If you're ever looking for a cappuccino in Moose Jaw, Saskatchewan, stop by Stephanie's Gourmet Coffee and More, located on Main Street. Staff there serve, on average, 650 cups of coffee a day, including both regular and specialty coffees, not to mention soups, Italian sandwiches, and a wide assortment of gourmet cheesecakes.
“We've got high school students who come here, and students from the community college,” says owner/manager Stephanie Mintenko, who has run the place since opening it in 1995. “We have customers who are retired, and others who are working people and have only 30 minutes for lunch. We have to be pretty quick.”
That means that the cashiers have to be efficient. Like most businesses where purchases are low-cost and high-volume, cash control has to be simple.
“We have an electronic cash register, but it's not the fancy new kind where you just punch in the item,” explains Ms. Mintenko. “You have to punch in the prices.” The machine does keep track of sales in several categories, however. Cashiers punch a button to indicate whether each item is a beverage, a meal, or other type of item. An internal tape in the machine keeps a record of all transactions. The customer receives a receipt only upon request.
There is only one cash register. “Up to three of us might operate it on any given shift, including myself,” says Ms. Mintenko.
She and her staff do two “cashouts” each day—one with the shift change at 5:00 p.m. and one when the shop closes at 10:00 p.m. At each cashout, they count the cash in the register drawer. That amount, minus the cash change carried forward (the float), should match the shift total on the register tape. If there's a discrepancy, they do another count. Then, if necessary, “we go through the whole tape to find the mistake,” she explains. “It usually turns out to be someone who punched in $18 instead of $1.80, or something like that.”
Ms. Mintenko sends all the cash tapes and float totals to a bookkeeper, who double-checks everything and provides regular reports. “We try to keep the accounting simple, so we can concentrate on making great coffee and food.”
Preview of Chapter 8
As the story about recording cash sales at Stephanie's Gourmet Coffee and More indicates, control of cash is important to ensure that fraud does not occur. Companies also need controls to safeguard other types of assets. For example, Stephanie's undoubtedly has controls to prevent the theft of food and supplies, and controls to prevent the theft of tableware and dishes from its kitchen.
In this chapter, we explain the essential features of an internal control system and how it prevents fraud. We also describe how those controls apply to a specific asset—cash. The applications include some controls with which you may be already familiar, such as the use of a bank.
The content and organization of Chapter 8 are as follows.
The Feature Story describes many of the internal control procedures used by Stephanie's Gourmet Coffee and More. These procedures are necessary to discourage employees from fraudulent activities.
A fraud is a dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. Examples of fraud reported in the financial press include:
Why does fraud occur? The three main factors that contribute to fraudulent activity are depicted by the fraud triangle in Illustration 8-1 (in the margin).
The most important element of the fraud triangle is opportunity. For an employee to commit fraud, the workplace environment must provide opportunities that an employee can take advantage of. Opportunities occur when the workplace lacks sufficient controls to deter and detect fraud. For example, inadequate monitoring of employee actions can create opportunities for theft and can embolden employees because they believe they will not be caught.
A second factor that contributes to fraud is financial pressure. Employees sometimes commit fraud because of personal financial problems caused by too much debt. Or, they might commit fraud because they want to lead a lifestyle that they cannot afford on their current salary.
The third factor that contributes to fraud is rationalization. In order to justify their fraud, employees rationalize their dishonest actions. For example, employees sometimes justify fraud because they believe they are underpaid while the employer is making lots of money. Employees feel justified in stealing because they believe they deserve to be paid more.
What can be done to prevent or to detect fraud? After numerous corporate scandals came to light in the early 2000s, Congress addressed this issue by passing the Sarbanes-Oxley Act (SOX). Under SOX, all publicly traded U.S. corporations are required to maintain an adequate system of internal control. Corporate executives and boards of directors must ensure that these controls are reliable and effective. In addition, independent outside auditors must attest to the adequacy of the internal control system. Companies that fail to comply are subject to fines, and company officers can be imprisoned. SOX also created the Public Company Accounting Oversight Board (PCAOB) to establish auditing standards and regulate auditor activity.
One poll found that 60% of investors believe that SOX helps safeguard their stock investments. Many say they would be unlikely to invest in a company that fails to follow SOX requirements. Although some corporate executives have criticized the time and expense involved in following the SOX requirements, SOX appears to be working well. For example, the chief accounting officer of Eli Lily noted that SOX triggered a comprehensive review of how the company documents controls. This review uncovered redundancies and pointed out controls that needed to be added. In short, it added up to time and money well spent. And the finance chief at General Electric noted, “We have seen value in SOX. It helps build investors’ trust and gives them more confidence.”1
Internal control consists of all the related methods and measures adopted within an organization to safeguard assets, enhance the reliability of accounting records, increase efficiency of operations, and ensure compliance with laws and regulations. Internal control systems have five primary components as listed below.2
PEOPLE, PLANET, AND PROFIT INSIGHT
And the Controls Are . . .
Internal controls are important for an effective financial reporting system. The same is true for sustainability reporting. An effective system of internal controls for sustainability reporting will help in the following ways: (1) prevent the unauthorized use of data; (2) provide reasonable assurance that the information is accurate, valid, and complete; and (3) report information that is consistent with overall sustainability accounting policies. With these types of controls, users will have the confidence that they can use the sustainability information effectively.
Some regulators are calling for even more assurance through audits of this information. Companies that potentially can cause environmental damage through greenhouse gases are subject to reporting requirements as well as companies in the mining and extractive industries. And, as demand for more information in the sustainability area expands, the need for audits of this information will grow.
Why is sustainability information important to investors? (See page 424.)
Each of the five components of an internal control system is important. Here, we will focus on one component, the control activities. The reason? These activities are the backbone of the company's efforts to address the risks it faces, such as fraud. The specific control activities used by a company will vary, depending on management's assessment of the risks faced. This assessment is heavily influenced by the size and nature of the company.
The six principles of control activities are as follows.
We explain these principles in the following sections. You should recognize that they apply to most companies and are relevant to both manual and computerized accounting systems.
An essential principle of internal control is to assign responsibility to specific employees. Control is most effective when only one person is responsible for a given task.
To illustrate, assume that the cash on hand at the end of the day in a Safeway supermarket is $10 short of the cash entered in the cash register. If only one person has operated the register, the shift manager can quickly determine responsibility for the shortage. If two or more individuals have worked the register, it may be impossible to determine who is responsible for the error. In the Feature Story, the principle of establishing responsibility does not appear to be strictly applied by Stephanie's Gourmet Coffee and More, since three people operate the cash register on any given shift.
Many retailers solve this problem by having registers with multiple drawers. This makes it possible for more than one person to operate a register but still allows identification of a particular employee with a specific drawer. Only the signed-in cashier has access to his or her drawer.
Establishing responsibility often requires limiting access only to authorized personnel, and then identifying those personnel. For example, the automated systems used by many companies have mechanisms such as identifying pass-codes that keep track of who made a journal entry, who entered a sale, or who went into an inventory storeroom at a particular time. Use of identifying pass-codes enables the company to establish responsibility by identifying the particular employee who carried out the activity.
