Accounting Fraud & Internal Controls | McGraw-Hill (PDF)

Incorrect Financial Statements Reasons:  Errors—accidental errors in recording transactions or applying accounting rules  Fraud—a person intentionally deceives another person for personal gain or to damage that person Occupational fraud: the use of one’s...

Incorrect Financial Statements Reasons:  Errors—accidental errors in recording transactions or applying accounting rules  Fraud—a person intentionally deceives another person for personal gain or to damage that person Occupational fraud: the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employer’s resources 4-1 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill. Illustration 4–1 Fraud Triangle Opportunity — the situation allows the Opportuni fraud to occur. ty Motivation — someone feels the need to commit fraud, such as the need Fra for money. Rationalization — ud justification for the Motivatio Rationalizatiodeceptive act by the one n n committing the fraud. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-2 aw-Hill. Internal Controls Internal controls attempt to eliminate the opportunity element of fraud Internal controls represent plans to:  Safeguard the company’s assets  Improve the accuracy and reliability of accounting information Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-3 aw-Hill. Accounting Scandals and Response by Congress Managers are entrusted with the resources of both the company’s lenders and owners Managers act as stewards or caretakers of the company’s assets Some managers have shirked their ethical responsibilities  Top executives misused or misreported the company’s funds Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-4 aw-Hill. Accounting Fraud in U.S. History Enron WorldCom Misclassified Avoided reporting expenditures to billions in overstate assets and debt and losses profitability Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-5 aw-Hill. Sarbanes-Oxley Act of 2002 Passed by Congress Also known as the Public Company Accounting Reform and Investor Protection Act of 2002 Applies to all companies that are required to file financial statements with the SEC Established guidelines related to:  Internal control procedures  Auditor-client relations Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-6 aw-Hill.  Illustration 4–2 Major Provisions of the Sarbanes-Oxley Act of 2002 Oversight The Public Company Accounting Oversight Board (PCAOB) has the authority to establish standards dealing with auditing, quality control, ethics, independence, and board other activities relating to the preparation of audited financial reports. The board consists of five members who are appointed by the Securities and Exchange Commission. Corporate Corporate executives must personally certify the company’s financial statements and financial disclosures. Severe financial penalties and the possibility of imprisonment executive are consequences of fraudulent misstatement. accountabilit y Nonaudit It’s unlawful for the auditors of public companies to also perform certain nonaudit services, such as investment advising, for their clients. services Retention of Auditors of public companies must retain all work papers for seven years or face a prison term for willful violation. work papers Auditor The lead auditor in charge of auditing a particular company (referred to as the audit partner) must rotate off that company within five years and allow a new audit partner rotation to take the lead. Conflicts of Audit firms are not allowed to audit public companies whose chief executives worked for the audit firm and participated in that company’s audit during the preceding year. interest Hiring of Audit firms are hired by the audit committee of the board of directors of the company, not by company management. auditor Internal Section 404 of the act requires (a) that company management document and assess the effectiveness of all internal control processes that could affect financial reporting control Copyright ©2022and (b) that McGraw-Hill. company All rights reserved. auditors express No reproduction an opinion or distribution on without the whether prior management’s written consent of McGr 4-7 aw-Hill. Components of Internal Control The overall attitudes and actions of management greatly affect the control environment. Risk assessment includes careful consideration of internal and external risk factors. Control activities include a 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 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-8 aw-Hill. Control Activities – Preventative Controls Separation of duties – A set of procedures intended to separate employees’ duties for authorizing transactions, recording transactions, and controlling the related assets. Physical controls – A set of procedures that ensure assets and accounting records are kept safe. Proper authorization – A set of procedures designed to prevent improper use of the company’s resources. Employee management – Providing employees with appropriate guidance to ensure they have the knowledge necessary to carry out their job duties. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill. 4-9 Separation of Duties Assigning responsibilities to more than one individual so that no individual has sole control over an entire process Duties separated could include Who initiates a transaction Who authorizes/approves the transaction Who executes the transaction or has custody to the assets involved Who accounts for the transaction and maintains records 4-10 Separation of Duties Important for business processes like Purchases of goods/services Inventory Payroll Cash receipts/disbursements IT systems Requires a Cost/Benefit analysis and can be challenging for smaller businesses Minimizes the risk of errors, theft, fraud 4-11 Control Activities – Detective Controls Reconciliations – Management should periodically determine whether the amount of physical assets of the company (cash, supplies, inventory, and other property) agree with the accounting records. Performance reviews – The actual performance of individuals or processes should be checked against their expected performance. Audits – Hire an independent auditor to assess the internal control procedures to Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill. 4-12 Bank Reconciliation The balance of cash in the company’s records may not equal the balance of cash in the bank’s records. Bank Balance per Bank's Reconciliation Company' Cash = s Cash Records Possible Company Possible Records Differences Balance per Differences 1. Timing Reconciliation 1. Timing 2. Errors 2. Errors A bank reconciliation matches the balance of cash in the bank with the balance of cash in the company’s own records. Timing differences in cash occur when the company records transactions before or after the bank records the same transactions. Errors can be made either by the company or its bank and may be accidental or intentional. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill. 4-13 Responsibilities for Internal Control  Everyone in a company has an impact on the operation and effectiveness of internal controls.  However, the top executives are the ones who must take final responsibility for their establishment and success. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-14 aw-Hill. Concept Check 4–2 If a company places cash receipts from the day in a safe or bank deposit box, this would be an example of: a. Separation of duties b. Physical control c. Reconciliation d. Performance This is an example of review a physical control. Important items (like cash receipts) should be kept in safe places—like a safe or a bank deposit box. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-15 aw-Hill. Limitations of Internal Control Even with the best internal control systems, financial misstatements can occur. Internal control systems are especially susceptible to collusion.  Collusion: Two or more people acting in coordination to circumvent internal controls Top-level employees who can override internal control procedures also have opportunity to commit fraud. Effective internal controls and ethical employees alone cannot ensure a company’s success, or even survival. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-16 aw-Hill. Concept Check 4–3 Everyone in the company has an impact on the operations and effectiveness of internal control, but who must take final responsibility? a. Auditors b. Top executives c. The firm’s attorney d. The majority shareholder The top executives take final responsibility for the establishment and success of internal controls. In fact, the CEO and CFO of companies that are required to file financial statements with the SEC must sign a report each year assessing whether the internal controls are adequate. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-17 aw-Hill. Illustration 4–7 Components of the Total Cash Balance Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-18 aw-Hill. Key Point Cash includes: Coins and currency, checks received, and balances in savings and checking accounts, Credit card and debit card sales, and Cash equivalents, defined as investments that mature within three months from the date of purchase (such as money market funds, Treasury bills, and certificates of deposit). Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-19 aw-Hill. Concept Check 4–4 Which of the following would NOT be considered a cash equivalent? a. Credit card sales for the day b. Debit card sales for the day c. Checks received from customers d. Certificate of deposit (CD) that matures one year from now Cash includes currency, coins, savings accounts, checking accounts, credit card sales, debit card sales, and other cash equivalents. Cash equivalents are generally defined as investments that mature within three months from the date of purchase, such as money market funds, treasury bills, and certificates of deposit. Since the CD doesn’t mature until 1 year from now, it would NOT be considered a cash equivalent. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-20 aw-Hill. Collections of Payments from Customers Cash and checks (“paper”) Credit cards and debit cards (“plastic”) Mobile payments Electronic funds transfers (EFTs) Prepaid cards Cryptocurrencies Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-21 aw-Hill. Controls over Receipt of Cash and Checks 1. Open mail each day, and make a list of cash and checks received, including the amount and payer’s name. 2. Designate an employee to deposit cash and checks into the company’s bank account each day, different from the person who receives cash and checks. 3. Have another employee record cash receipts in the accounting records as soon as possible. Verify cash receipts by comparing the bank deposit slip with the accounting records. 4. Accept credit cards or debit cards, to limit the amount of cash employees handle. 4-22 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill. Acceptance of Credit Cards The acceptance of credit cards provides an additional control by reducing employees’ need to directly handle cash. Meanwhile, the credit card company deposits cash in the company’s bank for the amount of the sale, less service fees. Bottom line – credit cards are treated the same as cash Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-23 aw-Hill. Acceptance of Debit Cards Like credit cards, debit cards offer customers a way to purchase goods and services without a physical exchange of cash. They differ, however, in that most debit cards (sometimes referred to as check cards) work just like a check and withdraw funds directly from the cardholder’s bank account at the time of use. Similar to credit cards, the use of debit cards by customers results in a fee being charged to the retailer. However, the fees charged for debit cards are typically much lower than those charged for credit cards. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-24 aw-Hill. Controls Over Cash Disbursements (1 of 2) 1. Make all disbursements, other than very small ones, by check, debit card, or credit card. This provides a permanent record of all disbursements. 2. Authorize all expenditures before purchase and verify the accuracy of the purchase itself. The employee who authorizes payment should not also be the employee who prepares the check. 3. Make sure checks are serially numbered and signed only by authorized employees. Require two signatures for larger checks. 4-25 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill. Controls Over Cash Disbursements (2 of 2) 4. Periodically compare amounts shown in the debit card and credit card statements with purchase receipts. The employee verifying the accuracy of the debit card and credit card statements should not also be the employee responsible for actual purchases. 5. Set maximum purchase limits on debit cards and credit cards. Give approval to purchase above these amounts only to upper-level employees. 6. Employees responsible for making cash disbursements should not also be in charge4-26 Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill. Key Point Because cash is the asset of a company most susceptible to employee fraud, controls over cash receipts and cash disbursements are an important part of a company’s overall internal control system. Important controls over cash receipts include separation of duties for those who handle cash and independent verification of cash receipts. Important controls over cash disbursements include payment by check, credit card, or debit card, separation of duties, and various authorization and documentation procedures. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-27 aw-Hill. Reporting Cash Balance of cash Snapshot at end Balance of period Sheet Current or noncurrent asset Stateme Inflows/Outflows Covers a period of nt of time Cash Operating, Investing, and Flows Financing Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-28 aw-Hill. Statement of Cash Flows Operating activities  Cash transactions involving revenues and expenses  Examples: Cash received from customers, cash paid for rent, utilities, supplies, and salaries Investing activities  Cash investments in long-term assets and investment securities  Examples: Purchase or sale of land, equipment, and buildings for cash Financing activities  Transactions designed to finance the business through borrowing and owner investment  Examples: Issue common stock or pay dividends; borrow or repay debt Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-29 aw-Hill.  Illustration 4–14 External Transactions of Eagle Soccer Academy Type of Is Cash Inflow or Transaction External Transactions in December Activ (1) Sell shares of common stock for $200,000 to Financing YES Inflow obtain the funds necessary to start the business. Financing YES Inflow (2) Borrow $100,000 from the local bank and sign a note promising to repay the full amount of Investing YES Outflow the debt in three years. Operating YES Outflow (3) Purchase equipment necessary for giving soccer Operating NO — training, $120,000 cash. Operating YES Inflow (4) Pay one year of rent in advance, $60,000 Operating NO — ($5,000 per month). Operating YES Inflow (5) Purchase supplies on account, $23,000. (6) Provide soccer training to customers for Operating YES Outflow cash, $43,000. Financing YES Outflow (7) Provide soccer training to customers on account, $20,000. Copyright ©2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of 4-30 30 McGraw-Hill Education. Illustration 4–15 Statement of Cash Flows for Eagle Soccer Academy EAGLE SOCCER ACADEMY Statement of Cash Flows For the period ended December 31, 2024 Cash Flows from Operating Activities Cash inflows: From customers [6 and 8] $ 49,000 Cash outflows: For salaries (28,000) For rent (60,000) Net cash flows from operating activities $ (39,000) Cash Flows from Investing Activities Purchase equipment (120,000) Net cash flows from investing activities (120,000) Cash Flows from Financing Activities Issue common stock 200,000 Borrow from bank 100,000 Pay dividends (4,000) Net cash flows from financing activities 296,000 Net increase in cash 137,000 CashMcGraw-Hill at the beginning of the period Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of -0- 4-31 Education. Concept Check 4–8 Which of the following items would be categorized as an investing activity on a statement of cash flows? a. Borrowed money from the local bank by signing a note to repay the full amount two years later b. Paid for supplies in cash c. Paid for the purchase of equipment Cash flows from investing activities include the using purchase or cash sale of long-term assets. The purchase of equipment using cash would be shown in the investing d. Paidsection—as activities salaries atodecrease. employees Borrowing money would be shown in the financing activities section, and the purchase of supplies and payment of salaries would be in the operating activities section. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr 4-32 aw-Hill. Concept Check 4–9 Which of the following statements is true? a. Having too much cash represents idle resources that are not being used to produce revenues. b. One way to assess cash holdings is to compare cash assets to noncash assets. c. In recent years cash holdings have increased tremendously. All of the above statements about cash d. All of the above are true. Copyright ©2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGr aw-Hill. 4-33