Chapter 4

Learning Objective
1. Describe fraud and its impact
4-1
Copyright 2015 Pearson Education Inc. All rights reserved.
DESCRIBE FRAUD AND ITS IMPACT

Fraud
4-2
Intentional misrepresentation of facts
Causes injury or damage to another party
Increased with expansion of e-commerce via the

Internet
Some common types
Insurance fraud
Credit card fraud
Check forgery
Identity theft
Medicare fraud
LO 1

Two common types of fraud that impact financial
statements
Misappropriation of
Assets
4-3
Fraudulent Financial
Reporting
Committed by employees
Committed by managers
Theft of money or inventory
Bribery or kickback schemes
False and misleading

entries in the books
Overstate expense
reimbursement
Deceives investors and

creditors
LO 1

Exhibit 4-1 | The Fraud Triangle
Motive
Opportunity
4-4
Fraud
is the ultimate
unethical act in
business!
Rationalization
LO 1
Learning Objective
2. Explain the objectives and components of internal
control
4-5
EXPLAIN THE OBJECTIVES AND

COMPONENTS OF INTERNAL CONTROL
Internal Control
4-6
Primary way fraud and errors are:
Prevented
Detected or
Corrected
Management and Board of Directors implement a:
Plan of organization
System of procedures
LO 2
EXPLAIN THE OBJECTIVES AND

COMPONENTS OF INTERNAL CONTROL
Objectives of Internal Control
Safeguard
assets
Encourage
employees to
follow policies
Ensure
accurate,
reliable records
4-7
Promote
operational
efficiency
Comply with
legal
requirements
LO 2
The Sarbanes-Oxley Act (SOX)

SOX Provisions
4-8
Public companies must
maintain a system of internal control
issue an internal control report
Auditors must evaluate and report on internal controls
Created Public Company Accounting Oversight Board
Limits non-audit services of auditing firms
Penalties for violators
LO 2
The Sarbanes-Oxley Act (SOX)

Exhibit 4-3 | The Shield of Internal Control
Internal
Controls
Company Assets
4-9
LO 2
The Components of Internal Control

Exhibit 4-4 | The Components of Internal Control
RISK ASSESSMENT
4-10
LO 2

Control
Environment
Risk
Assessment
Control
Procedures
4-11
Tone at the top
Code of ethics
Information
System
Monitoring of
Controls
LO 2

Control
Environment
Risk
Assessment
Control
Procedures
4-12
Information
System
Monitoring of
Controls
Identify business risks
Establish procedures to deal with risks
LO 2

Control
Environment
Risk
Assessment
Control
Procedures
4-13
Information
System
Monitoring of
Controls
System to capture, process, and

report transactions
LO 2

Control
Environment
Risk
Assessment
Control
Procedures
4-14
Information
System
Monitoring of
Controls
Built into the control environment and

information system
LO 2

Control
Environment
Risk
Assessment
Control
Procedures
4-15
Information
System
Monitoring of
Controls
Controls programmed into a companys

information technology
Internal and external auditors

LO 2
Internal Control Procedures

Smart Hiring Practices
Background checks
Separation of Duties
Training and supervision
Competitive salaries
Clear employee
responsibility
Comparison and
Compliance Monitoring
Adequate Records
Limited Access
Proper Approvals
4-16
LO 2

Comparison and
Separates three key duties:
Asset handling
Record keeping
Transaction approval
Adequate Records
Limited Access
Proper Approvals
4-17
LO 2

Comparison and
Operating and cash

budgets
Exception reporting
Audits
Adequate Records
Limited Access
Proper Approvals
4-18
LO 2

Comparison and
Details of business
transactions
Adequate Records
Hard copy documents or

electronic
Prenumbered documents
Limited Access
Proper Approvals
4-19
LO 2

Comparison and
Physical access to assets
Adequate Records
Lock-box system
Limited Access
Lock and key
Passwords
Encryption
Proper Approvals
4-20
LO 2

Comparison and
Managements general or
specific approval
Credit department
Limited Access
Purchasing department
Proper Approvals
Human resources
department
Adequate Records
4-21
LO 2
Information Technology
Accounting systems rely
less on manual procedures and
more on information technology (IT)
Examples:
Electronic sensors
Bar code scanning
Use of computers greatly improves speed and accuracy
4-22
LO 2
Safeguard Controls
Job rotation
Fireproof
vaults
Fidelity
bonds
Security
cameras
Mandatory
vacations
4-23
Alarms
Loss
prevention
specialists
LO 2
Internal Controls for E-Commerce

