Chapter 8 Lecture and Notes

Analyze Fraud in the Accounting Workplace

• Fraud can be defined in many ways, but for the purposes of this course we define it as the act of intentionally deceiving a person or organization or misrepresenting a relationship in order to secure some type of benefit, either financial or nonfinancial.

 

All companies, regardless of size or type, must be aware of fraud potential in their organization.

 

 

Incentive (or financial pressure):

• Vices, such as gambling or drug use
• Financial pressures, such as greed or living beyond their means
• Work pressure, such as being unhappy with a job
• Other pressures, such as the desire to appear successful

Perceived opportunity is when a potential fraudster thinks that the internal controls are weak or sees a way to override them.

• This is the area in which an accountant has the greatest ability to mitigate fraud.

Rationalization is a way for the potential fraudster to internalize the concept that the fraudulent actions are acceptable.

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Types of Auditors

Internal auditor

• Employee of the company
• Job is to provide an independent and objective evaluation of the company’s accounting and operational activities
• Provides recommendations for management to review and implement stronger internal controls

External auditor

• Works for an outside certified public accountant (CPA) firm or his or her own private practice; not an employee of the client
• Conducts audits and other assignments, such as reviews
• Prepares reports and then provides opinions as to whether or not the financial statements accurately reflect the financial conditions of the company; subject to generally accepted accounting principles (GAAP) 

Define and Explain Internal Controls and Their Purpose within an Organization

Internal controls are the systems used by an organization to manage risk and diminish the occurrence of fraud.

The internal control structure is made up of the control environment, the accounting system, and procedures called control activities.

   

The five components that the Committee of Sponsoring Organizations (COSO) determined were necessary in an effective internal control system make up the components in the internal controls triangle.

 

The internal control system consists of the formal policies and procedures that do the following:

• Ensure assets are properly used
• Ensure that the accounting system is functioning properly
• Monitor operations of the organization to ensure maximum efficiency
• Ensure that assets are kept secure
• Ensure that employees are in compliance with corporate policies

A properly designed and functioning internal control system will not eliminate the risk of loss, but it will reduce the risk.

 

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Major Accounting Components of the Sarbanes-Oxley Act

The Sarbanes-Oxley Act (SOX) requires the certification and documentation of internal controls; specifically, an auditor must do the following:

1.Issue an internal control report following the evaluation of internal controls.

2.Limit non-audit services, such as consulting, that are provided to a client.

3.Rotate who can lead the audit. The person in charge of the audit can serve for a period of no longer than seven years without a break of two years.

 

This video shows you how the Enron scandal, which was one of the largest frauds in the history of modern business, was the main fraud that was responsible for creation of the Sarbanes-Oxley Act as well as the Public Company Accounting Oversight Board (PCAOB).

 

If you are interested in a comprehensive view a the Enron scandal, here is a really good video:

 

Describe Internal Controls within an Organization

Elements of internal control:

 

 

   

Establishment of clear responsibilities

• Control is most effective when only one person is responsible for a given task.
• Establishing responsibility often requires limiting access only to authorized personnel, and then identifying those personnel.

 

 

Proper Documentation

• Companies should use prenumbered documents, and all documents should be accounted for.
• Employees should promptly forward source documents for accounting entries to the accounting department.

 

 

 

 

  Separation of of duties

• Records periodically verified by an employee who is independent.
• Discrepancies reported to management.

 

 

 

 

Adequate insurance

• Bond employees who handle cash.
• Acquire liability coverage

Separation of assets from custody

• The person who controls the asset does not record it
  • petty cash
  • Check writing
  • Receiving product 

Use of technology

•  Use of surveillance cameras
• Limit access 
• Password control

Human Resource Controls

• Rotate employees’ duties and require vacations.
• Conduct background checks.

   

 

 

 

 

 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries

One of the hardest assets to control within any organization is cash.

• One way to control cash is for an organization to require that all payments be made by check.
  • But there are situations in which it is not practical to use a check. For example, it is not efficient to write a check for a small purchase.
• Companies set up a petty cash fund.
  • This is a predetermined amount of cash held on hand to be used to make payments for small day-to-day purchases.
  • A petty cash fund is a type of imprest account.
    • It contains a fixed amount of cash that is replaced as it is spent in order to maintain a set balance.
    • Petty Cash Fund - Used to pay small amounts. Involves:

1. 1. 1. 1. establishing the fund,
         2. making payments from the fund, and
         3. replenishing the fund.

