CHAPTER 7

FRAUD, INTERNAL CONTROL, AND CASH

PREVIEW OF CHAPTER 7

As the story about recording cash sales at Stephanie's Gourmet Coffee and More indicates, control of cash is important to ensure that fraud does not occur. Companies also need controls to safeguard other types of assets. For example, Stephanie's undoubtedly has controls to prevent the theft of food and supplies, and controls to prevent the theft of tableware and dishes from its kitchen.

In this chapter, we explain the essential features of an internal control system and how it prevents fraud. We also describe how those controls apply to a specific asset—cash. The applications include some controls with which you may be already familiar, such as the use of a bank.

The content and organization of Chapter 7 are as follows.

Fraud and Internal Control

The Feature Story describes many of the internal control procedures used by Stephanie's Gourmet Coffee and More. These procedures are necessary to discourage employees from fraudulent activities.

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:

• 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 in Illustration 7-1.

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 exploit. 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. These employees feel justified in stealing because they believe they deserve to be paid more.

THE SARBANES-OXLEY ACT

What can be done to prevent or to detect fraud? After numerous corporate scandals came to light in the early 2000s, Congress addressed this issue by passing the Sarbanes-Oxley Act (SOX). Under SOX, all publicly traded U.S. corporations are required to maintain an adequate system of internal control. Corporate executives and boards of directors must ensure that these controls are reliable and effective. In addition, independent outside auditors must attest to the adequacy of the internal control system. Companies that fail to comply are subject to fines, and company officers can be imprisoned. SOX also created the Public Company Accounting Oversight Board (PCAOB) to establish auditing standards and regulate auditor activity.

One poll found that 60% of investors believe that SOX helps safeguard their stock investments. Many say they would be unlikely to invest in a company that fails to follow SOX requirements. Although some corporate executives have criticized the time and expense involved in following the SOX requirements, SOX appears to be working well. For example, the chief accounting officer of Eli Lily noted that SOX triggered a comprehensive review of how the company documents controls. This review uncovered redundancies and pointed out controls that needed to be added. In short, it added up to time and money well spent. And the finance chief at General Electric noted, “We have seen value in SOX. It helps build investors’ trust and gives them more confidence.”¹

INTERNAL CONTROL

Internal control consists of all the related methods and measures adopted within an organization 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.²

• 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.

Establishment of Responsibility

An essential principle of internal control is to assign responsibility to specific employees. Control is most effective when only one person is responsible for a given task.

To illustrate, assume that the cash on hand at the end of the day in a Safeway supermarket is $10 short of the cash entered in the cash register. If only one person has operated the register, the shift manager can quickly determine responsibility for the shortage. What happens, though, if two or more individuals work the register? For example, in the Feature Story, the principle of establishing responsibility does not appear to be strictly applied by Stephanie's Gourmet Coffee and More since three people operate the cash register on any given shift. Many retailers solve this problem by having registers with multiple drawers. This makes it possible for more than one person to operate a register but still allows identification of a particular employee with a specific drawer. Only the signed-in cashier has access to his or her drawer.

Establishing responsibility often requires limiting access only to authorized personnel, and then identifying those personnel. For example, the automated systems used by many companies have mechanisms such as identifying passcodes that keep track of who made a journal entry, who entered a sale, or who went into an inventory storeroom at a particular time. Use of identifying passcodes enables the company to establish responsibility by identifying the particular employee who carried out the activity.

Segregation of Duties

Segregation of duties is indispensable in an internal control system. There are two common applications of this principle:

1. Different individuals should be responsible for related activities.
2. The responsibility for record-keeping for an asset should be separate from the physical custody of that asset.

The rationale for segregation of duties is this: The work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of another employee. For example, the personnel that design and program computerized systems should not be assigned duties related to day-to-day use of the system. Otherwise, they could design the system to benefit them personally and conceal the fraud through day-to-day use.

SEGREGATION OF RELATED ACTIVITIES. Making one individual responsible for related activities increases the potential for errors and irregularities. Instead, companies should, for example, assign related purchasing activities to different individuals. Related purchasing activities include ordering merchandise, order approval, receiving goods, authorizing payment, and paying for goods or services. Various frauds are possible when one person handles related purchasing activities:

• If a purchasing agent is allowed to order goods without supervisory approval, the likelihood of the agent receiving kickbacks from suppliers increases.
• If an employee who orders goods also handles receipt of the goods and in-voice, as well as payment authorization, he or she might authorize payment for a fictitious invoice.

These abuses are less likely to occur when companies divide the purchasing tasks.

