PART A: INTERNAL CONTROLS

Fraud Triangle

To eliminate opportunity: use internal controls

→ represents the company’s plan to
1. Safeguard the company’s assets
2. Improve the accuracy & reliability of accounting information

LO4–1 Discuss the impact of accounting scandals and the passage of the Sarbanes-Oxley Act.
The accounting scandals in the early 2000s prompted passage of the Sarbanes-Oxley Act (SOX). Among other
stipulations, SOX sets forth a variety of guidelines related to auditor–client relations and additional internal
controls. Section 404, in particular, requires company management and auditors to document and assess the
effectiveness of a company’s internal controls.

LO4–2 Identify the components, responsibilities, and limitations of internal control.

Framework for Internal Control
COMPONENTS OF INTERNAL CONTROL

● Built on the foundation of the ethical tone set by top management in its control environment
● Management assesses risks, implements specific control activities, and continuously monitors all systems
● Running throughout this structure: the need for timely information and communication.
○ Employees at all levels must understand the importance of high-quality information.
○ Lower-level employees must report information accurately and in a timely manner to those
higher in the organization.
○ Top executives of a company then must effectively communicate this information to external
parties such as investors and creditors through financial statements.
➢ Control environment: overall attitudes and actions of management (employees more likely to follow
unethical behavior of management)
 ➢ Risk assessment: careful consideration of internal (product risks) and external (decline in demand due to
competition) risk factors
➢ Control activities: policies & procedures used to protect a company’s assets
○ Preventive controls: keep errors/fraud from happening
■ Separation of duties: not allowing the same person to be responsible for both
controlling the asset & accounting for the asset
■ Physical controls (over assets & accounting records): important documents should only
be accessed by authorized personnel
■ Proper authorization: formal guidelines on how to handle cash receipts & make
purchases to prevent improper use of company’s assets
■ Employee management: employees should be made aware of internal control
procedures, ethical responsibilities, and channels for reporting irregular activities.
■ E-commerce controls: maintain firewall settings to prevent unauthorized access to
accounts & credit card numbers
○ Defective controls: detect errors/fraud that have occurred
■ Reconciliations: Management should periodically determine whether the amount of
physical assets of the company (cash, supplies, inventory, and other property) agree
with the accounting records. Accounting personnel should routinely reconcile the
company’s cash records with those of its bank, and any discrepancy should be
investigated.
■ Performance reviews: The actual performance of individuals or processes should be
checked against their expected performance. (e.g. the amount of concessions sold
should be compared to the number of tickets sold over a period of time). Management
may also compare ticket sales for the current year with ticket sales for the previous
year.
■ Audits: an independent auditor attesting to the adequacy of their internal control
procedures, can voluntarily choose each year to have an auditor assess their internal
control procedures to detect any deficiencies/fraudulent behavior of employees
➢ Monitoring: occurs on an ongoing basis
➢ Information & communication: A system should be in place to ensure that current trans- actions of the
company are reflected in current reports. Employees also should be aware of procedures in place to deal
with any perceived internal control failures (anonymous tip hotline → most common means of detecting
employee fraud).

RESPONSIBILITIES FOR INTERNAL CONTROL

● Everyone has an impact on the operation & effectiveness of internal controls, but top executives must
take the final responsibility for their establishment and success

LIMITATIONS OF INTERNAL CONTROLS

● Internal control systems → susceptible to collusion (2 or more people act in coordination to circumvent
internal controls)
● Top-level employees have the ability to override internal control features → opportunity to commit fraud
● Effective internal controls & ethical employees alone can’t ensure a company’s success/survival

PART B: CASH
● Most susceptible to employee fraud
LO4-3 Define cash and cash equivalents.
Cash and Cash Equivalents
● Amount of cash recorded in a company’s balance sheet: currency, coins, balances in savings and checking
accounts, items acceptable for deposit in these accounts (e.g. checks received from customers)
○ In addition, when a company sells g/s to customers who uses credit/debit cards, the cash to be
collected is included in the total cash balance immediately
● Balance of cash also includes cash equivalents (short-term investments that have a maturity date no
longer than 3 months from the date of purchase) → money market funds, Treasury bills, certificates of
deposit
● All combined into a single asset in the balance sheet → usually referred to as “cash”/”cash and cash
equivalents”

LO4-4 Understand controls over cash receipts and cash disbursements.

Cash Controls
CONTROLS OVER CASH RECEIPTS
Common controls of cash:
1. Open mail each day, make a list of cash received (amount + payer’s name)
2. Designate an employee to deposit cash & checks into company’s bank account each day (different person
than who receives)
3. Another employee records cash receipt in the accounting record (verify cash receipts by comparing bank
deposit slip with the accounting records)
4. Accept credit/debit cards, to limit the amount of cash employees handle

Acceptance of Customer Checks

● Whether using cash/check to make purchases, company records as a cash sale
Acceptance of Credit Cards

● Service fee paid to credit card company

Acceptance of Debit Cards

● Also has service fees (by company), but usually much lower than credit card

CONTROLS OVER CASH DISBURSEMENTS

Common:
1. Make disbursements by check, debit card, or credit card → provides a permanent record of all
disbursements
2. Authorize all expenditures before purchase and verify the accuracy of the purchase itself (employee who
authorizes payment =/= employee who prepares the check)
3. Make sure checks are serially numbered and signed only by authorized employees. Require two
signatures for larger checks.
4. Periodically compare amounts shown in the debit/credit card statements with purchase receipts.
(employee verifying the accuracy of the debit/credit card statements =/= employee responsible for actual
purchases)
5. Set maximum purchase limits on debit cards and credit cards.
6. Employees responsible for making cash disbursements =/= in charge of cash receipts.

