Ch. 6 HW Solutions - Edward Lynch PDF

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CHAPTER 06Employee Fraud and the Audit of CashLEARNING OBJECTIVESReview CheckpointsMultiple ChoiceExercises, Problems, and Simulations1. Define and explain the differences amongseveral kinds of employee fraud thatmight occur at an audit client.1, 2 29, 36 56, 602. Identify and explain the three cond...

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Chapter 06 - Employee Fraud and the Audit of Cash

CHAPTER 06 Employee Fraud and the Audit of Cash LEARNING OBJECTIVES

Review Checkpoints

1. Define and explain the differences among several kinds of employee fraud that might occur at an audit client. 2. Identify and explain the three conditions (i.e., the fraud triangle) that often exist when a fraud occurs. 3. Describe techniques that can be used to prevent employee fraud. 4. Identify the relevant assertions and risks of material misstatement that are typically related to the cash balance. 5. Identify important internal control activities present in a properly designed system to mitigate the risk of material misstatements for each relevant assertion related to cash and to help prevent or detect employee fraud. 6. Give examples of substantive procedures used to test cash and relate them to the relevant assertions. 7. Describe some extended procedures for detecting employee fraud schemes involving cash.

Multiple Choice

Exercises, Problems, and Simulations

1, 2

29, 36

56, 60

3, 4, 5, 6

22, 26, 41, 45

62, 63

7, 8

23, 24, 25, 27

49

9, 10

33, 34, 35, 38

11, 12, 13, 14

28, 30, 31, 32, 37, 40

46, 47, 48, 55

15, 16, 17

39

50, 52, 53, 61

18, 19, 20, 21

42, 43, 44

51, 54, 57, 58, 59

SOLUTIONS FOR REVIEW CHECKPOINTS 6.1

Employee fraud is the use of fraudulent means to take money or other property from an employer. The defining characteristics are (1) the fraudulent act, (2) the conversion of the money or property to the fraudster’s use, and (3) the cover up. Embezzlement is a type of fraud by employees or nonemployees. Its defining characteristic is wrongfully taking money or property entrusted to their care, custody, and control, often accompanied by false accounting entries and other forms of lying and cover up.

6.2

Fraud perpetrators look like other people, hence the difficulty in spotting them easily. However, for most people, committing a fraudulent act is stressful. Observation of changes in a person’s’ habits and lifestyles may reveal some red flags such as:

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Chapter 06 - Employee Fraud and the Audit of Cash

• Drinking too much. • Taking drugs. • Becoming irritable easily. • Being unable to relax, to sleep. • Becoming defensive, argumentative. • Being unable to look people in the eye. • Sweating excessively. • Going to confession (e.g., priest, psychiatrist). • Finding excuses and scapegoats for mistakes. • Working standing up. • Working alone. • Working late frequently. Personality red flags are difficult because (1) honest people often show them as well, (2) they often are hidden from view, and (3) auditors are not in a good position to notice these characteristics. However, auditors need to do the best they can to catch a fraudster. 6.3 A number of pressures/motivations might lead an honest person to commit fraud: Egocentric pressures/motivations  

My father was wealthy, and I need to be wealthy too. My friends admire cars, and I need to have an expensive one.

Ideological pressures/motivations  

Because the company sells tobacco and alcohol, it doesn’t deserve to make a profit. I can award the government housing grants to best use without the HUD red tape. (Justifying diversion of funds in government housing programs.)

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Chapter 06 - Employee Fraud and the Audit of Cash

Economic pressures/motivations I need to:  Pay college tuition.  Pay hospital bills for my parent with cancer.  Pay gambling debts.  Buy drugs.  Pay alimony and child support.  Pay for high life style (homes, cars, boats).  Finance business or stock speculation losses.  Report good financial results. 6.4

A number of conditions might provide the opportunity for employee fraud, for example:       

6.5

Nobody counts the inventory, so losses are not known for certain. The petty cash box is often left unattended. Supervisors set a bad example by taking supplies home. Upper management considered a written statement of ethics but decided not to publish or circulate one to employees. Another employee was caught and fired but was never prosecuted. The finance vice president has investment authority without any review. Frequent emergency jobs leave a lot of excess material just lying around the plant.

A number of conditions might provide the rationalization for employee fraud, for example:      

“I need it more than the other person” (Robin Hood theory). “I’m borrowing the money and will pay it back.” “Nobody will get hurt.” “The company is big enough to afford it.” “A successful image is the name of the game.” “Everybody is doing it.”

6.6

Some auditors look at capability as a fourth item necessary for committing a fraud. They argue that if a control weakness exists, but an individual does not have the skills and knowledge to take advantage of the weakness, an opportunity is not really present. Others would argue that these are separate issues and the opportunity exists whether the potential fraudster has the capability or not. This issue remains open and up for debate.

