WILEY

IFRS EDITION
Prepared by
Coby Harmon
University of California, Santa Barbara
7-1 Westmont College
 PREVIEW OF CHAPTER 7

Financial Accounting
IFRS 3rd Edition
Weygandt ● Kimmel ● Kieso
7-2
 Fraud and Internal Control
Learning
Objective 1
Fraud Define fraud and
internal control.
Dishonest act by an employee that results
in personal benefit to the employee at a cost to the
employer.

Three factors that

contribute to
fraudulent activity.

Illustration 7-1
Fraud triangle

7-3 LO 1
 Internal Control

Methods and measures adopted to:

1. Safeguard assets.

2. Enhance accuracy and reliability of accounting records.

3. Increase efficiency of operations.

4. Ensure compliance with laws and regulations.

7-4 LO 1
 Internal Control

Question
Internal control is used in a business to enhance the
accuracy and reliability of its accounting records and to:

a. safeguard its assets.

b. prevent fraud.

c. produce correct financial statements.

d. deter employee dishonesty.

7-5 LO 1
 Internal Control

Five Primary Components:

● Control environment.

● Risk assessment.

● Control activities.

● Information and communication.

● Monitoring.

7-6 LO 1
 Principles of Internal Control Activities
Learning Objective 2
Identify the principles of
ESTABLISHMENT OF internal control activities.

RESPONSIBILITY
 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.

7-7 LO 2
 Principles of Internal Control Activities

SEGREGATION OF DUTIES
 Different individuals should be
responsible for related activities.

 The responsibility for record-

keeping for an asset should be
separate from the physical custody
of that asset.

7-8 LO 2
 Principles of Internal Control Activities

DOCUMENTATION PROCEDURES
 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.

7-9 LO 2
 Principles of Internal Control Activities

PHYSICAL Illustration 7-2

Physical controls
CONTROLS

7-10 LO 2
 Principles of Internal Control Activities

INDEPENDENT INTERNAL VERIFICATION

 Records periodically
verified by an
employee who is
independent.

 Discrepancies
reported to
management.

Illustration 7-3
Comparison of segregation of duties principle with
independent internal verification principle
7-11 LO 2
 Principles of Internal Control Activities

HUMAN RESOURCE CONTROLS

 Bond employees who handle cash.

 Rotate employees’ duties and require

vacations.

 Conduct background checks.

7-12 LO 2
 Principles of Internal Control Activities
Learning Objective 2
Identify the principles of
1. Establishment of responsibility internal control activities.

2. Segregation of duties

3. Documentation procedures

4. Physical controls

5. Independent internal verification

6. Human resource controls

7-13 LO 2
 Principles of Internal Control Activities

Question
The principles of internal control do not include:

a. establishment of responsibility.

b. documentation procedures.

c. management responsibility.

d. independent internal verification.

7-14 LO 2
 ANATOMY OF A FRAUD

Maureen Frugali was a training supervisor for claims processing at Colossal

Healthcare. As a standard part of the claims processing training program,
Maureen created fictitious claims for use by trainees. These fictitious claims
were then sent to the accounts payable department. After the training claims
had been processed, she was to notify Accounts Payable of all fictitious claims,
so that they would not be paid. However, she did not inform Accounts Payable
about every fictitious claim. She created some fictitious claims for entities that
she controlled (that is, she would receive the payment), and she let Accounts
Payable pay her.

Total take: $11 million

The Missing Control

Establishment of responsibility. The healthcare company did not adequately
restrict the responsibility for authorizing and approving claims transactions. The
training supervisor should not have been authorized to create claims in the
company’s “live” system.

7-15 LO 2
 ANATOMY OF A FRAUD

Lawrence Fairbanks, the assistant vice-chancellor of communications at Aesop

University, was allowed to make purchases of under $2,500 for his department
without external approval. Unfortunately, he also sometimes bought items for
himself, such as expensive antiques and other collectibles. How did he do it?
He replaced the vendor invoices he received with fake vendor invoices that he
created. The fake invoices had descriptions that were more consistent with the
communications department’s purchases. He submitted these fake invoices to
the accounting department as the basis for their journal entries and to the
accounts payable department as the basis for payment.

