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Chapter 4

Internal Control & Cash

Short Exercises

(5 min.) S 4-1

Fraud is an intentional misrepresentation of facts, made for

the purpose of persuading another party to act in such a way

that causes injury or damage to that party.

The Three Components of the Fraud Triangle

1. Motive - Fraud generally results from either critical

need or greed on the part of the perpetrator. Regardless of

whether the driving force is need or greed most perpetrators

are driven to attempt to acquire something that belongs to

others.

2. Opportunity - The opportunity to commit fraud usually arises

through weak internal controls.

Chapter 4 Internal Control & Cash 274

3. Rationalization - The perpetrator(s) is (are) convinced, in

their own minds, that they deserve the object of the fraudulent

behavior. They may believe no one else will ever know or even

that everybody else is engaging in fraudulent behavior

Financial Accounting 8/e Solutions Manual275

(5-10 min.) S 4-2

COMPONENTS OF INTERNAL CONTROL

1. Control environment — Top managers must set the “tone at

the top” to establish a control environment.

2. Risk assessment — Each company must evaluate its own

risks, based upon its particular line of business.

3. Control procedures — Specific procedures are needed for a

good system of internal control.

4. Monitoring of controls — Auditors can monitor a company’s

actions and its financial statements.

5. Information system — Accurate information is essential for

success in business.

Student responses may vary for the descriptions.


(5-10 min.) S 4-3

Separation of duties is essential for safeguarding assets. The

person who has custody of an asset should not also account

for the asset. A person who performs both duties can steal the

asset and hide the theft by making a bogus entry in the

accounting records.

Student responses may vary.


(5-10 min.) S 4-4

There are several major internal control procedures as

discussed in the chapter besides separation of duties:

1. Smart hiring practices. The company should be careful to

hire both competent and honest personnel. Smart hiring

practices involve conducting background checks on job

applicants, as well as training and supervision on the job.

2. Comparisons and compliance monitoring. No person or

department should be allowed to completely process a

transaction from beginning to end without being checked by

another person or a computer program. Examples of

comparisons and compliance monitoring are the use of

operating and cash budgets. Also, in key functions, one

employee (or a computer program) double checks the work of

another for accuracy.

3. Adequate records help to assure that sufficient hard copy

documents or electronic information is kept by the entity to

support the validity of transactions that were processed.

Examples include sales invoices, purchase orders, shipping

records, and customer remittance advices. Among the benefits

of adequate records is the ability to provide an audit trail later


(Continued) S 4-4

for internal or external auditors to follow in auditing the entity’s

financial statements.

4. Limited access goes hand in hand with separation of duties

to assure that only authorized individuals are allowed access to

(a) the assets of the company, such as cash or inventory; and

(b) the records. Generally, only persons with custodial

responsibilities (such as the cashier or the warehouse) should

be allowed access to assets (such as cash or inventory). Only

persons with recordkeeping responsibilities (such as

accountants) should have access to the company’s journals

and ledgers.

5. Proper approvals. No transaction should be processed

without management’s general or specific approval. Generally,

the larger the transaction, the higher the organizational level of

approval necessary.

Notice that the first letters of these attributes spell the acronym

SCALP. That’s an easy and comprehensive way to remember

the control procedures involved in internal controls.


(10 min.) S4-5

A computer virus enters program code without your consent

and performs destructive action to your computer files or

programs.

A Trojan Horse is a malicious computer program that hides

inside a legitimate program and works like a virus to corrupt

your computer files or programs.

A phishing expedition can be a Web site that attracts visitors

who may be tricked into revealing their account numbers,

social security numbers, passwords, or other valuable data.

The creator of the Web site then uses the unsuspecting Web-

site visitors’ data to steal from them and for other illicit

purposes.


(20-30 min.) S 4-6

Cash is important not because of its amount as reported on

the balance sheet, but because of its effect on a business. All

transactions ultimately affect cash. Businesses purchase

assets and must pay cash. They make sales and collect cash.

All expenses ultimately require cash. Also, cash is

susceptible to theft because it is a medium of exchange.

These factors combine to give cash more importance than its

account balance would suggest.



(20-30 min.) S 4-7

Punching a hole through supporting documents reduces the

opportunity for fraud. Without this control procedure, a

dishonest employee could resubmit documents for payment

a second time. The employee could change the payee’s

address and have the check sent to an address the employee

controls. Or the employee could arrange to have the second

payee split the payment with the employee. Canceling the

documents makes it difficult to get approval for a duplicate

payment.



(10 min.) S 4-8

Randell Corp.Bank Reconciliation

October 31, 2010BANK BOOKS

Balance, October 31 $3,180 Balance, October 31 $2,400Add: Add:

Deposit in transit 200 Bank collection 530 3,380 Interest revenue 10

2,940Less:

Less: Service charge (20)Outstanding checks (500 ) NSF check (40 )

Adjusted bank balance $2,880 Adjusted book balance $2,880

Randell has cash of $2,880.

(5 min.) S 4-9

Aug. 31 Cash……………………………………….. 530Accounts Receivable………………... 530

Collection on account.

31 Cash……………………………………….. 10Interest Revenue……………………... 10

Interest earned on bank balance.

