Chapter 7

Internal Control and Cash

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Fraud

 Any act by management or employees of a business

involving an intentional deception for personal gain.
 Types of fraud:
 Embezzlement of cash
 Theft of assets
 Filing false insurance claims
 Financial statement fraud

 Any person, under the right circumstances, is

capable of committing fraud.

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The Fraud Triangle

 Pressure
 Nearly all frauds are committed by individuals under financial
pressure.
 Financial statement fraud is often associated with pressure to
meet or beat expectations.
 Rationalization
 Attempt to justify actions to overcome
feelings of guilt.
 Opportunity
 Perception that there is a chance
to get away with it.

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Internal Controls

 Measures undertaken by a business to ensure the

reliability of the accounting data, protect assets
from unauthorized use, and ensure employees are
following policies and procedures.
 Reduce the likelihood of errors.
 Catch any errors that may occur.
 Responsibility of management.

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The COSO Framework

 The Committee On Sponsoring Organizations’

framework identifies five internal control
components:
1. Control environment
2. Risk assessment
3. Control activities
4. Information and communication
5. Monitoring activities

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(1) Control Environment

 The control environment sets the tone for the

organization.
 Provides the foundation for all other internal control
components
 The control environment includes:
 Management philosophy and style
 Assignment of authority and responsibility
 Process for attracting and developing competent employees
 Reward system to drive accountability

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(2) Risk Assessment

 Risk is the possibility that an event will occur that

will have a negative impact on the organization.
 Risk assessment involves identifying and analyzing
relevant risks.
 Ongoing dynamic and iterative process.

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(3) Control Activities

 Control activities are the specific policies and

procedures designed to reduce risk.
 Prevention controls are intended to deter a problem
before it occurs
 Detection controls are designed to uncover problems
after they occur.
 Prevention controls are generally preferred
to detection controls.
 It is almost always less expensive to prevent
a problem than it is to recover from one.
 “An ounce of prevention is worth a pound
of cure.”

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Establish Clear Lines of Authority
and Responsibility

 Prevention control
 Employees are more likely to follow established policies and
procedures if they know somebody with authority is
evaluating their performance.
 Detection control
 Supervisors are likely to discover errors when reviewing the
performance of employees.

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Segregation of Duties

 Prevention control
 No one individual is assigned responsibilities that allow them
to perpetrate and then conceal fraud.
 The following functions should be separated:
1. Authorization
2. Recording
3. Custody

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Hire Competent Personnel

 Prevention control
 Screening job applicants and providing training to employees
to ensure they are capable of meeting the requirements and
expectations of their job.
 Detection control
 Job rotation and mandatory vacations can result
in the discovery of errors or irregularities.

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Use Control Numbers

 Detection control
 Pre-printing business documents such as checks, sales
invoices, and purchase orders with control numbers makes it
possible to identify missing or unapproved transactions.

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Develop Plans and Budgets

 Prevention control
 Plans and budgets provide a roadmap that guides business
decisions.
 Detection control
 Budgets provide a benchmark for comparison to actual
results.
 Material deviations should be carefully examined.

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Maintain Adequate
Accounting Records

 Detection control
 Accounting records make it possible to verify company assets
and liabilities.
 Compare to physical counts of inventory and plant assets.
 Compare to confirmations from external parties of the amount of
cash, accounts receivable, and accounts payable.

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Provide Physical
and Electronic Controls

 Prevention control
 Limits the ability of unauthorized individuals (external
parties or employees) to access company assets and
records.
 Locked doors, safes, fences with guards, security cameras,
electronic cash registers
 Detection control
 If a breach does occur, can aid in tracking down
the perpetrator.

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Select the Correct Answer…

The element of internal control which limits the

responsibilities assigned to any one individual is:

A. Maintain adequate accounting records

B. Segregation of duties
C. Conduct internal audits
D. Use control numbers

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(4) Information and Communication

 Individuals must receive a clear message from top

management that control responsibilities are to be
taken seriously.
 Updating and communicating information should be a
continual process.

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(5) Monitoring Activities

 Monitoring activities involve ongoing evaluations,

special evaluations, or both.
 Internal audits
 Provide an appraisal of a company’s internal control, financial
records, and operations.
 Role of the internal auditor
 Determines if adequate controls are in
place and functioning as planned.
 Makes recommendations to management
for improvements.

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Control Failures

 Even the best internal controls may fail at times.

 Unintentional―employee forgets to lock a door
 Intentional―collusion among employees to steal
assets
 Difficult to prevent or detect
 Hire high-quality employees, pay them adequately, provide
adequate supervision, and maintain an ethical environment
 Companies typically purchase insurance to
compensate for losses when control failures occur.

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Sarbanes-Oxley Act

 Requires publicly traded companies to maintain an

adequate system of internal controls.
 Top management must ensure the reliability of controls.
 External auditors must attest to the adequacy of controls.

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Accounting for Cash

 Cash includes coins, currency, checks, money

orders, checking and savings accounts.
 Cash is often reported combined with cash
equivalents
 Liquid investments with maturity of 90 days or less
 Certificates of deposit, U.S. Treasury bills, and
money market accounts.
 Cash that is restricted in its use
must be reported separately.

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Internal Control for Cash

 Most companies have developed elaborate internal

controls to safeguard cash.
 Segregation of duties:
 Mailroom or retail sales area receives cash and prepares a
remittance list. Sends cash to Treasurer and remittance list to
Controller.
 Treasurer deposits cash and sends
deposit slip to controller.
 Controller compares deposit slip to
remittance list and records journal entry.
 Internal audit reconciles bank statement
to general ledger cash account.

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Select the Correct Answer…

Proper control for cash includes each of the following

except:

A. Mailroom prepares remittance list

B. Internal audit prepares bank reconciliation
C. Treasurer records journal entry
D. Treasurer deposits cash

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Bank Reconciliation

 The bank reconciliation is a schedule that accounts

for all differences between the balance of cash on
the bank statement and the Cash account in the
general ledger.
 After preparing the bank reconciliation, internal
audit records journal entries to bring the balance
in the Cash account to the reconciled cash
balance.

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Bank Reconciliation Process

Record
journal entries
to bring the
balance in the
Cash account to
the reconciled
cash balance.

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Effective Cash Management
 Manage accounts receivable
 Faster collection provides cash to pay obligations as they come due.

 Manage inventory levels

 Keep inventory levels as low as possible without losing sales.

 Manage payables
 Delay payment as long as reasonably possible without damaging
relationships with suppliers or incurring penalties.
 Invest excess cash
 Hold the amount of cash necessary to meet day-to-day needs;
invest any excess to earn a higher return.
 Monitor the effectiveness of a company’s cash
management using the statement of cash flows.

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Auditing
 Financial Statement Audits
 Examination of the annual financial statements by an
independent external auditor.
 Audit procedures established by the Public Company
Accounting Oversight Board (PCAOB).
 The audit report expresses an opinion on the financial
statements.
 Operational Audits
 An evaluation of activities, systems, and internal controls to
determine their efficiency and effectiveness.
 Can be performed by an external auditor or the internal audit
department of the company.

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