Total take: $475,000

The Missing Control

Segregation of duties. The university had not properly segregated related
purchasing activities. Lawrence was ordering items, receiving the items, and
receiving the invoice. By receiving the invoice, he had control over the
documents that were used to account for the purchase and thus was able to
substitute a fake invoice.
7-16 LO 2
 ANATOMY OF A FRAUD

Angela Bauer was an accounts payable clerk for Aggasiz Construction

Company. She prepared and issued checks to vendors and reconciled bank
statements. She perpetrated a fraud in this way: She wrote checks for costs
that the company had not actually incurred (e.g., fake taxes). A supervisor then
approved and signed the checks. Before issuing the check, though, she would
“white-out” the payee line on the check and change it to personal accounts that
she controlled. She was able to conceal the theft because she also reconciled
the bank account. That is, nobody else ever saw that the checks had been
altered.

Total take: $570,000

The Missing Control

Segregation of duties. Aggasiz Construction Company did not properly
segregate record-keeping from physical custody. Angela had physical custody
of the blank checks, which essentially was control of the cash. She also had
record-keeping responsibility because she prepared the bank reconciliation.

7-17 LO 2
 ANATOMY OF A FRAUD

To support their reimbursement requests for travel costs incurred, employees at

Mod Fashions Corporation’s design center were required to submit receipts. The
receipts could include the detailed bill provided for a meal, or the credit card
receipt provided when the credit card payment is made, or a copy of the
employee’s monthly credit card bill that listed the item. A number of the designers
who frequently traveled together came up with a fraud scheme: They submitted
claims for the same expenses. For example, if they had a meal together that cost
$200, one person submitted the detailed meal bill, another submitted the credit
card receipt, and a third submitted a monthly credit card bill showing the meal as
a line item. Thus, all three received a $200 reimbursement.

Total take: $75,000

The Missing Control

Documentation procedures. Mod Fashions should require the original,
detailed receipt. It should not accept photocopies, and it should not accept
credit card statements. In addition, documentation procedures could be further
improved by requiring the use of a corporate credit card (rather than a personal
credit card) for all business expenses.
7-18 LO 2
 ANATOMY OF A FRAUD

At Centerstone Health, a large insurance company, the mailroom each day

received insurance applications from prospective customers. Mailroom
employees scanned the applications into electronic documents before the
applications were processed. Once the applications are scanned they can be
accessed online by authorized employees. Insurance agents at Centerstone
Health earn commissions based upon successful applications. The sales agent’s
name is listed on the application. However, roughly 15% of the applications are
from customers who did not work with a sales agent. Two friends—Alex, an
employee in record keeping, and Parviz, a sales agent—thought up a way to
perpetrate a fraud. Alex identified scanned applications that did not list a sales
agent. After business hours, he entered the mailroom and found the hardcopy
applications that did not show a sales agent. He wrote in Parviz’s name as the
sales agent and then rescanned the application for processing. Parviz received
the commission, which the friends then split.

Total take: $240,000

The Missing Control

7-19 LO 2
 Total take: $240,000

The Missing Control

Physical controls. Centerstone Health lacked two basic physical controls that
could have prevented this fraud. First, the mailroom should have been locked
during nonbusiness hours, and access during business hours should have
been tightly controlled. Second, the scanned applications supposedly could be
accessed only by authorized employees using their passwords. However, the
password for each employee was the same as the employee’s user ID. Since
employee user-ID numbers were available to all other employees, all
employees knew all other employees’ passwords. Unauthorized employees
could access the scanned applications. Thus, Alex could enter the system
using another employee’s password and access the scanned applications.