31 Miscellaneous Expense………………... 20Cash……………………………………. 20

Bank service charge.

31 Accounts Receivable…………………… 40Cash…………………………………….. 40

NSF check.


(5 min.) S 4-10

It appears that the employee has stolen $800 (adjusted book

balance, $4,800 − adjusted bank balance, $4,000). The adjusted

bank balance is the company’s true cash balance, and the

company books show more cash on hand. Therefore, the books

must be incorrect.

(5 min.) S 4-11

Stevens will notice a gap in the sequence of sales receipts for

the receipt that Cassidy destroyed. This knowledge will lead

Stevens to investigate what happened to the missing receipt

and what happened to the related cash.


(10 min.) S 4-12

1. Paying by check carries three controls over cash:

The check provides a record of the payment. The check must be signed by an authorized official. Before signing the check, the official should study the

evidence supporting the payment.

2. A dishonest purchasing agent could:

Purchase goods and have them delivered to his home or other location that he controls.

Approve payment by the company for goods that he spent too much on, and then split the excess with the supplier.

Companies avoid this internal control weakness by separating the following duties related to the purchase of, and payment for, goods:

purchasing goods receiving goods approving and paying for goods


(5 min.) S 4-13

A cash budget starts with the beginning cash balance, adds

budgeted cash receipts, and subtracts budgeted cash

payments. The result is cash available at the end of the period.

By comparing cash available to our budgeted cash balance, we

can see whether we have cash available for additional

investments, or if we’ll need new financing.



(5-10 min.) S 4-14

Crescent Artichoke GrowersCash Budget

Year 2010Millions

Cash balance, beginning $ 11Estimated cash receipts—total 104

115Estimated cash payments—total (93 )Cash available (needed) before new financing 22Budgeted cash balance needed (17 )Cash available for additional investments $ 5

(5 min.) S 4-15

Rourke should report the errors to Dunn because Dunn is

Rourke’s supervisor, and Dunn is responsible for the errors. If

Dunn fails to take action, then Rourke should report the errors

to the manager of the organization. In any event, outsiders who

are relying on Dublin Limited’s financial statements must be

made aware of the need to correct the reported net income

figure.


Exercises

Group A (5-20 min.) E 4-16A

a. Mason has access to the cash collected, and he also

prepares the cash report. With access to both items, Mason

can steal cash and falsify his cash report to conceal his theft.

b. Fleming prepares the purchase order and also receives the

goods. She can add some items to the purchase order and

have these extra items shipped to a location she controls.

When the goods come in, she checks the incoming

shipment, so there’s no outside party to learn of her

dishonesty.



(10 min.) E 4-17A

Cash payments:

a. Strong internal control. There is a good separation of duties.

Supervisors request equipment, and the home office

purchases the equipment.

b. Weak internal control. Supervisors both request, purchase,

and pay for equipment with little oversight by the home

office.

Cash receipts:

a. Weak internal control. The accountant both handles cash and

accounts for cash.

b. Strong internal control. There is a good separation of duties.

Different people handle cash and account for cash.


(10 min.) E 4-18A

To prevent Flynn’s embezzlement, Downtown Kalamazoo’s

board of directors could have:

a. Not permitted Flynn to write Downtown Kalamazoo

Checks. Instead, appoint a board member to write the

checks.

b. Not permitted Flynn to receive cash that came to

Downtown Kalamazoo. Have cash sent to a lock box at the

bank and appoint a board member to get the cash from the

lock box.

c. Supervised Flynn’s work by examining Downtown

Kalamazoo’s documents such as paid checks.

d. Had an audit of Downtown Kalamazoo’s transactions and




(5-10 min.) E 4-19A

1. b 5. d

2. b 6. c

3. d 7. c

4. a

(10-20 min.) E 4-20A

J. D. HunterBank Reconciliation

June 30, 2010BANK: Balance, June 30 $ 399 Add: Deposit in transit 1,210 Less: Outstanding checks: Check No. 626 $ 85 627 285 (370 ) Adjusted bank balance $1,239

BOOKS: Balance, June 30 $1,287 Less: Correction of book error — Recorded $86 check as $68 $ 18 NSF check 20 Service charge 10 (48 ) Adjusted book balance $1,239


(10-20 min.) E 4-21A

Evan RootBank Reconciliation

April 30, 2010BANK: Balance, April 30 $ 565 Add: Deposit in transit 1,790 2,355 Less: Outstanding checks (602 ) Adjusted bank balance $1,753

BOOKS: Balance, April 30 $1,827 Add: EFT collection — rent 320

2,147 Less: Service charge $ 7 NSF checks 115 Charge for printed checks 11 Correction of book error — recorded $290 check as $29 261 (394 Adjusted book balance $1,753

Root’s actual cash balance is $1,753


(10-15 min.) E 4-22A

JournalDATE ACCOUNT TITLES AND EXPLANATION DEBIT CREDIT

Apr 30 Cash……………………………………. 320Rent Revenue……………………… 320

EFT collection of rent.