Similarly, companies should assign related sales activities to different individuals. Related selling activities include making a sale, shipping (or delivering) the goods to the customer, billing the customer, and receiving payment. Various frauds are possible when one person handles related sales activities. For example:

• If a salesperson can make a sale without obtaining supervisory approval, he or she might make sales at unauthorized prices to increase sales commissions.
• A shipping clerk who also has access to accounting records could ship goods to himself.
• A billing clerk who handles billing and cash receipts could understate the amount billed for sales made to friends and relatives.

These abuses are less likely to occur when companies divide the sales tasks: the salespeople make the sale; the shipping department ships the goods on the basis of the sales order; and the billing department prepares the sales invoice after comparing the sales order with the report of goods shipped.

SEGREGATION OF RECORD-KEEPING FROM PHYSICAL CUSTODY. The accountant should have neither physical custody of the asset nor access to it. Likewise, the custodian of the asset should not maintain or have access to the accounting records. The custodian of the asset is not likely to convert the asset to personal use when one employee maintains the record of the asset, and a different employee has physical custody of the asset. The separation of accounting responsibility from the custody of assets is especially important for cash and inventories because these assets are very vulnerable to fraud.

Documentation Procedures

Documents provide evidence that transactions and events have occurred. At Stephanie's Gourmet Coffee and More, the cash register tape is the restaurant's documentation for the sale and the amount of cash received. More sophisticated registers, called point-of-sale terminals, do not rely on tapes. Rather, they are networked with the company's computing and accounting records, which results in direct documentation. Similarly, a shipping document indicates that the goods have been shipped, and a sales invoice indicates that the company has billed the customer for the goods. By requiring signatures (or initials) on the documents, the company can identify the individual(s) responsible for the transaction or event. Companies should document transactions when the transaction occurs.

Companies should establish procedures for documents. First, whenever possible, companies should use prenumbered documents, and all documents should be accounted for. Prenumbering helps to prevent a transaction from being recorded more than once, or conversely, from not being recorded at all. Second, the control system should require that employees promptly forward source documents for accounting entries to the accounting department. This control measure helps to ensure timely recording of the transaction and contributes directly to the accuracy and reliability of the accounting records.

Physical Controls

Use of physical controls is essential. Physical controls relate to the safeguarding of assets and enhance the accuracy and reliability of the accounting records. Illustration 7-2 shows examples of these controls.

Independent Internal Verification

Most internal control systems provide for independent internal verification. This principle involves the review of data prepared by employees. To obtain maximum benefit from independent internal verification:

1. Companies should verify records periodically or on a surprise basis.
2. An employee who is independent of the personnel responsible for the information should make the verification.
3. Discrepancies and exceptions should be reported to a management level that can take appropriate corrective action.

Independent internal verification is especially useful in comparing recorded transactions with existing assets. The reconciliation of the cash register tape with the cash in the register at Stephanie's Gourmet Coffee and More is an example of this internal control principle. Another common example is the reconciliation of a company's cash balance per books with the cash balance per bank and the verification of the perpetual inventory records through a count of physical inventory. Illustration 7-3 shows the relationship between this principle and the segregation of duties principle.

Large companies often assign independent internal verification to internal auditors. Internal auditors are company employees who continuously evaluate the effectiveness of the company's internal control systems. They review the activities of departments and individuals to determine whether prescribed internal controls are being followed. They also recommend improvements when needed. In fact, most fraud is discovered by the company through internal mechanisms such as existing internal controls and internal audits. For example, WorldCom was at one time the second largest U.S. telecommunications company. The fraud that caused its bankruptcy (the largest ever when it occurred) involved billions of dollars. It was uncovered by an internal auditor.

Human Resource Controls

Human resource control activities include the following.

1. Bond employees who handle cash. Bonding involves obtaining insurance protection against theft by employees. It contributes to the safeguarding of cash in two ways. First, the insurance company carefully screens all individuals before adding them to the policy and may reject risky applicants. Second, bonded employees know that the insurance company will vigorously prosecute all offenders.
2. Rotate employees' duties and require employees to take vacations. These measures deter employees from attempting thefts since they will not be able to permanently conceal their improper actions. Many banks, for example, have discovered employee thefts when the employee was on vacation or assigned to a new position.
3. Conduct thorough background checks. Many believe that the most important and inexpensive measure any business can take to reduce employee theft and fraud is for the human resources department to conduct thorough background checks. Two tips: (1) Check to see whether job applicants actually graduated from the schools they list. (2) Never use telephone numbers for previous employers provided by the applicant; always look them up yourself.

LIMITATIONS OF INTERNAL CONTROL

Companies generally design their systems of internal control to provide reasonable assurance of proper safeguarding of assets and reliability of the accounting records. The concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not exceed their expected benefit.

