Chapter 4: Internal Control and Cash

Learning Objectives

• Describe fraud and its impact

• Explain the objectives and components of internal control

• Evaluate internal controls over cash receipts and cash payments

• Prepare a bank reconciliation

• Report cash on the balance sheet

• Describe unsupervised machine learning and its application to expense reimbursement fraud detection

Fraud and Its Impact

Definition and Consequences

Fraud is the intentional misrepresentation of facts for the purpose of persuading another party to act in a certain way, causing injury or damage. It is a growing problem, especially with the expansion of e-commerce.

• Common examples: Insurance fraud, check forgery, Medicare fraud, credit card fraud, identity theft

• Types of fraud:

  • Misappropriation of assets: Theft of money or inventory, bribery, kickbacks, overstated expense reimbursements (committed by employees)

  • Fraudulent financial reporting: False and misleading journal entries to deceive investors and creditors (committed by managers)

Fraud has economic, legal, and ethical implications. It is illegal and unethical, resulting in penalties such as imprisonment, fines, and damages.

The Fraud Triangle

The fraud triangle illustrates the three elements necessary for fraud to occur: motive, opportunity, and rationalization.

Objectives and Components of Internal Control

Purpose of Internal Control

Internal control is the primary method for preventing, detecting, and correcting fraud. It is a plan of organization and procedures implemented to accomplish five objectives:

• Safeguard assets

• Encourage employees to follow company policy

• Promote operational efficiency

• Ensure accurate, reliable accounting records

• Comply with legal requirements

Excerpt from Public Company Management Report on Internal Controls

Management is responsible for establishing and maintaining adequate internal control over financial reporting, including maintaining accurate records and ensuring transactions are recorded in accordance with generally accepted accounting principles (GAAP).

Function of an Internal Control System

Internal controls act as a barrier to protect company assets from fraud, waste, and inefficiency.

Components of Internal Control

The internal control system consists of five components:

• Control Environment: Tone at the top, code of ethics

• Risk Assessment: Identifying business risks and establishing procedures

• Information System: Tracks assets, profits, and losses

• Control Procedures: Methods to achieve internal control objectives

• Monitoring of Controls: Internal and external audits, often programmed into technology

Internal Control Procedures

Smart Hiring Practices

• Background checks

• Training and supervision

• Competitive salaries

• Clear employee responsibility

Separation of Duties

• Asset handling

• Record keeping

• Transaction approval

Comparison and Compliance Monitoring

• Operating and cash budgets

• Exception reporting

• Audit

Adequate Records

• Details of business transactions

• Hard copy or electronic documents

• Prenumbered documents

Limited Access

• Limit access to assets based on job responsibilities

• Physical access controls (lock and key)

• Password and encryption

Proper Approvals

• Management’s general or specific approval

• Purchasing department buys only from approved vendors based on competitive bids

Information Technology in Internal Control

Accounting systems increasingly rely on IT for improved accuracy and speed. Examples include electronic sensors and bar codes.

Safeguard Controls

• Fireproof vaults for important documents

• Burglar alarms and security cameras

• Loss prevention specialists

• Fidelity bonds on cashiers

• Mandatory vacations and job rotation

Internal Controls for E-Commerce

E-commerce introduces risks such as stolen credit card numbers, malware, and phishing. Security measures include encryption and firewalls.

Encryption and Firewalls

• Encryption: Mathematical rearrangement of messages to protect data

• Firewalls: Limit unauthorized access to computer networks

Example: Check-sum digits for account numbers, where the last digit is the sum of the previous digits.

Internal Controls Over Cash Receipts and Payments

Cash Receipts Over the Counter

Point-of-sale terminals provide control over cash receipts, record sales, and reduce inventory. Customers receive receipts, and cash drawers are reconciled and deposited.

Cash Receipts by Mail

Checks and remittance advices are processed by the mailroom, treasurer, accounting department, and controller to ensure proper recording and deposit.

Controls Over Payment by Check or EFT

• Payments are made by check or electronic funds transfer (EFT)

• Provides record of payment

• Must be signed by authorized official

• Payment supported by evidence

Controls Over Purchase and Payment

• Split duties: purchasing goods, receiving goods, preparing check/EFT, approval of payment

Petty Cash

• Used for minor expenses

• Opened with a specific amount

• Custodian prepares voucher list

• Imprest system: fund plus vouchers paid equals specified balance

• Debit cards may be used

Limitations of Internal Control

• Collusion: two or more people working together

• Management override

• Human limitations: fatigue and negligence

• Benefits should outweigh costs

Bank Reconciliation

Documents Used to Control a Bank Account

• Signature card

• Deposit ticket

• Check

• Bank statement

• Bank reconciliation

Check with Remittance Advice

A check involves three parties: maker (signs the check), payee (receives payment), and bank (draws the check).

Bank Statement

• Sent monthly to customer

• Reports cash activity

• Shows beginning and ending balances, receipts, and payments

Bank Reconciliation Process

Bank reconciliation explains differences between the book (company’s cash records) and bank balance, often due to timing.

• Bank Side: Deposits in transit, outstanding checks, bank errors

• Book Side: Bank collections, EFTs, service charges, interest revenue, NSF checks, cost of printed checks, book errors

Summary of reconciling items:

• Bank Balance: Add deposits in transit, subtract outstanding checks, correct bank errors

• Book Balance: Add bank collections, interest, EFT receipts; subtract service charges, NSF checks, EFT payments; correct book errors

Reporting Cash on the Balance Sheet

Cash and Cash Equivalents

• Time deposits

• Certificates of deposit

• High-grade government securities (close to maturity)

Cash equivalents are highly liquid investments with maturities of three months or less at the date of purchase.

Unsupervised Machine Learning in Expense Reimbursement Fraud Detection

Application of Machine Learning

Machine learning models can detect fraud in employee expense reimbursements by flagging unusual receipts for investigation. This process is known as unsupervised learning.

• Examines every transaction

• Combines structured and unstructured data

• Reduces human error and bias

• Fraudsters are increasingly sophisticated

• Immediate checking of every expense reimbursement request

Types of Expense Reimbursement Fraud Schemes

• Mischaracterized expenses

• Fictitious expenses

• Overstated expenses

• Multiple reimbursements

Association of Certified Fraud Examiners (ACFE): Largest antifraud professional organization.