30 Miscellaneous Expense ($7 + $11)... 18 Cash ………………………………. 18Bank service charge and chargefor printed checks.

30 Accounts Receivable………………... 115 Cash ………………………………. 115NSF checks returned by bank.

30 Salary Expense ($290 − $29)……….. 261 Cash ………………………………. 261Correction of book error.


(10-15 min.) E 4-23A

TO: Store Manager

FROM: Student

SUBJECT: Evaluation of internal control and plan for improvement

There is a weakness in internal control over cash receipts. The

cash registers do not keep a record of sales. With no record,

there is no way to determine how much cash should be in the

cash drawer. This omission makes it easy for the cashier to

steal cash and not get caught.

To improve internal control, the company should use cash

registers that record each sale. The manager can prove the

amount of cash in the cash drawer against this recorded

amount.


(10-15 min.) E 4-24A

The main internal control weakness is that the payroll

department both prepares and distributes the paychecks. With

both duties, a dishonest person in the payroll department can

create a time sheet for a fictitious employee and then keep the

related paycheck after the treasurer returns the signed checks

to the payroll department.

To correct this weakness, Green Grass Golf should have

someone other than the payroll department or the shop

foreman distribute paychecks to employees. For example, the

human resources department, which has no control over the

time sheets or the paychecks, could distribute paychecks to

the workers.


(20-30 min.) E 4-25A

Cole Communications, Inc.Cash Budget

Year Ended December 31, 2011Millions

Cash balance, December 31, 2010 $ 86

Budgeted cash receipts:

Collections from customers 11,305

Sale of assets 118

11,509

Budgeted cash payments:

Payments for cost of

services and products $6,167

Payments of operating expenses 2,544

Investment in equipment 1,826

Payment of debt 603

Payment of dividends 347 11,487

Cash available (needed) before financing 22

Budgeted cash balance, December 31, 2011 (82 )

Cash available for additional investments, or

(New financing needed) $ (60 )

Cole Communications expects to need new financing of $60

million during 2011.


(10 min.) E 4-26A

Actual Interest paideffective

=each year

=$14,000,000 × .077

=$1,078,000

interest rate Amount actually borrowed

$14,000,000 − $14,000,000(.057)

$13,202,000

= 8.17%


Exercises

Group B

(5-20 min.) E 4-27B

a. Monroe has access to the cash collected, and he also

prepares the cash report. With access to both items, Monroe

can steal cash and falsify his cash report to conceal his theft.

b. Adams prepares the purchase order and also receives the

goods. She can add some items to the purchase order and

have these extra items shipped to a location she controls.

When the goods come in, she checks the incoming

shipment, so there’s no outside party to learn of her

dishonesty.



(10 min.) E 4-28B

Cash payments:

a. Strong internal control. There is a good separation of duties.

Supervisors request equipment, and the home office

purchases the equipment.

b. Weak internal control. Supervisors both request, purchase,

and pay for equipment with little oversight by the home

office.

Cash receipts:

a. Weak internal control. The accountant both handles cash and

accounts for cash.

b. Strong internal control. There is a good separation of duties.

Different people handle cash and account for cash.


(10 min.) E 4-29B

To prevent Smith’s embezzlement, Downtown Scanlon’s

board of directors could have:

a. Not permitted Smith to write Downtown Scanlon checks.

Instead, appoint a board member to write the checks.

b. Not permitted Smith to receive cash that came to

Downtown Scanlon. Have cash sent to a lock box at the

bank and appoint a board member to get the cash from the

lock box.

c. Supervised Smith’s work by examining Downtown

Scanlon’s documents such as paid checks.

d. Had an audit of Downtown Scanlon’s transactions and




(5-10 min.) E 4-30B

1. b 5. d

2. b 6. c

3. d 7. c

4. a

(10-20 min.) E 4-31B

J. D. HillBank ReconciliationFebruary 28, 2010

BANK: Balance, February 28 $ 383 Add: Deposit in transit 1,215 Less: Outstanding checks: Check No. 626 $ 85 627 275 (360 ) Adjusted bank balance $1,238

BOOKS: Balance, February 28 $1,282 Less: Correction of book error — Recorded $87 check as $78 $ 9 NSF check 20 Service charge 15 (44 ) Adjusted book balance $1,238


(10-20 min.) E 4-32B

Harry SmithBank ReconciliationSeptember 30, 2010

BANK: Balance, September 30 $ 545 Add: Deposit in transit 1,790 2,335 Less: Outstanding checks (609 ) Adjusted bank balance $1,726

BOOKS: Balance, September 30 $1,823 Add: EFT collection — rent 325

2,148 Less: Service charge $ 8 NSF checks 125 Charge for printed checks 10 Correction of book error — recorded $310 check as $31 279 (422 ) Adjusted book balance $1,726

Smith’s actual cash balance is $1,726


(10-15 min.) E 4-33B


May 31 Cash……………………………………. 325Rent Revenue……………………… 325

EFT collection of rent.

31 Miscellaneous Expense ($8 + $10)... 18 Cash ………………………………. 18Bank service charge and chargefor printed checks.

31 Accounts Receivable………………... 125 Cash ………………………………. 125NSF checks returned by bank.

31 Salary Expense ($310 − $31)……….. 279 Cash ………………………………. 279Correction of book error.


(10-15 min.) E 4-34B

TO: Store Manager

FROM: Student

SUBJECT: Evaluation of internal control and plan for improvement

There is a weakness in internal control over cash receipts. The

cash registers do not keep a record of sales. With no record,

there is no way to determine how much cash should be in the

cash drawer. This omission makes it easy for the cashier to

steal cash and not get caught.