ANATOMY OF A FRAUD
Maureen Frugali was a training supervisor for claims processing at Colossal Health-care. As a standard part of the claims-processing training program, Maureen created fictitious claims for use by trainees. These fictitious claims were then sent to the accounts payable department. After the training claims had been processed, she was to notify Accounts Payable of all fictitious claims, so that they would not be paid. However, she did not inform Accounts Payable about every fictitious claim. She created some fictitious claims for entities that she controlled (that is, she would receive the payment), and she let Accounts Payable pay her.
THE MISSING CONTROL
Establishment of responsibility. The health-care company did not adequately restrict the responsibility for authorizing and approving claims transactions. The training supervisor should not have been authorized to create claims in the company's “live” system.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 61–70.
Segregation of duties is indispensable in an internal control system. There are two common applications of this principle:
1. Different individuals should be responsible for related activities.
2. The responsibility for record-keeping for an asset should be separate from the physical custody of that asset.
The rationale for segregation of duties is this: The work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of another employee. For example, the personnel that design and program computerized systems should not be assigned duties related to day-today use of the system. Otherwise, they could design the system to benefit them personally and conceal the fraud through day-to-day use.
SEGREGATION OF RELATED ACTIVITIES. Making one individual responsible for related activities increases the potential for errors and irregularities. Instead, companies should, for example, assign related purchasing activities to different individuals. Related purchasing activities include ordering merchandise, order approval, receiving goods, authorizing payment, and paying for goods or services. Various frauds are possible when one person handles related purchasing activities:
These abuses are less likely to occur when companies divide the purchasing tasks.
Similarly, companies should assign related sales activities to different individuals. Related selling activities include making a sale, shipping (or delivering) the goods to the customer, billing the customer, and receiving payment. Various frauds are possible when one person handles related sales activities:
These abuses are less likely to occur when companies divide the sales tasks: The salespeople make the sale; the shipping department ships the goods on the basis of the sales order; and the billing department prepares the sales invoice after comparing the sales order with the report of goods shipped.
ANATOMY OF A FRAUD
Lawrence Fairbanks, the assistant vice-chancellor of communications at Aesop University, was allowed to make purchases of under $2,500 for his department without external approval. Unfortunately, he also sometimes bought items for himself, such as expensive antiques and other collectibles. How did he do it? He replaced the vendor invoices he received with fake vendor invoices that he created. The fake invoices had descriptions that were more consistent with the communications department's purchases. He submitted these fake invoices to the accounting department as the basis for their journal entries and to the accounts payable department as the basis for payment.
Total take: $475,000
THE MISSING CONTROL
Segregation of duties. The university had not properly segregated related purchasing activities. Lawrence was ordering items, receiving the items, and receiving the invoice. By receiving the invoice, he had control over the documents that were used to account for the purchase and thus was able to substitute a fake invoice.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 3–15.
SEGREGATION OF RECORD-KEEPING FROM PHYSICAL CUSTODY. The accountant should have neither physical custody of the asset nor access to it. Likewise, the custodian of the asset should not maintain or have access to the accounting records. The custodian of the asset is not likely to convert the asset to personal use when one employee maintains the record of the asset, and a different employee has physical custody of the asset. The separation of accounting responsibility from the custody of assets is especially important for cash and inventories because these assets are very vulnerable to fraud.
ANATOMY OF A FRAUD
Angela Bauer was an accounts payable clerk for Aggasiz Construction Company. Angela prepared and issued checks to vendors and reconciled bank statements. She perpetrated a fraud in this way: She wrote checks for costs that the company had not actually incurred (e.g., fake taxes). A supervisor then approved and signed the checks. Before issuing the check, though, Angela would “white-out” the payee line on the check and change it to personal accounts that she controlled. She was able to conceal the theft because she also reconciled the bank account. That is, nobody else ever saw that the checks had been altered.
Total take: $570,000
THE MISSING CONTROL
Segregation of duties. Aggasiz Construction Company did not properly segregate record-keeping from physical custody. Angela had physical custody of the checks, which essentially was control of the cash. She also had record-keeping responsibility because she prepared the bank reconciliation.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 100–107.
Documents provide evidence that transactions and events have occurred. At Stephanie's Gourmet Coffee and More, the cash register tape is the restaurant's documentation for the sale and the amount of cash received. More sophisticated registers, called point-of-sale terminals, do not rely on tapes. Rather, they are networked with the company's computing and accounting records, which results in direct documentation.
Similarly, a shipping document indicates that the goods have been shipped, and a sales invoice indicates that the company has billed the customer for the goods. By requiring signatures (or initials) on the documents, the company can identify the individual(s) responsible for the transaction or event. Companies should document transactions when the transaction occurs.
Companies should establish procedures for documents. First, whenever possible, companies should use prenumbered documents, and all documents should be accounted for. Prenumbering helps to prevent a transaction from being recorded more than once, or conversely, from not being recorded at all. Second, the control system should require that employees promptly forward source documents for accounting entries to the accounting department. This control measure helps to ensure timely recording of the transaction and contributes directly to the accuracy and reliability of the accounting records.
To support their reimbursement requests for travel costs incurred, employees at Mod Fashions Corporation's design center were required to submit receipts. The receipts could include the detailed bill provided for a meal, the credit card receipt provided when the credit card payment is made, or a copy of the employee's monthly credit card bill that listed the item. A number of the designers who frequently traveled together came up with a fraud scheme: They submitted claims for the same expenses. For example, if they had a meal together that cost $200, one person submitted the detailed meal bill, another submitted the credit card receipt, and a third submitted a monthly credit card bill showing the meal as a line item. Thus, all three received a $200 reimbursement.
Total take: $75,000
THE MISSING CONTROL
Documentation procedures. Mod Fashions should require the original, detailed receipt. It should not accept photocopies, and it should not accept credit card statements. In addition, documentation procedures could be further improved by requiring the use of a corporate credit card (rather than a personal credit card) for all business expenses.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 79–90.
Use of physical controls is essential. Physical controls relate to the safeguarding of assets and enhance the accuracy and reliability of the accounting records. Illustration 8-2 shows examples of these controls.
ANATOMY OF A FRAUD
At Centerstone Health, a large insurance company, the mailroom each day received insurance applications from prospective customers. Mailroom employees scanned the applications into electronic documents before the applications were processed. Once the applications were scanned, they could be accessed online by authorized employees.
Insurance agents at Centerstone Health earn commissions based upon successful applications. The sales agent's name is listed on the application. However, roughly 15% of the applications are from customers who did not work with a sales agent. Two friends—Alex, an employee in record-keeping, and Parviz, a sales agent—thought up a way to perpetrate a fraud. Alex identified scanned applications that did not list a sales agent. After business hours, he entered the mailroom and found the hard-copy applications that did not show a sales agent. He wrote in Parviz's name as the sales agent and then rescanned the application for processing. Parviz received the commission, which the friends then split.