E-commerce pitfalls include:
Stolen credit card numbers
Computer viruses and Trojan Horses
Phishing expeditions
Security measures:
4-24
Encryption
Firewalls
LO 2
The Limitations of Internal Control

Costs and Benefits
Ways internal control can be circumvented
Collusion
Management override
Fatigue & negligence
Benefits should outweigh the costs
4-25
LO 2
Learning Objective
3. Design and use a bank reconciliation
4-26
DESIGN AND USE A BANK RECONCILIATION

Documents used to control a bank account
Signature
Card
Deposit
Ticket
Bank
Statement
4-27
Check
Bank
Reconciliation
Protects against forgery

LO 3

Signature
Card
Deposit
Ticket
Bank
Statement
4-28
Check
Bank
Reconciliation
Proof of deposit transaction

LO 3

Signature
Card
Deposit
Ticket
Bank
Statement
4-29
Check
Bank
Reconciliation
Maker, payee, and bank

LO 3
Check
Exhibit 4-5 | Check with Remittance Advice
Maker
Three parties
to a check
Payee
Bank
4-30
LO 3

Signature
Card
Deposit
Ticket
Bank
Statement
4-31
Check
Bank
Reconciliation
Report of customers cash activity

LO 3
Exhibit 4-6 | Bank Statement
4-32

Signature
Card
Deposit
Ticket
Bank
Statement
4-33
Check
Bank
Reconciliation
Differences between companys cash records

and bank balance
LO 3
Bank Reconciliation
Two records of a businesss cash
1. Cash account in companys general ledger
2. Bank statement
Differences because of time lag in recording transactions
4-34
LO 3
Bank Reconciliation
Bank Side
4-35
Book Side
Deposits in transit
Bank collections
Outstanding checks
Electronic funds transfers
Bank errors
Service charge
Interest revenue
Nonsufficient funds (NSF)

checks
Cost of printed checks
Book errors
LO 3
Bank Reconciliation Illustrated

The December 31 bank balance of Mid-Atlantic Manufacturing is $5,900. The
companys Cash account has a balance of $3,340. Additional information
related to the cash account at December 31 is as follows:
1.
Deposit in transit, $1,600.
2.
Bank error: The bank deducted $100 for a check written by another
company. Add $100 to the bank balance.
3.
Outstanding checkstotal of $1,340.
4.
EFT receipt of your dividend revenue earned on an investment, $900.
5.
Bank collection of your account receivable, $2,100.
6.
Interest revenue earned on your bank balance, $30.
7.
Book error: You recorded check no. 333 for $510. The amount you actually
paid on account was $150. Add $360 to your book balance.
8.
Bank service charge, $20.
9.
NSF check from a customer, $50. Subtract $50 from your book balance.
10. EFT payment of insurance expense, $400.
4-36
LO 3
Bank Reconciliation Illustrated

Bank reconciliation for Mid-Atlantic at December 31
Cash balance per bank statement $
Add:
Deposit in transit 1,600
Correction of bank error 100
Less: Outstanding checks (1,340)
Adjusted bank balance
$
6,260
5,900
Cash balance per books $

3,340
Add: EFT receipt of dividends 900
Bank collection of accounts receivable 2,100
Interest revenue 30
Correction of book error (Check no. 333) 360
Less: Service charge
NSF check
EFT payment of insurance expense (400)
Adjusted book balance
$
6,260
4-37
(20)
(50)
LO 3
Journalizing transactions from Bank reconciliation

3,340
Interest revenue 30
NSF check
$
6,260
Account
Cash
Debit
(20)
(50)
Credit
900
Dividend Revenue
900
Receipt of dividend earned

4-38
LO 3

3,340
Interest revenue 30
NSF check
$
6,260
Account
Cash
Debit
(20)
(50)
Credit
2,100
Accounts Receivable
2,100
Receivables collected by bank

4-39
LO 3

3,340
Interest revenue 30
NSF check
$
6,260
Account
Cash
Debit
(20)
(50)
Credit
30
Interest Revenue
30
Interest earned on bank balance

4-40
LO 3

3,340
Interest revenue 30
NSF check
$
6,260
Account
Cash
Debit
(20)
(50)
Credit
360
Accounts Payable
360
Correction of check no. 333