To illustrate, consider shoplifting losses in retail stores. Stores could eliminate such losses by having a security guard stop and search customers as they leave the store. But store managers have concluded that the negative effects of such a procedure cannot be justified. Instead, they have attempted to control shoplifting losses by less costly procedures. They post signs saying, “We reserve the right to inspect all packages” and “All shoplifters will be prosecuted.” They use hidden TV cameras and store detectives to monitor customer activity, and they install sensor equipment at exits.

The human element is an important factor in every system of internal control. A good system can become ineffective as a result of employee fatigue, carelessness, or indifference. For example, a receiving clerk may not bother to count goods received and may just “fudge” the counts. Occasionally, two or more individuals work together to get around prescribed controls. Such collusion can significantly reduce the effectiveness of a system, eliminating the protection offered by segregation of duties. No system of internal control is perfect.

The size of the business also may impose limitations on internal control. Small companies often find it difficult to segregate duties or to provide for independent internal verification. A study by the Association of Certified Fraud Examiners (2012 Report to the Nation on Occupational Fraud and Abuse) indicates that businesses with fewer than 100 employees are most at risk for employee theft. In fact, 31.8% of frauds occurred at companies with fewer than 100 employees. The median loss at small companies was $147,000, which was higher than the median fraud at companies with more than 10,000 employees ($140,000). A $147,000 loss can threaten the very existence of a small company.

Cash Controls

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 RECEIPTS CONTROLS

Illustration 7-4 shows how the internal control principles explained earlier apply to cash receipts transactions. As you might expect, companies vary considerably in how they apply these principles. To illustrate internal control over cash receipts, we will examine control activities for a retail store with both over-the-counter and mail receipts.

Over-the-Counter Receipts

In retail businesses, control of over-the-counter receipts centers on cash registers that are visible to customers. A cash sale is entered in a cash register with the amount clearly visible to the customer. This activity prevents the cashier from entering a lower amount and pocketing the difference. The customer receives an itemized cash register receipt slip and is expected to count the change received. (One weakness at Stephanie's Gourmet Coffee and More in the Feature Story is that customers were only given a receipt if they requested it.) The cash register's tape is locked in the register until a supervisor removes it. This tape accumulates the daily transactions and totals. Alternatively, cash registers called point-of-sale terminals are often networked with the company's computers for direct recording in its records.

At the end of the clerk's shift, the clerk counts the cash and sends the cash and the count to the cashier. The cashier counts the cash, prepares a deposit slip, and deposits the cash at the bank. The cashier also sends a duplicate of the deposit slip to the accounting department to indicate cash received. The supervisor removes the cash register tape and sends it to the accounting department (in a non-point-of-sale system) as the basis for a journal entry to record the cash received. The tape is compared to the deposit slip for any discrepancies. Illustration 7-5 summarizes this process.

This system for handling cash receipts uses an important internal control principle—segregation of record-keeping from physical custody. The supervisor has access to the cash register tape, but not to the cash. The clerk and the cashier have access to the cash, but not to the register tape. In addition, the cash register tape provides documentation and enables independent internal verification with the deposit slip. Use of these three principles of internal control (segregation of record-keeping from physical custody, documentation, and independent internal verification) provides an effective system of internal control. Any attempt at fraudulent activity should be detected unless there is collusion among the employees.

In some instances, the amount deposited at the bank will not agree with the cash recorded in the accounting records based on the cash register tape. These differences often result because the clerk hands incorrect change back to the retail customer. In this case, the difference between the actual cash and the amount reported on the cash register tape is reported in a Cash Over and Short account. For example, suppose that the cash register tape indicated sales of $6,956.20 but the amount of cash was only $6,946.10. A cash shortfall of $10.10 exists. To account for this cash shortfall and related cash, the company makes the following entry.

Cash Over and Short is an income statement item. It is reported as miscellaneous expense when there is a cash shortfall, and as miscellaneous revenue when there is an overage. Clearly, the amount should be small. Any material amounts in this account should be investigated.

Mail Receipts

All mail receipts should be opened in the presence of at least two mail clerks. These receipts are generally in the form of checks. A mail clerk should endorse each check “For Deposit Only.” This restrictive endorsement reduces the likelihood that someone could divert the check to personal use. Banks will not give an individual cash when presented with a check that has this type of endorsement.

The mail clerks prepare, in triplicate, a list of the checks received each day. This list shows the name of the check issuer, the purpose of the payment, and the amount of the check. Each mail clerk signs the list to establish responsibility for the data. The original copy of the list, along with the checks, is then sent to the cashier's department. A copy of the list is sent to the accounting department for recording in the accounting records. The clerks also keep a copy.

