Chapter 7 – Fraud, Ethics, and Internal Controls

 

This chapter will also introduce the topic of workplace fraud and the components required to design a system of internal control.  After we have completed this chapter, you should be able to:

1.         Describe the major types of workplace fraud.

2.         Explain the purpose or goals of an internal control system.

3.         Define and discuss some basic internal control principles that should be followed when setting internal control policies.

 

Key Points to Remember:

 

1.         Types of workplace fraud

            1.         Asset misappropriation – theft or misuse of the employer’s resources

            2.         Corruption – wrongful use of influence in a business transaction with the result that the                                employee receives financial gain at the expense of the employer

            3.         Fraudulent financial statements – falsification of financial statements 

 

 

2.         Internal control  – the policies and procedures by which management

            1.         Protects the assets of the company

            2.         Ensures the accuracy and reliability of the accounting records

            3.         Promotes efficient operations

            4.         Urges adherence (compliance) to company polices 

           

3.         Principles for designing internal control activities or procedures

1.         Establish responsibility – authorization for completion of transactions/events

2.         Maintain adequate documentation and records – establishes policies and recordkeeping          practices for documenting and recording transactions or events

3.         Insure assets and bond key employees --  insure assets against loss and require employees     that handle large amounts of cash to be bonded by an outside agency

4.         Separation of duties – separate the authorization of transactions, handling of assets, and        recordkeeping of those assets

5.         Physical (technological) controls – maintain physical protection of assets and accounting       records

6.         Periodic independent verification – establishes system for reviewing/verifying accounting      records and assets

 

 

4.         Limitations to Internal control

            1.         Human error/fraud can never be totally controlled

            2.         Cost-benefit principle – the cost of the internal control system should not exceed its                          benefit

 

 

 


CHAPTER 7 REVIEW

 

I.          TRUE-FALSE (Circle T if the statement is true, F is it is false.  Provide explanations false answers.)

 

T   F     1.         A good system of internal control will guarantee that the accounting records are accurate.

T   F     2.         The mail should be opened in the accounting department so that transactions may be recorded immediately.

T   F     3.         Rotating employees in job assignments is poor internal control because employees would continually be forced to learn a new job skill.

T   F     4.         Internal control consists of the plan of organization and all of the related policies and measures adopted within a business to (a) safeguard its assets, and (b) ensure the accuracy and reliability of its accounting records.

T   F     5.         Proper internal control means that responsibility for a task is clearly established and assigned to one person. 

T   F     6.         The responsibility for related transactions should be assigned to one person.

T   F     7.         The responsibility for establishing the accountability for an asset should be separate from the physical custody of that asset.

T   F     8.         Only designated personnel should be authorized to handle or have access to cash receipts.

T   F     9.         It will improve your internal controls over cash if only one person is authorized to sign checks, record the cash payments, and prepare the bank reconciliation.

T   F     10.        You must be a licensed CPA to perform an internal review of any type of accounting records.

T   F     11.        Once a good set of control practices are in place, there is no need to waste time

                        and money on reviews of the system.

T   F     12.        Separation of duties divides responsibility for a transaction or a series of transactions            between two or more individuals or departments. Separation of duties reduces the risk of error and fraud. 

T    F    13.        The best person to perform a system review is the person who is most familiar with the        system. 

T    F    14.        Technology such as cash registers, check protectors, time clocks and personal        identification scanners can improve internal control. 

T    F    15       Bonding does not decrease loss from theft because employees know that bonding is an                    insurance policy against loss from theft. 

T    F    16.        Two important limitations of internal control systems are (1) human error or human fraud,    and (2) cost-benefit. 

 

II.        MULTIPLE CHOICE  (Circle the letter that best completes each of the following statements)

 

            1.         The principles of internal controls include: 
            a.          Using technology where appropriate
            b.         Separating asset custody and record keeping duties
            c.         Performing frequent reviews
            d.         Insure assets
            e.          All of these

            2.         An internal control system consists of the policies and procedures managers use                               to: 
                        a.          Protect assets.
                        b.         Ensure reliable accounting.
                        c.         Promote efficient operations.
                        d.         Urge adherence to company policies.
                        e.          All of these.

 

            3.         The principles of internal control include: 
                        a.          Establish responsibilities.
                        b.         Maintain minimal records.
                        c.         Use only computerized systems.
                        d.         Bond all employees.
                        e.          Require automated sales systems.

 

            4.         When two clerks share the same cash register it is a violation of which internal                                             control principle? 
                        a.          Establish responsibilities.
                        b.         Maintain adequate records.
                        c.         Insure assets.
                        d.         Bond key employees.
                        e.          Apply technological controls.

 

            5.         Which of the following procedures would weaken control over cash receipts that

                        arrive through the mail? 

                        a.          After the mail is opened, a list (in triplicate) of the money received is prepared with a record of the sender's name, the amount, and an explanation of why the money is sent.

                        b.         The bank reconciliation is prepared by a person who does not handle cash or record cash receipts

                        c.         Only one person should open the mail, and that person should immediately deposit the cash received in the bank.

                        d.         The cashier should not also be the record keeper who records the amounts received in the accounting records.

                        e.          All of these are good internal control procedures over cash receipts that arrive through the mail.

 

            6.         Pre-numbered printed checks are an example of which internal control principle? 

                        a.          Technological controls.

                        b.         Maintain adequate records.

                        c.         Perform regular and independent reviews.

                        d.         Establish responsibilities.

                        e.          Divide responsibility for related transactions.