7-20 LO 2
 ANATOMY OF A FRAUD

Bobbi Jean Donnelly, the office manager for Mod Fashions Corporation’s design
center, was responsible for preparing the design center budget and reviewing
expense reports submitted by design center employees. Her desire to upgrade
her wardrobe got the better of her, and she enacted a fraud that involved filing
expense-reimbursement requests for her own personal clothing purchases. She
was able to conceal the fraud because she was responsible for reviewing all
expense reports, including her own. In addition, she sometimes was given
ultimate responsibility for signing off on the expense reports when her boss was
“too busy.” Also, because she controlled the budget, when she submitted her
expenses, she coded them to budget items that she knew were running under
budget, so that they would not catch anyone’s attention.
Total take: $275,000
The Missing Control
Independent internal verification. Bobbi Jean’s boss should have verified her
expense reports. When asked what he thought her expenses were, the boss
said about $10,000. At $115,000 per year, her actual expenses were more than
ten times what would have been expected. However, because he was “too
busy” to verify her expense reports or to review the budget, he never noticed.
7-21 LO 2
 ANATOMY OF A FRAUD

Ellen Lowry was the desk manager and Josephine Rodriquez was the head of
housekeeping at the Excelsior Inn, a luxury hotel. The two best friends were so
dedicated to their jobs that they never took vacations, and they frequently filled in
for other employees. In fact, Ms. Rodriquez, whose job as head of housekeeping
did not include cleaning rooms, often cleaned rooms herself, “just to help the
staff keep up.” Ellen, the desk manager, provided significant discounts to guests
who paid with cash. She kept the cash and did not register the guest in the
hotel’s computerized system. Instead, she took the room out of circulation “due
to routine maintenance.” Because the room did not show up as being used, it did
not receive a normal housekeeping assignment. Instead, Josephine, the head of
housekeeping, cleaned the rooms during the guests’ stay.

Total take: $95,000

The Missing Control
Human resource controls. Ellen, the desk manager, had been fired by a
previous employer. If the Excelsior Inn had conducted a background check, it
would not have hired her. The fraud was detected when Ellen missed work due
to illness. A system of mandatory vacations and rotating days off would have
increased the chances of detecting the fraud before it became so large.
7-22 LO 2
 ACCOUNTING ACROSS THE ORGANIZATION
Internal Control and the Role of Human Resources
Companies needs to keep track of employees’ degrees and
certifications to ensure that employees continue to meet the
specified requirements of a job. Also, to ensure proper employee
supervision and proper separation of duties, companies must
develop and monitor an organizational chart. When one corporation
went through this exercise it found that out of 17,000 employees,
there were 400 people who did not report to anyone. The
corporation had 35 people who reported to each other. In addition, if
an employee complains of an unfair firing and mentions financial
issues at the company, the human resources department must refer
the case to the company audit committee and possibly to its legal
counsel.

7-23 LO 2
 Limitations of Internal Control

 Costs should not exceed benefit.

 Human element.

 Size of the business.

• HELPFUL HINT
 Employee collusion Controls may vary with the risk
level of the activity. For
example, management may
consider cash to be high risk
and maintaining inventories in
the stockroom as lower risk.
Thus, management would have
stricter controls for cash.

7-24 LO 2
 > DO IT!

Identify which control activity is violated in each of the

following situations.
SOLUTION
1. The person with primary responsibility for
reconciling the bank account and making all Segregation
bank deposits is also the company’s of duties
accountant.
2. Wellstone Company’s treasurer received an Human
award for distinguished service because he had resource
not taken a vacation in 30 years. controls
3. In order to save money on order slips and to
Documentation
reduce time spent keeping track of order slips, a
procedures
local bar/restaurant does not buy prenumbered
order slips.
7-25 LO 2
 Cash Controls
Learning
Objective 3
Cash Receipt Controls Explain the
applications of
internal control
principles to cash
receipts.