To improve internal control, the company should use cash

registers that record each sale. The manager can prove the

amount of cash in the cash drawer against this recorded

amount.


(10-15 min.) E 4-35B

The main internal control weakness is that the payroll

department both prepares and distributes the paychecks. With

both duties, a dishonest person in the payroll department can

create a time sheet for a fictitious employee and then keep the

related paycheck after the treasurer returns the signed checks

to the payroll department.

To correct this weakness, Beautiful Meadows Golf should have

someone other than the payroll department or the shop

foreman distribute paychecks to employees. For example, the

human resources department, which has no control over the

time sheets or the paychecks, could distribute paychecks to

the workers.


(20-30 min.) E 4-36B

Fallon Communications, Inc.Cash Budget

Year Ended December 31, 2011Millions




Sale of assets 121

11,510


Payments for cost of

services and products $6,174

Payments of operating expenses 2,545

Investment in equipment 1,831

Payment of debt 604


Cash available (needed) before financing 15



(New financing needed) $ (66 )

Fallon expects to need new financing of $66 million during

2011.


(10 min.) E 4-37B

Actual Interest paideffective

=each year

=$19,000,000 × .071

=$1,349,000

interest rate Amount actually borrowed

$19,000,000 − $19,000,000(.058)

$17,898,000

= 7.54%


Challenge Exercises

(15-25 min.) E 4-38

Owens could be: Healey could investigate by:

1. Writing business checks to herself.

1. Performing the bank reconciliation and examining all checks written by the business.

2. Submitting purchase invoices a second time for duplicate payment, perhaps altering the mailing address on the duplicate invoice and sending the check to a post office box that Owens controls.

2. Examining purchase invoices for authenticity and comparing invoices to receiving reports to determine that the business received all goods it paid for.

Any invoice with a hole indicates it was paid earlier.

Calling the suppliers directly to inquire about any questionable invoices.

3. Paying suppliers excess amounts and arranging for suppliers to kick back part of the excess to Owens.

3. Comparing the business’s ratio of cost of goods sold to retail selling price to the cost-to-retail ratio in the past. A kickback scheme would show up in higher cost figures and a lower profit percentage.

4. Making small cash payments to herself.

4. Examining all cash records and comparing the records to actual quantities of supplies and other items needed by the business.



(20-30 min.) E 4-39

Req. 1

The Furniture Mart, Inc.Cash Budget

Year Ended December 31, 2010Thousands




Issuance of stock 647

22,577


Purchases of inventory items $14,545

Payment of operating expenses 2,349

Purchase of property and equipment 1,528

Payment of long-term and short-term debt 980


Cash available (shortage) before financing 2,858


Cash available for additional investments $ 2,728


(continued) E 4-39

Req. 2

Current ratio =Total current assets

=$7,976

= 1.87Total current liabilities $4,260

Debt ratio =Total liabilities

=$11,088

= 0.50Total assets $22,377

I would lend $100 thousand to The Furniture Mart because the

company’s ratio values are strong. Also, the cash budget

indicates strong cash flows during 2010.


Quiz

Q4-40 bQ4-41 aQ4-42 dQ4-43 dQ4-44 dQ4-45 bQ4-46 bQ4-47 cQ4-48 dQ4-49 dQ4-50 dQ4-51 c ($6,000 + $83,000 − $36,000 − $26,000 − $19,000

− $15,000 = − $7,000; arrange financing for this amount.)


Problems

Group A

(15-20 min.) P 4-52A

The internal control weaknesses in Celtic Import’s system are:

1. McNicholas controls the content of the invoices. With no supervision of her work, McNicholas could have the suppliers overstate their prices and then arrange to have them split the excess with her after Celtic Import pays the invoices.

2. Sweeney has both cash handling and accounting duties.

With both responsibilities, Sweeney could steal incoming cash and cover her theft by manipulating the accounting records.

As with all small businesses, the key to effective internal control is more owner involvement. Sullivan could:

1. Make the purchase and pay arrangements with the Irish artisans who supply Celtic Import’s products. Let McNicholas keep locating new products, but don’t let her arrange for the purchases and payment.

2. Sullivan could assign either cash handling or accounting duties to Sweeney and then hire someone else to do the other (accounting or cash-handling) duties. Also Sullivan needs to perform the bank reconciliation to keep her eye on cash receipts and cash payments.


(10-20 min.) P 4-53A

Requirement 1 Requirement 2 Requirement 3Missing Internal

Control Characteristic Possible Problem Solution

a. Separation of duties

Theft of diamonds — the purchasing agent could have diamonds sent to a location he controls.

Separate purchasing, approval, and check-signing duties.

b. Assignment of responsibility

Lost revenue because too many employees are managing the office and neglecting their duties.

Assign a single employee to manage the office when the owner is absent.

c. Separation of duties

Theft of cash. Separate accounting and cash-handling duties.