 

 

Errors in Petty Cash

• Errors may be the result of an employee not getting a receipt.
• Or they may result from getting back incorrect change from the store where the purchase was made.
• An expense is created that creates a cash overage or shortage.

 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization

 Management’s role in internal control

• Because internal controls protect the integrity of financial statements, large companies have become highly regulated in their implementation.
• SOX makes sure ultimate responsibility for the controls is on the management of the company.
  • Both the chief executive officer (CEO), who is the executive within a company with the highest-ranking title and the overall responsibility for management of the company, and the chief financial officer (CFO), who is the corporation officer who reports to the CEO and oversees all of the accounting and finance concerns of a company, must personally certify that
    • (1) they have reviewed the internal control report provided by the auditor
    • (2) the report does not contain any inaccurate information
    • (3) they believe that all financial information fairly states the financial conditions, income, and cash flows of the entity. The sign-off under Section 302 makes the CEO and CFO personally responsible for financial reporting as well as internal control structure.

  

 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries

• The bank reconciliation is the internal financial report that explains and documents any differences that may exist between the balance of a checking account as reflected by the bank’s records (bank balance) for a company and the company’s accounting records (company balance).
• The bank reconciliation is an internal document prepared by the company that owns the checking account. The transactions with timing differences are used to adjust and reconcile both the bank and company balances; after the bank reconciliation is prepared accurately, both the bank balance and the company balance will be the same amount.
• Note that the transactions the company is aware of have already been recorded (journalized) in its records. However, the transactions that the bank is aware of but the company is not must be journalized in the entity’s records.

 

 

  

 

Typical Differences that Appear on a Bank Reconciliation

Outstanding check: This is a check that was written and deducted from the financial records of the company but has not been cashed by the recipient, so the amount has not been removed from the bank account.

Deposit in transit: This is a deposit that was made by the business and recorded on its books but has not yet been recorded by the bank.

Deductions for a bank service fee: Banks often charge fees each month for management of the bank account. These may be fixed maintenance fees, per-check fees, or a fee for a check that was written for an amount greater than the balance in the checking account, called an nonsufficient funds (NSF) check. These fees are deducted by the bank from the account but would not appear on the financial records.

Errors initiated by either the client or the bank: For example, the client might record a check incorrectly in its records, for either a greater or lesser amount than was written. Also, the bank might report a check either with an incorrect balance or in the wrong client’s checking account.

Additions such as interest or funds collected by the bank for the client: Interest is added to the bank account as earned but is not reported on the financial records. These additions might also include funds collected by the bank for the client.

 

 

  

 

 

 

 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements

  

• Financial statement fraud occurs when the financial statements are used to conceal the actual financial condition of a company or to hide specific transactions that may be illegal.
• Financial statement fraud may take on many different methods, but it is generally called cooking the books. This issue may occur for many purposes.
  • A common reason to cook the books is to create a false set of a company’s books used to convince investors or lenders to provide money to the company.
    • Investors and lenders rely on a properly prepared set of financial statements in making their decision to provide the company with money.
  • Another reason to misstate a set of financial statements is to hide corporate looting such as excessive retirement perks of top executives, unpaid loans to top executives, improper stock options, and any other wrongful financial action.
  • Another reason to misreport a company’s financial data is to drive the stock price higher.
• Internal controls assist the accountant in locating and identifying when management of a company wants to mislead the inventors or lenders.

 

• The fraud triangle helps explain the mechanics of fraud by examining the common contributing factors of perceived opportunity, incentive, and rationalization.
• Due to the nature of their functions, internal and external auditors, through the implementation of effective internal controls, are in excellent positions to prevent opportunity-based fraud.
• A system of internal control is the policies combined with procedures created by management to protect the integrity of assets and ensure efficiency of operations.
• The system prevents losses and helps management maintain an effective means of performance.
• Principles of an effective internal control system include having clear responsibilities, documenting operations, having adequate insurance, separating duties, and setting clear responsibilities for action.
• The purpose of a petty cash fund is to make payments for small amounts that are immaterial, such as postage, minor repairs, or day-to-day supplies.
• Though management has always had responsibility over internal controls, the Sarbanes-Oxley Act has added additional assurances that management takes this responsibility seriously, and placed sanctions against corporate officers and boards of directors who do not take appropriate responsibility.
• The bank reconciliation is an internal control document that ensures transactions to the bank account are properly recorded, and allows for verification of transactions.
• Financial statement fraud has occurred when financial statements intentionally hide illegal transactions or fail to accurately reflect the true financial condition of an entity.