Chapter 7: Fraud, Internal Control, and Cash

Study Guide
Learning Objectives:
1. Define fraud and the principles of internal control.
2. OMIT: Apply internal control principles to cash.LO2 in textbook.
3. Identify the control features of a bank account.
4. Explain the reporting of cash and the basic principles of cash management.
OMIT: Pages 7-27 (starting at “Managing and Monitoring Cash” section) to
7-32

Learning Objective 1: Define fraud and the principles of internal control.

Fraud and Internal Control

What is fraud? A dishonest act by an employee that results in personal benefit to the
employee at a cost to the employer.

The three main factors that contribute to fraudulent activity are depicted by the
fraud triangle.

The three elements of the fraud triangle are:

1) opportunity
2) financial pressure
3) rationalization

Which element of the fraud triangle is the most important? (It is the most
important because it is the element that the organization can control)
opportunity

After numerous corporate scandals came to light in the early 2000s, Congress
addressed fraud by passing the Sarbanes Oxley Act (SOX).

Under SOX, all publicly traded U.S. corporations are required to maintain an
adequate system of internal controls.

SOX also created the public company accounting oversight board (PCAOB) to
establish auditing standards and regulate auditor activity.

Internal controls are processes designed to safeguard assets, enhance the

reliability of accounting records, increase efficiency of operations, and ensure
compliance with laws and regulations.

ACCT 2001: Ch. 07 Page 1 of 11

Internal control systems have five primary components:

Internal Control Definition

Component

Control Environment “Tone at the top” set by top

management

Risk Assessment Identifying and Analyzing the risks

of the entity

Control Activities Policies and procedures put in

place

Information and Must document and communicate

Communication controls

Monitoring Must monitor and adjust

continually

Principles of Internal Controls

Control 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.

What are the six principles of control activities?

1) Establishment of Responsibility:
When is control most effective? Only 1 person responsible for a task

Establishing responsibility often requires limiting access only to authorized

personnel, and then identifying those personnel. Example: cash register drawer
assigned to 1 person, only authorized people can issue authorize special transactions

2) Segregation of Duties:
There are two common applications of this principle:
 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.

Making one individual responsible for related activities increases the potential for
errors and irregularities.

Companies should assign related purchase activities, or related sales activities, to

different individuals. This is because abuses are less likely to occur when
companies divide the purchasing, or sales, tasks.

The accountant should have neither physical custody of the asset nor access to it.

The separation of accounting responsibility from the custody of assets is

especially important for cash and inventory because these assets are very
vulnerable to fraud.

3) Documentation Procedures:
Whenever possible, companies should use prenumbered documents, and all
documents should be accounted for.

The control system should require that employees promptly forward source
documents for accounting entries to the accounting department.

4) Physical Controls:
Physical Controls relate to the safe guarding of assets and enhance the accuracy
and reliability of the accounting records. Examples: safes, alarms, passwords, time
clocks

5) Independent Internal Verification:

To obtain maximum benefit from independent internal verification:
 Companies should verify records periodically or on a surprise basis.
 An employee who is independent of the personnel responsible for the
information should make the verification.
 Discrepancies and exceptions should be reported to a management
level that can take appropriate corrective action.

Example: manager reviewing casher daily count

Who are internal auditors? Auditors who work for the company they audit. They do
financial, IT and internal control audits.

3
 They also evaluate the activities of departments and individuals to determine
whether prescribed internal controls are being followed and recommend
improvements when needed.

A growing field that has changed the aspects of internal auditing (and
accounting) is data analytics. Allows for continuous monitoring of transactions.
Transactions can be flagged by dollar amount, vendor, source.

6) Human Resource Controls

 Bond employees who handle cash. What is bonding? Type of insurance
policy for employees who handle large amounts of cash.
 Rotate employee’s duties and require employees to take vacations.
 Conduct thorough background checks.

Some Limitations of Internal Control: Human Element and Collusion

Before you go on, review DO IT! 1 on Principles of Control Activities.

Learning Objective 3: Identify the control features of a bank account.

Control Features: Use of a Bank

Contributes to good internal controls over cash.

 Safeguards cash and minimizes the amount of cash on hand.

 Creates a double record of bank transactions.

 The asset account of Cash maintained by the company is the “flipside” of the bank’s
liability account for that company.

 A bank reconciliation is a process of comparing the bank’s balance with the

company’s balance and explaining the differences.

 Many companies may use multiple bank accounts for different offices/branches or
even separate ones for payroll.

Electronic Banking

4
 Most companies take advantage of electronic banking which allows companies to
access their banking on a computer or mobile device.

 Strong internal controls such as strong passwords and documenting transactions is

important. It is also important to safeguard checks to make sure they are not stolen or
misused.

 Companies use electronic fund transfers to make deposits and payments frequently.

Bank Statements
Bank statements are prepared from the bank’s perspective.