(20-30 min.) P 4-54A

Req. 1

Dunlap AutomotiveBank Reconciliation

July 31, 2010BANK: Balance, June 30, 2010 $10,379 Add: Deposits in transit ($924 + $2,008) 2,932

13,311 Less: Outstanding checks — Check No. 3119 $ 440 3120 965 3121 205 3122 2,260 (3,870 )Adjusted bank balance, July 31, 2010 $ 9,441

BOOKS: Balance, June 30, 2010 $ 7,937 Add: EFT collection of rent $ 750

Bank collection of note receivable 1,250Book error — $1,360 check recorded as $1,630 270 2,270

10,207 Less: EFT payment of insurance $ 334 Unauthorized signature check 407 Service charge 25 (766 ) Adjusted book balance, July 31, 2010 $ 9,441


(continued) P 4-54A

Req. 2

A bank account helps control cash by providing a place for

safekeeping. The bank also provides a detailed list of the

company’s cash transactions that managers can compare to

the company’s own cash records and thereby correct any book

errors quickly.

The bank reconciliation helps control cash by ensuring that the

company accounts for its cash transactions correctly and that

the bank and book records of cash are correct. Also, the bank

reconciliation establishes the balance of cash to report on the

balance sheet.


(20-30 min.) P 4-55A

Req. 1

Dickson Engineering AssociatesBank Reconciliation

August 31, 2010BANK: Balance, August 31 $8,879.24

Add: Deposit of August 31 in transit 383 .54

9,262.78

Less: Outstanding checks ($401.00 +

$74.82 + $33.25 + $165.55 +

$236.00 + $47.75 + $107.85) $1,066.22

Correction of bank error, which

credited our account for the

deposit of another company 398 .00 (1,464 .22 )

Adjusted bank balance, August 31 $7,798 .56

BOOKS:

Balance, August 31 $8,152.71

Add: Interest revenue earned on bank

balance $ 15.85

Bank collection of account receivable 899 .15 915.00

9,067.71

Less: EFT (utilities $730, insurance $280) $1,010.00

Service charge 5.50

Returned check due to unauthorized

signature 185.50

NSF check 68 .15 (1,269.15 )

Adjusted book balance, August 31 $7,798 .56


(continued) P 4-55A

Req. 2 (entries based on the reconciliation)


May 31 Cash………………………………………………… 15.85

Interest Revenue………………………………. 15.85

Interest earned on bank balance.

31 Cash………………………………………………… 899.15

Accounts Receivable…………………………. 899.15

Account receivable collected by bank.

31 Utilities Expense………………………………….. 730.00

Cash……………………………………………... 730.00

Monthly utilities.

31 Insurance Expense………………………………. 280.00

Cash……………………………………………... 280.00

Monthly insurance.

31 Miscellaneous Expense…………………………. 5.50

Cash……………………………………………... 5.50


31 Accounts Receivable ($185.50 + $68.15)…… 253.65

Cash……………………………………………... 253.65

NSF customer checks returned by bank.


(10-15 min.) P 4-56A

TO: President, Sun Skin Care

FROM: Concerned Employee

It is unwise to have the employee who opens the mail also

grant allowances to customers. Suppose a customer pays an

invoice in full. The mailroom employee can steal the customer

check and grant an allowance to cover the theft. To correct this

internal control weakness, deny the mailroom employee access

to all accounting records. Also, appoint a separate employee to

grant allowances to customers.

Notes:

1. Student responses may vary.

2. The mailroom employee obviously has access to the

accounting records—to know that a customer has paid

less than the full amount.

3. It may be necessary to explain to students that the

mailroom employee must forge the company endorsement

on customer checks stolen. This person must also open—

and control—a bank account in the company’s name. This

may be quite easy.


(30-45 min.) P 4-57A

Req. 1

Jasper WirelessCash Budget

2011Thousands

Cash balance, beginning $ 1,500

Budgeted cash receipts: Collections from customers ($64,000 × 1.10) 70,400 Receipt of interest 300

72,200Budgeted cash payments: Purchases of inventory ($49,000 × 1.20) $58,800 Operating expenses 13,500 Purchases of equipment 4,800

Payment of dividends 300 Purchases of investments 400 Payment of long-term debt 400 (78,200 )Cash available (needed) before financing $ (6,000)Budgeted cash balance, ending (3,800 )Cash available for additional investments, or

(New financing needed) $ (9,800 )


(continued) P 4-57A

Req. 2

Jasper Wireless appears to be growing. The company expects

a 10% increase in collections from customers and a 20%

increase in the purchases of inventory. It is also continuing to

invest in new equipment, with no sales of long-term assets.


Problems

Group B (15-20 min.) P 4-58B

The internal control weaknesses in International Import’s system are:

1. Walsh controls the content of the invoices. With no supervision of her work, Walsh could have the suppliers overstate their prices and then arrange to have them split the excess with her after International Import pays the invoices.

2. Durkin has both cash handling and accounting duties. With both responsibilities, Durkin could steal incoming cash and cover her theft by manipulating the accounting records.

As with all small businesses, they key to effective internal controls is more owner involvement. Spencer could:

1. Make the purchase and pay arrangements with the French artisans who supply International Import’s products. Let Walsh keep locating new products, but don’t let her arrange for the purchases and payment.

