CHAPTER 6 Employee Fraud and the Audit of Cash LEARNING OBJECTIVES

Review Checkpoints 1. Define and explain the differences among several kinds of employee frauds that might occur in an organization. 2. List and explain some conditions that can lead to frauds. 3. Describe ways and means for preventing employee frauds. 4. Describe the controls over the receipt and disbursement of cash. 5. Design and perform substantive audit procedures for 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. 1, 2, 3 Exercises, Problems, and Simulations

4, 5, 6, 7

46

9, 10, 11, 12

43, 44, 45, 62

13, 14, 15, 16, 17, 18

47, 48, 49, 50, 58, 59, 60, 61 53, 55, 56, 57

19, 20

21, 22, 23

51, 52, 54, 63

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SOLUTIONS FOR REVIEW CHECKPOINTS

6.1 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 coverup. 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 coverup. 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. 6.2 6.3 Fraud perpetrators look like other people, hence the difficulty in spotting them easily. However, they sometimes exhibit behavioral red flags of odd habits. (1) (2) (3) If the employees cannot be found, maybe they do not exist. The names are odd. All the first and last names begin with the same letter. 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. Somebody is working on holidays! These dates are normal workdays off for most businesses: New Year's Day, Memorial day, Independence day, Labor day, Thanksgiving day, Christmas day. (Would students have been able to identify holidays like memorial day and labor day if the other more obvious ones had not been listed?)

6.4

Egocentric 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 motivations: The company sells tobacco and alcohol, and 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.) Economic Motivations Pay college tuition Pay hospital bills for a parent with cancer Pay gambling debts Pay for drugs Pay alimony and child support Pay for high life style (homes, cars, boats) Finance business or stock speculation losses Report good financial results

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6.5

Conditions related directly to employee fraud: Nobody counts the inventory, so losses are not known 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 one Another employee was caught and fired, but not prosecuted The finance vice-president has investment authority without any review Frequent emergency jobs leave a lot of excess material just laying around Rationalizations: 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 The fraud diamond proposed in a text box includes capability as a forth item necessary for committing a fraud. Some may argue that if a control weakness exists, but you do not have the skills and knowledge to take advantage of the weakness then an opportunity does not present itself. Others would argue that these are separate issues and the opportunity exists whether the potential fraudster has the capability or not and, therefore, capability is a requirement that must be present to produce fraud.

6.6

6.7

6.8

Fraud-Prevention Management Style Democratic, open-door management Trust the employees and give them power in their jobs Install controls that don't make work difficult Let people design and manage their jobs and work Decentralize authority Manage with foresight Measure performance on long-run basis Have multiple measures of performance Make rewards positive and generous Give constructive positive and negative feedback Create a cooperative workplace Boss' exemplary behavior and decisions Make background checks on new employees Prosecute fraudsters

Style Leading to Fraud Autocratic management Orient management to low trust and power Install tight, bureaucratic controls Insist everything be documented with a rule for everything Centralize authority in top management Manage by crisis Measure performance on a short-term basis Make profits the only criterion for success Make rewards punitive, stingy and political Give feedback that is always critical and negative Create a highly hostile, competitive workplace Boss' questionable behavior and decisions Be lax about background checks Fire fraudsters without prosecution

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6.9

The basic sequence of activities and accounting in a revenue and collection cycle is: 1. 2. 3. 4. 5. Receiving and processing customer orders. Entering data in an order system and obtaining a credit check. Delivering goods and services to customers. Authorizing release from storekeeping to shipping to customer. Entering shipping information in the accounting system Billing customers, producing sales invoices. Accounting for customer trade accounts receivable. Collecting cash and depositing it in the bank. Accounting for cash receipts. Reconciling bank statements.

6.10

It might be easier just to send the cash to the accounts receivable accountants, but (1) that would delay the bank deposit and the company would lose interest income, and (2) a dishonest accountant could steal cash while still giving the customer credit (to forestall complaints). The accountant could cover the theft by making false debit entries to such accounts as allowance for doubt accounts (account write-offs) or discounts and allowances expense. The term "lapping" refers to an employee's stealing the cash receipts of a company and then covering the amount with a following day's payment received for another customer's account. 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 which an auditor can use to uncover such activity. Also, details of deposit slips and cash remittance reports can be compared to detect discrepancies.

