Chapter Four

Internal Controls,

Accounting for Cash, and

Ethics

© 2015 McGraw-Hill Education.

An Integrated Framework

1. Control Environment – integrity and ethical values of a company

2. Risk Assessment – management identification of potential risks

3. Control Activities – internal controls4. Information and Communication – internal

and external reporting process5. Monitoring – over time assessment and

correction of internal controls

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Internal Controls1. Separation of Duties2. Quality of Employees3. Bonded Employees4. Required Absences5. Procedures Manual6. Authority and Responsibility7. Prenumbered Documents8. Physical Control9. Performance Evaluations

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Separation of Duties

When duties are separated, the work of one employee can act as a check on the work of another employee. The likelihood of fraud

or theft is greatly reduced.

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Quality of Employees

The ability of cross-trained employees to substitute for one another prevents

disruptions in the workplace. Job rotation may help relieve boredom and increase

productivity.

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Bonded Employees

A fidelity bond provides insurance that protects a company from loss caused by

employee dishonesty. To become bonded, an employee’s background is investigated.

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Required Absences

An employee may be able to cover up fraudulent activities if they are always present at work. All employees should be required to take regular vacations

and their duties should be rotated periodically.

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Procedures Manual

Accounting and other important procedures should bewritten in a procedures manual. Periodically,

management should conduct an investigation to seethat required procedures are actually being followed.

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Authority and Responsibility

General authority applies to all members of the organization. For example, all employees are required to fly coach and purchase airline tickets from a specific vendor.

Specific authority applies only to a specific position within the organization. For example, all checks must be cosigned by the Controller and Treasurer.

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Prenumbered Documents

Prenumbered forms are used for all important documents such as checks, purchase orders, receiving reports, and invoices. The use of prenumbered forms helps keep track of all

forms issued during a particular period.

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Physical Control

All companies should maintain adequate physical control over valuable assets that

may be misappropriated. For example, inventory should be properly stored in a

secure location. Serial numbers should be placed on all valuable assets to assist in a

physical count of these assets.

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Performance Evaluation

• Internal controls should include independent verification of employee performance.

• A physical inventory should be taken at least annually by someone other than a person who has control over inventory. An independent reconciliation between the general ledger balance and inventory should be compared to the inventory count.

• Auditors should evaluate the effectiveness of the control system.

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LimitationsInternal controls can be circumvented by collusion among employees. Two or more

employees working together can hide embezzlement by covering for each

other. No system can prevent all fraud. Good internal controls minimize fraud and increase likelihood of detection.

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Accounting for Cash

ControllingCash

ControllingCash

Cash receipts should be recorded immediately upon

receipt and deposited intact

daily.

Cash receipts should be recorded immediately upon

receipt and deposited intact

daily.

Cash disbursements should be made by

prenumbered check.

Cash disbursements should be made by

prenumbered check.

Up to date signature card

should be maintained.

Up to date signature card

should be maintained.

A deposit ticket should be used for

all deposits.

A deposit ticket should be used for

all deposits.

A monthly bank reconciliation should be prepared by an independent party.

A monthly bank reconciliation should be prepared by an independent party.

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Reconciling the Bank Account

Unadjusted bank balance

Add + Deposits in transit

Deduct - Outstanding checks

Equals = True cash balance

Adjustment to the Bank Balance

The bank reconciliation reports on the differences between the balance on the bank

statement and the balance in the general ledger cash account. The reconciliation results

in the true cash balance that will appear on the balance sheet.

The bank reconciliation reports on the differences between the balance on the bank

statement and the balance in the general ledger cash account. The reconciliation results

in the true cash balance that will appear on the balance sheet.

Unadjusted book balance

Add + Accounts receivable collections

Add + Interest earned

Deduct - Bank service charges

Deduct - Non-sufficient funds (NSF) check

Equals = True cash balance

Adjustments to the Book Balance

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Reconciling the Bank Statement

If an error is found on the bank statement, an adjustment for it is made

to the unadjusted bank balance to determine the true cash balance. An error

found on our book balance requires an adjustment to our books.

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Importance of Ethics

The accountant’s role requires trust and credibility.

Accounting information is worthless if the accountant is not trustworthy.

Therefore, the accounting profession requires high ethical standards.

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The Fraud Triangle

Rationalization

Pressure

Opportunity

Key to protecting yourself and your company: personal integrity.

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Materiality and Financial Audits

Auditors do not guarantee that financial statements are absolutely

correct—only that they are materially correct.

Material ItemAn error, or other

reporting problem, that would influence

the decision of an average prudent

investor. 4-19

Types of Audit Opinions

Unqualified Adverse

Qualified Disclaimer

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End of Chapter Four

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