4-41
LO 3

3,340
Interest revenue 30
NSF check
$
6,260
Account
Miscellaneous Expense
Cash
Debit
(20)
(50)
Credit
20
20
Bank service charge

4-42
LO 3

3,340
Interest revenue 30
NSF check
$
6,260
Account
Accounts Receivable
Cash
Debit
(20)
(50)
Credit
50
50
NSF check returned by bank

4-43
LO 3

3,340
Interest revenue 30
NSF check
$
6,260
Account
Insurance Expense
Cash
Debit
(20)
(50)
Credit
400
400
Payment of monthly insurance

4-44
LO 3
Summary of the various reconciling items:

BANK BALANCEALWAYS
Add deposits in transit
Subtract outstanding checks
Add or subtract corrections of bank errors
BOOK BALANCEALWAYS
Add bank collections, interest revenue, and EFT receipts
Subtract service charges, NSF checks, and EFT
payments
Add or subtract corrections of book errors
4-45
LO 3
Illustration
Logan Harmon operates an ice skating rink. He has just received
the monthly bank statement at July 31 from Valley National
Bank, and the statement shows an ending balance of $1,500.
Listed on the statement are a bank collection of accounts
receivable of $818, a service charge of $14, two NSF checks
totaling $240, and a $20 charge for printed checks. In reviewing
his cash records, Logan identifies outstanding checks totaling
$1,220 and a July 31 deposit in transit of $3,530. During July, he
recorded a $540 check for the salary of a part-time employee as
$54. Logans Cash account shows a July 31 cash balance of
$3,752.
How much cash does Logan actually have at July 31, 2014?
4-46
LO 3
Illustration
The monthly bank statement at July 31 from Valley National
Bank shows an ending balance of $1,500.
Bank
Balance, July 31
$1,500

4-47
Books
Balance, July 31
LO 3
Illustration
Logans Cash account shows a July 31 cash balance of $3,752.
Bank
Balance, July 31
$1,500

4-48
Books
Balance, July 31
$3,752
LO 3
Illustration
Listed on the bank statement are a bank

collection of an accounts receivable of $818, a service charge of $14,
two NSF checks totaling $240, and a $20 charge for printed checks.
Bank
Balance, July 31
Books
$1,500
Balance, July 31
Add: Collection on account
$3,752
818
Less:
Service charge (14)
NSF checks (240)
Printed check charge(20)

4-49
LO 3
Illustration
In reviewing his cash records, Logan identifies a July 31 deposit in
transit of $3,530 and outstanding checks totaling $1,220.
Bank
Balance, July 31
Books
$1,500
Add: Deposit in transit

Less: Outstanding checks
3,530
(1,220)
Balance, July 31
$3,752
818
Less:
Service charge (14)
NSF checks (240)

4-50
LO 3
Illustration
During July, Logan recorded a $540 check for the salary of a parttime employee as $54.
Bank
Balance, July 31
Books
$1,500

3,530
(1,220)
Balance, July 31
$3,752
818
Less:
Service charge (14)
NSF checks (240)
Correction of book error (486)

4-51
LO 3
Illustration
How much cash does Logan actually have at July 31, 2014?
Bank
Balance, July 31
Books
$1,500

3,530
(1,220)
Balance, July 31
$3,752
818
Less:
Service charge (14)
NSF checks (240)

4-52
$3,810
$3,810
LO 3
Illustration
Prepare the journal entries that Logan should record on July 31 to
update his Cash account.
Journal Entries
Cash
818
Accounts Receivable
818
Miscellaneous Expense 34
Cash
240
Salary Expense 486

Cash
4-53
486
Balance, July 31
$3,752
818
Less:
Service charge (14)
34
Accounts Receivable
Cash
Books
240
NSF checks (240)

$3,810
LO 3
Learning Objective
4. Evaluate internal controls over cash receipts and
cash payments
4-54
EVALUATE INTERNAL CONTROLS OVER