6.11

6.12

Duplicate payment based on the same supporting documents can be prevented by stamping or impressing "paid" on the voucher and supporting documents, or by perforating (mutilating) the documents so they cannot be reprocessed unintentionally. Compare the amount written on the check with the bank's magnetic imprint of the amount paid by the bank. There are several clues that the bank statement has been altered:

6.13 6.14

The statement does not add up to the $7,374.93 balance shown. The font of the 7s do not match. 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 statement reports 26 checks, but only 25 are listed.

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 basic use of the statement by the auditor is to determine whether outstanding checks were actually mailed before the reconciliation date and outstanding deposits in transit were actually received in a timely manner by the bank.

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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, using a hot check. Kiting is the deliberate floating of funds between two or more bank accounts. By this method, a bank customer utilizes the time required for checks to clear to obtain an unauthorized loan without any interest charge. Auditors 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 (other) banks 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

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. A schedule of interbank transfers can be constructed from the canceled checks and cleared deposits in the bank statements. This schedule shows each check amount, the name of the paying bank (with the book recording date and the check clearing date), the name of the receiving bank (with the book deposit date and the bank clearing date). The purpose of this schedule is to see that both sides of the transfer transaction are recorded in the same period (and in the proper period). 6.17 A schedule of interbank transfers shows improper cash transfer transactions when the auditors find (a) no recording of transfers shown in the bank statement, and (2) dates of bank and general ledger recording that are out of order. A "proof of cash" can reveal unrecorded cash deposit and cash payment transactions when the attempt to reconcile the deposits and payments reported by the bank to the deposits and payments recorded in the general ledger requires 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. The former petty cash custodian apparently had more expenditures than the new one. Maybe the former one was running false expense claims.

6.18

6.19

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6.20

No separation of these duties and responsibilities: (1) transaction authorization, (2) recordkeeping, (3) custody of, or access to, assets, and (4) reconciliation of actual assets to the accounting records. A supervisor may not take approval responsibilities seriously and fail to perform them (like the supervisor of the petty cash custodian in the text case). Tight control may be too expensive and simply not performed (like the lack of observation of the laundry money collectors in the text case). The payroll employee who has responsibility for preparing personnel files for new hires, approval of wages, verification of time cards, and distribution of payroll checks can "hire" fictitious employees, fake their records, and order checks through the payroll system. Managers can override controls and order people to ship bricks (as in the text case) or manipulate records to create false numbers from a position of accounting authority (inventory falsification text case).

6.21

Extended procedures are audit procedures performed only when (external) auditors think something deserves imaginative investigation in the circumstances . Usually they are more complicated and expensive than "normal" audit procedures, and they usually suggest a suspicion of something fraudulent going on. The text contains brief explanations of several "extended procedures," but these may seem "normal" for fraud examiners. 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 fictitious. Net worth analysis is used when fraud has been discovered or 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), then try to account for the difference as (1) known 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 is 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.

6.22 6.23

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

6.24 a. b. c. d. Correct Incorrect Incorrect Incorrect Risk is high when the company always estimates the inventory but never take a complete physical count. Risk is low when the petty cash box is always locked in the desk of the custodian. Risk is lower when management has published a company code of ethics and sends frequent communication newsletters about it. Risk is lower when the board of directors reviews and approves all investment transactions.

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6.25

a. b. c. d.

