Chapter 4: Internal Control and Cash

Learning Objectives

• Describe fraud and its impact

• Explain the objectives and components of internal control

• Evaluate internal controls over cash receipts and cash payments

• Prepare a bank reconciliation

• Report cash on the balance sheet

• Describe unsupervised machine learning and its application to expense reimbursement fraud detection

Fraud and Its Impact

Definition and Consequences of Fraud

Fraud is the intentional misrepresentation of facts with the purpose of persuading another party to act in a certain way, resulting in injury or damage. It is a growing problem, especially with the expansion of e-commerce. Common examples include insurance fraud, check forgery, Medicare fraud, credit card fraud, and identity theft.

• Misappropriation of assets: Theft of money or inventory, often committed by employees. Includes bribery, kickback schemes, and overstated expense reimbursements.

• Fraudulent financial reporting: False or misleading journal entries made by managers to deceive investors and creditors, often due to pressure to meet or exceed financial targets. This type of fraud is typically more costly (e.g., Enron, MCI/WorldCom).

The Fraud Triangle

The fraud triangle illustrates the three elements necessary for fraud to occur: motive, opportunity, and rationalization. Weak internal controls often create the opportunity for fraud.

Fraud and Ethics

Fraud is not only illegal but also unethical. It results in economic losses for many, while only a few benefit temporarily. Legal consequences include imprisonment, fines, and monetary damages. Ethically, fraud violates the rights of others and undermines trust in business.

Objectives and Components of Internal Control

Purpose of Internal Control

Internal control is a system of organizational plans and procedures designed to accomplish five main objectives:

• Safeguard assets

• Encourage employees to follow company policy

• Ensure accurate and reliable accounting records

• Comply with legal requirements

• Promote operational efficiency (secondary to other objectives)

Management Report on Internal Controls

Public companies are required to report on the effectiveness of their internal controls over financial reporting. This includes maintaining accurate records, ensuring compliance with accounting principles, and safeguarding assets.

Function of an Internal Control System

Internal controls act as a barrier to prevent fraud, waste, and inefficiency, thereby protecting company assets.

Components of Internal Control

The five components of an internal control system are:

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

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

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

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

• Monitoring of Controls: Ongoing evaluations of the effectiveness of internal controls, often involving internal and external auditors.

Internal Control Procedures

Types of Controls

• Preventative Controls: Designed to prevent errors or fraud before they occur (e.g., smart hiring practices, separation of duties, limited access).

• Monitoring (Detective) Controls: Designed to detect errors or fraud after they have occurred (e.g., audits, reconciliations, exception reporting).

Key Internal Control Procedures

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

• Separation of Duties: No one person should handle more than one of the following: asset handling, record keeping, transaction approval.

• Comparison and Compliance Monitoring: Comparing actual results to budgets, exception reporting, audits, and reconciliations.

• Adequate Records: Maintaining detailed, prenumbered documents (e.g., Positive Pay service for checks).

• Limited Access: Restricting physical and electronic access to assets and records.

• Proper Approvals: Requiring management approval for transactions, often delegated to specific departments.

Information Technology and Safeguard Controls

Modern accounting systems rely heavily on IT, which improves accuracy and speed. Safeguard controls include fireproof vaults, security systems, loss prevention specialists, fidelity bonds, and mandatory vacations/job rotation.

Internal Controls for E-Commerce

E-commerce introduces risks such as stolen credit card numbers, malware, and phishing. Security measures include encryption and firewalls to protect data and limit unauthorized access.

Internal Controls Over Cash Receipts and Payments

Cash Receipts Over the Counter

Point-of-sale terminals provide control by recording sales, inventory reductions, and issuing receipts. Cash drawers are reconciled at the end of each shift and compared to sales records.

Cash Receipts by Mail

Cash received by mail is processed through a series of steps involving checks, remittance advices, deposit tickets, and accounting records to ensure proper control and recording.

Controls Over Payment by Check or EFT

Most payments are made by check or electronic funds transfer (EFT), providing a record of payment and requiring authorization. Duties are separated among purchasing, receiving, preparing payments, and approving payments.

Payment Packet

A payment packet typically includes a purchase order, invoice, and receiving report, which are matched before payment is made to ensure validity.

Petty Cash

Petty cash funds are used for minor expenses and are managed using an imprest system, where the sum of cash on hand plus vouchers equals the specified balance. Debit cards are increasingly used as an alternative.

Limitations of Internal Control

Internal controls can be circumvented by collusion, management override, or human error. The cost of controls should not exceed their benefits.

Bank Reconciliation

Purpose and Documents

Bank reconciliation explains differences between the company’s cash records (book balance) and the bank statement (bank balance), often due to timing differences or errors. Key documents include signature cards, deposit tickets, checks, bank statements, and the reconciliation itself.

Check Structure

A check involves three parties: the maker (who signs), the payee (who receives payment), and the bank (which pays the check). Checks include details such as amount, date, and remittance advice.

Bank Statement

The bank statement summarizes all cash activity, including deposits, withdrawals, service charges, and the ending balance.

Bank Reconciliation Process

To reconcile, adjust the bank and book balances for items such as deposits in transit, outstanding checks, bank errors, bank collections, EFTs, service charges, interest, NSF checks, and book errors. The goal is for the adjusted balances to agree.

• Bank Side Adjustments: Add deposits in transit, subtract outstanding checks, correct bank errors.

• Book Side Adjustments: Add bank collections, interest, EFT receipts; subtract service charges, NSF checks, EFT payments; correct book errors.

Journalizing Transactions from the Bank Reconciliation

All reconciling items on the book side require journal entries, as these transactions have not yet been recorded in the company’s books.

Online Banking

Online banking provides real-time access to account history, facilitating monitoring and reconciliation of cash balances.

Reporting Cash on the Balance Sheet

Cash and Cash Equivalents

Cash includes currency, checking and savings accounts, and money market accounts. Cash equivalents are short-term, highly liquid investments with maturities of three months or less, such as time deposits, certificates of deposit, and near-maturity government securities. Equity securities like Apple stock are not cash equivalents due to risk and lack of maturity.

Disclosure

Companies typically disclose their policy for classifying cash equivalents in the notes to the financial statements.

Unsupervised Machine Learning in Fraud Detection

Expense Reimbursement Fraud

Expense reimbursement fraud occurs when employees claim reimbursement for non-legitimate expenses. The Association of Certified Fraud Examiners (ACFE) classifies these schemes as mischaracterized, fictitious, overstated, or multiple reimbursements.

Machine Learning Applications

Unsupervised machine learning models can flag unusual receipts for further investigation, improving fraud detection by analyzing both structured and unstructured data. This approach is more effective and immediate than manual review, especially as fraudsters become more sophisticated.