This process provides excellent internal control for the company. By employing two clerks, the chance of fraud is reduced. Each clerk knows he or she is being observed by the other clerk(s). To engage in fraud, they would have to collude. The customers who submit payments also provide control because they will contact the company with a complaint if they are not properly credited for payment. Because the cashier has access to cash but not the records, and the accounting department has access to records but not cash, neither can engage in undetected fraud.

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.³

Companies generally issue checks only after following specified control procedures. Illustration 7-6 shows how principles of internal control apply to cash disbursements.

Voucher System Controls

Most medium and large companies use vouchers as part of their internal control over cash disbursements. A voucher system is a network of approvals by authorized individuals, acting independently, to ensure that all disbursements by check are proper.

The system begins with the authorization to incur a cost or expense. It ends with the issuance of a check for the liability incurred. A voucher is an authorization form prepared for each expenditure in a voucher system. Companies require vouchers for all types of cash disbursements except those from petty cash.

The starting point in preparing a voucher is to fill in the appropriate information about the liability on the face of the voucher. The vendor's invoice provides most of the needed information. Then, an employee in accounts payable records the voucher (in a journal called a voucher register) and files it according to the date on which it is to be paid. The company issues and sends a check on that date, and stamps the voucher “paid.” The paid voucher is sent to the accounting department for recording (in a journal called the check register). A voucher system involves two journal entries, one to record the liability when the voucher is issued and a second to pay the liability that relates to the voucher.

The use of a voucher system, whether done manually or electronically, improves internal control over cash disbursements. First, the authorization process inherent in a voucher system establishes responsibility. Each individual has responsibility to review the underlying documentation to ensure that it is correct. In addition, the voucher system keeps track of the documents that back up each transaction. By keeping these documents in one place, a supervisor can independently verify the authenticity of each transaction. Consider, for example, the case of Aesop University presented on page 340. Aesop did not use a voucher system for transactions under $2,500. As a consequence, there was no independent verification of the documents, which enabled the employee to submit fake invoices to hide his unauthorized purchases.

Petty Cash Fund

As you learned earlier in the chapter, better internal control over cash disbursements is possible when companies make payments by check. However, using checks to pay such small amounts as those for postage due, employee working lunches, and taxi fares is both impractical and a nuisance. A common way of handling such payments, while maintaining satisfactory control, is to use a petty cash fund. A petty cash fund is a cash fund used to pay relatively small amounts. We explain the operation of a petty cash fund in the appendix at the end of this chapter.

Control Features: Use of a Bank

The use of a bank contributes significantly to good internal control over cash. A company can safeguard its cash by using a bank as a depository and clearinghouse for checks received and checks written. The use of a bank checking account minimizes the amount of currency that must be kept on hand. It also facilitates control of cash because a double record is maintained of all bank transactions—one by the business and the other by the bank. The asset account Cash maintained by the company is the “flip-side” of the bank's liability account for that company. A bank reconciliation is the process of comparing the bank's balance with the company's balance, and explaining the differences to make them agree.

Many companies have more than one bank account. For efficiency of operations and better control, national retailers like Wal-Mart and Target often have regional bank accounts. Similarly, a company such as ExxonMobil with more than 100,000 employees may have a payroll bank account as well as one or more general bank accounts. In addition, a company may maintain several bank accounts in order to have more than one source for short-term loans.

BANK STATEMENTS

Each month, the company receives from the bank a bank statement showing its bank transactions and balances.⁴ For example, the statement for Laird Company in Illustration 7-7 shows the following: (1) checks paid and other debits (such as debit card transactions or direct withdrawals for bill payments) that reduce the balance in the depositor's account, (2) deposits and other credits that increase the balance in the depositor's account, and (3) the account balance after each day's transactions.

Remember that bank statements are prepared from the bank's perspective. For example, every deposit the bank receives is an increase in the bank's liabilities (an account payable to the depositor). Therefore, in Illustration 7-7, National Bank and Trust credits to Laird Company every deposit it received from Laird. The reverse occurs when the bank “pays” a check issued by Laird Company on its checking account balance: Payment reduces the bank's liability and is therefore debited to Laird's account with the bank.

The bank statement lists in numerical sequence all paid checks along with the date the check was paid and its amount. Upon paying a check, the bank stamps the check “paid”; a paid check is sometimes referred to as a canceled check. In addition, the bank includes with the bank statement memoranda explaining other debits and credits it made to the depositor's account.

A check that is not paid by a bank because of insufficient funds in a bank account is called an NSF check (not sufficient funds). The bank uses a debit memorandum when a previously deposited customer's check “bounces” because of insufficient funds. In such a case, the customer's bank marks the check NSF (not sufficient funds) and returns it to the depositor's bank. The bank then debits (decreases) the depositor's account, as shown by the symbol NSF in Illustration 7-7, and sends the NSF check and debit memorandum to the depositor as notification of the charge. The NSF check creates an account receivable for the depositor and reduces cash in the bank account.