Items shown on the bank statement include:

1. Checks paid and other debits that reduce the balance in a depositor’s
account. Examples include: cleared checks, Electronic withdrawals, bank
charges

2. Deposits and other credits that increase the balance in a depositor’s

account. Examples include: check/cash deposits, electronic deposits, interest
earned

3. The account balance after each day’s transactions.

5
Illustration 7.7

Special terms related to the bank statement:

A cancelled check is a check that has been paid through the bank account.

The bank statement may have memorandum explaining debits and credits made during
the month. The above bank statement has several memorandum symbols listed at the
bottom.

A check that is not paid by the bank because of insufficient funds in the bank account is
called an nonsufficient funds (NSF) check.

If a company deposits a customer’s check and it “bounces” because of insufficient

funds, it will be listed as a debit memorandum. The depositor company will be returned
the check and will reestablish an accounts receivable for the depositor and reduce the
cash in the bank account.

6
 Reconciling a Bank Account
 Reconcile balance per bank and balance per book (company) to their adjusted
(corrected) true balances.

 The need for a reconciliation has two causes

o Time lags - which prevent one of the parties from recording the transaction
in the same period.

o Errors - can be made by either party (bank or company(books).

Common Reconciling Items:

Adjustments to the bank balance:

Deposits in transit.
Outstanding checks.
Bank Errors

Adjustments to the book balance:

EFT collections and other deposits
NSF customer checks
Bank fees and service charges and other
withdrawals
Company “bookkeeper” errors

7
Bank Reconciliation Illustrated
Illustration 7-7 presents the bank statement for Laird Company. It shows a balance per
bank of $15,907.45 on April 30, 2025. On this date the balance of cash per books is
$11,709.45. From the foregoing steps, Laird determines the following reconciling items.

Reconciling items for the bank

Step Deposits in Transit – April 30 deposit (received by bank on May $2,201.40
1 1st)

Step Outstanding checks – No. 453, $3,000.00; No. 457, $1,401.30; 5,904.00
2 No. 460, $1,502.70
Step Bank Errors (+/-) none 0.00
3

Reconciling items per the books

Step Other deposits – Unrecorded receipts determined by a review of $1,035.00
1 bank statement is as follows:
 Electronic receipt from customer on account on April 9th

Step Other payments – Unrecorded charges determined by a review 575.60

2 of bank statement are as follows:
 Returned NSF check from JR Baron on April 29. $425.60
 Debit and credit card fees on April 30. $120.00
 Bank service charge on April 30. $30.00
Step Company Errors (+/-) 36.00
3  Check No. 443 was correctly written by Laird to a supplier
(Andrea Company) for $1,226 and was correctly paid by
the bank on April 12. However, it was recorded as $1,262
on Laird’s books.

8
Illustration: Prepare a bank reconciliation at April 30.

Cash balance per bank statements $15,907.45

Add:
Less:
Adjusted cash balance per bank

Cash balance per books $11,709.45

Add:

Less:

Adjusted cash balance per books

Journalize the adjusting entries at April 30 on the books of Laird Company.

To record collection of electronic funds transfer:

Apr. 30

To record NSF check

Apr. 30

To record bank service charges

Apr. 30

To correct error in recording check No. 443:

Apr. 30

Helpful Tip: In previous chapters, we considered Cash an account that never needed
adjustment. This was because we had not been introduced to the bank reconciliation
yet.

Before you go on, review DO IT! 3 on Bank Reconciliation.

9
Learning Objective 4: Explain the reporting of cash and the basic principles of
cash management. OMIT: “Managing and Monitoring Cash” section.

Reporting Cash

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 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.

Cash is the most liquid asset owned by the company.

Many companies report cash and cash equivalents together.

Cash equivalents are short-term highly investments. They must be

1. readily convertible and
2. near maturity (generally with maturities of only 3 months or less).

Restricted cash is cash that is not available for general purpose but is restricted
for a special purpose. Cash restricted must be reported separately on the balance
sheet.

Before you go on, review DO IT! 4a on Reporting Cash.

10
 In Class Problems

On October 30, 2023, Keeds Company had a cash balance per books of $6,140. The statement
from Dakota State Bank on that date showed a balance of $7,690.80. A comparison of the bank
statement with the Cash account revealed the following facts.

1. Checks outstanding on October 31 totaled $1,860.10.

2. A fee for new checks was charged in October for $25.
3. On October 31, the bank statement showed an NSF charge of $575 for a check received
by Keeds Company from a customer on account.
4. The bank collected $1,520 for Keeds Company for collection of a note receivable of
$1,500 and interest earned of $20.
5. Deposits in transit at October 31 totaled $1,193.30.
6. Check No. 2480 issued to L. Taylor, a creditor, for $384 that cleared the bank in October
was incorrectly recorded on October 10 by the bookkeeper for $348.

Instructions
(a) Prepare the bank reconciliation as of October 31.
(b) Prepare the necessary adjusting entries at October 31.

11