2. Spencer could assign either cash handling or accounting duties to Durkin and then hire someone else to do the other (accounting or cash-handling) duties. Also Spencer needs to perform the bank reconciliation to keep her eye on cash receipts and cash payments.


(10-20 min.) P 4-59B

Requirement 1 Requirement 2 Requirement 3Missing Internal

Control Characteristic Possible Problem Solution

a. Separation of duties

Theft of cash by the purchasing agent.

Have a manager, not the purchasing agent approve invoices for payment and sign the checks

b. Assignment of responsibilities

Lost revenue due to delay of architectural drawings.

Assign one senior architect to fulfill management duties while White is absent. Other senior architect should focus on producing architectural drawings.

c. Separation of duties

Theft of cash. Keep accounting and cash handling duties separate.


(20-30 min.) P 4-60B

Req. 1

Donald AutomotiveBank Reconciliation

January 31, 2010BANK: Balance, January 31, 2010 $ 8,817 Add: Deposits of January 29 & 30 in transit 2,909

11,726 Less: Outstanding checks Check No. 3119 $ 493 3120 985 13121 219 3122 2,322 (4,019 )Adjusted bank balance, January 31, 2010 $ 7,707

BOOKS: Balance, January 31, 2010 $ 6,344 Add: EFT collection of rent $ 650 Bank collection of note receivable 1,350 Book error — $1,350 check recorded 180 2,180 as $1,530 8,524

Less: NSF check $ 466 EFT payment of insurance 331 Service charge 20 (817 ) Adjusted book balance, January 31, 2010 $ 7,707


(continued) P 4-60B

Req. 2

A bank account helps control cash by providing a place for

safekeeping. The bank also provides a detailed list of the

company’s cash transactions that Donald Automotive

managers can compare to the company’s own cash records

and thus correct any book errors quickly.

The bank reconciliation helps control cash by ensuring that the

company accounts for its cash transactions correctly and that

the bank and book records of cash are correct. Also, the bank

reconciliation establishes the balance of cash to report on the

balance sheet.


(20-30 min.) P 4-61B

Req. 1

Dunlap Engineering AssociatesBank Reconciliation

October 31, 2010BANK: Balance, October 31 $8,343.87 Add: Deposit of October 31 in transit $380.50 $380 .50

$8,724.37

Less: Outstanding checks ($403.15 + $78.98 + $36.39 + $155.45 + $234.00 + $47.50 + $106.79) 1,062.26 Correction of bank error — credited our account for the deposit of another company 405 .00 (1,467.26) Adjusted bank balance, October 31 $7,257 .11

BOOKS: Balance, October 31 $7,605.86 Add: Bank collection on account $915.20 Interest revenue on bank balance 15 .45 930 .65

8,536.51 Less: Service charge $ 6.25 EFT Payment of utility bill 770.00 EFT Payment of insurance bill 250.00

NSF check 67.65 Returned item due to unauthorized signature 185 .50 (1,279 .40 )Adjusted book balance, October 31 $7,257 .11


(continued) P 4-61B

Req. 2 (entries based on the reconciliation)


Jan. 31 Cash…………………………………………... 915.20 Accounts Receivable………..………… 915.20Accounts Receivable collected by bank.

31 Cash…………………………………………... 15.45 Interest Revenue………………………... 15.45Interest earned on bank balance.

31 Utility Expense …………………………..… 770.00 Prepaid Insurance …………………...…… 250.00 Cash ……………………………………… 1,020.00EFT payments

31 Miscellaneous Expense…………………… 6.25Cash……………………………………….. 6.25


31 Accounts Receivable ($67.65 + $185.50).. 253.15 Cash………………………………………… 253.15NSF customer checks returned by bank.


(10-15 min.) P 4-62B

TO: President, Flawless Skin Care

FROM: Concerned Employee

It is unwise to have the employee who opens the mail also

grant allowances to customers. Suppose a customer pays an

invoice in full. The mailroom employee can steal the customer

check and grant an allowance to cover the theft. To correct this

internal control weakness, deny the mailroom employee access

to all accounting records. Also, appoint a separate employee to

grant allowances to customers.

Notes:

1. Student responses may vary.

2. The mailroom employee obviously has access to the

accounting records — to know that a customer has paid

less than the full amount.

3. It may be necessary to explain to students that the

mailroom employee must forge the company endorsement

on customer checks stolen. This person must also open —

and control — a bank account in the company’s name.

This may be quite easy.


(30-45 min.) P 4-63B

Req. 1

Carvel WirelessCash Budget

2011

Cash balance, beginning $ 1,900


Collections from customers ($62,000 × 1.14) 70,680

Receipt of interest 700

73,280


Purchases of inventory ($47,000 × 1.25) $58,750

Operating expenses 13,700

Purchase of property and equipment 4,100

Purchases of investments 300

Payment of dividends 400

Payments of long-term debt 500 77,750

Cash available (needed) before financing (4,470)

Budgeted cash balance, ending (3,550 )


(New financing needed) $ (8,020 )


(continued) P 4-63B

Req. 2

Carvel Wireless appears to be growing. The company expects a

14% increase in collections from customers and a 25% increase

in purchases of inventory. It is maintaining its purchases of

property and equipment, with no sales of long-term assets.