Total take: $240,000
THE MISSING CONTROL
Physical controls. Centerstone Health lacked two basic physical controls that could have prevented this fraud. First, the mailroom should have been locked during non-business hours, and access during business hours should have been tightly controlled. Second, the scanned applications supposedly could be accessed only by authorized employees using their passwords. However, the password for each employee was the same as the employee's user ID. Since employee user-ID numbers were available to all other employees, all employees knew all other employees’ passwords. Unauthorized employees could access the scanned applications. Thus, Alex could enter the system using another employee's password and access the scanned applications.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 316–326.
Most internal control systems provide for independent internal verification. This principle involves the review of data prepared by employees. To obtain maximum benefit from independent internal verification:
1. Companies should verify records periodically or on a surprise basis.
2. An employee who is independent of the personnel responsible for the information should make the verification.
3. Discrepancies and exceptions should be reported to a management level that can take appropriate corrective action.
Independent internal verification is especially useful in comparing recorded accountability with existing assets. The reconciliation of the cash register tape with the cash in the register at Stephanie's Gourmet Coffee and More is an example of this internal control principle. Another common example is the reconciliation of a company's cash balance per books with the cash balance per bank and the verification of the perpetual inventory records through a count of physical inventory. Illustration 8-3 shows the relationship between this principle and the segregation of duties principle.
ANATOMY OF A FRAUD
Bobbi Jean Donnelly, the office manager for Mod Fashions Corporations design center, was responsible for preparing the design center budget and reviewing expense reports submitted by design center employees. Her desire to upgrade her wardrobe got the better of her, and she enacted a fraud that involved filing expense-reimbursement requests for her own personal clothing purchases. Bobbi Jean was able to conceal the fraud because she was responsible for reviewing all expense reports, including her own. In addition, she sometimes was given ultimate responsibility for signing off on the expense reports when her boss was “too busy.” Also, because she controlled the budget, when she submitted her expenses, she coded them to budget items that she knew were running under budget, so that they would not catch anyone's attention.
Total take: $275,000
THE MISSING CONTROL
Independent internal verification. Bobbi Jean's boss should have verified her expense reports. When asked what he thought her expenses for a year were, the boss said about $10,000. At $115,000 per year, her actual expenses were more than 10 times what would have been expected. However, because he was “too busy” to verify her expense reports or to review the budget, he never noticed.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 79–90.
Large companies often assign independent internal verification to internal auditors. Internal auditors are company employees who continuously evaluate the effectiveness of the company's internal control systems. They review the activities of departments and individuals to determine whether prescribed internal controls are being followed. They also recommend improvements when needed. For example, WorldCom was at one time the second largest U.S. telecommunications company. The fraud that caused its bankruptcy (the largest ever when it occurred) involved billions of dollars. It was uncovered by an internal auditor.
Human resource control activities include the following.
1. Bond employees who handle cash. Bonding involves obtaining insurance protection against theft by employees. It contributes to the safeguarding of cash in two ways. First, the insurance company carefully screens all individuals before adding them to the policy and may reject risky applicants. Second, bonded employees know that the insurance company will vigorously prosecute all offenders.
2. Rotate employees’ duties and require employees to take vacations. These measures deter employees from attempting thefts since they will not be able to permanently conceal their improper actions. Many banks, for example, have discovered employee thefts when the employee was on vacation or assigned to a new position.
3. Conduct thorough background checks. Many believe that the most important and inexpensive measure any business can take to reduce employee theft and fraud is for the human resources department to conduct thorough background checks. Two tips: (1) Check to see whether job applicants actually graduated from the schools they list. (2) Never use telephone numbers for previous employers provided by the applicant. Always look them up yourself.
ANATOMY OF A FRAUD
Ellen Lowry was the desk manager and Josephine Rodriguez was the head of housekeeping at the Excelsior Inn, a luxury hotel. The two best friends were so dedicated to their jobs that they never took vacations, and they frequently filled in for other employees. In fact, Ms. Rodriguez, whose job as head of housekeeping did not include cleaning rooms, often cleaned rooms herself, “just to help the staff keep up.” These two “dedicated” employees, working as a team, found a way to earn a little more cash. Ellen, the desk manager, provided significant discounts to guests who paid with cash. She kept the cash and did not register the guest in the hotel's computerized system. Instead, she took the room out of circulation “due to routine maintenance.” Because the room did not show up as being used, it did not receive a normal housekeeping assignment. Instead, Josephine, the head of housekeeping, cleaned the rooms during the guests’ stay.
Total take: $95,000
THE MISSING CONTROL
Human resource controls. Ellen, the desk manager, had been fired by a previous employer after being accused of fraud. If the Excelsior Inn had conducted a thorough background check, it would not have hired her. The hotel fraud was detected when Ellen missed work for a few days due to illness. A system of mandatory vacations and rotating days off would have increased the chances of detecting the fraud before it became so large.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 145–155.
ACCOUNTING ACROSS THE ORGANIZATION
SOX Boosts the Role of Human Resources
Under SOX, a company needs to keep track of employees’ degrees and certifications to ensure that employees continue to meet the specified requirements of a job. Also, to ensure proper employee supervision and proper separation of duties, companies must develop and monitor an organizational chart. When one corporation went through this exercise, it found that out of 17,000 employees, there were 400 people who did not report to anyone. The corporation also had 35 people who reported to each other. In addition, if an employee complains of an unfair firing and mentions financial issues at the company, HR should refer the case to the company audit committee and possibly to its legal counsel.
Why would unsupervised employees or employees who report to each other represent potential internal control threats? (See page 424.)
Companies generally design their systems of internal control to provide reasonable assurance of proper safeguarding of assets and reliability of the accounting records. The concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not exceed their expected benefit.
To illustrate, consider shoplifting losses in retail stores. Stores could eliminate such losses by having a security guard stop and search customers as they leave the store. But store managers have concluded that the negative effects of such a procedure cannot be justified. Instead, they have attempted to control shoplifting losses by less costly procedures. They post signs saying, “We reserve the right to inspect all packages” and “All shoplifters will be prosecuted.” They use hidden TV cameras and store detectives to monitor customer activity, and they install sensor equipment at exits.
The human element is an important factor in every system of internal control. A good system can become ineffective as a result of employee fatigue, carelessness, or indifference. For example, a receiving clerk may not bother to count goods received and may just “fudge” the counts. Occasionally, two or more individuals may work together to get around prescribed controls. Such collusion can significantly reduce the effectiveness of a system, eliminating the protection offered by segregation of duties. No system of internal control is perfect.
The size of the business also may impose limitations on internal control. Small companies often find it difficult to segregate duties or to provide for independent internal verification. A study by the Association of Certified Fraud Examiners (2012 Report to the Nation on Occupational Fraud and Abuse) indicates that businesses with fewer than 100 employees are most at risk for employee theft. In fact, 31% of frauds occurred at companies with fewer than 100 employees. The median loss at small companies was $147,000, which was higher than the median fraud at companies with more than 10,000 employees ($140,000). A $147,000 loss can threaten the very existence of a small company.
