1. Employee Fraud and the Audit of Cash
Chapter 6
Employee Fraud and the
Audit of Cash
"Rather fail with honor than succeed by fraud."
--Sophocles ( BCE)
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Chapter 6 Objectives
Define and explain the differences among several kinds of employee frauds that could occur in an organization.
List and explain some conditions that can lead to frauds.
Describe ways and means to prevent employee frauds.
Describe the controls over the receipt and disbursement of cash.
Design and perform substantive audit procedures for the audit of cash.
Discuss actual cash fraud cases and describe how the schemes were uncovered.
Describe some extended procedures for detecting employee fraud schemes involving cash.
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3. Fraud Opportunities Revisited
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4. 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.
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5. Exhibit 6-1 Fraud Elements
Motivation
Opportunity
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 20.
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Motive
A motive is some kind of pressure a person experiences and believes unshareable with friends and confidants
Psychotic: “Habitual criminal” who steals for the sake of stealing
Egocentric: Committing fraud for personal prestige
Ideological: Cause is morally superior, justified in making others victims
Economic: Desperate or perceived need for money
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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.
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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.
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9. Red Flags: Employee Fraud
Missing documents.
Second endorsements on checks.
Unusual endorsements.
Unexplained adjustments to accounts receivable and inventory balances.
Old outstanding checks.
Unusual patterns in deposits in transit.
Cash shortages and overages.
Excessive voids and credit memos.
Customer complaints.
General ledgers that do not balance.
Increased past due receivables.
Inventory shortages.
Increased scrap.
Alterations on documents.
Duplicate payments.
Employees that cannot be found.
Photocopied documents.
Dormant accounts that have become active.
Common names or addresses for refunds.
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Fraud Prevention
Managing people pressures in the workplace
Counseling services
Hotlines
Control procedures and employee monitoring
Integrity by example and enforcement
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11. 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
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Exhibit 6.2 Processing Cash Receipts
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13. 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
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14. 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
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15. Cash Disbursements: Control Risk Assessment
Control considerations
Proper segregation of duties
Detail control (error-checking) activities
Internal control questionnaires (ICQs)
Transaction process “walkthrough”
Detail test of controls audit procedures (Exhibit 6.4)
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Exhibit 6.4 Tests of Controls Over Cash Disbursements
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17. 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.
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Exhibit 6.5 How to Read a Cancelled Check and Endorsement
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Exhibit 6.6 Small Business Bank Statement
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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.
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Bank Reconciliation
Balance per bank
CONFIRM (STANDARD BANK CONFIRMATION) directly with bank
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
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Exhibit 6.7 Bank Reconciliation
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23. 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.
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Exhibit 6.8 Bank Confirmation
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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.
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Exhibit 6.9 Illustrative Check Kiting Transactions
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Exhibit 6.10 Illustration of Interbank Transfer Schedule
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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.
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Exhibit 6.11 Illustration of Proof of Cash—First National Bank
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30. 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
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