 


III.       QUESTIONS/PROBLEMS

 

1.         Define an internal control system and describe its purpose. 

 

2.         How does technology improve internal controls in an accounting system? 

 

3.         Match each of the following transactions 1 through 10 with the applicable internal control principle a through g (some answers refer to more than one principle).
                                    a.          Establish responsibility.
                                    b.         Maintain adequate records.
                                    c.         Insure assets and bond employees.
                                    d.         Separate recordkeeping from custody of assets.
                                    e.          Divide responsibility for related transactions.
                                    f.          Apply technological controls.
                                    g.         Perform regular and independent reviews.

 

                        _____ 1.            Cashier does not have access to the cash register recorded tape or file.
            _____ 2.            A company uses a voucher system.
            _____ 3.            No two clerks share the same cash drawer.
            _____ 4.            The bookkeeper prepares and signs checks.
            _____ 5.            A company uses a computerized point of sale system.
            _____ 6.            A company hires CPAs to perform an audit.
            _____ 7.            A company buys an insurance policy to protect against employee theft.
            _____ 8.            A company has separate departments for purchasing, receiving, and                                                            accounts payable.
            _____ 9.            A company has an internal auditor on staff.
            _____ 10.          A company uses a check protector. 

 

4.         For each of the independent cases below, identify the principle of internal control that is violated, and recommend what should be done to remedy the violation.
 
 1.        In order to save money, Regal Company has decided to drop its property insurance on          assets, and to stop bonding the cashiers who handle about $10,000 in cash each day.
 2.        Halton Company records each sale on a preprinted invoice. Since sometimes invoices are s    poiled when they are prepared, the invoices are not prenumbered, but the sales clerk writes          the next number onto each invoice.
 3.        Marion Company is a very small business. Bob Lepley, one of the two office clerks, opens    the mail each day and removes the cash receipts that come in the mail. Bob then records   the receipts in the cash records and the customer's account and deposits the cash in the         bank.
 4.        Gerald McNichols, the owner of McNichols Company prides himself on hiring only the         most competent employees. McNichols believes that since these employees are highly           competent and to show that he trusts them completely, he feels there is no need for anyone     to check up on the employees' performance.
 5.        Service Products is a small business with only 3 accounting employees. Each employee is     well-trained and so can perform any of the accounting tasks, including handling cash    receipts and cash disbursements, and preparing the bank reconciliation.  

 

 


ANSWERS

 

I.          TRUE/FALSE

 

1.         F          It increases the probability of accuracy, but will not guarantees it.

2.         F          This procedure could easily result in theft.

3.         F          Rotating employees is good for internal control because it might uncover theft.

4.         T         

5.         T

6.         F          The responsibility for related transactions should be assigned to different individuals.

7.         T

8.         T

9.         F          Theses responsibilities should be assigned to different individuals.

10.        F          Any employee that has been properly trained and is independent of the employee they are                               reviewing can complete internal reviews.

11.        F          The internal control system should be reviewed and revised as needed

12.        T

13.        F          System reviews should be completed by an independent employee

14.        T         

15.        F          It decreases loss from theft

16.        T

 

II.        MULTIPLE CHOICE

           

            1.         E                      4.         A

            2.         E                      5.         C

            3.         A                      6.         B

           

 

III.       QUESTIONS/PROBLEMS

 

1.         An internal control system refers to the policies and procedures designed to protect the firm's assets and to ensure reliable accounting. It also should promote efficient operations and urge employees to comply with company policies. Internal control systems can help prevent losses, help mangers plan operations, and monitor company and employer performance.

 

2.         Technology improves the effectiveness of internal controls, and can reduce the human-element risk with repetitive processing. Technology improves our ability to test records, and can track users.

 

3.         1. a, d,

            2. e, b,

            3. a, 4. d,

            5. f,

            6. g,

            7. c,

            8. e, d,

            9. g,

            10. f

 


4.         1.         Insure assets and bond key employees. Even though it may save money in the short run,                   insurance protects the company if assets are stolen. Bonding reduces the risk of loss from                   the theft of cash by employees. It also discourages theft because bonded employees know                     that an independent company will be involved when a theft is discovered. It is unlikely               that the bonding company will be sympathetic to any employee involved in the theft.


2.         Maintain adequate records. All important documents, including sales invoices, should be                    prenumbered. This will help ensure that all sales are recorded and that salespeople cannot                  pocket cash from a sale and destroying the sales invoice.

 

            3.         Divide responsibility for related transactions. Lepley has too many responsibilities with                      respect to cash. He controls the cash and maintains the records of cash. These                                   responsibilities with respect to cash should be split up among several employees. One                   person should open the mail (ideally with a second employee present), and prepare a list in     triplicate that indicates each sender's name, the amount sent, and an explanation of why              the money was sent. One copy goes to the cashier with the money. The cashier deposits                   the money in the bank and records the amounts received in the accounting records for               cash. The second copy goes to the recordkeeper in the accounting area who records the                        amounts in the customer's records. The third copy stays with the person who opens the                        mail. Lepley may carry out one of these tasks, but not all of them.


4.         Perform regular and independent reviews. Even the most competent person sometimes                     makes mistakes. Sometimes individuals who appear honest may turn out to not to be.                     McNichols should set up regular, independent reviews of each employee's performance to                 evaluate possible errors and to ensure that procedures are followed.


5.         Establish responsibilities. Each employee should be assigned specific tasks. Now, if a                        problem occurs, it is difficult to know who is at fault. It is hard to hold employees                            accountable for their actions if it cannot be determined who is responsible for the action.