Decision Cases

(20-30 min.) Decision Case 1

Environmental Concerns, Inc.Bank ReconciliationSeptember 30, 2010

BANK:Balance, September 30 $ 8,224

Add: Deposit of September 30 in transit 3,794

12,018

Less: Outstanding checks ($116 + $150 +

$853 + $990 + $206 + $145) (2,460 )

Adjusted bank balance, September 30 $ 9,558

BOOKS:

Balance, September 30 $10,402

Add: Bank collection 200

10,602

Less: Service charge $ 8

NSF check 36 (44 )

Adjusted book balance, September 30 $10,558

Based on the above reconciliation, it appears the bookkeeper has stolen $1,000, the difference between the adjusted bank and book amounts ($9,558 − $10,558). He understated the total of outstanding checks by $1,000 to cover his theft.

Benz should assign an employee with no cash-handling duties to prepare the bank reconciliation. The bookkeeper should not perform this duty, because a person who handles cash and also prepares the reconciliation can steal cash and manipulate


Adjustedbalancesdo notagree.

the reconciliation to cover the theft. Perhaps Benz should prepare the reconciliation himself.


(15-30 min.) Decision Case 2

The internal control weakness in this case is a lack of

separation of duties. The foreman performs too many duties.

1. The foreman hires the workers.

2. The foreman controls workers’ employment documents.

3. The foreman fills out workers’ time sheets and transmits

all documents to the home office.

4. The foreman passes out paychecks to workers.

5. The workers never go to the home office, so home-office

personnel do not even know whether all workers exist.

The foreman could steal from the company as follows:

1. The foreman could enter a fictitious worker into the payroll

system and fill out bogus time sheets for the fictitious

employee. Then the foreman could pocket the pay check

written to the employee.

2. The foreman could enter more time than actually worked

by an employee and arrange to split the extra pay received

by the worker.

3. The foreman could pad his own hours to receive pay for

time that he did not work.


(continued) Decision Case 2

The following actions will correct the internal control

weakness:

1. The home office could have the construction workers

come to the office for processing their employee

documents. Then home office would at least know that all

the workers exist.

2. Have employees sign their own time sheets.

3. Have a home-office employee compare signatures on the

workers’ time sheets to their signatures on file and,

occasionally, to their endorsements on the backs of their

paychecks.

4. Occasionally — or always — have a home-office employee

go to the construction site to pass out paychecks.

5. Have a home-office employee go to the construction site

occasionally to “take attendance” of workers on duty that

day. Then match the names of workers on duty to the time

sheets turned in at the end of the week.


Ethical Issue 1

1. Identify the ethical issue. You must decide whether it is

ethical for the auditor not to require the bank to record the

loss.

2. What are the alternatives? Require the client to record the

loss, or permit the client not to record the loss.

3. Identify the stakeholders. The auditor, the bank, and the

public at large can be affected. The auditor’s reputation is on

the line. The bank’s financial statements are in question. The

public can be affected if the bank issues financial statements

that include erroneous amounts.

Assess the possible outcomes. If the auditors require the

bank to record the loss, the auditor will keep its reputation

intact. But the auditor will lose the client and also lose the

revenue from this large audit. The accounting firm may then

be unable to expand the firm as it had hoped to do.

(continued on next page)


(continued) Ethical Issues

If the auditors okay the bank’s financial statements even

after the bank did not record the loss, the auditor would keep

the bank as a client, earn the audit revenue, and be able to

expand the firm as planned. But the bank’s financial

statements would report erroneous amounts for the notes

receivable. People relying on the bank’s financial statements

may suffer losses as a result. The accounting firm’s

reputation would be hurt.

4. Make the decision. The auditor should require the bank to

record the loss even if that means losing the bank as a client.

By sticking to its belief that the bank should record the loss,

the auditors’ reputation will not be harmed as it would by

okaying financial statements that include errors. It’s far

better to lose a client than to lose your reputation.

(continued on next page)



Ethical Issue 2

1. Identify the ethical issue. Galvin’s ethical issue is whether to

use his knowledge of The Salvation Army’s plans and of

Nadar’s situation to either party’s advantage (or

disadvantage). Should Galvin help The Salvation Army buy

the land at the lowest price? Should he help Nadar sell the

land at the highest price? Galvin’s position presents him with

a conflict of interest.

2. What are the alternatives? There are several:

(a) Let other members of the Salvation Army board of

directors know of Nadar’s situation in order to help The

Salvation Army buy the land at a bargain price.

(b) Disclose Nadar’s situation to fellow board members and

insist that The Salvation Army pay market price ($2.2

million) for the land.

(c) Advise Nadar of The Salvation Army’s plans and

encourage her to hold out for a high price on the sale of

the land.

(d) Reveal nothing to The Salvation Army’s board or to

Nadar and take no part in the negotiation between the

two parties.


(e) Take a temporary leave of absence from The Salvation

Army board for unspecified “personal reasons.”

3. Identify the stakeholders involved. Galvin, The Salvation

Army, Nadar, and Community Banks.