Incorrect Incorrect Incorrect Correct Correct

Airtight control systems of checks and supervision is not the best long-run way to stop fraud. Name an "ethics officer" who is responsible for receiving and acting upon fraud tips is not the best long-run way to stop fraud. Place dedicated "hotline" telephones on walls around the workplace with direct communication to the company ethics officer is not the best long-run way to stop fraud. Practice management "of the people and for the people" to help them share personal and professional problems is the best long-run way to stop fraud. Many frauds are motivated by employees who have problems due to debt, addictions, or family problems. Establishing an employee assistance program addresses these issues and may reduce the motivation to commit fraud for some employees. A fidelity bond reduces the risk to the employer for theft since this is a form of insurance. It also provides a background check on employees. Neither of these issues addresses employee motivation. Reconciliations are methods of detecting problems that have occurred. While these are good controls and may reduce the opportunities for employees to steal, reconciliations to not address employee motivation to commit fraud. Audits may detect fraud and even provide a deterrence for fraud. Audits do not address the employees motivation to commit fraud. An appointment of a chief ethics officer would increase the effectiveness of the code of ethics. A hot line that allowed employees to report ethical violations would increase the effectiveness of the code of ethics.. The violation of the code of ethics by senior management would reduce the effectiveness of the code of ethics since the tone at the top would provide a message to employees that the code of ethics was not important. The posting of the code of ethics and any other means of presenting the code of ethics to employees in a prominent manner would increase the effectiveness of the code of ethics.. Numerous cash refunds have been made to different people at the same post office box address is an indicator of cash refund fraud. Internal auditor cannot locate several credit memos to support reductions of customers' balances is an indicator of returned goods fraud. Bank reconciliation has no outstanding checks or deposits older than 15 days is a sign of a good bank reconciliation, a fraud detection technique. Three people were absent the day the auditors handed out the paychecks and have not picked them up four weeks later is an indicator of padded payroll fraud. Overstating sales revenue and overstating customer accounts receivable balances is a way to misstate financial statements for management fraud. Overstating sales revenue and overstating bad debt expense does not misstate income or assets but will hide an employee embezzlement. Understating interest expense and understating accrued interest payable is a way to misstate financial statements for management fraud. Omit the disclosure information about related party sales to the president's relatives at below-market prices is a way to misstate financial statements for management fraud.

6.26

a.

b. c. d. 6.27 a. b. c. d.

Incorrect Incorrect Incorrect Incorrect Incorrect Correct Incorrect

6.28

a. b. c. d.

Incorrect Incorrect Correct Incorrect Incorrect Correct Incorrect Incorrect

6.29

a. b. c. d.

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6.30

a. b. c.

Incorrect Incorrect Correct

d.

Incorrect

Inventory should be counted on a regular basis, therefore, the fraud would be detected. Expense accounts are often good places to hide fraud since accounts are closed at the end of the year. Wage expense accounts may be compared to budget and may be reviewed by department managers that might detect the fraud. Expense accounts are often good places to hide fraud since accounts are closed at the end of the year. Consulting expense is a particularly good place to hide a fraud since no actual product is provided which may be counted or compared to the expense. Property tax expenses would likely be compared to the property tax bill and any discrepancies investigated. The inventory warehouse manager can steal inventory and manipulate the records. Cashier prepared the bank deposit, endorsed the checks with a company stamp, and took the cash and checks to the bank for deposit (no other bookkeeping duties). The cashier might steal currency, but needs access to the records to cover up a theft of customer payments. Accounts receivable clerk received a list of payments received by the cashier so he could make entries in the customers' accounts receivable subsidiary accounts. Good arrangement because the bookkeeper does not have access to cash. Financial vice president received checks made out to suppliers and the supporting invoices, signed the checks, and put them in the mail to the payees. Fraud would be harder because financial VP would also need to be able to create fictitious vendors and invoices. The cashier would have both custody of cash and record keeping responsibility, hence could steal money and fix the records without interference by anyone else. Kiting involves a mismatching of dates of recording around year-end, and the schedule of bank transfers is designed to show all the relevant dates so the auditor can see that the entries are in the proper periods. Effective control of cash requires that receipts be recorded promptly. For mail receipts, a listing of remittance advices by an employee not performing incompatible functions is a standard control procedure. If the customer does not return the remittance advice, one should be prepared at the time the mail is opened. If remittance advices are not used, a listing of receipts should still be made when the mail is opened. A check returned for insufficient funds would make the balance per bank different than the balance per books and would need to be a reconciling item. It would not change any of the information that was provided to the assistant controller. If the cash received was split into two or more deposits the deposits would not match the remittances or the payments recorded. Controls over unauthorized access into accounts receivable strengthens the control indicated in the question since information on the payment report would be more reliable. Having someone else reconcile the accounts payable process adds an additional person to the control process.

6.31

a. b.

Correct Incorrect

c. d.

Incorrect Incorrect

6.32 6.33

c. c.

Correct Correct

6.34

b.

Correct

6.35

a.

Incorrect

b. c. d.