Helpful Hint Controls may vary with the risk level of the activity. For example, management may consider cash to be high risk and maintaining inventories in the stockroom as low risk. Thus, management would have stricter controls for cash.
Control Activities
Identify which control activity is violated in each of the following situations, and explain how the situation creates an opportunity for a fraud.
1. The person with primary responsibility for reconciling the bank account and making all bank deposits is also the company's accountant.
2. Wellstone Company's treasurer received an award for distinguished service because he had not taken a vacation in 30 years.
3. In order to save money spent on order slips and to reduce time spent keeping track of order slips, a local bar/restaurant does not buy prenumbered order slips.
Action Plan
Familiarize yourself with each of the control activities summarized on page 378.
Understand the nature of the frauds that each control activity is intended to address.
Solution
1. Violates the control activity of segregation of duties. Record-keeping should be separate from physical custody. As a consequence, the employee could embezzle cash and make journal entries to hide the theft.
2. Violates the control activity of human resource controls. Key employees must take vacations. Otherwise, the treasurer, who manages the company's cash, might embezzle cash and use his position to conceal the theft.
3. Violates the control activity of documentation procedures. If prenumbered documents are not used, then it is virtually impossible to account for the documents. As a consequence, an employee could write up a dinner sale, receive the cash from the customer, and then throw away the order slip and keep the cash.
Related exercise material: BE8-1, BE8-2, BE8-3, BE8-4, E8-1, and DO IT! 8-1.
Cash is the one asset that is readily convertible into any other type of asset. It also is easily concealed and transported, and is highly desired. Because of these characteristics, cash is the asset most susceptible to fraudulent activities. In addition, because of the large volume of cash transactions, numerous errors may occur in executing and recording them. To safeguard cash and to ensure the accuracy of the accounting records for cash, effective internal control over cash is critical.
Illustration 8-4 shows how the internal control principles explained earlier apply to cash receipts transactions. As you might expect, companies vary considerably in how they apply these principles. To illustrate internal control over cash receipts, we will examine control activities for a retail store with both over-the-counter and mail receipts.
In retail businesses, control of over-the-counter receipts centers on cash registers that are visible to customers. A cash sale is entered in a cash register, with the amount clearly visible to the customer. This activity prevents the cashier from entering a lower amount and pocketing the difference. The customer receives an itemized cash register receipt slip and is expected to count the change received. (One weakness at Stephanie's Gourmet Coffee and More in the Feature Story is that customers were only given a receipt if they requested it.) The cash register's tape is locked in the register until a supervisor removes it. This tape accumulates the daily transactions and totals.
At the end of the clerk's shift, the clerk counts the cash and sends the cash and the count to the cashier. The cashier counts the cash, prepares a deposit slip, and deposits the cash at the bank. The cashier also sends a duplicate of the deposit slip to the accounting department to indicate cash received. The supervisor removes the cash register tape and sends it to the accounting department as the basis for a journal entry to record the cash received. Illustration 8-5 summarizes this process.
Helpful Hint Flowcharts such as this one enhance the understanding of the flow of documents, the processing steps, and the internal control procedures.
This system for handling cash receipts uses an important internal control principle—segregation of record-keeping from physical custody. The supervisor has access to the cash register tape but not to the cash. The clerk and the cashier have access to the cash but not to the register tape. In addition, the cash register tape provides documentation and enables independent internal verification. Use of these three principles of internal control (segregation of record-keeping from physical custody, documentation, and independent internal verification) provides an effective system of internal control. Any attempt at fraudulent activity should be detected unless there is collusion among the employees.
In some instances, the amount deposited at the bank will not agree with the cash recorded in the accounting records based on the cash register tape. These differences often result because the clerk hands incorrect change back to the retail customer. In this case, the difference between the actual cash and the amount reported on the cash register tape is reported in a Cash Over and Short account. For example, suppose that the cash register tape indicated sales of $6,956.20 but the amount of cash was only $6,946.10. A cash shortfall of $10.10 exists. To account for this cash shortfall and related cash, the company makes the following entry.
Cash Over and Short is an income statement item. It is reported as miscellaneous expense when there is a cash shortfall, and as miscellaneous revenue when there is an overage. Clearly, the amount should be small. Any material amounts in this account should be investigated.
All mail receipts should be opened in the presence of at least two mail clerks. These receipts are generally in the form of checks. A mail clerk should endorse each check “For Deposit Only.” This restrictive endorsement reduces the likelihood that someone could divert the check to personal use. Banks will not give an individual cash when presented with a check that has this type of endorsement.
The mail clerks prepare, in triplicate, a list of the checks received each day. This list shows the name of the check issuer, the purpose of the payment, and the amount of the check. Each mail clerk signs the list to establish responsibility for the data. The original copy of the list, along with the checks, is then sent to the cashier's department. A copy of the list is sent to the accounting department for recording in the accounting records. The clerks also keep a copy.
This process provides excellent internal control for the company. By employing two clerks, the chance of fraud is reduced. Each clerk knows he or she is being observed by the other clerk(s). To engage in fraud, they would have to collude. The customers who submit payments also provide control because they will contact the company with a complaint if they are not properly credited for payment. Because the cashier has access to cash but not the records, and the accounting department has access to records but not cash, neither can engage in undetected fraud.
Control over Cash Receipts
L. R. Cortez is concerned about the control over cash receipts in his fast-food restaurant, Big Cheese. The restaurant has two cash registers. At no time do more than two employees take customer orders and enter sales. Work shifts for employees range from 4 to 8 hours. Cortez asks your help in installing a good system of internal control over cash receipts.
Differentiate among the internal control principles of (1) establishing responsibility, (2) using physical controls, and (3) independent internal verification.
Design an effective system of internal control over cash receipts.
Solution
Cortez should assign a separate cash register drawer to each employee at the start of each work shift, with register totals set at zero. Each employee should have access to only the assigned register drawer to enter all sales. Each customer should be given a receipt. At the end of the shift, the employee should do a cash count. A separate employee should compare the cash count with the register tape to be sure they agree. In addition, Cortez should install an automated system that would enable the company to compare orders entered in the register to orders processed by the kitchen.
Related exercise material: BE8-5, BE8-6, BE8-7, E8-2, and DO IT! 8-2.
Companies disburse cash for a variety of reasons, such as to pay expenses and liabilities or to purchase assets. Generally, internal control over cash disbursements is more effective when companies pay by check or electronic funds transfer (EFT) rather than by cash. One exception is payments for incidental amounts that are paid out of petty cash.3
Companies generally issue checks only after following specified control procedures. Illustration 8-6 (page 390) shows how principles of internal control apply to cash disbursements.
Most medium and large companies use vouchers as part of their internal control over cash disbursements. A voucher system is a network of approvals by authorized individuals, acting independently, to ensure that all disbursements by check are proper.
