Internal Control and Cash: Study Notes for Financial Accounting

Chapter 4: Internal Control and Cash

Introduction

This chapter explores the importance of internal controls in financial accounting, focusing on the prevention and detection of fraud, the components of internal control systems, and specific procedures for safeguarding cash. Understanding these concepts is essential for ensuring the reliability of financial information and protecting organizational assets.

Fraud and Its Impact

Definition and Consequences of Fraud

• Fraud is the intentional misrepresentation of facts to persuade another party to act in a certain way, resulting in injury or damage.

• Fraud is a growing global problem, especially with the expansion of e-commerce.

• Common examples include insurance fraud, check forgery, Medicare fraud, credit card fraud, and identity theft.

Types of Fraud

• Misappropriation of Assets: Typically committed by employees, involving theft of money or inventory, bribery, kickback schemes, or overstating expense reimbursements.

• Fraudulent Financial Reporting: Usually committed by managers, involving false or misleading journal entries to deceive investors and creditors.

The Fraud Triangle

Elements of the Fraud Triangle

• Opportunity: The ability to commit fraud, often due to weak internal controls.

• Pressure: Motivation or incentive to commit fraud, such as financial difficulties.

• Rationalization: The mindset that justifies the fraudulent behavior.

The fraud triangle illustrates that all three elements must be present for fraud to occur.

Objectives and Components of Internal Control

Objectives of Internal Control

• Safeguard assets

• Encourage employees to follow company policy

• Promote operational efficiency

• Ensure accurate, reliable accounting records

• Comply with legal requirements

Components of Internal Control

• Control Environment: The overall attitude of management and employees about the importance of controls ("tone at the top" and code of ethics).

• Risk Assessment: Identifying and analyzing business risks and establishing procedures to address them.

• Information System: The methods and records used to identify, measure, record, and communicate financial information.

• Control Procedures: Policies and procedures that help ensure management directives are carried out.

• Monitoring of Controls: Ongoing evaluations, often by internal and external auditors, to ensure controls are effective.

Internal Control Procedures

Key Procedures

• Smart Hiring Practices: Background checks, training, supervision, competitive salaries, and clear responsibilities.

• Separation of Duties: Dividing responsibilities among different employees for asset handling, record keeping, and transaction approval.

• Comparison and Compliance Monitoring: Use of budgets, exception reporting, and audits to monitor compliance.

• Adequate Records: Maintaining detailed, prenumbered documents (hard copy or electronic) for all transactions.

• Limited Access: Restricting access to assets through physical controls (locks, passwords, encryption).

• Proper Approvals: Requiring management or departmental approval for transactions, especially purchases.

Information Technology and Internal Control

Role of IT in Internal Control

• Modern accounting systems rely heavily on information technology, improving accuracy and speed.

• Examples include electronic sensors and bar codes for inventory control.

Safeguard Controls

Physical and Procedural Safeguards

• Storing important documents in fireproof vaults

• Using burglar alarms and security cameras

• Employing loss prevention specialists

• Purchasing fidelity bonds for cashiers

• Implementing mandatory vacations and job rotation

Internal Controls for E-Commerce

Risks and Security Measures

• E-commerce introduces risks such as stolen credit card numbers, malicious software, and phishing.

• Security measures include encryption and firewalls to protect sensitive information.

Internal Controls Over Cash Receipts and Payments

Cash Receipts Over the Counter

• Point-of-sale terminals record sales, cost of goods sold, and inventory reduction.

• Customers receive receipts; cash drawers are reconciled and deposited at the end of shifts.

• The accounting department reconciles terminal sales with cash in the drawer.

Cash Receipts by Mail

• Mail receipts should be opened by two people, listed, and deposited promptly.

• Remittance advices are used to record payments and update accounts receivable.

Controls Over Payment by Check

• Most payments are made by check or EFT, providing a record and requiring authorization.

• Duties are split among purchasing, receiving, preparing payments, and approving payments.

Petty Cash

• Used for minor expenses, managed by a custodian using an imprest system (fund plus vouchers equals specified balance).

• Debit cards may also be used for small payments.

Limitations of Internal Control

Cost-Benefit Considerations and Limitations

• Internal controls can be circumvented by collusion, management override, or human error (fatigue, negligence).

• The benefits of controls should always outweigh their costs.

Case Study: Detecting Fraud in Cash Payments

Scenario Analysis

• Potential fraud methods: writing checks to oneself, resubmitting invoices, kickback schemes, making unauthorized cash payments.

• Detection methods: bank reconciliation, examining checks and invoices, contacting suppliers, comparing cost ratios, and reconciling cash records with inventory.

Historical Accounting Scandals

Notable Cases

• Waste Management, Inc. (1998): $1.7 billion in fake earnings

• Enron Corporation (2001): Inflated earnings and assets through creative accounting

• WorldCom (2002): Overreported assets by ~$11 billion

• Lehman Brothers (2008): Overstated assets by billions

• Theranos (2018): Defrauded investors about medical technology (not strictly accounting fraud)

Summary Table: Key Internal Control Procedures

Procedure	Description
Smart Hiring Practices	Background checks, training, supervision, competitive salaries, clear responsibilities
Separation of Duties	Dividing asset handling, record keeping, and approval among different employees
Comparison and Compliance Monitoring	Budgets, exception reporting, audits
Adequate Records	Detailed, prenumbered documents for all transactions
Limited Access	Physical and electronic restrictions on asset access
Proper Approvals	Management or departmental approval for transactions

Key Equations and Concepts

• Imprest System for Petty Cash:

$\text{Petty Cash Fund Balance} + \text{Petty Cash Vouchers Paid} = \text{Specified Petty Cash Balance}$

• Bank Reconciliation: The process of matching the balances in an entity's accounting records for a cash account to the corresponding information on a bank statement.

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