Chapter 16 PPT

1.
Describe the internal control over the major

components of assets of a business enterprise
namely
a. Cash
Expected b. Financial Investments
Learning c. Receivables: Accounts and Notes and related

revenue accounts.
Outcomes: d. Inventories and related Cost of Goods Sold
e. Property, Plant and Equipment
2. Understand the potential misstatements (due to

fraud and errors) of the asset accounts and how
weakness in internal control increases the risks
misstatements.
INTERNAL CONTROL OVER
CASH TRANSACTIONS
Cash handling are the responsibility of the nance department,
under the direcon of the treasurer.
Ideally, the funcons of the nance department and the accounng
department should be integrated in a manner that provides
1. All cash that should have been received was in fact received,
recorded accurately and deposited promptly.
2. Cash disbursements have been made for authorized
purposes only and have been properly recorded.
3. Cash balances are maintained at adequate, but not
excessive, levels by forecasng expected cash receipts and
payments related to normal operaons.
Guidelines for achieving internal control over cash:
1) Do not permit any one employee to handle a transacon from
beginning to end.
2) Separate cash handling from record keeping.
3) Centralize receiving of cash to the extent praccal.
4) Record cash receipts on a mely basis.
5) Encourage customers to obtain receipts and observe cash register

totals.
Guidelines for achieving internal control over cash:
6) Deposit cash receipts daily.
7) Make all disbursements by check or electronic funds transfer, with the

excepon of small expenditures from pe0y cash.
8) Have monthly bank reconciliaon prepared by employees not

responsible for issuance of checks or custody of cash. The completed
reconciliaon should be reviewed promptly by an appropriate o4cial.
9) Monitor cash receipts and disbursements by comparing recorded

amounts to forecasted amounts and invesng variances from forecasted
amounts.
Potenal Misstatements – Cash Receipts
Internal Control Weakness or

Descripon of Examples Factors that Increase the Risk
Misstatement of the Misstatement
Recording Fraud:
cous cash • Overstang cash receipts on the • Lack of segregaon of dues of
receipts books by transferring cash the funcons of access to cash
between bank accounts and record keeping; no eecve
without appropriate recording review of bank reconciliaons.
of the transfer to cover up an
embezzlement of cash.

Descripon of Examples Factors that Increase the Risk
Misstatement of the Misstatement
Failure to record Fraud:

receipts from • A cashier fails to ring up and • Inadequate supervision of
cash sales record cash sales and cashiers; failure to encourage
embezzles the cash. customers to obtain cash
receipts.
Error:
• A bookkeeper accidentally • Inadequate controls for
omits the recording of the reconciling cash register tapes
receipts from one cash register and accounng records;
for the day. inadequate controls for
reconciling bank accounts.
Descripon of Examples Factors that Increase the Risk of the
Misstatement Misstatement
Failure to record Fraud:

cash from • A cashier embezzles cash payments by • Lack of segregaon of dues
customers on receivables, without between personnel who have access
collecon of recording the recipients in the to cash receipts and those who
accounts customer’s accounts. make entries into the accounts
receivable • A bookkeeper accidentally who has receivable records.
access to cash receipts embezzles cash
collected from customers and writes
o the related receivables.
Error:
• A bookkeeper accidentally fails to • Inadequate reconciliaons of subsidiary
record payment on a receivable. records of accounts receivable with the
general ledger control account.
Early (late) Fraud:

recognion of • Holding the cash receipts • Ineecve board of directors,
cash receipts – journal open to record next audit commi0ee, or internal
year’s cash receipts as having audit funcon; “tone at the top”
“cuto problems” not conducve to ethical
occurred in this year.
conduct; undue pressure to
Error: show improved nancial
• Recording cash receipts based posion.
on bad informaon about date
of receipt. • Failure to list and deposit cash
receipts on a mely basis.
Potenal Misstatements – Cash Disbursements
Internal Control Weakness or Factors

Descripon of Examples that Increase the Risk of the
Inaccurate Fraud: • Inadequate segregaon of dues of

recording of a • A bookkeeper prepares a check to record keeping and preparing cash
himself and records it as having disbursements, or check signer does not
purchase or review and cancel supporng
disbursement been issued to a major supplier. documents.
Error:
• A disbursement is made to pay an • Ineecve control for matching invoices
invoice for goods that have not with receiving documents before
been received. disbursements are authorized.
• Disbursements for travel and • Ineecve accounng coding
entertainment are improperly procedures may result from
incompetent accounng personnel,
included with merchandise inadequate chart of accounts, or no
purchases. controls over the posng process.