CASH RECEIPTS AND CASH PAYMENTS
Cash requires specific internal controls because
4-55
Cash is easy to steal
All transactions ultimately affect cash
Cash receipts should be deposited quickly
Companies can receive cash
Over the counter
Through the mail
LO 4
Cash Receipts Over the Counter
Point-of-sale terminals
provide control over cash receipts
record sale, cost of item sold, and reduction to

inventory
Customer issued a receipt as proof of purchase
Sales associate turns in cash drawer at end of shift
4-56
Combined with other cash and deposited
Accounting department reconciles sales per terminal

to cash in drawer
LO 4
Cash Receipts
by Mail
Deposit
ticket
Checks
Remittance
advices
Exhibit 4-11 | Cash Receipts by Mail
4-57
Debit to
Cash
LO 4
Controls over Payment by Check

Payment by check or electronic funds transfer (EFT) is an
important internal control
4-58
Provides record of the payment
Check must be signed by an authorized official
EFT must be approved by an authorized official
Should be supported by evidence
LO 4

Controls over Purchase and Payment
4-59
Fax or e-mail purchase order
Receive goods and prepare a receiving report
Receive invoice
Approve and agree all documents
Sends check or authorizes an electronic funds transfer

(EFT)
LO 4

Exhibit 4-12 | Cash Payments by Check or EFT
4-60
LO 4

Controls over Purchase and Payment
Before signing the check
or approving the EFT, the
treasurers department
should examine the
packet to prove that all
the documents agree.
Exhibit 4-13 | Payment Packet

4-61
LO 4

Petty Cash
Small fund to make minor purchases
Custodian solely responsible for the accounting
Set amount of cash
Voucher prepared for each payment
Imprest system
4-62
Sum of fund plus paid vouchers should equal set

amount
LO 4
Learning Objective
5. Construct and use a cash budget
4-63
CONSTRUCT AND USE A CASH BUDGET
Budget
4-64
Financial plan to coordinate business activities
Cash budget
Planned receipts and payments
Steps:
Start with beginning cash balance
Add budgeted receipts and subtract budgeted

payments
Equals cash available before new financing
Compare cash available to budgeted cash balance

LO 5
CONSTRUCT AND USE A CASH BUDGET

Exhibit 4-14 | Cash Budget
4-65
LO 5

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Learning Objective

1. Describe fraud and its impact

Copyright 2015 Pearson Education Inc. All rights reserved.

DESCRIBE FRAUD AND ITS IMPACT

Intentional misrepresentation of facts

Causes injury or damage to another party

Increased with expansion of e-commerce via the

Some common types

Credit card fraud

DESCRIBE FRAUD AND ITS IMPACT

Theft of money or inventory

Bribery or kickback schemes

False and misleading

Deceives investors and

Copyright 2015 Pearson Education Inc. All rights reserved.

DESCRIBE FRAUD AND ITS IMPACT

Copyright 2015 Pearson Education Inc. All rights reserved.

Copyright 2015 Pearson Education Inc. All rights reserved.

EXPLAIN THE OBJECTIVES AND

Primary way fraud and errors are:

Management and Board of Directors implement a:

EXPLAIN THE OBJECTIVES AND

Copyright 2015 Pearson Education Inc. All rights reserved.

The Sarbanes-Oxley Act (SOX)

Public companies must

maintain a system of internal control

issue an internal control report

Auditors must evaluate and report on internal controls

Created Public Company Accounting Oversight Board

Limits non-audit services of auditing firms

Penalties for violators

Copyright 2015 Pearson Education Inc. All rights reserved.

The Sarbanes-Oxley Act (SOX)

Copyright 2015 Pearson Education Inc. All rights reserved.

The Components of Internal Control

Copyright 2015 Pearson Education Inc. All rights reserved.

The Components of Internal Control

Tone at the top

Copyright 2015 Pearson Education Inc. All rights reserved.

The Components of Internal Control

Identify business risks

Establish procedures to deal with risks

Copyright 2015 Pearson Education Inc. All rights reserved.

The Components of Internal Control

System to capture, process, and

Copyright 2015 Pearson Education Inc. All rights reserved.

The Components of Internal Control

Built into the control environment and

Copyright 2015 Pearson Education Inc. All rights reserved.

The Components of Internal Control

Controls programmed into a companys

Internal and external auditors

Internal Control Procedures

Training and supervision

Copyright 2015 Pearson Education Inc. All rights reserved.

Internal Control Procedures

Separates three key duties:

Copyright 2015 Pearson Education Inc. All rights reserved.

Internal Control Procedures

Operating and cash

Copyright 2015 Pearson Education Inc. All rights reserved.

Internal Control Procedures

Hard copy documents or