Cash, Fraud, and Internal Control

Key Terms and Definitions

• Automated Clearing House (ACH): A U.S. electronic payment network that processes electronic funds transfer (EFT) transactions in batches, such as direct deposit and automatic bill payments.

• Bank Reconciliation: A report explaining the difference between the book (company) balance of cash and the cash balance reported on the bank statement, used to compute the adjusted cash balance.

• Bank Statement: A report from the bank showing the depositor’s beginning and ending cash balances and a listing of changes for a period.

• Canceled Checks: Checks that the bank has paid and deducted from the depositor’s account.

• Cash: Currency, coins, and amounts on deposit in bank checking or savings accounts.

• Cash Equivalents: Short-term investment assets readily convertible to a known cash amount, typically maturing within 90 days.

• Check: A document signed by a depositor instructing the bank to pay a specified amount to a designated recipient.

• Check Register: A cash disbursements journal with a column for check numbers.

• Cloud Storage: Remote, network-based storage of data, allowing secure off-site storage of financial records and internal control documentation.

• Committee of Sponsoring Organizations (COSO): A joint initiative providing frameworks and guidance on enterprise risk management, internal control, and fraud deterrence.

• Days’ Sales Uncollected: A liquidity measure showing how many days it takes to collect receivables. Formula:

• Deposit Ticket: A form listing items (currency, coins, checks) deposited and their amounts.

• Deposits in Transit: Deposits recorded by the company but not yet by the bank.

• Electronic Funds Transfer (EFT): Electronic communication to transfer cash between parties.

• Enterprise Resource Planning (ERP): Programs managing a company’s vital operations, including accounting.

• Fraud Triangle: Model highlighting three factors that push a person to commit fraud: opportunity, pressure, and rationalization.

• Internal Control System: Policies and procedures to protect assets, ensure reliable accounting, promote efficient operations, and urge adherence to company policies.

• Invoice: An itemized record of goods prepared by the vendor, listing customer, items sold, prices, and terms.

• Invoice Approval: Document with a checklist for approving the recording and payment of an invoice.

• Liquid Assets: Resources easily converted into other assets or used to pay for goods, services, or liabilities.

• Liquidity: The availability of resources to meet short-term cash requirements.

• Outstanding Checks: Checks written and recorded by the depositor but not yet paid by the bank.

• Principles of Internal Control: Prescriptions for management to establish responsibility, maintain records, insure assets, separate recordkeeping from custody, divide responsibility, apply technological controls, and perform reviews.

• Purchase Order: Document used by the purchasing department to place an order with a vendor.

• Purchase Requisition: Document listing merchandise needed and requesting purchase.

• Receiving Report: Form reporting that ordered goods were received, describing quantity and condition.

• Sarbanes-Oxley Act (SOX): Legislation enhancing corporate governance, accounting disclosures, and internal controls.

• Signature Card: Card with signatures of persons authorized to sign checks.

• Vendee: Buyer of goods or services.

• Vendor: Seller of goods or services.

• Voucher: Internal file storing documents and information to control cash disbursements and ensure proper authorization and recording.

• Voucher Register: Journal where all approved vouchers are recorded.

• Zero Balance Account (ZBA): Checking account that always stays at $0; the bank transfers just enough from the main account to cover payments, then returns the ZBA to $0.

Objectives and Components of Internal Control

Objectives of Internal Controls

An internal control system is a set of policies and procedures designed to monitor and control business activities. The four main objectives are:

• Safeguard Assets: Prevent theft, loss, misuse, or damage to company assets.

• Ensure Reliable Accounting: Ensure financial information is correct, complete, and trustworthy.

• Promote Efficient Operations: Help employees work efficiently, reduce waste, and improve productivity.

• Uphold Company Policies: Ensure employees follow company rules, laws, and standards.

COSO's Five Components of Internal Control

The Committee of Sponsoring Organizations (COSO) identifies five essential components that contribute to the quality of accounting information:

• Control Environment: The company’s structure, ethics, and integrity ("tone at the top").