● Debit accounts payable whether use credit card (small companies) or on account/on credit (larger
companies)

LO4-5 Reconcile a bank statement.

Bank Reconciliation
● Matches the balance between the cash in the bank account with the balance of cash in the company’s
own records. Differences occur because:
○ Timing differences: company records cash before/after bank does
■ E.g. record check before deposit → earlier
■ Only record when aware of some service fees in bank statement → later
○ Errors: by bank/company, can be accidental/intentional
 ● Starlight Drive-In Example: uses Starlight’s bank statement (monthly record of company’s activities from
bank)

Company Records of Cash Activities

Bank Statement

Reconciling the bank account:

STEP 1: RECONCILE THE BANK’S CASH BALANCE
Cash Collection

● Determine cash transactions that have been recorded by the company but not yet by the bank
 ● $2,200 not recorded in bank → deposits outstanding (bank’s balance < company’s balance of cash)
Cash Payment

● #295 & #297 → checks outstanding (haven’t been subtracted from bank’s book balance) → bank’s balance
> company’s balance of cash
● #294 → incorrectly recorded by company (adjusted in step 2)

Bank Reconciliation

● Bank: + deposits outstanding; - checks outstanding

STEP 2: RECONCILE THE COMPANY’S CASH BALANCE

Reconcile per general ledger cash transactions recorded by the bank but not the company:
1. Cash receipts
a. Bank collection of $3,000 cash ($2,800 principal + $200 interest)
→ deposits immediately into bank: common in recurring payments from customers, real estate
transactions, collection agencies, lending agreements
b. Interest earned of $20
→ companies earn interest based on the average daily balance of their savings account and some
checking accounts
2. Cash disbursements (not recorded + incorrect recording)
a. Electronic funds transfer (EFT) of $400
 → automatic transfers from 1 bank account to another (=electronic checks/e-checks); usually
used in routine expenditures (e.g. monthly mortgage payments/utility bills)
b. Nonsufficient funds check (NSF) of $750
→ Starlight previously recorded cash received from customer, now bank is notifying that its cash
balance is being decreased because customer didn’t pay with valid check
c. Debit card purchase of $200
→ company may not know until given bank statement
d. Service fees of $50
e. Company error of recording $2,900 as $2,300 (check #294)
→ needs to decrease balance by additional $300

STEP 3: UPDATE THE COMPANY’S CASH ACCOUNT

● Accounts Receivable → +$750 to show customer who paid with NSF check still owes the company money

If company is unable to resolve the discrepancy, it records the difference to either Miscellaneous
Expense/Miscellaneous Revenue (depending on whether it has a credit/debit balance)
● E.g. company is unable to account for $100 missing cash

Basic items included in bank reconciliation:

LO4-6 Account for employee purchases.

Employee Purchases
● Purchases made on behalf of company uses purchase cards (company-issued debit/credit card)
● Petty cash fund → cash on hand to pay for minor purchases (e.g. delivery fee for pizza for lunch meeting)
○ Employee responsible for the fund → petty cash custodian
● Employee purchases should be included in the accounting records at the end of the period

Starlight withdraws $200 in petty cash fund

May expenses:

● Company’s accountant collects vouchers from the petty cash fund & credit card receipts
● Records:

● Credit cards not paid immediately so put in Accounts Payable

● $200 has to be replenished

○ $150 has been disbursed during May → $50 remaining
○ Management withdraws additional $150 from bank
○ If only $30 left → $20 might be stolen/missing receipt → charge $20 in Miscellaneous Expense

PART C: STATEMENT OF CASH FLOWS

LO4-7 Identify the major inflows and outflows of cash.
● Companies record cash in: balance sheet & statement of cash flows
● Balance sheet
○ Reports cash as a current asset available for spending at the end of a period (final balance only)
○ Companies may separately report restricted asset (not available for current operations → e.g.
cash set aside for repaying debt, purchasing equipment, or making future investments)
● Statement of cash flows → provides details regarding cash receipts and payments
○ Investors knows the company’s cash inflows & outflows related to operating, investing and
financing activities
 ■ Operating activities: cash transactions involving revenue and expense events during the
period. In other words, operating activities include the cash effect of the same activities
that are reported in the income statement to calculate net income.
■ Investing activities: cash investments in long-term assets and investment securities.
When the firm later sells those assets, we consider those transactions investing activities
also. So, investing activities tend to involve long-term assets.
■ Financing activities: transactions designed to raise cash or finance the business. There
are two ways to do this: borrow cash from lenders or raise cash from stockholders. We
also consider cash outflows to repay debt and cash dividends to stockholders to be
financing activities. So, financing activities involve liabilities and stockholders’ equity.
Eagle Soccer Academy example

● Only transactions involving cash affect a company’s cash flows

● Net cash flows from operating activities → related most directly to the company’s profitability
● Final amount $6,900 → same amount of cash reported in the balance sheet
ANALYSIS: CASH ANALYSIS
LO4-8 Demonstrate the link between cash reported in the balance sheet and cash reported in the statement of
cash flows.