Duplicate Error:
recording and • A purchase is recorded when an • Ineecve controls for review
invoice is received from a and cancellaon of supporng
payment of documents by the check signer.
purchases vendor and recorded again
when a duplicate invoice is sent
by the vendor.

Unrecorded Fraud:
disbursements • In conjuncon with recorded • Ineecve controls over record
(but deposited) cash receipts, keeping for access to cash.
an employee writes and chases
an unrecorded check for the
idencal amount.
FINANCIAL INVESTMENTS
Financial investments are assets that can be traded, or they can
also be seen as packages of capital that may be traded.
Marketable stock and bonds are the most important
group of nancial investments.
Derivaves are nancial instruments that “derive” their value
from other nancial instruments, underlying assets, or
indexes.
Example, a simple derivave would involve a commitment by a
company to purchase a commodity at a certain price at some point
in the future.
CONTRACT
The major elements of adequate
internal control over 'nancial
investments:
1) Formal investment policies that limit the nature if investments in

securies and other nancial instruments.
2) An investment commi0ee of the board of directors that authorizes and

reviews nancial investment acvies for compliance with investment
policies.
3) Separaon of dues between the execuve authorizing purchases and

sales of securies and derivave instruments, the custodian of the
securies, and the person maintaining the records of investments.
The major elements of adequate
internal control over 'nancial
investments:
4) Complete detailed records of all securies and derivave
instruments owned and the related provisions and terms.
5) Registraon of securies in the name of the company.
6) Periodic physical inspecon of securies on hand by an internal

auditor or an o4cial having no responsibility for the authorizaon,
custody, or record keeping of investments.
7) Determinaon of appropriate accounng for complex nancial

instruments by competent personnel.
 In many concerns, segregaon of the funcons of custody and
record keeping is achieved by the use of an independent
safekeeping agent.
 If no independent agent, it should be kept in a bank safe-
deposit box under the joint control of two or more of the
company’s o4cial.
 Complete detailed records of all securies and derivave

instruments owned are essenal to sasfactory control.
Potenal Misstatements – Financial Investments

Misstatement of Error:
recorded value of • Failure to record changes in • Inadequate accounng manual;
market values of investments. incompetent accounng
investments personnel.
Fraud:
• Misstatement of the value of • Ineecve board of directors,
closely held investment. audit commi0ee, or internal
audit funcon; not conducve to
ethical conduct; undue pressure
to meet earnings targets.
Potenal Misstatements – Financial Investments

Unauthorized Fraud:
investment • An employee with access to • Inadequate segregaon of dues
securies converts them for of record keeping for and
transacons custody of securies.
personal use.
Incomplete Error: a) Inadequate accounng manual;

recording of • Failure to record derivave incompetent accounng
investments agreements which are personnel.
embedded in other
agreements. b) In adequate monitoring by
internal auditors.
RECEIVABLES
Accounts receivable
include not only claims against customers arising from the sale of
goods or services , but also a variety of miscellaneous claims
such as loans to officers or employees or subsidiaries, claims
against various other films, claims for tax refunds and advantages
to suppliers
Notes receivable
written promises to pay certain amount at future dates
Internal Control of Accounts Receivable
and Revenue
To understand internal control of accounts receivable and
revenue, we must consider the various components:
 Control Environment
 Risk Assessment
 Monitoring
 (Accounting) Information and Communication
System
 Control Activities
Control Environment
 The Control Environment is very important to effective

internal control over revenue and receivables
 An independent audit committee of the board of directors

that monitors management’s judgment about revenue
recognition principles and estimates
 As well as an effective internal audit function
 The control environment is greatly influenced by the extent

to which individuals recognize that they will be held
accountable
Potenal Misstatements – Revenue / Receivables
Internal Control Weakness

Description of Examples or Factors that Increase the
Misstatement Risk of the Misstatement
Recording Fraud:
unearned • International over • Ineffective billing process
revenue shipment of goods in which billing is not tied
to shipping information
Error
• Inadequate billing and
recording of sales • Inadequate accounting
manual; incompetent
accounting personnel

Description of Examples Factors that Increase the Risk of
Misstatement the Misstatement
Early (late) Fraud:

recognition of • Holding the sales journal open • Ineffective board of directors,
revenue – “cutoff to record next year’s sales as audit committee, or internal
error” having occurred in the current audit function; not conducive to
year ethical conduct; undue
pressure to meet sales targets
Error
• Recording sales in the wrong
period based on incorrect • Ineffective cutoff procedures in
shipping information the shipping department