Correct Incorrect Incorrect

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6.36

c.

Correct

The individuals with record-keeping responsibility should have custody of cash. Hence, they should use either the remittance advices or a listing of the remittances to make entries o the cash and accounts receivable control account and to the subsidiary accounts receivable records. Indeed, having different people make entries in the control account and in the subsidiary records is an effective control. Not recording sales on account in the books of original entry is the most effective way to conceal a subsequent theft of cash receipts. The accounts will be incomplete but balanced, and procedures applied to the accounting records will not detect the defalcation. The definition of embezzlement involves property that is entrusted to the employees control (as in (d). This statement refers to larceny. This statement is similar to the definition of management fraud. This statement is similar to mere error in accounting This statement is the textbook and criminological definition of embezzlement. A final review by the treasurer can catch mistakes made in prior processing.

6.37

a.

Correct

6.38

a. b. c. d.

Incorrect Incorrect Incorrect Correct Correct

6.39

b.

6.40

a.
b. c. d.

Correct
Incorrect Incorrect Incorrect

The overstatement of cash would be of most concern. Cash is overstated by claiming that the organization has more cash then it does.
It is possible that a firm could borrow money to include in a cash count and, therefore, not have the rights to the cash. However, such a scheme is of lesser concern then if the company claimed cash that did not exist. Since the value of cash is easily discernable this is usually not an issue Improper cash presentation is of lower risk then the existence of cash.

6.41

a.
b. c. d.

Incorrect
Incorrect Correct Incorrect

Since the sources and use of cash can vary greatly from year to year, balances in prior year are of little use.
Management inquiry would provide poor information for use in performing analytical procedures. Budgets provided by management provide the best estimates by management for the sources and use of cash. Where cash receipts or cash expenditures vary form the budget by a material amount, a higher level of risk may be assessed. Failure to collect accounts receivable may indicate a problem with cash sources but would only be one part of an estimate of cash. Cancellation ("paid") of vouchers prevent their use a second time.

6.42

d.

Correct

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SOLUTIONS TO PROBLEMS, EXERCISES AND SIMULATIONS

6.43 Tests of Controls over Cash Disbursements Note to Instructor: Procedure #2 below is designed to indicate that work on one sample of cash disbursements can produce evidence related to several objectives. The tasks numbered 2a through 2l all relate to the #2 sample items. AUDIT PROGRAM OF TEST OF CONTROLS AUDIT PROCEDURES Internal Control Objective Test of Controls Procedure 1. Observe who has custody of signed checks for evidence of segregation of duties from persons having cash disbursement or accounts payable record-keeping responsibilities and from persons who have cash disbursement authorization responsibilities. Validity Objective 2. Select a sample of cash disbursements recorded during the period, Recorded disbursements are valid and and documented--- representing payment 2a. Compare to the cancelled check. for goods and services received. 2b. Examine for authorized signature and proper endorsement matching payee name. 2c. Compare recorded amount and check amount. 2d. Compare recorded payee name and name on check. 3. Scan the recorded cash disbursements for large or unusual amounts and perform the same work on these items as in the #2 sample. Authorization Objective Cash disbursements are authorized according to company policy. Accuracy Objective Cash disbursement dollar amounts are calculated and recorded accurately. Classification Objective Cash disbursements are properly classified in the accounts. Accounting Objective Cash disbursements accounting is complete-properly summarized and posted in the general ledger. Proper Period Objective Cash disbursements are recorded in the proper period. 2e. 2f. 2g. 2h. 2i. Examine supporting documents for a proper authorizing signature or initials approving the amount for payment. Trace authorizing signature to list of authorized approvers. Trace vendor's name to approved vendor list. Recalculate amounts shown on supporting vendor's invoices and compare to check amount. Recalculate cash discount, if any.

4. Obtain a chart of accounts and the accounting manual pertaining to classification policy. 2j. For each disbursement, determine whether the debit entry is classified accurately. 5. Foot selected summaries (daily, monthly) of cash disbursements. 6. Trace these totals to the general ledger debit and credit entries. 7. Foot the general ledger cash account. 8. Observe cash disbursement procedures and inquire to find out whether checks are held for time before mailing. 2k. Compare date on check to date of recorded disbursement. 2l. Compare dates to payee's bank clearance date for any apparent lengthy delay that indicate that checks are held before mailing.