The system begins with the authorization to incur a cost or expense. It ends with the issuance of a check for the liability incurred. A voucher is an authorization form prepared for each expenditure. Companies require vouchers for all types of cash disbursements except those from petty cash.
The starting point in preparing a voucher is to fill in the appropriate information about the liability on the face of the voucher. The vendor's invoice provides most of the needed information. Then, an employee in accounts payable records the voucher (in a journal called a voucher register) and files it according to the date on which it is to be paid. The company issues and sends a check on that date, and stamps the voucher “paid.” The paid voucher is sent to the accounting department for recording (in a journal called the check register). A voucher system involves two journal entries, one to record the liability when the voucher is issued and a second to pay the liability that relates to the voucher.
The use of a voucher system, whether done manually or electronically, improves internal control over cash disbursements. First, the authorization process inherent in a voucher system establishes responsibility. Each individual has responsibility to review the underlying documentation to ensure that it is correct. In addition, the voucher system keeps track of the documents that back up each transaction. By keeping these documents in one place, a supervisor can independently verify the authenticity of each transaction. Consider, for example, the case of Aesop University presented on page 380. Aesop did not use a voucher system for transactions under $2,500. As a consequence, there was no independent verification of the documents, which enabled the employee to submit fake invoices to hide his unauthorized purchases.
As you just learned, better internal control over cash disbursements is possible when companies make payments by check. However, using checks to pay small amounts is both impractical and a nuisance. For instance, a company would not want to write checks to pay for postage due, working lunches, or taxi fares. A common way of handling such payments, while maintaining satisfactory control, is to use a petty cash fund to pay relatively small amounts. The operation of a petty cash fund, often called an imprest system, involves (1) establishing the fund, (2) making payments from the fund, and (3) replenishing the fund.4
Two essential steps in establishing a petty cash fund are (1) appointing a petty cash custodian who will be responsible for the fund, and (2) determining the size of the fund. Ordinarily, a company expects the amount in the fund to cover anticipated disbursements for a three- to four-week period.
To establish the fund, a company issues a check payable to the petty cash custodian for the stipulated amount. For example, if Laird Company decides to establish a $100 fund on March 1, the general journal entry is:
The fund custodian cashes the check and places the proceeds in a locked petty cash box or drawer. Most petty cash funds are established on a fixed-amount basis. The company will make no additional entries to the Petty Cash account unless management changes the stipulated amount of the fund. For example, if Laird Company decides on July 1 to increase the size of the fund to $250, it would debit Petty Cash $150 and credit Cash $150.
Ethics Note
Petty cash funds are authorized and legitimate. In contrast, “slush” funds are unauthorized and hidden (under the table).
The petty cash custodian has the authority to make payments from the fund that conform to prescribed management policies. Usually, management limits the size of expenditures that come from petty cash. Likewise, it may not permit use of the fund for certain types of transactions (such as making short-term loans to employees).
Each payment from the fund must be documented on a prenumbered petty cash receipt (or petty cash voucher), as shown in Illustration 8-7. The signatures of both the fund custodian and the person receiving payment are required on the receipt. If other supporting documents such as a freight bill or invoice are available, they should be attached to the petty cash receipt.
Helpful Hint The petty cash receipt satisfies two internal control procedures:
(1) establishing responsibility (signature of custodian), and (2) documentation procedures.
The petty cash custodian keeps the receipts in the petty cash box until the fund is replenished. The sum of the petty cash receipts and the money in the fund should equal the established total at all times. Management can (and should) make surprise counts at any time to determine whether the fund is being maintained correctly.
Internal control over a petty cash fund is strengthened by (1) having a supervisor make surprise counts of the fund to confirm whether the paid petty cash receipts and fund cash equal the imprest amount, and (2) canceling or mutilating the paid petty cash receipts so they cannot be resubmitted for reimbursement.
The company does not make an accounting entry to record a payment when it is made from petty cash. It is considered both inexpedient and unnecessary to do so. Instead, the company recognizes the accounting effects of each payment when it replenishes the fund.
When the money in the petty cash fund reaches a minimum level, the company replenishes the fund. The petty cash custodian initiates a request for reimbursement. The individual prepares a schedule (or summary) of the payments that have been made and sends the schedule, supported by petty cash receipts and other documentation, to the treasurer's office. The treasurer's office examines the receipts and supporting documents to verify that proper payments from the fund were made. The treasurer then approves the request and issues a check to restore the fund to its established amount. At the same time, all supporting documentation is stamped “paid” so that it cannot be submitted again for payment.
To illustrate, assume that on March 15 Laird's petty cash custodian requests a check for $87. The fund contains $13 cash and petty cash receipts for postage $44, freight-out $38, and miscellaneous expenses $5. The general journal entry to record the check is:
Note that the reimbursement entry does not affect the Petty Cash account. Replenishment changes the composition of the fund by replacing the petty cash receipts with cash. It does not change the balance in the fund.
Occasionally, in replenishing a petty cash fund, the company may need to recognize a cash shortage or overage. This results when the total of the cash plus receipts in the petty cash box does not equal the established amount of the petty cash fund. To illustrate, assume that Laird's petty cash custodian has only $12 in cash in the fund plus the receipts as listed. The request for reimbursement would therefore be for $88, and Laird would make the following entry.
Conversely, if the custodian has $14 in cash, the reimbursement request would be for $86. The company would credit Cash Over and Short for $1 (overage). A company reports a debit balance in Cash Over and Short in the income statement as miscellaneous expense. It reports a credit balance in the account as miscellaneous revenue. The company closes Cash Over and Short to Income Summary at the end of the year.
Companies should replenish a petty cash fund at the end of the accounting period, regardless of the cash in the fund. Replenishment at this time is necessary in order to recognize the effects of the petty cash payments on the financial statements.
Helpful Hint Cash over and short situations result from mathematical errors or from failure to keep accurate records.
How Employees Steal
A recent study by the Association of Certified Fraud Examiners found that two-thirds of all employee thefts involved a fraudulent disbursement by an employee. The most common form (24.9% of cases) was fraudulent billing schemes. In these, the employee causes the company to issue a payment to the employee by submitting a bill for nonexistent goods or services, purchases of personal goods by the employee, or inflated invoices. The graph below shows various types of fraudulent disbursements and the median loss from each.
Source: 2012 Report to the Nation on Occupational Fraud and Abuse, Association of Certified Fraud Examiners, www.acfe.com/uploadedfiles/ACFE_website/content/rttn/2012-report-to-nations.pdf, p. 12.
How can companies reduce the likelihood of fraudulent disbursements? (See page 424.)
Petty Cash Fund
Bateer Company established a $50 petty cash fund on July 1. On July 30, the fund had $12 cash remaining and petty cash receipts for postage $14, office supplies $10, and delivery expense $15. Prepare journal entries to establish the fund on July 1 and to replenish the fund on July 30.
Action Plan
To establish the fund, set up a separate general ledger account.
Determine how much cash is needed to replenish the fund: subtract the cash remaining from the petty cash fund balance.
