Chapter 4
Incorrect Financial Statements
 Errors – accidental errors in recording transactions or applying
accounting rules
 Fraud – a person intentional deceives another person for personal
gain or to damage that person
o Occupational Fraud – the use of one’s occupation for personal
enrichment through the deliberate misuse or misapplication of
the employer’s resource
Fraud Triangle
Internal Controls
 Internal Controls attempt to eliminate the opportunity element of
fraud
 Internal controls represent plans to:
o Safeguard the company’s assets
o Improve the accuracy and reliability of accounting information
Sarbanes-Oxley Act of 2002
 Passed by Congress
 Applies to all companies that are required to file financial statements
with the SEC
 Established guidelines related to
o Internal control procedures
o Auditor-client relations
Components of Internal Control
 Control Environment: overall attitudes and actions of management
greatly affect
 Risk Assessment: includes careful consideration of internal and
external risk factors
 Control Activities: include variety of policies and procedures used to
protect a company’s assets
 Monitoring: of internal controls needs to occur on an ongoing basis
 Information and Communication: depend on the reliability of the
accounting information system itself
Preventive Controls
 Separation of Duties: Fraud is prevented by not allowing the same
person to be responsible for both CONTROLLING the asset and
ACCOUNTING for the asset
 Physical Control: Assets and accounting records must be kept safe and
accessible only to authorized personnel
 Proper Authorization: Fraud is prevented when unauthorized
individuals are not allowed to use company resources
 Employee Management: The company should provide employees
appropriate guidelines in how to perform their jobs as well as their
responsibilities for internal controls
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 E-Commerce Controls: Passwords should be required to conduct
electronics business transactions, and firewalls and antiviruses
software should be kept current
Detective Controls
 Reconciliations: Management should periodically determine whether
the amount of physical assets of the company agree with accounting
records
 Performance Reviews: Reviews of actual vs. expected results, which
can be applied to the employees as well as business processes
 Audits: Hire an independent auditor to assess the internal control
procedure to detect any deficiencies or fraudulent behavior of
employees
Responsibilities for Internal Control
 CEO and CFO
o Sign a report each year assessing whether the internal controls
are adequate
 Auditors
o Provide an opinion on management’s assessment of internal
control over financial reporting
o Provide their own opinion on company’s internal control over
financial reporting
Components of the Total Cash Balance
 Checks received, coins and currency, savings accounts, checking
accounts, credit card sales, debit card sales, cash equivalents
Cash Controls
 Controls over CASH RECEIPTS
o Each day: an employee should open mail and list checks
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o Each day: a different employee should deposit cash and checks
into the company’s bank account
o As soon as possible: a separate employee should record cash
receipts in the accounting records
o Accept credit cards or debit cards, to limit the amount of cash
handled
 Controls over CASH DISBURSEMENTS
o Disbursements should be made by check, debit card, or credit
card
o Authorize all expenditures; authorizing employee should not
also prepare the check
o Checks should be serially numbered and should require two
signatures for large amounts
o Periodically compare debit and credit card statements to
purchase receipts
o Set maximum purchase limits
o Separate cash disbursement and cash receipt duties
Account for Employee Purchases
 Petty cash fund: small amount of cash kept on hand to pay minor
purchases
o Accounting for the petty cash fund involved:
 Establishing the fund
 Recognizing expenditures from the fund
 Replenishing the fund
 Company-issued debit and credit cards
o Debit cards (and checks) captured in the bank reconciliation
o Credit card purchases need to be recorded
Bank Reconciliation
 The balance of cash in the company’s records may NOT equal the
balance of cash in the bank’s records
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 Matches the balance of cash in the bank with the balance of cash in
the company’s own records
 Timing differences occur when the company records transactions
before or after the bank records the transactions
 Errors can result from mistakes by the bank or by the company
Step 1: Reconcile the Bank’s Cash Balance
 Cash transactions recorded by the company, but not yet recorded by
its bank:
o Deposits outstanding: cash receipts of the company that have
not been added to the bank’s record of the company’s balance
o Checks outstanding: checks the company has written that have
not been subtracted from the company’s balance
o Bank errors
Step 2: Reconcile the Company’s Cash Balance
 Cash transactions recorded by bank but not company
 Common items that will increase cash balance
o Bank collections on the company’s behalf
o Interest earned on average daily balance
 Common items that will decrease cash balance
o Electronic funds transfers
o NSF checks – customer has nonsufficient funds
o Debit card purchases
o Bank service fees
 Company errors
Step 3: Update the Company’s Cash Account
 We examine items used to reconcile the company’s cash balance
 Debit Cash for items that add to the balance
 Credit Cash for items that subtract from the balance
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Reporting Cash
 Balance Sheet
o Balance of cash
o Snapshot at end of period
o Current or noncurrent asset
 Statement of Cash Flows
o Inflows/Outflows
o Covers a period of time
o Operating, investing and financing
Statement of Cash Flows
 Operating Activities
o Cash transactions involving revenues and expenses
 Investing Activities
o Cash investment in long-term assets and investment securities
 Financing Activities
o Transactions designed to finance the business through
borrowing and owner investment
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