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6.44

Internal Control Questionnaire for Book Buy-Back Cash Fund University Books, Incorporated REVOLVING CASH FUND INTERNAL CONTROL QUESTIONNAIRE 1. 2. 3. 4. 5. 6. 7. 8. 9. Question Is responsibility for the fund vested in one person? Is physical access to the fund denied to all others? Is the custodian independent of other employees who handle cash? Is the custodian bonded? Is the custodian denied access to other cash funds? Are receipts unalterable? Are receipts prenumbered? Is the integrity of the prenumbered sequence periodically accounted for? Does the seller sign receipts? Yes No

10. Are receipts attached to reimbursement vouchers? 11. Are vouchers that are submitted for reimbursement approved by someone other than the custodian? 12. Are reimbursement vouchers and attachments (receipts) cancelled after reimbursement? 13. Is the fund used exclusively for the acquisition of books? 14. Is the fund periodically counted and reconciled by someone other than the custodian? 15. Is the fund maintained on an imprest basis? 16. Is the size of the fund appropriate for the purpose intended?

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6.45 1.

Audit Simulation: Test of Controls over Cash Receipts Other Audit Procedures Source of debit entries in general ledger cash account, other than from cash receipts journal, should be investigated and supporting documents examined. A surprise examination of cash receipts should be performed. Prior to the accounts receivable clerk obtaining the cash receipts, the auditor should make a list of them without the clerk's knowledge. The undeposited mail receipts should then be controlled after completion of their preparation for deposit and postings have been made to the subsidiary accounts receivable ledger. The deposit slip should be compared to the remittances for accuracy and totaled. Individual items on the deposit slip should be compared to postings to the subsidiary accounts receivable ledger. The auditor should then supervise the mailing of the deposit to the bank. The auditor should ask Gutzler to ask the bank to send the statement containing this deposit directly to the auditor. Postings from the deposit slips should be traced to the subsidiary accounts receivable ledger. Also, entries in the subsidiary accounts ledger should be traced to deposit slips. 1. Reason for Other Audit Procedures Since the auditor, using standard procedures, only examined the cash receipts journal, he must investigate the occurrence of all other sources of cash receipts that are not recorded in these journals. Since there are no initial controls over cash receipts established prior to the time the accounts receivable clerk obtains the cash, a surprise examination is the only method of determining if cash receipts are being recorded and deposited correctly.

2.

2.

3.

3.

Since there is no separation of duties between cash receipts and accounts receivable, the accounts receivable clerk may have been careless in performing her posting duties. This procedure may also disclose whether the accounts receivable clerk may have been lapping the accounts. See No. 3 above.

4.

Review the subsidiary accounts receivable ledger and confirm accounts that have abnormal transaction activity (consistently late payments.) If Gutzler allows customers to take discounts, the amount of such discounts and the discount period should be checked.

4.

5.

5.

6.

Dates and amounts of daily deposits per bank statement should be compared with entries in the cash receipts journal. A proof-of-cash working paper should be prepared which reconciles total cash receipts with credits per bank statement. For those periods for which the above audit procedures were not performed and for a period after the balance sheet date, scan the cash receipts journal and bank statements for unusual items.

6.

Since there is no separation of duties between cash receipts and accounts receivables the account receivable clerk may have appropriated discounts which could have been but were not taken or may have been careless in checking the appropriateness of discounts taken. Since there are no initial controls over cash receipts established prior to the time the accounts receivable clerk obtains the cash, she may have become careless about prompt deposit of the daily receipts. Since internal control over cash receipts is weak, the auditor should perform this overall check to help substantiate that he has investigated all material items during his detail tests. Since internal control over cash receipts is weak, the auditor should perform this review to help substantiate that he has investigated all material items not covered during his other tests. The McGraw-Hill Companies, Inc., 2007 6-12

7.

7.

8.

8.

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6.46

Establishing a Returned Goods System a. b. Employees can falsify returned goods (no goods were actually returned) and take the cash from the register as if it was provided to a customer. Procedures that may prevent this type of fraud include: 1. 2. Having one employee authorize the return and have the customer bring the authorization of a cash register to obtain the money. Management authorization for all returns.