Total the petty cash receipts. Determine any cash over or short—the difference between the cash needed to replenish the fund and the total of the petty cash receipts.
Record the expenses incurred according to the petty cash receipts when replenishing the fund.
Solution
Related exercise material: BE8-9, E8-7, E8-8, and DO IT! 8-3.
The use of a bank contributes significantly to good internal control over cash. A company can safeguard its cash by using a bank as a depository and as a clearinghouse for checks received and written. Use of a bank minimizes the amount of currency that a company must keep on hand. Also, use of a bank facilitates the control of cash because it creates a double record of all bank transactions—one by the company and the other by the bank. The asset account Cash maintained by the company should have the same balance as the bank's liability account for that company. A bank reconciliation compares the bank's balance with the company's balance and explains any differences to make them agree.
Many companies have more than one bank account. For efficiency of operations and better control, national retailers like Wal-Mart Stores, Inc. and Target may have regional bank accounts. Large companies, with tens of thousands of employees, may have a payroll bank account, as well as one or more general bank accounts. Also, a company may maintain several bank accounts in order to have more than one source for short-term loans when needed.
An authorized employee, such as the head cashier, should make a company's bank deposits. Each deposit must be documented by a deposit slip (ticket), as shown in Illustration 8-8.
Deposit slips are prepared in duplicate. The bank retains the original; the depositor keeps the duplicate, machine-stamped by the bank to establish its authenticity.
Most of us write checks without thinking very much about them. A check is a written order signed by the depositor directing the bank to pay a specified sum of money to a designated recipient. There are three parties to a check: (1) the maker (or drawer) who issues the check, (2) the bank (or payer) on which the check is drawn, and (3) the payee to whom the check is payable. A check is a negotiable instrument that one party can transfer to another party by endorsement. Each check should be accompanied by an explanation of its purpose. In many companies, a remittance advice attached to the check, as shown in Illustration 8-9, explains the check's purpose.
It is important to know the balance in the checking account at all times. To keep the balance current, the depositor should enter each deposit and check on running-balance memo forms (or online statements) provided by the bank or on the check stubs in the checkbook.
If you have a personal checking account, you are probably familiar with bank statements. A bank statement shows the depositor's bank transactions and balances.5 Each month, a depositor receives a statement from the bank. Illustration 8-10 (page 396) presents a typical bank statement for Laird Company. It shows (1) checks paid and other debits (such as debit card transactions or direct withdrawals for bill payments) that reduce the balance in the depositor's account, (2) deposits and other credits that increase the balance in the depositor's account, and (3) the account balance after each day's transactions.
Helpful Hint Essentially, the bank statement is a copy of the bank's records sent to the customer (or available online) for review.
Helpful Hint The bank credits to the customer's account every deposit it receives. The reverse occurs when the bank “pays” a check issued by a company on its checking account balance. Payment reduces the bank's liability. Thus, the bank debits check payments to the customer's account with the bank.
The bank statement lists in numerical sequence all “paid” checks, along with the date the check was paid and its amount. Upon paying a check, the bank stamps the check “paid”; a paid check is sometimes referred to as a canceled check. On the statement, the bank also includes memoranda explaining other debits and credits it made to the depositor's account.
Some banks charge a monthly fee for their services. Often, they charge this fee only when the average monthly balance in a checking account falls below a specified amount. They identify the fee, called a bank service charge, on the bank statement by a symbol such as SC. The bank also sends with the statement a debit memorandum explaining the charge noted on the statement. Other debit memoranda may also be issued for other bank services such as the cost of printing checks, issuing traveler's checks, and wiring funds to other locations. The symbol DM is often used for such charges.
Banks also use a debit memorandum when a deposited check from a customer “bounces” because of insufficient funds. For example, assume that Scott Company, a customer of Laird Company, sends a check for $800 to Laird Company for services performed. Unfortunately, Scott does not have sufficient funds at its bank to pay for these services. In such a case, Scott's bank marks the check NSF (not sufficient funds) and returns it to Laird's (the depositor's) bank. Laird's bank then debits Laird's account, as shown by the symbol NSF on the bank statement in Illustration 8-10. The bank sends the NSF check and debit memorandum to Laird as notification of the charge. Laird then records an Account Receivable from Scott Company (the writer of the bad check) and reduces cash for the NSF check.
Sometimes a depositor asks the bank to collect its notes receivable. In such a case, the bank will credit the depositor's account for the cash proceeds of the note. This is illustrated by the symbol CM on the Laird Company bank statement. The bank issues and sends with the statement a credit memorandum to explain the entry. Many banks also offer interest on checking accounts. The interest earned may be indicated on the bank statement by the symbol CM or INT.
The bank and the depositor maintain independent records of the depositor's checking account. People tend to assume that the respective balances will always agree. In fact, the two balances are seldom the same at any given time, and both balances differ from the “correct” or “true” balance. Therefore, it is necessary to make the balance per books and the balance per bank agree with the correct or true amount—a process called reconciling the bank account. The need for agreement has two causes:
1. Time lags that prevent one of the parties from recording the transaction in the same period as the other party.
2. Errors by either party in recording transactions.
Time lags occur frequently. For example, several days may elapse between the time a company mails a check to a payee and the date the bank pays the check. Similarly, when the depositor uses the bank's night depository to make its deposits, there will be a difference of at least one day between the time the depositor records the deposit and the time the bank does so. A time lag also occurs whenever the bank mails a debit or credit memorandum to the depositor.
The incidence of errors depends on the effectiveness of the internal controls maintained by the company and the bank. Bank errors are infrequent. However, either party could accidentally record a $450 check as $45 or $540. In addition, the bank might mistakenly charge a check drawn by C. D. Berg to the account of C. D. Burg.
The bank reconciliation should be prepared by an employee who has no other responsibilities pertaining to cash. If a company fails to follow this internal control principle of independent internal verification, cash embezzlements may go unnoticed. For example, a cashier who prepares the reconciliation can embezzle cash and conceal the embezzlement by misstating the reconciliation. Thus, the bank accounts would reconcile, and the embezzlement would not be detected.
In reconciling the bank account, it is customary to reconcile the balance per books and balance per bank to their adjusted (correct or true) cash balances. The starting point in preparing the reconciliation is to enter the balance per bank statement and balance per books on the reconciliation schedule. The company then makes various adjustments, as shown in Illustration 8-11 (page 398).
The following steps should reveal all the reconciling items that cause the difference between the two balances.
Helpful Hint Deposits in transit and outstanding checks are reconciling items because of time lags.
The bank statement for Laird Company, in Illustration 8-10, shows a balance per bank of $15,907.45 on April 30, 2014. On this date the balance of cash per books is $11,589.45. Using the four reconciliation steps, Laird determines the following reconciling items.
Helpful Hint Note in the bank statement on page 396 that checks no. 459 and 461 have been paid but check no. 460 is not listed. Thus, this check is outstanding. If a complete bank statement were provided, checks no. 453 and 457 would also not be listed. The amounts for these three checks are obtained from the company's cash payments records.