6.7

The cover-up or concealment of a fraud is a distinguishing attribute of a fraud. Often the audit team’s first indication of a fraud is the identification of a control violation. Cover-up attempts generally appear in the accounting records. The key for an auditor is to be aware of and notice exceptions and oddities such as the following:

•

Unusual (either large or small) number or dollar amount of transactions.

•

Transactions for “round” dollar amounts (e.g., $50,000).

•

Transactions recorded at unusual times of the day, month, or year.

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Chapter 06 - Employee Fraud and the Audit of Cash

•

Transactions associated with unusual branches or locations of a multilocation entity.

•

Cash shortages and overages.

•

Excessive voids and credit memos.

•

General ledgers that do not balance.

•

Increase in past due receivables.

•

Inventory shortages.

•

Unexplained adjustments to inventory or accounts receivable balances, especially without

support. •

Increased scrap or waste in a manufacturing plant.

•

Alterations on official documents.

•

Duplicate payments made to the same vendor.

•

Employees who cannot be found.

•

Use of copies instead of originals for supporting documentation.

•

Missing documentation to support transactions.

•

Unusual endorsements on checks.

•

Unusual patterns in deposits in transit.

•

Common names or addresses for refunds.

6.8

a. b.

6.9

If Eloise Garfunkle is a company employee, somehow she cashed a check payable to a supplier. Maybe she is related to the supplier, or maybe she intercepted the check before it reached the supplier. The auditor may want to investigate further. Somebody is working on holidays! These dates—New Year’s Day, Memorial Day, Independence Day, Labor Day, Thanksgiving Day, and Christmas day—are normal days off for most businesses. A key question to consider is whether an auditor would have been able to identify holidays like Memorial Day and Labor Day if the other more obvious ones had not been listed

Whether the auditor examines the actual check or a scanned image obtained from the bank, knowledge of the codes for Federal Reserve districts, offices, states, and bank identification numbers could enable an auditor to spot a crude check forgery. If the amount of a check is altered after it has cleared the bank, the alteration would be noted by comparing the magnetic imprint of the amount paid by the bank to the actual amount that was written on the check face. If the numbers are different, further investigation should be completed.

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Chapter 06 - Employee Fraud and the Audit of Cash 6.10

On this bank statement, only three clues indicate that the statement may have been altered:   

The low balance is $2,374.93 (the correct balance) and no transactions occurred after this point. There is a space for a gap in the check sequence, but no “**”‘s as with the other gaps. The “7” in $7,374.93 appears in a different font.

An auditor can also scrutinize other parts of the bank statement for reasonableness. For example, the number and dollar amount of deposits and checks can be compared to the detail data on the bank statement, the mathematical accuracy of the statement can be checked, and the statement itself can be studied for alterations. 6.11

In a cash collection process, someone will have to receive the cash and checks and thus has custody of the physical cash for at least a short period of time. Because this initial custody cannot be avoided, it is always a good control to (1) have two people open the mail containing customer receipts if possible, resulting in joint custody, (2) restrictively endorse the checks immediately after removing them from the envelope, (3) prepare a list of the cash receipts as early in the process as possible, and then (4) separate the actual cash from the record-keeping documents. The cash should be sent to the cashier or treasurer’s office where a bank deposit is prepared and the money is sent to the bank daily and intact (no money should be withheld from the deposit). The list or remittance advices go to the accountants (controller’s office), who then would record the cash receipts.

6.12

The accountant who records cash receipts and makes credits to customer accounts should never actually handle the cash. Rather, the accountant should receive a remittance list or remittance advice to make the entries to the cash and accounts receivable control accounts and to the customers’ accounts receivable subsidiary account records. An accountant who had custody of the cash and made the entries to the different accounts could steal and then conceal their theft. This would be a violation of the segregation of duties. This is why the accountant should not perform both functions. In fact, a good additional internal control activity is to have control account and subsidiary account entries made by different people so that later the accounts receivable entries and balances can be compared (reconciled) to determine whether they agree in total. So, while it might be easier just to send the cash to the accounts receivable accountants, a dishonest accountant could steal cash while still giving the customer credit.

6.13

The word lapping refers to an employee’s stealing the cash receipts of a company from a particular customer (Customer A) and then covering the amount with a following day’s payment received for another customer’s account (Customer B). In essence, the amount of money received from Customer B is applied to Customer A’s account. This type of activity continues because when a check comes from Customer C, the employee would apply those funds to Customer B, etc. A lapping operation is possible when a single employee has access to both cash and accounts receivable records. The auditor is alerted to the possibility of a lapping operation when duties are not properly separated. Surprise confirmation is the primary means that an auditor can use to uncover such activity. Also, to detect this type of lapping scheme, a detailed audit should include comparison of the checks listed on a sample of deposit slips (from say Customer B) to the detail of customer remittances recorded to customer accounts (Customer A). Doing so is an attempt to find credits given to customers for whom no payments were received on the day in question. It can be hard to detect. However, detailed scrutiny will allow the auditor to catch the fraudster.