RECONCILING THE BANK ACCOUNT

Because the bank and the company maintain independent records of the company's checking account, you might assume that the respective balances will always agree. In fact, the two balances are seldom the same at any given time, and both balances differ from the “correct or true” balance. Therefore, it is necessary to make the balance per books and the balance per bank agree with the correct or true amount—a process called reconciling the bank account. The need for reconciliation has two causes:

1. Time lags that prevent one of the parties from recording the transaction in the same period.
2. Errors by either party in recording transactions.

Time lags occur frequently. For example, several days may elapse between the time a company pays by check and the date the bank pays the check. Similarly, when a company uses the bank's night depository to make its deposits, there will be a difference of one day between the time the company records the receipts and the time the bank does so. A time lag also occurs whenever the bank mails a debit or credit memorandum to the company.

You might think that if a company never writes checks (for example, if a small company uses only a debit card or electronic bill payment), it does not need to reconcile its account. However, the possibility of errors or fraud still necessitates periodic reconciliation. The incidence of errors or fraud depends on the effectiveness of the internal controls maintained by the company and the bank. Bank errors are infrequent. However, either party could accidentally record a $450 check as $45 or $540. In addition, the bank might mistakenly charge a check drawn by C. D. Berg to the account of C. D. Burg.

Reconciliation Procedure

In reconciling the bank account, it is customary to reconcile the balance per books and balance per bank to their adjusted (correct or true) cash balances. To obtain maximum benefit from a bank reconciliation, an employee who has no other responsibilities related to cash should prepare the reconciliation. When companies do not follow the internal control principle of independent internal verification in preparing the reconciliation, cash embezzlements may escape unnoticed. For example, in the Anatomy of a Fraud box on page 341, a bank reconciliation by someone other than Angela Bauer might have exposed her embezzlement.

Illustration 7-8 shows the reconciliation process. The starting point in preparing the reconciliation is to enter the balance per bank statement and balance per books on a schedule. The following steps should reveal all the reconciling items that cause the difference between the two balances.

Bank Reconciliation Illustrated

Illustration 7-7 presented the bank statement for Laird Company which the company accessed online. It shows a balance per bank of $15,907.45 on April 30, 2014. On this date the balance of cash per books is $11,589.45. From the foregoing steps, Laird determines the following reconciling items.

Illustration 7-9 shows Laird's bank reconciliation.

Entries from Bank Reconciliation

The depositor (that is, the company) next must record each reconciling item used to determine the adjusted cash balance per books. If the company does not journalize and post these items, the Cash account will not show the correct balance. The adjusting entries for the Laird Company bank reconciliation on April 30 are as follows.

COLLECTION OF NOTE RECEIVABLE. This entry involves four accounts. Assuming that the interest of $50 has not been recorded and the collection fee is charged to Miscellaneous Expense, the entry is:

BOOK ERROR. An examination of the cash disbursements journal shows that check No. 443 was a payment on account to Andrea Company, a supplier. The correcting entry is:

NSF CHECK. As indicated earlier, an NSF check becomes an accounts receivable to the depositor. The entry is:

BANK SERVICE CHARGES. Companies typically debit to Miscellaneous Expense the check printing charges (DM) and other bank service charges (SC) because they are usually small in amount. Laird's entry is:

The foregoing entries could also be combined into one compound entry.

After Laird posts the entries, the Cash account will appear as in Illustration 7-10. The adjusted cash balance in the ledger should agree with the adjusted cash balance per books in the bank reconciliation in Illustration 7-9 (page 356).

What entries does the bank make? If the company discovers any bank errors in preparing the reconciliation, it should notify the bank so the bank can make the necessary corrections on its records. The bank does not make any entries for deposits in transit or outstanding checks. Only when these items reach the bank will the bank record these items.

Electronic Funds Transfer (EFT) System

It is not surprising that companies and banks have developed approaches to transfer funds among parties without the use of paper (deposit tickets, checks, etc.). Such procedures, called electronic funds transfers (EFTs), are disbursement systems that use wire, telephone, or computers to transfer cash from one location to another. Use of EFT is quite common. For example, many employees receive no formal payroll checks from their employers. Instead, employers send electronic payroll data to the appropriate banks. Also, individuals and companies now frequently make regular payments such as those for house, car, and utilities by EFT.

EFT transactions normally result in better internal control since no cash or checks are handled by company employees. This does not mean that opportunities for fraud are eliminated. In fact, the same basic principles related to internal control apply to EFT transactions. For example, without proper segregation of duties and authorizations, an employee might be able to redirect electronic payments into a personal bank account and conceal the theft with fraudulent accounting entries.