Step 1. | Deposits in transit: April 30 deposit (received by bank on May 1). | $2,201.40 |
Step 2. | Outstanding checks: No. 453, $3,000.00; no. 457, $1,401.30; no. 460, $1,502.70. | 5,904.00 |
Step 3. | Errors: Laird wrote check no. 443 for $1,226.00 and the bank correctly paid that amount. However, Laird recorded the check as $1,262.00. | 36.00 |
Step 4. | Bank memoranda: a. Debit—NSF check from J. R. Baron for $425.60. b. Debit—Charge for printing company checks $30.00. c. Credit—Collection of note receivable for $1,000 plus interest earned $50, less bank collection fee $15.00. |
425.60 30.00 1,035.00 |
Illustration 8-12 shows Laird's bank reconciliation.
Alternative Terminology The terms adjusted cash balance, true cash balance, and correct cash balance are used interchangeably.
Helpful Hint The entries that follow are adjusting entries. In prior chapters, Cash was an account that did not require adjustment. That was a simplifying assumption for learning purposes because we had not yet explained a bank reconciliation.
The company records each reconciling item used to determine the adjusted cash balance per books. If the company does not journalize and post these items, the Cash account will not show the correct balance. Laird Company would make the following entries on April 30.
COLLECTION OF NOTE RECEIVABLE. This entry involves four accounts. Assuming that the interest of $50 has not been accrued and the collection fee is charged to Miscellaneous Expense, the entry is:
BOOK ERROR. The cash disbursements journal shows that check no. 443 was a payment on account to Andrea Company, a supplier. The correcting entry is:
NSF CHECK. As indicated earlier, an NSF check becomes an account receivable to the depositor. The entry is:
BANK SERVICE CHARGES. Depositors debit check printing charges (DM) and other bank service charges (SC) to Miscellaneous Expense because they are usually nominal in amount. The entry is:
Instead of making four separate entries, Laird could combine them into one compound entry.
After Laird has posted the entries, the Cash account will show the following.
The adjusted cash balance in the ledger should agree with the adjusted cash balance per books in the bank reconciliation in Illustration 8-12 (page 399).
What entries does the bank make? If the company discovers any bank errors in preparing the reconciliation, it should notify the bank. The bank then can make the necessary corrections in its records. The bank does not make any entries for deposits in transit or outstanding checks. Only when these items reach the bank will the bank record these items.
It is not surprising that companies and banks have developed approaches to transfer funds among parties without the use of paper (deposit tickets, checks, etc.). Such procedures, called electronic funds transfers (EFT), are disbursement systems that use wire, telephone, or computers to transfer cash balances from one location to another. Use of EFT is quite common. For example, many employees receive no formal payroll checks from their employers. Instead, employers send electronic payroll data to the appropriate banks. Also, individuals and companies now frequently make regular payments such as those for house, car, and utilities by EFT.
EFT transactions normally result in better internal control since no cash or checks are handled by company employees. This does not mean that opportunities for fraud are eliminated. In fact, the same basic principles related to internal control apply to EFT transfers. For example, without proper segregation of duties and authorizations, an employee might be able to redirect electronic payments into a personal bank account and conceal the theft with fraudulent accounting entries.
INVESTOR INSIGHT
Madoff's Ponzi Scheme
No recent fraud has generated more interest and rage than the one perpetrated by Bernard Madoff. Madoff was an elite New York investment fund manager who was highly regarded by securities regulators. Investors flocked to him because he delivered very steady returns of between 10% and 15%, no matter whether the market was going up or going down. However, for many years, Madoff did not actually invest the cash that people gave to him. Instead, he was running a Ponzi scheme: He paid returns to existing investors using cash received from new investors. As long as the size of his investment fund continued to grow from new investments at a rate that exceeded the amounts that he needed to pay out in returns, Madoff was able to operate his fraud smoothly. To conceal his misdeeds, he fabricated false investment statements that were provided to investors. In addition, Madoff hired an auditor that never verified the accuracy of the investment records but automatically issued unqualified opinions each year. Although a competing fund manager warned the SEC a number of times over a nearly 10-year period that he thought Madoff was engaged in fraud, the SEC never aggressively investigated the allegations. Investors, many of which were charitable organizations, lost more than $18 billion. Madoff was sentenced to a jail term of 150 years.
How was Madoff able to conceal such a giant fraud? (See page 424.)
Bank Reconciliation
Sally Kist owns Linen Kist Fabrics. Sally asks you to explain how she should treat the following reconciling items when reconciling the company's bank account: (1) a debit memorandum for an NSF check, (2) a credit memorandum for a note collected by the bank, (3) outstanding checks, and (4) a deposit in transit.
Understand the purpose of a bank reconciliation.
Identify time lags and explain how they cause reconciling items.
Solution
Sally should treat the reconciling items as follows.
(1) NSF check: Deduct from balance per books.
(2) Collection of note: Add to balance per books.
(3) Outstanding checks: Deduct from balance per bank.
(4) Deposit in transit: Add to balance per bank.
Related exercise material: BE8-11, BE8-12, BE8-13, BE8-14, E8-9, E8-10, E8-11, E8-12, E8-13, and DO IT! 8-4.
Cash consists of coins, currency (paper money), checks, money orders, and money on hand or on deposit in a bank or similar depository. Companies report cash in two different statements: the balance sheet and the statement of cash flows. The balance sheet reports the amount of cash available at a given point in time. The statement of cash flows shows the sources and uses of cash during a period of time. The statement of cash flows was introduced in Chapter 1 and will be discussed in much detail in Chapter 17. In this section, we discuss some important points regarding the presentation of cash in the balance sheet.
When presented in a balance sheet, cash on hand, cash in banks, and petty cash are often combined and reported simply as Cash. Because it is the most liquid asset owned by the company, cash is listed first in the current assets section of the balance sheet.
Many companies use the designation “Cash and cash equivalents” in reporting cash. (See Illustration 8-14 for an example.) Cash equivalents are short-term, highly liquid investments that are both:
1. Readily convertible to known amounts of cash, and
2. So near their maturity that their market value is relatively insensitive to changes in interest rates.
Examples of cash equivalents are Treasury bills, commercial paper (short-term corporate notes), and money market funds. All typically are purchased with cash that is in excess of immediate needs.
Occasionally, a company will have a net negative balance in its bank account. In this case, the company should report the negative balance among current liabilities. For example, farm equipment manufacturer Ag-Chem recently reported “Checks outstanding in excess of cash balances” of $2,145,000 among its current liabilities.
Ethics Note
Recently, some companies were forced to restate their financial statements because they had too broadly interpreted which types of investments could be treated as cash equivalents. By reporting these items as cash equivalents, the companies made themselves look more liquid.
A company may have restricted cash, cash that is not available for general use but rather is restricted for a special purpose. For example, landfill companies are often required to maintain a fund of restricted cash to ensure they will have adequate resources to cover closing and clean-up costs at the end of a landfill site's useful life. McKesson Corp. recently reported restricted cash of $962 million to be paid out as the result of investor lawsuits.