• Risk Assessment: Identifying, analyzing, and managing risks that could disrupt business goals.

• Control Activities: Policies and procedures to reduce risk (e.g., physical locks, separation of duties).

• Information & Communication: Systems for reporting and communicating information internally and externally.

• Monitoring: Regular review of internal control effectiveness to identify and correct weaknesses.

Seven Principles of Internal Control

These principles apply to all companies, regardless of size:

1. Establish Responsibilities: Assign each task to one clearly identified person to ensure accountability.

2. Maintain Adequate Records: Keep organized, complete records to protect assets and monitor activity.

3. Insure Assets and Bond Key Employees: Use insurance and bonding to protect against loss and employee theft.

4. Separate Recordkeeping from Custody of Assets: The person handling an asset should not keep its records, reducing the risk of theft and concealment.

5. Divide Responsibility for Related Transactions: Split transaction steps among multiple people to create checks and balances.

6. Apply Technological Controls: Use devices and software (e.g., cash registers, time clocks, ID scanners, VPNs, 2FA) to strengthen internal control.

7. Perform Regular and Independent Reviews: Have auditors check that controls are working and procedures are followed.

Limitations of Internal Control

Internal controls provide reasonable assurance, not a guarantee, due to inherent limitations:

• Human Error: Mistakes due to misunderstanding, distraction, fatigue, or poor judgment.

• Human Fraud: Deliberate attempts to bypass controls, often through collusion or management override.

• Cost-Benefit Constraint: The cost of a control should not exceed its expected benefit.

• Technological Limitations: Software glitches, shared or compromised passwords, and hacking risks.

The Fraud Triangle

The Fraud Triangle explains the three factors necessary for workplace fraud:

• Pressure (Incentive): Financial or personal problems that motivate fraud (e.g., debt, medical bills, unrealistic sales targets).

• Opportunity: Weak internal controls or poor supervision that allow fraud to occur with low risk of detection.

• Rationalization (Attitude): The employee justifies dishonest actions (e.g., "the company owes me," "I’ll pay it back").

Prevention: Companies can only directly control the 'opportunity' side by strengthening internal controls.

Bank Services and Banking Transactions

Bank accounts and related documents serve as critical internal controls by providing independent records of cash transactions.

• Signature Card: Used by the bank to verify authorized signatures.

• Deposit Ticket: Lists details of deposits made to the account.

• Check: Written order to pay a specific sum to a payee.

• Electronic Funds Transfer (EFT): Electronic movement of cash between accounts.

• Bank Statement: Monthly report of account activity and balances.

Bank Reconciliations

Bank reconciliation is the process of adjusting the book and bank balances of cash until they match, accounting for timing differences and errors.

Essential Reconciliation Items

1. Deposits in Transit: Add to bank balance; company has recorded, bank has not.

2. Outstanding Checks: Subtract from bank balance; company has recorded, bank has not.

3. Interest Earned and Cash Collected by Bank: Add to book balance; bank has recorded, company has not.

4. Bank Fees and NSF Checks: Subtract from book balance; bank has recorded, company has not.

5. Errors: Adjust the side (bank or book) that made the error.

Key Rule: Adjustments to the book side require journal entries; bank side adjustments do not.

Example: Book Error Correction

If a check was written for $910 but recorded as $190, the books are short by $720. To correct, subtract $720 from the book balance.

Days’ Sales Uncollected

This ratio measures the average number of days it takes to collect cash from accounts receivable, indicating liquidity and collection efficiency.

Formula:

Interpretation: If the result is 42, it takes an average of 42 days to collect cash after a credit sale. If payment terms are "Net 30," a result above 30 suggests customers are paying late, which may cause cash flow issues.

Summary Table: Internal Control Principles and Examples

Additional info: The above notes expand on the original study guide by providing full academic explanations, examples, and context for each key concept, as well as formulas and tabular summaries for exam preparation.