Reporting Cash

Cash consists of coins, currency (paper money), checks, money orders, and money on hand or on deposit in a bank or similar depository. Checks that are dated later than the current date (post-dated checks) are not included in cash. Companies report cash in two different statements: the balance sheet and the statement of cash flows. The balance sheet reports the amount of cash available at a given point in time. The statement of cash flows shows the sources and uses of cash during a period of time. The statement of cash flows was introduced in Chapters 1 and 2 and will be discussed in much detail in Chapter 12. In this section, we discuss some important points regarding the presentation of cash in the balance sheet.

When presented in a balance sheet, cash on hand, cash in banks, and petty cash are often combined and reported simply as Cash. Because it is the most liquid asset owned by the company, cash is listed first in the current assets section of the balance sheet.

CASH EQUIVALENTS

Many companies use the designation “Cash and cash equivalents” in reporting cash. (See Illustration 7-11 for an example.) Cash equivalents are short-term, highly liquid investments that are both:

1. Readily convertible to known amounts of cash, and
2. So near their maturity that their market value is relatively insensitive to changes in interest rates.

Examples of cash equivalents are Treasury bills, commercial paper (short-term corporate notes), and money market funds. All typically are purchased with cash that is in excess of immediate needs.

Occasionally a company will have a net negative balance in its bank account. In this case, the company should report the negative balance among current liabilities. For example, farm equipment manufacturer Ag-Chem recently reported “Checks outstanding in excess of cash balances” of $2,145,000 among its current liabilities.

RESTRICTED CASH

A company may have restricted cash, cash that is not available for general use but rather is restricted for a special purpose. For example, landfill companies are often required to maintain a fund of restricted cash to ensure they will have adequate resources to cover closing and clean-up costs at the end of a landfill site's useful life. McKesson Corp. recently reported restricted cash of $962 million to be paid out as the result of investor lawsuits.

Cash restricted in use should be reported separately on the balance sheet as restricted cash. If the company expects to use the restricted cash within the next year, it reports the amount as a current asset. When this is not the case, it reports the restricted funds as a noncurrent asset.

Illustration 7-11 shows restricted cash reported in the financial statements of Delta Air Lines. The company is required to maintain restricted cash as collateral to support insurance obligations related to workers’ compensation claims. Delta does not have access to these funds for general use, and so it must report them separately, rather than as part of cash and cash equivalents.

Managing and Monitoring Cash

Many companies struggle, not because they fail to generate sales, but because they can't manage their cash. A real-life example of this is a clothing manufacturing company owned by Sharon McCollick. McCollick gave up a stable, high-paying marketing job with Intel Corporation to start her own company. Soon she had more orders from stores such as JC Penney and Dayton Hudson (now Target) than she could fill. Yet she found herself on the brink of financial disaster, owing three mortgage payments on her house and $2,000 to the IRS. Her company could generate sales, but it was not collecting cash fast enough to support its operations. The bottom line is that a business must have cash.⁵

A merchandising company's operating cycle is generally shorter than that of a manufacturing company. Illustration 7-12 shows the cash to cash operating cycle of a merchandising operation.

To understand cash management, consider the operating cycle of Sharon McCollick's clothing manufacturing company. First, it purchases cloth. Let's assume that it purchases the cloth on credit provided by the supplier, so the company owes its supplier money. Next, employees convert the cloth to clothing. Now the company also owes its employees money. Next, it sells the clothing to retailers, on credit. McCollick's company will have no money to repay suppliers or employees until it receives payments from customers. In a manufacturing operation there may be a significant lag between the original purchase of raw materials and the ultimate receipt of cash from customers.

Managing the often-precarious balance created by the ebb and flow of cash during the operating cycle is one of a company's greatest challenges. The objective is to ensure that a company has sufficient cash to meet payments as they come due, yet minimize the amount of non-revenue-generating cash on hand.

BASIC PRINCIPLES OF CASH MANAGEMENT

Management of cash is the responsibility of the company treasurer. Any company can improve its chances of having adequate cash by following five basic principles of cash management.