Cash restricted in use should be reported separately on the balance sheet as restricted cash. If the company expects to use the restricted cash within the next year, it reports the amount as a current asset. When this is not the case, it reports the restricted funds as a noncurrent asset.
Illustration 8-14 shows restricted cash reported in the financial statements of Delta Air Lines. The company is required to maintain restricted cash as collateral to support insurance obligations related to workers’ compensation claims. Delta does not have access to these funds for general use, and so it must report them separately, rather than as part of cash and cash equivalents.
Poorten Company's bank statement for May 2014 shows the following data.
The cash balance per books at May 31 is $13,319. Your review of the data reveals the following.
1. The NSF check was from Copple Co., a customer.
2. The note collected by the bank was a $500, 3-month, 12% note. The bank charged a $10 collection fee. No interest has been accrued.
3. Outstanding checks at May 31 total $2,410.
4. Deposits in transit at May 31 total $1,752.
5. A Poorten Company check for $352, dated May 10, cleared the bank on May 25. The company recorded this check, which was a payment on account, for $325.
Instructions
(a) Prepare a bank reconciliation at May 31.
(b) Journalize the entries required by the reconciliation.
Solution to Comprehensive DO IT!
Action Plan
Follow the four steps in the reconciliation procedure (pp. 398–399).
Work carefully to minimize mathematical errors in the reconciliation.
Prepare entries from reconciling items per books.
Make sure the cash ledger balance after posting the reconciling entries agrees with the adjusted cash balance per books.
1 Define fraud and internal control. A fraud is a dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. The fraud triangle refers to the three factors that contribute to fraudulent activity by employees: opportunity, financial pressure, and rationalization. Internal control consists of all the related methods and measures adopted within an organization to safeguard its assets, enhance the reliability of its accounting records, increase efficiency of operations, and ensure compliance with laws and regulations.
2 Identify the principles of internal control activities. The principles of internal control are establishment of responsibility; segregation of duties; documentation procedures; physical controls; independent internal verification; and human resource controls such as bonding and requiring employees to take vacations.
3 Explain the applications of internal control principles to cash receipts. Internal controls over cash receipts include (a) designating specific personnel to handle cash; (b) assigning different individuals to receive cash, record cash, and maintain custody of cash; (c) using remittance advices for mail receipts, cash register tapes for over-the-counter receipts, and deposit slips for bank deposits; (d) using company safes and bank vaults to store cash with access limited to authorized personnel, and using cash registers in executing over-the-counter receipts; (e) making independent daily counts of register receipts and daily comparison of total receipts with total deposits; and (f) bonding personnel that handle cash and requiring them to take vacations.
4 Explain the applications of internal control principles to cash disbursements. Internal controls over cash disbursements include (a) having specific individuals such as the treasurer authorized to sign checks and approve invoices; (b) assigning different individuals to approve items for payment, pay the items, and record the payment; (c) using prenumbered checks and accounting for all checks, with each check supported by an approved invoice; (d) storing blank checks in a safe or vault with access restricted to authorized personnel, and using a check-writing machine to imprint amounts on checks; (e) comparing each check with the approved invoice before issuing the check, and making monthly reconciliations of bank and book balances; and (f) bonding personnel who handle cash, requiring employees to take vacations, and conducting background checks.
5 Describe the operation of a petty cash fund. Companies operate a petty cash fund to pay relatively small amounts of cash. They must establish the fund, make payments from the fund, and replenish the fund when the cash in the fund reaches a minimum level.
6 Indicate the control features of a bank account. A bank account contributes to good internal control by providing physical controls for the storage of cash. It minimizes the amount of currency that a company must keep on hand, and it creates a double record of a depositor's bank transactions.
7 Prepare a bank reconciliation. It is customary to reconcile the balance per books and balance per bank to their adjusted balances. The steps in the reconciling process are to determine deposits in transit, outstanding checks, errors by the depositor or the bank, and unrecorded bank memoranda.
8 Explain the reporting of cash. Companies list cash first in the current assets section of the balance sheet. In some cases, they report cash together with cash equivalents. Cash restricted for a special purpose is reported separately as a current asset or as a noncurrent asset, depending on when the cash is expected to be used.
Bank reconciliation The process of comparing the bank's balance of an account with the company's balance and explaining any differences to make them agree. (p. 394).
Bank service charge A fee charged by a bank for the use of its services. (p. 396).
Bank statement A monthly statement from the bank that shows the depositor's bank transactions and balances. (p. 395).
Bonding Obtaining insurance protection against misappropriation of assets by employees. (p. 383).
Cash Resources that consist of coins, currency, checks, money orders, and money on hand or on deposit in a bank or similar depository. (p. 402).
Cash equivalents Short-term, highly liquid investments that can be converted to a specific amount of cash. (p. 402).
Check A written order signed by a bank depositor, directing the bank to pay a specified sum of money to a designated recipient. (p. 394).
Deposits in transit Deposits recorded by the depositor but not yet recorded by the bank. (p. 398).
Electronic funds transfer (EFT) A disbursement system that uses wire, telephone, or computers to transfer funds from one location to another. (p. 401).
Fraud A dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. (p. 376).
Fraud triangle The three factors that contribute to fraudulent activity by employees: opportunity, financial pressure, and rationalization. (p. 376).
Internal auditors Company employees who continuously evaluate the effectiveness of the company's internal control system. (p. 383).
Internal control All of the related methods and activities adopted within an organization to safeguard assets and enhance the accuracy and reliability of accounting records. (p. 377).
NSF check A check that is not paid by a bank because of insufficient funds in a customer's bank account. (p. 397).
Outstanding checks Checks issued and recorded by a company but not yet paid by the bank. (p. 398).
Petty cash fund A cash fund used to pay relatively small amounts. (p. 390).
Restricted cash Cash that must be used for a special purpose. (p. 403).
Sarbanes-Oxley Act (SOX) Regulations passed by Congress to try to reduce unethical corporate behavior. (p. 376).
Voucher An authorization form prepared for each payment in a voucher system. (p. 389).
Voucher system A network of approvals by authorized individuals acting independently to ensure that all disbursements by check are proper. (p. 389).
Self-Test, Brief Exercises, Exercises, Problem Set A, and many more components are available for practice in WileyPLUS.
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1“Corporate Regulation Must Be Working—There's a Backlash,” Wall Street Journal (June 16, 2004), p. C1; and Judith Burns, “Is Sarbanes-Oxley Working?” Wall Street Journal (June 21, 2004), pp. R8–R9.
2The Committee of Sponsoring Organizations of the Treadway Commission, “Internal Control—Integrated Framework,” http://www.coso.org/publications/executive_summary_integrated_framework.htm (accessed March 2008).
3We explain the operation of a petty cash fund on pages 390–392.
4The term “imprest” means an advance of money for a designated purpose.
5Our presentation assumes that the depositor makes all adjustments at the end of the month. In practice, a company may also make journal entries during the month as it reviews information from the bank regarding its account.