Chapter 6 Employee Fraud and the Audit of Cash "Rather fail with honor than succeed by fraud." --Sophocles ( BCE) McGraw-Hill/IrwinCopyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Fraud Opportunities Revisited 6-2

Definitions Related to Employee Fraud White collar crime is fraud perpetrated by people who work in offices and steal with a pencil or a computer terminal. The contrast is violent street crime. Employee fraud is the use of fraudulent means to take money or other property from an employer. It consists of three phases: (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 involving employees' or nonemployees' 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. Larceny is simple theft of an employers property that is not entrusted to an employee's care, custody or control. Defalcation is another name for employee fraud and embezzlement. 6-3

Exhibit 6-1 Fraud Elements MotivationOpportunity Rationalization High Risk Source: W.Hillison, D. Sinason, and C. Pacini, “The Role of the Internal Auditor in Implementing SAS 82,” Corporate Controller, July/August 1998, page

Motive A motive is some kind of pressure a person experiences and believes unshareable with friends and confidants –Actual or perceived need for money (Economic motive) –“Habitual criminal” who steals for the sake of stealing (Psychotic motive) –Committing fraud for personal prestige (Egocentric motive) –Cause is morally superior, justified in making others victims (Ideological motive) 6-5

Opportunity An opportunity is an open door for solving the unshareable problem by violating a trust. –Weak internal controls –Circumvention of internal controls –The greater the position, the greater the trust and exposure to unprotected assets. 6-6

Rationalization When people do things that are contrary to their personal beliefs – outside their normal behavior – they provide an argument to make the action seem like it is in line with their moral and ethical beliefs. –Some of the most frequent rationalizations are: I need it more than the other person. I’m borrowing the money and will pay it back. Everybody does it. The company is big and will never miss it. Nobody will get hurt. I am underpaid, so this is due compensation I need to maintain a lifestyle and image. 6-7

Red Flags: Employee Fraud oMissing documents. oAlterations on documents. oPhotocopied documents. oSecond endorsements on checks. oUnusual endorsements. oOld outstanding checks. oUnexplained adjustments to accounts receivable and inventory balances. oUnusual patterns in deposits in transit. oGeneral ledgers that do not balance. oCash shortages and overages. oExcessive voids and credit memos. oCustomer complaints. oCommon names or addresses for refunds. oIncreased past due receivables. oInventory shortages. oIncreased scrap. oDuplicate payments. oEmployees that cannot be found. oDormant accounts that have become active. 6-8

Fraud Prevention Managing people pressures in the workplace –Counseling services –Hotlines Control procedures and employee monitoring Integrity by example and enforcement 6-9

Cash Collections and Disbursements Cash is highly liquid, easily transportable, and not easily identifiable, and therefore is a primary target for employee thieves. Some strong internal controls: –Dual custody of cash at all times –Lockbox arrangement –Fidelity bonds 6-10

Exhibit 6.2 Processing Cash Receipts 6-11

Cash Collections: Typical Activities Receive cash and REMITTANCE ADVICE in mail. Prepare REMITTANCE LISTING. Enter total from REMITTANCE LISTING (or REMITTANCE ADVICE) in CASH RECEIPTS JOURNAL. Prepare DEPOSIT SLIP and deposit cash receipts in bank (INTACT and DAILY). Record update to SUBSIDIARY ACCOUNTS RECEIVABLE using REMITTANCE ADVICE. Reconcile REMITTANCE LISTING, SUBSIDIARY ACCOUNTS RECEIVABLE, and DEPOSIT SLIP daily 6-12

Cash Collections and Disbursements: Key Control Activities INFORMATION PROCESSING –Voucher packet (Purchase requisition, purchase order, receiving report, invoice) matched prior to cash disbursement authorization –Deposits reconciled to amounts credited to accounts receivable ledger –Bank reconciliation PHYSICAL CONTROLS OVER THE SECURITY OF ASSETS –Deposit cash and checks daily and intact –Lock box account –EDI transactions –Dual custody over cash –Unused checks secured –Check imprinting machine SEGREGATION OF DUTIES –Separate custody, authorization, recording, execution PERFORMANCE REVIEWS RECONCILIATIONS 6-13

Cash Disbursements: Control Risk Assessment Control considerations –Proper separation of duties –Detail control (error-checking) activities –Internal control questionnaires (ICQs) –Transaction process “walkthrough” Detail test of controls audit procedures (Exhibit 6.4) 6-14

Exhibit 6.4 Tests of Controls Over Cash Disbursements 6-15

Audit Evidence in Management Reports and Data Files Cash receipts journal Cash disbursements journal Bank reconciliations Cancelled checks Bank statements –The audit team will often request that a CUTOFF BANK STATEMENT be sent directly to the auditor prior to subsequent month-end in order to verify deposits-in-transit and cleared checks on a timely basis. 6-16

Exhibit 6.5 How to Read a Cancelled Check and Endorsement 6-17

Exhibit 6.6 Small Business Bank Statement 6-18

Audit of Cash Cash on hand –Count SIMULTANEOUSLY with other liquid assets –Count in presence of client employee –Undeposited receipts Trace to cash receipts journal (CRJ) Vouch to subsequent deposit in bank statement Cash on Deposit –Audited mainly through the client’s BANK RECONCILIATION.BANK RECONCILIATION 6-19

Bank Reconciliation Balance per bank –CONFIRM (STANDARD BANK CONFIRMATION) directly with bankSTANDARD BANK CONFIRMATION –Agree to CUTOFF BANK STATEMENT Add Deposits-in-transit –TRACE to cash receipts journal –VOUCH to CUTOFF BANK STATEMENT Subtract Outstanding Checks –VOUCH to cash disbursements journal –TRACE checks cleared from cutoff bank statement Add/Subtract Debit/Credit Memos –Inspect bank credit/debit memo Balance per books –FOOT Reconciliation –TRACE to trial balance 6-20

Exhibit 6.7 Bank Reconciliation 6-21

Standard Bank Confirmation In addition to corroborating cash and loan balances, a STANDARD BANK CONFIRMATION INQUIRY also requests information about contingent liabilities and secured transactions. 6-22

Exhibit 6.8 Bank Confirmation 6-23

Check Kiting KITING is a fraud that occurs by reporting cash simultaneously in two different bank accounts. A Schedule of Interbank Transfers (Exhibit 6-10) is generally useful in detecting KITING. 6-24

Exhibit 6.9 Illustrative Check Kiting Transactions 6-25

Exhibit 6.10 Illustration of Interbank Transfer Schedule 6-26

Proof of Cash A PROOF OF CASH is used when controls over cash are weak. It essentially combines two bank reconciliations, reconciling all transactions that occurred during the period to the client’s Cash Receipts Journal and Cash Disbursements Journal. 6-27

Exhibit 6.11 Illustration of Proof of Cash—First National Bank 6-28

Fraud Detection Procedures for Cash Count the petty cash twice in one day Examine endorsements on canceled checks Audit general journal entries Retrieve customer checks Use marked coins and currency Measure deposit lag time Examine documents (bank statements) for alteration (See Exhibit 6.6) Inquiry, ask questions Covert surveillance 6-29