1. Increase the speed of receivables collection. Money owed Sharon McCollick by her customers is money that she can't use. The more quickly customers pay her, the more quickly she can use those funds. Thus, rather than have an average collection period of 30 days, she may want an average collection period of 15 days. However, she must carefully weigh any attempt to force her customers to pay earlier against the possibility that she may anger or alienate customers. Perhaps her competitors are willing to provide a 30-day grace period. As noted in Chapter 5, one common way to encourage customers to pay more quickly is to offer cash discounts for early payment under such terms as 2/10, n/30.
2. Keep inventory levels low. Maintaining a large inventory of cloth and finished clothing is costly. It ties up large amounts of cash, as well as warehouse space. Increasingly, companies are using techniques to reduce the inventory on hand, thus conserving their cash. Of course, if Sharon McCollick has inadequate inventory, she will lose sales. The proper level of inventory is an important decision.
3. Monitor payment of liabilities. Sharon McCollick should monitor when her bills are due, so she avoids paying bills too early. Let's say her supplier allows 30 days for payment. If she pays in 10 days, she has lost the use of that cash for 20 days. Therefore, she should use the full payment period. But, she should not pay late. This could damage her credit rating (and future borrowing ability). Also, late payments to suppliers can damage important supplier relationships and may even threaten a supplier's viability. Sharon McCollick's company also should conserve cash by taking cash discounts offered by suppliers, when possible.
4. Plan the timing of major expenditures. To maintain operations or to grow, all companies must make major expenditures. These often require some form of outside financing. To increase the likelihood of obtaining outside financing, McCollick should carefully consider the timing of major expenditures in light of her company's operating cycle. If at all possible, she should make any major expenditure when the company normally has excess cash—usually during the off-season.

   International Note International sales complicate cash management. For example, if Nike must repay a Japanese supplier 30 days from today in Japanese yen, Nike will be concerned about how the exchange rate of U.S. dollars for yen might change during those 30 days. Often, corporate treasurers make investments known as hedges to lock in an exchange rate to reduce the company's exposure to exchange-rate fluctuation.

5. Invest idle cash. Cash on hand earns nothing. An important part of the treasurer's job is to ensure that the company invests any excess cash, even if it is only overnight. Many businesses, such as Sharon McCollick's clothing company, are seasonal. During her slow season, when she has excess cash, she should invest it.

   To avoid a cash crisis, however, it is very important that investments of idle cash be highly liquid and risk-free. A liquid investment is one with a market in which someone is always willing to buy or sell the investment. A risk-free investment means there is no concern that the party will default on its promise to pay its principal and interest. For example, using excess cash to purchase stock in a small company because you heard that it was probably going to increase in value in the near term is totally inappropriate. First, the stock of small companies is often illiquid. Second, if the stock suddenly decreases in value, you might be forced to sell the stock at a loss in order to pay your bills as they come due. The most common form of liquid investments is interest-paying U.S. government securities.

Illustration 7-13 summarizes these five principles of cash management.

Summary of Learning Objectives

1. Define fraud and internal control. A fraud is a dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. The fraud triangle refers to the three factors that contribute to fraudulent activity by employees: opportunity, financial pressure, and rationalization. Internal control consists of all the related methods and measures adopted within an organization to safeguard assets, enhance the reliability of accounting records, increase efficiency of operations, and ensure compliance with laws and regulations.
2. Identify the principles of internal control activities. The principles of internal control are establishment of responsibility; segregation of duties; documentation procedures; physical controls; independent internal verification; and human resource controls.
3. Explain the applications of internal control principles to cash receipts. Internal controls over cash receipts include: (a) designating only personnel such as cashiers to handle cash; (b) assigning the duties of receiving cash, recording cash, and having custody of cash to different individuals; (c) obtaining remittance advices for mail receipts, cash register tapes or computer records for over-the-counter receipts, and deposit slips for bank deposits; (d) using company safes and bank vaults to store cash with access limited to authorized personnel, and using cash registers in executing over-the-counter receipts; (e) making independent daily counts of register receipts and daily comparisons of total receipts with total deposits; and (f) conducting background checks and bonding personnel who handle cash, as well as requiring them to take vacations.
4. Explain the applications of internal control principles to cash disbursements. Internal controls over cash disbursements include: (a) having only specified individuals such as the treasurer authorized to sign checks; (b) assigning the duties of approving items for payment, paying the items, and recording the payment to different individuals; (c) using prenumbered checks and accounting for all checks, with each check supported by an approved invoice; after payment, stamping each approved invoice “paid”; (d) storing blank checks in a safe or vault with access restricted to authorized personnel, and using a machine with indelible ink to imprint amounts on checks; (e) comparing each check with the approved invoice before issuing the check, and making monthly reconciliations of bank and book balances; and (f) bonding personnel who handle cash, requiring employees to take vacations, and conducting background checks.
5. Prepare a bank reconciliation. In reconciling the bank account, it is customary to reconcile the balance per books and the balance per bank to their adjusted balance. The steps reconciling the Cash account are to determine deposits in transit, outstanding checks, errors by the depositor or the bank, and unrecorded bank memoranda.
6. Explain the reporting of cash. Cash is listed first in the current assets section of the balance sheet. Companies often report cash together with cash equivalents. Cash restricted for a special purpose is reported separately as a current asset or as a noncurrent asset, depending on when the company expects to use the cash.
7. Discuss the basic principles of cash management. The basic principles of cash management include: (a) increase the speed of receivables collection, (b) keep inventory levels low, (c) monitor the timing of payment of liabilities, (d) plan timing of major expenditures, and (e) invest idle cash.
8. Identify the primary elements of a cash budget. The three main elements of a cash budget are the cash receipts section, cash disbursements section, and financing section.