Procedures that might detect this fraud include: 1. 2. c. 6.47 Analytical procedures. Comparing returns per employee or returns per shift. Contacting customers to ascertain the reason for returns. This may also act as a fraud prevention if employees know that management may follow-up with customers.

Analytical procedures might detect an increase in returns. Also, since returned goods should go back to inventory, inventory shortage may indicate that goods returned were not genuine.

Procedures for Auditing a Client's Bank Reconciliation a. Identification of procedures: A. Balance per bank: Procedures 4 and 9 B. Deposits in transit: Procedures 1, 7, 8, 9, and 10 C. Outstanding checks: Procedures 2, 7, 8, 9, and 10 D. Customer note collected by the bank: Procedure 5 E. Error: Check #1282, written on Sept 26: Procedures 5 and 9 F. Balance per books: Procedure 3 The total of outstanding checks is $13,450, not $11,450. Someone has manipulated the bank reconciliation to match the general ledger balance, which is overstated $2,000 (provided the general ledger balance is $20,400.)

b.

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6.48

Proof of Cash Month of July Balance June 30 Bank statement amounts Deposits in transit October 31 December 31 Outstanding checks October 31 December 31 Unrecorded deposit Unrecorded disbursement General ledger amounts. $399,210 $650,187 $355,001 86,899 Deposits $835,846 (86,899) 51,240 (42,690) 73,340 (150,000) (150,000) $565,397 Payments $684,747 Balance July 31 $506,100

51,240

(42,690)

(73,340) (150,000) 150,000 $484,000

The company did not record deposits and disbursements in equal amounts of $150,000 (necessary to make the bank and general ledger deposits and disbursements reconcile).

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6.49

Audit Simulation: Interbank Transfers Note to Instructors: Check #1799 ($10,000 payable to Citizen National Bank) drawn on the 1st National Bank account was not recorded in EverReady's cash disbursements journal. This is the reason it is not in the schedule of interbank transfers in Exhibit 8.58-1. The auditors obtained the initial information from the cash receipts and cash disbursements journals, and #1799 was not in them. a. Complete the Schedule of Interbank Transfers (working paper C-5) by entering the new information. EXHIBIT 6.49-1 Schedule of Interbank Transfers C-5 EVERREADY CORPORATION SCHEDULE OF INTERBANK TRANSFERS Prepared __________ December 31, 200X Date ___________ Reviewed___________ Date ___________ Disbursing Account Check No. Bank Amount Date per Books Date per Bank Receiving Account Bank Date per Books Date per Bank 22-Dec 23-Dec 24-Dec 28-Dec 30-Dec 30-Dec 31-Dec 04-Jan 05-Jan 07-Jan 08-Jan 08-Jan

2220 Chase 11,000 28-Dec Citizen 4050 Citizen 10,000 29-Dec 1st Nat'l 1417 1st Nat'l 10,463 24-Dec 24-Dec 1st Nat payroll 4051 Citizen 12,000 31-Dec Chase 2221 Chase 15,000 05-Jan Citizen 4052 Citizen 12,000 05-Jan 1st Nat'l 1601 1st Nat'l 11,593 31-Dec 31-Dec 1st Nat payroll 4053 Citizen 14,000 07-Jan Chase 1799 1st Nat'l 10,000 08-Jan Citizen 2222 Chase 12,000 12-Jan Citizen 4054 Citizen 20,000 13-Jan 1st Nat'l 1982 1st Nat'l 9,971 08-Jan 08-Jan 1st Nat payroll --------------------------------------Traced from cash disbursements journal. Check properly listed as outstanding on bank reconciliation. Vouched to check cleared in bank statement. Traced from cash receipts journal. Vouched deposit cleared in bank statement.

24-Dec

31-Dec

08-Jan

Note: We scanned the cash disbursements and cash receipts journals for checks to and deposits from other bank accounts. Found none other than those noted in this work paper. b. What is the actual cash balance for the four bank accounts combined, considering only the amounts given in this case information, as of December 31, (before any of the December 31 payroll checks are cashed by employees)? As of January 8, (before any of the January 8 payroll checks are cashed by employees)? (Hint: Prepare a schedule of bank and actual balances like the one illustrated in Chapter 8 to explain check kiting.)