Illustration 7-4
Application of internal control
principles to cash receipts

7-26 LO 3
 Cash Receipt Controls

Illustration 7-4
Application of internal control
principles to cash receipts

7-27 LO 3
 Cash Receipt
Controls

OVER-THE-
COUNTER
RECEIPTS
Important internal
control principle—
segregation of
record-keeping from
physical custody.

Illustration 7-5
Control of over-the-counter
receipts

7-28 LO 3
 Cash Receipt Controls

MAIL RECEIPTS
 Mail receipts should be opened by two people, a list
prepared, and each check endorsed “For Deposit Only.”

 Each mail clerk signs the list to establish responsibility

for the data.

 Original copy of the list, along with the checks, is sent

to the cashier’s department.

 Copy of the list is sent to the accounting department for

recording. Clerks also keep a copy.

7-29 LO 3
 Cash Receipt Controls

Question
Permitting only designated personnel such as cashiers to
handle cash receipts is an application of the principle of:

a. segregation of duties.

b. establishment of responsibility.

c. independent internal verification.

d. human resource controls.

7-30 LO 3
 Cash Disbursement Controls
Learning
Generally, internal control over cash Objective 4
Explain the
disbursements is more effective when applications of
internal control
companies pay by check or electronic funds principles to cash
disbursements.
transfer (EFT) rather than by cash.

Applications:

 Voucher System Controls

 Petty Cash Fund

7-31 LO 4
 Cash Disbursement
Controls

Illustration 7-6
Application of internal control
7-32 LO 4
principles to cash disbursements
 Cash Disbursement
Controls

Illustration 7-6
Application of internal control
7-33 principles to cash disbursements
LO 4
 Cash Disbursement Controls

Question
The use of prenumbered checks in disbursing cash is an
application of the principle of:

a. establishment of responsibility.

b. segregation of duties.

c. physical controls.

d. documentation procedures.

7-34 LO 4
 Cash Disbursement Controls

VOUCHER SYSTEM CONTROLS

 A network of approvals by authorized individuals,
acting independently, to ensure all disbursements by
check are proper.

 A voucher is an authorization form prepared for each

expenditure in a voucher system.

7-35 LO 4
 Petty Cash Fund Controls
Learning
Objective 5
Petty Cash Fund - Used to pay small amounts. Describe the
operation of a
Involves: petty cash fund.

1. establishing the fund,

2. making payments from the fund, and

3. replenishing the fund.

7-36 LO 5
 ESTABLISHING THE PETTY CASH FUND

Illustration: If Zhu Ltd. decides to establish a NT$3,000 fund

on March 1, the journal entry is:

Mar. 1

7-37 LO 5
 ESTABLISHING THE PETTY CASH FUND

Illustration: If Zhu Ltd. decides to establish a NT$3,000 fund

on March 1, the journal entry is:

Mar. 1 Petty Cash 3,000

Cash 3,000

7-38 LO 5
 MAKING PAYMENTS FROM PETTY CASH

 Management usually limits the size of expenditures.

 Does not permit use of the fund for certain types of
transactions.
 Payments are documented on a prenumbered receipt.
 Signatures of both the custodian and the individual
receiving payment are required on the receipt.
 Supporting documents should be attached to the receipt.
 Custodian keeps the receipts in the petty cash box until the
fund is replenished.
 Sum of the receipts and money in the fund should equal
the established total at all times.
7-39 LO 5
 REPLENISHING THE PETTY CASH FUND

Illustration: Assume that on March 15 Zhu’s petty cash

custodian requests a check for NT$2,610. The fund contains
cash and petty cash receipts for postage NT$1,320, freight-out
NT$1,140, and miscellaneous expenses NT$150. The general
journal entry to record the check is:

Mar. 15

7-40 LO 5
 REPLENISHING THE PETTY CASH FUND

Illustration: Assume that on March 15 Zhu’s petty cash

custodian requests a check for NT$2,610. The fund contains
cash and petty cash receipts for postage NT$1,320, freight-out
NT$1,140, and miscellaneous expenses NT$150. The general
journal entry to record the check is:

Mar. 15 Postage Expense 1,320

Freight-Out 1,140
Miscellaneous Expense 150
Cash 2,610

7-41 LO 5
 ETHICS INSIGHT How Employees Steal
Occupational fraud is using your own occupation for personal gain through
the misuse or misapplication of the company’s resources or assets. This
type of fraud is one of three types:
1. Asset misappropriation, such as theft of cash on hand, fraudulent
disbursements, false refunds, ghost employees, personal purchases,
and fictitious employees. This fraud is the most common but the least
costly.
2. Corruption, such as bribery, illegal gratuities, and economic extortion.
This fraud generally falls in the middle between asset misappropriation
and financial statement fraud as regards frequency and cost.
3. Financial statement fraud, such as fictitious revenues, concealed
liabilities and expenses, improper disclosures, and improper asset
values. This fraud occurs less frequently than other types of fraud but
it is the most costly.

7-42
continued
 ETHICS INSIGHT How Employees Steal
The graph below shows the frequency and the median loss for each type
of occupational fraud. (Note that the sum of percentages exceeds 100%
because some cases of fraud involved more than one type.)

Source: 2014 Report to the Nations on Occupational Fraud and Abuse, Association
of Certified Fraud Examiners, pp. 10–12.

7-43
LO 5
 Control Features: Use of a Bank
Learning
Contributes to good internal control over cash. Objective 6
Indicate the
control features of
 Minimizes the amount of currency on hand. a bank account.

 Creates a double record of bank transactions.

 Bank reconciliation.

7-44 LO 6
 Making Bank Deposits
Illustration 7-8
Authorized employee Deposit slip

should make deposit.

Bank Code
Numbers

Front Side Reverse Side

7-45 LO 6
 Writing Checks

Written order signed by depositor directing bank to pay a

specified sum of money to a designated recipient.

Maker

Payee

Payer

Illustration 7-9
Check with remittance advice

7-46 LO 6
 Bank Statements Illustration 7-10
Bank statement

DEBIT
MEMORANDUM
 Bank service charge.
 NSF (not sufficient
funds).

CREDIT
MEMORANDUM
 Collect notes
receivable.
 Interest earned.
7-47 LO 6
 Reconciling the Bank Account
Learning
Reconcile balance per books and balance per Objective 7
Prepare a bank
bank to their adjusted (corrected) cash reconciliation.

balances.

Reconciling Items:
1. Deposits in transit.
Time Lags
2. Outstanding checks.

3. Bank memoranda.

4. Errors.

7-48 LO 7
 Reconciling the Bank Account

RECONCILIATION PROCEDURES Illustration 7-11

Bank reconciliation
adjustments

+ Deposit in Transit + Notes collected by bank

- Outstanding Checks - NSF (bounced) checks
+/- Bank Errors - Check printing or other
service charges
+/- Book Errors
CORRECT BALANCE CORRECT BALANCE

7-49 LO 7
 ENTRIES FROM BANK RECONCILIATION

COLLECTION OF NOTE RECEIVABLE: Assuming interest of

₤50 has not been accrued and collection fee of ₤15 is charged
to Miscellaneous Expense, the entry is:

Apr. 30

7-50 LO 7
 ENTRIES FROM BANK RECONCILIATION

COLLECTION OF NOTE RECEIVABLE: Assuming interest of

₤50 has not been accrued and collection fee of ₤15 is charged
to Miscellaneous Expense, the entry is:

Apr. 30 Cash 1,035.00

Miscellaneous Expense 15.00
Notes Receivable 1,000.00
Interest Revenue 50.00

7-51 LO 7
 ENTRIES FROM BANK RECONCILIATION

BOOK ERROR: The cash disbursements journal shows that

check no. 443 was a payment on account to Andrea Company,
a supplier. The correcting entry is:

Apr. 30

NSF CHECK: As indicated earlier, an NSF check becomes an

account receivable to the depositor. The entry is:

Apr. 30

7-52 LO 7
 ENTRIES FROM BANK RECONCILIATION

BOOK ERROR: The cash disbursements journal shows that

check no. 443 was a payment on account to Andrea Company,
a supplier. The correcting entry is:

Apr. 30 Cash 36.00

Accounts Payable 36.00

NSF CHECK: As indicated earlier, an NSF check becomes an

account receivable to the depositor. The entry is:

Apr. 30 Accounts Receivable 425.60

Cash 425.60
7-53 LO 7
 ENTRIES FROM BANK RECONCILIATION

Question
The reconciling item in a bank reconciliation that will result in
an adjusting entry by the depositor is:

a. outstanding checks.

b. deposit in transit.

c. a bank error.

d. bank service charges.

7-54 LO 7
 Electronic Funds Transfer (EFT) System

EFTs
 Are disbursement systems that use wire, telephone,
or computers to transfer cash from one location to
another.

 Use is quite common.

 Normally result in better internal control since no

cash or checks are handled by company employees.

7-55 LO 7
 INVESTOR INSIGHT Madoff’s Ponzi Scheme
No recent fraud has generated more interest and rage than the one perpetrated
by Bernard Madoff. Madoff was an elite New York investment fund manager
who was highly regarded by securities regulators. Investors flocked to him
because he delivered steady returns of between 10% and 15%, no matter
whether the market was going up or going down. However, for many years,
Madoff did not actually invest the cash that people gave to him. Instead, he was
running a Ponzi scheme: He paid returns to existing investors using cash
received from new investors. As long as the size of his investment fund
continued to grow from new investments at a rate that exceeded the amounts
that he needed to pay out in returns, Madoff was able to operate his fraud
smoothly. To conceal his misdeeds, Madoff fabricated false investment
statements that were provided to investors. In addition, Madoff hired an auditor
that never verified the accuracy of the investment records but automatically
issued unqualified opinions each year. A competing fund manager warned the
SEC a number of times over a nearly 10-year period that he thought Madoff
was engaged in fraud. The SEC never aggressively investigated the
allegations. Investors, many of which were charitable organizations, lost more
than $18 billion. Madoff was sentenced to a jail term of 150 years.

7-56
LO 7
 Reporting Cash
Learning
REPORTING CASH Objective 8
Explain the
reporting of cash.
 Cash consists of coins, currency, checks,
money orders, and money on hand or on deposit.

 Statement of financial position reports the amount of cash

available at a given point in time.

► Listed first in the current assets section.

► Includes cash on hand, cash in banks, and petty cash.

 Statement of cash flows shows the sources and uses of

cash during a period of time.

7-57 LO 8
 REPORTING CASH

Cash Equivalents
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.

Restricted Cash
Cash that is not available for general use but rather is
restricted for a special purpose.

7-58 LO 8
 REPORTING CASH

Illustration 7-14
Statement of financial position presentation of cash

7-59 LO 8
 REPORTING CASH

Question
Which of the following statements correctly describes the
reporting of cash?

a. Cash cannot be combined with cash equivalents.

b. Restricted cash funds may be combined with cash.

c. Cash is listed last in the current assets section.

d. Restricted cash funds cannot be reported as a

current asset.

7-60 LO 8
 > DO IT!
Indicate whether each of the following statements is true or false.
1. Cash and cash equivalents are comprised of coins,
currency (paper money), money orders, and NSF False
checks.
2. Restricted cash is classified as either a current asset
or noncurrent asset, depending on the circumstances.
True
3. A company may have a negative balance in its bank
account. In this case, it should offset this negative
balance against cash and cash equivalents on the
False
statement of financial position.
4. Because cash and cash equivalents often includes
short-term investments, accounts receivable should False
be reported as the last item on the statement of
7-61
financial position.
LO 8
 Copyright

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7-62