Fraud, Internal Control, and Cash | Financial Accounting | CPA Exam

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These lectures cover principles of internal control, fraud triangle, fraud, petty cash Fund, cash disbursements Controls and cash receipts Controls.

Internal Control and Fraud Financial Accounting CPA Exam FAR

Internal Control over Cash Receipts Financial Accounting CPA Exam FAR

Internal Control over Cash Disbursements Financial Accounting CPA Exam FAR

Petty Cash Fund Financial Accounting CPA Exam FAR

Example Petty Cash Fund Financial Accounting CPA Exam FAR

Bank Reconciliation

Example Bank Reconciliation

Cash and Cash Equivalents | Financial Accounting |

Fraud

A fraud is a dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. Examples of fraud reported in the financial press include the following.

  • •A bookkeeper in a small company diverted $750,000 of bill payments to a personal bank account over a three-year period.
  • •A shipping clerk with 28 years of service shipped $125,000 of merchandise to himself.
  • •A computer operator embezzled $21 million from Wells Fargo Bank over a two-year period.
  • •A church treasurer “borrowed” $150,000 of church funds to finance a friend’s business dealings.
Why does fraud occur? The three main factors that contribute to fraudulent activity are depicted by the fraud triangle.
The most important element of the fraud triangle is opportunity. For an employee to commit fraud, the workplace environment must provide opportunities that an employee can take advantage of. Opportunities occur when the workplace lacks sufficient controls to deter and detect fraud. For example, inadequate monitoring of employee actions can create opportunities for theft and can embolden employees because they believe they will not be caught.
A second factor that contributes to fraud is financial pressure. Employees sometimes commit fraud because of personal financial problems caused by too much debt. Or, they might commit fraud because they want to lead a lifestyle that they cannot afford on their current salary.
The third factor that contributes to fraud is rationalization. In order to justify their fraud, employees rationalize their dishonest actions. For example, employees sometimes justify fraud because they believe they are underpaid while the employer is making lots of money. Employees feel justified in stealing because they believe they deserve to be paid more.

Internal Control

Internal control is a process designed to provide reasonable assurance regarding the achievement of company objectives related to operations, reporting, and compliance. In more detail, the purposes of internal control are to safeguard assets, enhance the reliability of accounting records, increase efficiency of operations, and ensure compliance with laws and regulations. Internal control systems have five primary components as listed below.

  • •A control environment. It is the responsibility of top management to make it clear that the organization values integrity and that unethical activity will not be tolerated. This component is often referred to as the “tone at the top.”
  • •Risk assessment. Companies must identify and analyze the various factors that create risk for the business and must determine how to manage these risks.
  • •Control activities. To reduce the occurrence of fraud, management must design policies and procedures to address the specific risks faced by the company.
  • •Information and communication. The internal control system must capture and communicate all pertinent information both down and up the organization, as well as communicate information to appropriate external parties.
  • •Monitoring. Internal control systems must be monitored periodically for their adequacy. Significant deficiencies need to be reported to top management and/or the board of directors.

  • Principles of Internal Control Activities

    Each of the five components of an internal control system is important. Here, we will focus on one component, the control activities. The reason? These 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.

    The six principles of control activities are as follows.

    • •Establishment of responsibility
    • •Segregation of duties
    • •Documentation procedures
    • •Physical controls
    • •Independent internal verification
    • •Human resource controls

    We explain these principles in the following sections. You should recognize that they apply to most companies and are relevant to both manual and computerized accounting systems.

Cash is the one asset that is readily convertible into any other type of asset. It also is easily concealed and transported, and is highly desired. Because of these characteristics, cash is the asset most susceptible to fraudulent activities. In addition, because of the large volume of cash transactions, numerous errors may occur in executing and recording them. To safeguard cash and to ensure the accuracy of the accounting records for cash, effective internal control over cash is critical.

Cash Disbursements Controls

Companies disburse cash for a variety of reasons, such as to pay expenses and liabilities or to purchase assets. Generally, internal control over cash disbursements is more effective when companies pay by check or electronic funds transfer (EFT) rather than by cash. One exception is payments for incidental amounts that are paid out of petty cash.

Petty Cash Fund

As you just learned, better internal control over cash disbursements is possible when companies make payments by check. However, using checks to pay small amounts is both impractical and a nuisance. For instance, a company would not want to write checks to pay for postage due, working lunches, or taxi fares. A common way of handling such payments, while maintaining satisfactory control, is to use a petty cash fund to pay relatively small amounts. The operation of a petty cash fund, often called an imprest system, involves (1) establishing the fund, (2) making payments from the fund, and (3) replenishing the fund.