Recording revenue Fraud:

when significant • Recording sales when the • Ineffective board of directors,
uncertainties exist customer is likely to return the audit committee, or internal
goods audit function; not conducive to
ethical conduct; undue
Error pressure to meet sales targets
• Recording sales when the
customer’s payment is
contingent upon the customer • Aggressive attitude of
receiving financing or selling management toward financial
the goods to another party reporting; incompetent chief
accounting officer

Recording revenue Fraud:

when significant • Recording franchise revenue • Ineffective board of directors,
services still must when the franchises are sold audit committee, or internal
be performed by even though an obligation to audit function; not conducive to
seller perform significant services ethical conduct; undue
still exists pressure to meet sales targets
Error
• Amount of revenue earned on • Aggressive attitude of
franchises is miscalculated management toward financial
reporting; incompetent chief
accounting officer

Overestimation of Fraud:
the amount of • Misstating the percentage of • Ineffective board of directors,
revenue earned completion of several projects audit committee, or internal
by a construction company audit function; not conducive to
using the percentage-of ethical conduct; undue
completion method revenue pressure to meet sales targets
recognition
Error • Aggressive attitude of

• Overestimating the percentage management toward financial
of completion on projects by a reporting; incompetent chief
construction company using accounting officer
the percentage-of completion
method revenue recognition
Internal Control over Notes Receivable
A basic characteristic of effective control consists of the subdivision

of duties. As applied to notes receivable, this principle requires that:
1. The custodian of notes receivable not have access to

cash or to general accounting records
2. The acceptance and renewal of notes be authorized in
writing by a responsible official who does not have
custody of the notes
3. The write-off defaulted notes be approved in writing by
responsible officials and effective procedures adopted for
subsequent follow-up of such defaulted notes
INTERNAL CONTROL OVER INVENTORIES AND COST
OF GOODS SOLD
 The controls that assure the fair valuation of inventories are found in the
purchases (or acquisition) cycle
 These controls include:

• Procedures for selecting vendors
• Ordering merchandise or materials
• Inspecting goods received
• Recording the liability to the vendor
• Authorizing and making cash disbursements
 In a manufacturing business, the valuation of inventories also is

affected by the production cycle, in which manufacturing costs are
assigned to inventories, and the cost of inventories is then
transferred to the cost of goods sold
Potenal Misstatements – Inventories / Cost of Goods Sold

Misstatement of Fraud:
inventory costs • Intentional misstatements of • Ineffective board of directors,
inventory prices audit committee, or internal
audit function; “tone at the top”
Error not conductive to ethical
• Erroneous pricing of inventory conduct; undue pressure to
meet earning targets
• Ineffective cost accounting

system; failure to update
standard costs on a timely
basis

Misstatement of Fraud:
inventory quantities • Items are stolen with no • Ineffective board of directors,
journal entry reflecting theft audit committee, or internal
audit function; “tone at the top”
Error not conductive to ethical
• Miscounting of inventory by conduct; undue pressure to
personnel involved in physical meet earning targets
inventory
• Ineffective controls or
supervision of physical
inventory

Early (late) Fraud:
recognition of • Intentional recording of • Ineffective board of directors,
purchases purchases in the subsequent audit committee, or internal
period audit function; “tone at the top”
not conductive to ethical
Error conduct; undue pressure to
• Recording purchases of the meet earning targets
current period in the
subsequent period • Ineffective accounting
procedures that do not tie
recorded purchases to
receiving data
INTERNAL CONTROL OVER PROPERTY, PLANT AND
EQUIPMENT
 Property, Plant and Equipment – includes all tangible assets with a
service life of more than one year that are used in the operation of
business and are not acquired for the purpose of resale
 Three major subgroups of such asset are generally recognized:
1. Land, such as properly used in the operation of the business, has the
significant characteristic of not being subject to depreciation
2. Buildings, machinery, equipment and land improvements
3. Natural Assets (Wasting Assets)
Internal Control over Property, Plant and Equipment
 The amounts invested in plant and equipment represents a large portion of

the total assets of many industrial concerns
 Maintenance, rearrangement and depreciation of these assets are major

expenses in the income statement.
 The total expenditures for the assets and related expenses make strong
internal control essential to the preparation of reliable financial statements.
 The losses that inevitably arise from uncontrolled methods of acquiring,

maintaining and retiring plant and equipment are often greater than the
losses from fraud in cash handling
In large enterprises, the auditors may expect to find an

annual plant budget used to forecast and control acquisitions
and retirements of plant and equipment.
Many small companies also forecast expenditures for plant