6.14

All vendors should be required to be on an approved vendor list. Vendors are placed on this list with approval from multiple departments (e.g. purchasing, engineering, and quality control). In addition, payments should not be made without a complete voucher package including a purchase order and receiving report. Because fictitious vendors do not supply product or service, such a fraud would require collusion between purchasing and receiving. As a result, having an approved vendor list would help to prevent a fraud.

6.15

The cutoff bank statement is a bank statement sent by the bank directly to the auditor, and it is usually for a 15- or 20-day period following the reconciliation date. The auditor basically uses the statement to

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Chapter 06 - Employee Fraud and the Audit of Cash determine whether outstanding checks were actually mailed by the client before the reconciliation date and that the outstanding deposits in transit were actually received in a timely manner by the bank. 6.16

Check kiting is the practice of building up apparent balances in one or more bank accounts based on uncollected (float) checks drawn against similar accounts in other banks. Kiting involves depositing money from one bank account to another by using a bogus check. Kiting is the deliberate floating of funds between two or more bank accounts. This method enables a bank customer to utilize the time required for checks to clear to obtain an unauthorized loan without any interest charge. If these cash transfers are recorded in the books, a company will show the negative balances that result from checks drawn on insufficient funds. However, perpetrators may try to hide the kiting by not recording the deposits and checks. Such maneuvers may be detectable in a bank reconciliation audit. Auditors also can detect signs of kiting by observing in the bank statements:            

Frequent deposits and checks in same amounts. Frequent deposits and checks in round amounts. Frequent deposits with checks written on the same (but another) bank. Short time lag between deposits and withdrawals. Frequent ATM account balance inquiries. Many large deposits made on Thursday or Friday to take advantage of the weekend. Large periodic balances in individual accounts with no apparent business explanation. Low average balance compared to high level of deposits. Many checks made payable to other banks. Bank willingness to pay against uncollected funds. “Cash” withdrawals with deposit checks drawn on another bank. Checks drawn on foreign banks with lax banking laws and regulations.

In today’s environment, check kiting has become much less an issue for auditors. Today banks have implemented the Check Clearing for the 21st Century Act, referred to as Check 21. In this system, checks are converted to digital images allowing for a dramatic increase in speed in check clearing. The benefit is that the “float” on the check is virtually eliminated and kiting becomes very difficult to perform and conceal. 6.17

Auditors can prepare a schedule of interbank transfers to determine whether transfers of cash from one bank to another were recorded properly (correct amount and date). A schedule of interbank transfers would show improper cash transfer transactions when the auditors find (a) no recording of transfers shown in the bank statement and (b) dates of bank and general ledger recording that are not in alignment. When this is discovered, additional investigation is required.

6.18

A proof of cash can reveal unrecorded cash deposit and cash payment transactions when the deposits and payments reported by the bank are compared to the deposits and payments recorded in the general ledger and will require consideration of unrecorded amounts. Inspection of the bank statement and comparison to the general ledger (books) will uncover the problem provided the documents have not been destroyed.

6.19

Extended procedures are used as “specific responses to identified fraud risk factors.” These audit procedures are performed only when the audit team thinks that an area deserves focused investigation given the facts and circumstances. In some cases, they are more complicated and expensive than normal audit procedures, and they usually involve a suspicion of something fraudulent occurring.

6.20

Two endorsements may indicate that the payee of the check is not the party that received the benefit of the check payment. The payee may be fictitious and further investigation may be warranted.

6.21

An auditor would use net worth analysis when fraud has been discovered or is strongly suspected, and the information to calculate a suspect’s net worth can be obtained (e.g., asset and liability records, bank accounts). The method is to calculate the suspect’s net worth (known assets – known liabilities) at the beginning and end of a period (months or years) and then to try to account for the difference as (1) known

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Chapter 06 - Employee Fraud and the Audit of Cash income less living expenses and (2) unidentified difference. The unidentified difference may be the best available approximation of the amount of a theft. Expenditure analysis is similar to net worth analysis except the data involve the suspect’s spending for all purposes compared to known income. If spending exceeds legitimate and explainable income, the difference may be the amount of a theft.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 6.22

6.23

6.24

6.25

a.

Correct

b.

Incorrect

c.

Incorrect

d.

Incorrect

a.

Incorrect

b. c.

Incorrect Incorrect

d.

Correct

a.

Correct

b.

Incorrect