1. Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Auditing & Assurance Services, 6e

2. Chapter 06 Employee Fraud and the Audit of Cash "Rather fail with honor than succeed by fraud." --Sophocles (496-406 BC) 6-2

3. Learning Objectives 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.Describe the control activities over the receipt and disbursement of cash. 5.Describe the types of substantive procedures that are conducted during the audit of cash. 6.Discuss actual cash fraud cases and describe how the schemes were uncovered. 7.Describe some extended procedures for detecting employee fraud schemes involving cash. 6-3

4. Employee Fraud Overview Fraud consists of knowingly making material misrepresentations of fact with the intent of inducing someone to believe the falsehood and act upon it and thus, suffer a loss or damage. 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. Errors are unintentional misstatements or omissions of amounts or disclosures in financial statements. Direct-effect Illegal Acts are violations or government regulations by the company, or its management or employees that produce direct and material effects on dollar amounts in the financial statements. 6-4

5. The Fraud Triangle There are three conditions that are likely to be present when a fraud occurs. They are: Motivation Opportunity Rationalization 6-5

6. Motivation A motive is some kind of pressure a person experiences and believes to be 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) 6-6

7. 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. 6-7

8. 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. 6-8

9. Cash Internal Control Considerations Cash is highly liquid, easily transportable, and not easily identifiable, and therefore is a primary target for employee thieves. Some strong internal control activities: –Dual custody of cash at all times –Lockbox arrangement –Fidelity bonds 6-9

10. Cash Receipts 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 6-10

11. Audit Evidence Used to Test Cash Cash receipts journal Cash disbursements journal Bank reconciliations Cancelled checks Year-end bank statement Cutoff bank statement 6-11

12. Audit of Cash The first procedure in an audit of cash is to obtain a bank reconciliation for each cash account and audit them in the following manner: Balance per bank –CONFIRM (STANDARD BANK CONFIRMATION) directly with bank –Agree amount 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 other Debit/Credit Memos –Inspect bank credit/debit memo and audit for reasonableness. Examine relevant supporting documentation. Balance per books –FOOT the entire reconciliation for mathematical accuracy –TRACE the amount to the trial balance 6-12

13. Confirmation of Bank Balances Standard Bank Confirmation Inquiry –Must be mailed under auditor’s own control. –Used to confirm deposit balances and loan balances –Also can be used to request information about contingent liabilities and secured transactions. Electronic Confirmation Requests –Many banks now only complete confirmation requests electronically (e.g., confirmations.com)confirmations.com –Can improve the control of both delivery and receipt of the confirmation request –Allowed by professional auditing standards 6-13

14. Check Kiting Is the deliberate floating of funds between two or more bank accounts to make it appear that more cash is present and available than is really the case. This practice is also known as “playing the float.” Advances in technology and bank scrutiny has decreased this possibility in recent years. A Schedule of Interbank Transfers is generally used by auditors to detect check kiting. 6-14

15. Proof of Cash A proof of cash would be used in situations where 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. 6-15