Appendix 7A

Operation of the Petty Cash Fund

The operation of a petty cash fund involves (1) establishing the fund, (2) making payments from the fund, and (3) replenishing the fund.

ESTABLISHING THE PETTY CASH FUND

Two essential steps in establishing a petty cash fund are: (1) appointing a petty cash custodian who will be responsible for the fund, and (2) determining the size of the fund. Ordinarily, a company expects the amount in the fund to cover anticipated disbursements for a three- to four-week period.

When the company establishes the petty cash fund, it issues a check payable to the petty cash custodian for the stipulated amount. If Laird Company decides to establish a $100 fund on March 1, the entry in general journal form is:

The fund custodian cashes the check and places the proceeds in a locked petty cash box or drawer. Most petty cash funds are established on a fixed-amount basis. Moreover, the company will make no additional entries to the Petty Cash account unless the stipulated amount of the fund is changed. For example, if Laird Company decides on July 1 to increase the size of the fund to $250, it would debit Petty Cash $150 and credit Cash $150.

MAKING PAYMENTS FROM PETTY CASH

The custodian of the petty cash fund has the authority to make payments from the fund that conform to prescribed management policies. Usually, management limits the size of expenditures that come from petty cash and does not permit use of the fund for certain types of transactions (such as making short-term loans to employees).

Each payment from the fund must be documented on a prenumbered petty cash receipt (or petty cash voucher). The signatures of both the custodian and the individual receiving payment are required on the receipt. If other supporting documents such as a freight bill or invoice are available, they should be attached to the petty cash receipt.

The custodian keeps the receipts in the petty cash box until the fund is replenished. As a result, the sum of the petty cash receipts and money in the fund should equal the established total at all times. This means that management can make surprise counts at any time by an independent person, such as an internal auditor, to determine the correctness of the fund.

The company does not make an accounting entry to record a payment at the time it is taken from petty cash. It is considered both inexpedient and unnecessary to do so. Instead, the company recognizes the accounting effects of each payment when the fund is replenished.

REPLENISHING THE PETTY CASH FUND

When the money in the petty cash fund reaches a minimum level, the company replenishes the fund. The petty cash custodian initiates a request for reimbursement. This individual prepares a schedule (or summary) of the payments that have been made and sends the schedule, supported by petty cash receipts and other documentation, to the treasurer's office. The receipts and supporting documents are examined in the treasurer's office to verify that they were proper payments from the fund. The treasurer then approves the request, and a check is prepared to restore the fund to its established amount. At the same time, all supporting documentation is stamped “paid” so that it cannot be submitted again for payment.

To illustrate, assume that on March 15 the petty cash custodian requests a check for $87. The fund contains $13 cash and petty cash receipts for postage $44, supplies $38, and miscellaneous expenses $5. The entry, in general journal form, to record the check is:

Note that the reimbursement entry does not affect the Petty Cash account. Replenishment changes the composition of the fund by replacing the petty cash receipts with cash, but it does not change the balance in the fund.

Occasionally, in replenishing a petty cash fund the company may need to recognize a cash shortage or overage. To illustrate, assume in the preceding example that the custodian had only $12 in cash in the fund plus the receipts as listed. The request for reimbursement would therefore be for $88, and the following entry would be made.

Conversely, if the custodian had $14 in cash, the reimbursement request would be for $86, and Cash Over and Short would be credited for $1. A debit balance in Cash Over and Short is reported in the income statement as miscellaneous expense; a credit balance is reported as miscellaneous revenue. The company closes Cash Over and Short to Income Summary at the end of the year.

Companies should replenish a petty cash fund at the end of the accounting period, regardless of the cash in the fund. Replenishment at this time is necessary in order to recognize the effects of the petty cash payments on the financial statements.

Internal control over a petty cash fund is strengthened by (1) having a supervisor make surprise counts of the fund to ascertain whether the paid petty cash receipts and fund cash equal the designated amount, and (2) canceling or mutilating the paid petty cash receipts so they cannot be resubmitted for reimbursement.

Summary of Learning Objective for Appendix 7A

  9. Explain the operation of a petty cash fund. In operating a petty cash fund, a company establishes the fund by appointing a custodian and determining the size of the fund. The custodian makes payments from the fund for documented expenditures. The company replenishes the fund as needed, and at the end of each accounting period. Accounting entries to record payments are made each time the fund is replenished.