assets
A detailed knowledge of the kinds, quantities and condition of

existing equipment is an essential basis for intelligent
forecasting of the need for replacements and additions to the
plant.
Other key controls applicable to plant and equipment are as follows:
1. A subsidiary ledger consisting of a separate record for each unit

of property
2. A system of authorization requiring advance executive approval

of all plant and equipment acquisitions, whether by purchase, lease
or construction
3. A reporting procedure assuring prompt disclosure and analysis of

variances between authorized expenditures and actual costs
4. An authoritative written statement of company policy

distinguishing between capital expenditures and revenue
expenditures
5. A policy requiring all purchases of plant and equipment to be handled

through the purchasing department and subjected to a standard routine
for receiving, inspection and payment
6. Periodical physical inventories designed to verify the existence,

location and condition of all property listed in the accounts and to disclose
the existence of any unrecorded units
7. A system of retirement procedures, including serially numbered

retirement work orders, stating reasons for retirement and bearing
appropriate approvals
Potenal Misstatements – Investments in PPE

Misstatements of Fraud:
acquisitions of PPE • Expenditures for repair and • Undue pressure to meet
maintenance expenses earnings targets.
recorded as property, plant
and equipment acquisitions to • Inadequate accounting manual;
overstate income. incompetent accounting
personnel
Error
• Purchases of equipment
erroneously reported in
maintenance and repairs
expense account
Potenal Misstatements – Investments in PPE

Description of Examples Factors that Increase the
Failure to record Error
retirements of PPE • An asset that has been • Inadequate accounting policies,
replaced is discarded due to e.g., failure to use retirement
lack of value without an work orders
accounting entry
Improper reporting Error • Inadequate accounting manual;

of unusual • A gain recorded on an incompetent accounting
transactions exchange of nonmonetary personnel
assets that lacks commercial
substance

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1.

Describe the internal control over the major

Learning c. Receivables: Accounts and Notes and related

2. Understand the potential misstatements (due to

2) Separate cash handling from record keeping.

3) Centralize receiving of cash to the extent praccal.

4) Record cash receipts on a mely basis.

5) Encourage customers to obtain receipts and observe cash register

6) Deposit cash receipts daily.

7) Make all disbursements by check or electronic funds transfer, with the

8) Have monthly bank reconciliaon prepared by employees not

9) Monitor cash receipts and disbursements by comparing recorded

Internal Control Weakness or

Internal Control Weakness or

Failure to record Fraud:

Failure to record Fraud:

Early (late) Fraud:

Internal Control Weakness or Factors

Inaccurate Fraud: • Inadequate segregaon of dues of

Internal Control Weakness or

Internal Control Weakness or

1) Formal investment policies that limit the nature if investments in

2) An investment commi0ee of the board of directors that authorizes and

3) Separaon of dues between the execuve authorizing purchases and

5) Registraon of securies in the name of the company.

6) Periodic physical inspecon of securies on hand by an internal

7) Determinaon of appropriate accounng for complex nancial

 Complete detailed records of all securies and derivave

Internal Control Weakness or

Internal Control Weakness or

Incomplete Error: a) Inadequate accounng manual;

 The Control Environment is very important to effective

 An independent audit committee of the board of directors

 As well as an effective internal audit function

 The control environment is greatly influenced by the extent

Internal Control Weakness

Internal Control Weakness or

Early (late) Fraud:

Internal Control Weakness or

Recording revenue Fraud:

Internal Control Weakness or

Recording revenue Fraud:

Internal Control Weakness or

Error • Aggressive attitude of

A basic characteristic of effective control consists of the subdivision

1. The custodian of notes receivable not have access to

 These controls include:

 In a manufacturing business, the valuation of inventories also is

Internal Control Weakness

• Ineffective cost accounting

Internal Control Weakness

Internal Control Weakness

 Three major subgroups of such asset are generally recognized:

 The amounts invested in plant and equipment represents a large portion of

 Maintenance, rearrangement and depreciation of these assets are major

 The losses that inevitably arise from uncontrolled methods of acquiring,

In large enterprises, the auditors may expect to find an

Many small companies also forecast expenditures for plant

3) Centralize receiving of cash to the extent praccal.

4) Record cash receipts on a mely basis.

8) Have monthly bank reconciliaon prepared by employees not

Inaccurate Fraud: • Inadequate segregaon of dues of

3) Separaon of dues between the execuve authorizing purchases and

5) Registraon of securies in the name of the company.

6) Periodic physical inspecon of securies on hand by an internal

7) Determinaon of appropriate accounng for complex nancial

 Complete detailed records of all securies and derivave

Incomplete Error: a) Inadequate accounng manual;