Assess the possible consequences. Disclosing Nadar’s

weakened condition to The Salvation Army board may help

The Salvation Army buy the land at a low price, depending on

the ethical bearing of fellow board members. This would help

The Salvation Army and hurt Nadar, relative to her ability to

sell the land at market value of $2.2 million. Insisting that The

Salvation Army offer market price for the land would seem

fair to both parties, but that would betray the trust of Nadar.

And it may or may not sway the board to go along with a $2.2

million offer for the land.

Making Nadar aware of The Salvation Army’s plans may help

Nadar get a higher price for the land than she would get

otherwise. This would betray the trust of other members of

The Salvation Army’s board.

Remaining silent would preserve Galvin’s integrity. However,

if either The Salvation Army or Nadar ever learned of Galvin’s


relationship with the other party, they would wonder whether

Galvin used the information against them.

Taking a temporary leave of absence would preserve

Galvin’s integrity and remove him from the conflict of

interest. It would also preserve Galvin’s reputation for

fairness and the reputation of Community Bank for keeping

depositor information confidential.

4. Make the decision. The authors would take the leave of

absence and hope other Salvation Army board members do

not probe Galvin’s “personal reasons.” This way neither The

Salvation Army nor Nadar can accuse Galvin of using inside

information to the advantage of the other party.



Ethical Issue 3

1. Identify the ethical issue. French’s ethical issue is whether to

tell IMS personnel about Snicker Foods’ possible bankruptcy.

2. What are the alternatives?

(a) Keep quiet and let nature take its course, or

(b) Tell IMS’s top managers of Snicker’s possible

bankruptcy.

3. Identify the stakeholders involved. IMS, Snicker Foods,

Community Bank, and everyone connected to these

organizations — owners, employees, creditors, depositors,

and their communities.

Assess the possible consequences. Telling IMS about

Snicker’s possible bankruptcy may help IMS avoid wasted

effort on Snicker. This may enable IMS to seek more

profitable ventures and aid IMS’s recovery. In turn, this may

help IMS pay its loan to Community Bank.


4. Make the decision. French should not tell IMS of Snicker’s

financial difficulties (after all, Snicker isn’t bankrupt yet).

French should let nature take its course. Then she will

protect the bank’s (and her own) reputation for keeping client

information confidential. In her aiding IMS through the loan-

restructuring process, French may try to help IMS find other

customers that can take up the slack if the sale to Snicker

doesn’t go through.


Focus on Financials: Amazon.com, Inc.

(20-30 min.)

Req. 1

(All amounts in millions)

Bank Books

Balance, Dec. 31, 2008 $324 Balance, Dec. 31, 2008 $316+ Deposit in transit 3 + Interest earned 1− Outstanding checks (8) + Bank collections 2

Adjusted bank balance $319 Adjusted book balance $319

The adjusted balance ($319 million) agrees with the amount

reported for cash and cash equivalents on Amazon.Com, Inc.’s

December 31, 2008 Consolidated Balance Sheet.

Req. 2

Paragraph 2, Item 9A of Note 14 to Amazon.com, Inc.’s

Consolidated Financial Statements Note Amazon.Com’s

management states that:

Management is responsible for establishing and maintaining

adequate internal control over financial reporting….

Management has assessed the effectiveness of our internal

over financial reporting as of December 31, 2008…As a result,

management has concluded that our internal control over


financial reporting was effective in providing assurance

regarding the reliability of financial reporting and the

preparation of financial statements…in accordance with GAAP.

Ernst & Young has independently assessed the effectiveness

of our internal control over financial reporting and its report is

included below.

The statement mentions internal control, reliability of

financial reporting, and the fact that the internal control system

has been independently assessed by the company’s external

independent auditors, Ernst & Young.


Focus on Analysis: Foot Locker, Inc.

(20-30 min.)

Req. 1

The seven largest items affecting case are:

1. Sales of short-term investments, which provided $1,620

million, in the investing section.

2. Purchases of short-term investments, which used

$1,378 million, in the investing section.

3. Depreciation and amortization, which provided $166

million. Actually, these are expenses that do not use

cash, so they are added back to income to arrive at cash

provided by operations.

4. Capital expenditures, which used $148 million, in the

investing section

5. Reduction in deferred income taxes, which used $129

million, in the operating section.

6. Non-cash impairment charges and store closing

program costs, $124 million. Again, these are expenses

that do not use cash, so they are added back to net

income to arrive at cash provided by operations.

7. Payment of cash dividends, $77 million, in the financing

section.


(continued) Focus on Analysis: Foot Locker, Inc.

Req. 2

Objectives ofReport of Management States: Internal Control

“The company maintains a system of internal controls designed to provide reasonable assurance, at appropriate cost, that assets are safeguarded, transactions are executed in accordance with management’s authorization, and the accounting records provide a reliable basis for the preparation of financial statements.”

1. Safeguard assets2. Encourage

employees to follow company policy

3. Ensure accurate, reliable accounting records


Group Project

Student responses will vary.


hhtfa8e ch04 sm

Documents

components of internal

control environment

accounting records

separation of duties

shipping records

weak internal controls

continued s

benefits of adequate