at the end of each financial period.

• Establishment of the Public Company Accounting Oversight Board (PCAOB) to oversee the audits of public companies and enhance audit quality.

Purpose of Internal Control

• Internal control systems are established in organizations to protect assets, improve accuracy, enhance efficiency, and ensure compliance with laws and regulations.

• Safeguard Assets: Implement measures to prevent theft, loss, or unauthorized access to the company’s resources.

• Enhance Reliability: Maintain accurate accounting records to ensure stakeholders can trust financial statements.

• Increase Efficiency: Streamline operations to reduce waste and increase productivity.

• Ensure Compliance: Follow relevant laws and regulations to avoid legal issues and promote a culture of ethical behavior.

Components of Internal Control

Five Primary Components:

1. Control Environment: Sets the tone for the organization and influences the control consciousness of its people.

2. Risk Assessment: Involves identifying and analyzing risks that could prevent the organization from achieving its objectives.

3. Control Activities: Actions established through policies and procedures that help ensure management directives are carried out and risks mitigated.

4. Information and Communication: Ensures that relevant information is communicated in a timely manner to allow employees to perform their responsibilities effectively.

5. Monitoring: Ongoing evaluations of the internal control system to assess its performance and effectiveness.

Principles of Internal Control Activities

• Establishment of Responsibility: Assigning specific responsibilities to individuals enhances efficiency and accountability. Limiting access to authorized personnel is essential to mitigate risk.

Case Study: Fraud Due to Lack of Control

• Missing Control: Establishment of Responsibility at Colossal Healthcare.

• Fraud: Maureen Frugali created fictitious claims, leading to an embezzlement of $11 million.

• Lack of Control: The training supervisor had inappropriate access to create claims in the live system, highlighting the need for proper role definition and authority limits.

Segregation of Duties

Segregation of Duties Principle:

• Related activities should be assigned to different individuals to ensure accountability and reduce the risk of fraud.

• Implementing this principle protects against collusion between employees and ensures that no single employee has control over all aspects of any critical financial transaction.

Case Study: Segregation of Duties Issue

• Missing Control: Lawrence Fairbanks at Aesop University.

• Fraud: Controlled ordering, receiving, and invoicing, embezzling $475,000 through substituted fake invoices for personal gains.

Documentation Procedures

Control Activities:

• Utilize prenumbered documents to ensure that transactions are tracked systematically, preventing fraudulent activities.

• Ensure that source documents, such as receipts and invoices, are submitted promptly to the accounting department to maintain accurate records and prevent discrepancies.

Case Study: Documentation Procedures Failure

• Missing Control: At Mod Fashions, employees submitted multiple claims for the same expenses, using different documentation types leading to total embezzlement of $75,000.

Physical Controls

Definition:

• Safeguards for physical assets to prevent unauthorized access or theft, including the use of safes, vaults, and security systems.

• Require employee identification and access logs for all secure areas.

Case Study: Physical Controls Issue

• Fraud: Employees at Centerstone Health's mailroom embezzled $240,000 by altering applications for commissions.

• Lack of Security: The mailroom was not secured during off-hours, and passwords were easily accessible, leading to opportunistic fraud.

Additional Issues in Physical Controls

• Centerstone Health lacked proper security measures, allowing employees to exploit these vulnerabilities.

Independent Internal Verification

Definition:

• Regular verification of records by a knowledgeable and independent employee to ensure all records match and errors or discrepancies are quickly detected.

Case Study: Independent Verification Missing

• Fraud: Bobbi Jean Donnelly at Mod Fashions Corporation embezzled $275,000 due to the lack of independent verification of her own expense reports.

Consequences of Lack of Verification

• Failure of Bobbi Jean's boss to verify expense reports resulted in unnoticed fraud exceeding $100,000 in unauthorized claims.

Human Resource Controls

Important Controls:

• Bond employees who manage cash to provide insurance against potential losses due to theft.

• Rotate duties and require mandatory vacations to reduce opportunities for fraud and enhance oversight.

• Conduct thorough background checks on employees, especially for those in sensitive positions.

Case Study: Human Resource Control Failure

• Fraud: Ellen Lowry and Josephine Rodriguez at Excelsior Inn embezzled $95,000.

• Issue: Friends covered for each other, allowing unchecked access to cash and room keys, which facilitated theft.

Detection Through Proper Controls

• Without human resource controls such as background checks and mandatory vacations, fraud may remain undetected, leading to significant losses.

Limitations of Internal Control

Considerations:

• The cost of implementing controls should not exceed the benefits derived from those controls.

• Human elements, including employee behavior and compliance, affect the overall effectiveness of controls.

• The size and structure of an organization can limit the ability to establish comprehensive internal controls.

• High-risk areas, especially cash handling, may require stricter controls to mitigate the risks involved.

Example of Control Violation

Scenario:

• Accountant managing both bank reconciliation and deposits, violating segregation of duties, which creates an opportunity for embezzlement.

Example of Human Resource Control Violation

Scenario:

• Treasurer has not taken a vacation in 30 years, risking potential embezzlement due to the lack of rotation in responsibilities.

Example of Documentation Procedures Violation

Scenario:

• A local restaurant that lacks prenumbered tickets enables cash sales without accountability, demonstrating a significant oversight in documentation practices.

Cash Receipts Controls

Principles:

• Establishment of Responsibility: Cash handling should be limited to authorized personnel to safeguard cash assets.

• Segregation of Duties: Cash receipts and record management should be handled by different staff members to prevent fraudulent activity.

Cash Receipts Controls Continued

Documentation Procedures:

• Utilize remittance advice, cash registers, and deposit slips for all cash transactions to ensure traceability and accountability.

Physical Controls:

• Store cash securely in safes or locked cabinets to limit access and prevent theft.

Additional Cash Receipts Controls

Independent Internal Verification:

• Perform daily cash counts and compare them to bank deposits by supervisors to ensure accuracy.

Human Resource Controls:

• Bonding, mandatory vacations, and background checks are essential for all personnel handling cash to mitigate risks.

Control of Over-the-Counter Receipts

Process Overview:

• Clerk enters sales and receives cash, ensuring accurate recording of each transaction.

• Supervisor manages cash register tapes to verify cash collected against sales recorded.

• Cashier prepares deposit slips after counting cash, ensuring accountability before funds are sent to the bank.

• Accounting department records journal entries to reflect transactions and ensures funds are safely delivered to the bank.

Mail Receipts Controls

Process for Handling Mail Receipts:

• Opened by two clerks to promote oversight; both endorse checks to ensure authenticity before processing.