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6.49

Audit Simulation: Interbank Transfers (Continued)

Interbank Transfers Subtractions in the "bank" column indicate checks cleared and paid by the banks. Chase Bank Citizen Bank 1st National 1st Nat'l Payroll Combined ---------- ---------- ----------------------- ---------- ------------ ---------- ------------ ---------- -------------------Date Check Bank(1) Actual(2 Bank(1) Actual(2) Bank(1) Actual(2) Bank(1) Actual(2) Bank(1) Actual(2) ) ----------------- --------- ---------- ---------- ----------------------- ---------- ------------ ---------- ------------ ---------- ----------------------Dec 22 (Tue) 2220 (11,000) 11,000 11,000 Dec 23 (Wed) 4050 (10,000) 10,000 10,000 Dec 24 (Thu) 1417 (9,463) (9,463) 9,463 9,463 Payroll checks cashed (9,463) (9,463) Dec 28 (Mon) 4051 12,000 12,000 (12,000) Dec 28 (Mon) 2220 (11,000) Dec 29 (Tue) 4050 (10,000) Dec 30 (Wed) 2221 (15,000) 15,000 15,000 Dec 30 (Wed) 4052 (12,000) 12,000 12,000 Dec 31 (Thu) 1601 (11,593) (11,593) 11,593 11,593 Dec 31 (Thu) 4051 (12,000) ---------- ---------- ----------------------- ---------- ------------ ---------- ------------ ---------- -----------(a) Balances 1,000 (14,000) 4,000 (8,000) 944 944 11,593 11,593 17,537 (9,463) ---------- ---------- ----------------------- ---------- ------------ ---------- ------------ ---------- -----------Payroll checks cashed (11,593) (11,593) Jan 4 (Mon) 4053 14,000 14,000 (14,000) Jan 5 (Tue) 1799 10,000 10,000 (10,000) Jan 5 (Tue) 4052 (12,000) Jan 5 (Tue) 2221 (15,000) Jan 7 (Thu) 2222 (12,000) 12,000 12,000 Jan 7 (Thu) 4053 (14,000) Jan 8 (Fri) 4054 (20,000) 20,000 20,000 Jan 8 (Fri) 1799 (10,000) Jan 8 (Fri) 1982 (9,971) (9,971) 9,971 9,971 ---------- ---------- ----------------------- ---------- ------------ ---------- ------------ ---------- -----------(b) Balances 0 (12,000) 0 (20,000) 973 973 9,971 9,971 10,944 (21,056) ---------- ---------- ----------------------- ---------- ------------ ---------- ------------ ---------- -----------Payroll checks (9,971) (9,971) cashed Jan 12 (Tue) 2222 (12,000) Jan 13 (Wed) 4054 (20,000) ---------- ---------- --------------------------------- ------------ ---------- ---------------------- -----------Balances (12,000) (12,000) (20,000) (20,000) 973 973 0 0 (31,027) (31,027) ====== ====== ====== ======= ====== ======= ====== ======= ====== ======= (1) "Bank" means the bank's records of deposits received and checks paid (cleared). McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e The McGraw-Hill Companies, Inc., 2007 6-16

(2) "Actual" means the amounts the general ledger would have shown had the transfers been recorded. 6.50 Manipulated Bank Reconciliation Yes, something is wrong, and it takes a careful eye to detect it. The bank statement has been altered. Cleared check # 2233 for $5,000 has been erased, and the bank balance has been changed from $2,374.93 to $7,374.93. The bank balance is actually $5,000 lower than the reconciliation shows. Since the problem says: "all checks entered in Caulco's cash disbursements journal through February 29 have either cleared the bank or are listed as outstanding checks in the February bank reconciliation," the conclusion is that this $5,000 check was not recorded. Students can find the alteration several ways. (1) They can notice the check (!) and find that it is not on the bank statement, even though it is dated and cleared in February, (2) they can add the checks listed in the February bank statement and find that the total is $5,838.29, not the $10,838.29 shown on the bank statement, and the number of checks (25) does not match the bank statement (26), (3) they can add the previous balance to the deposit and subtract the withdrawals to find a balance of $2,374.93 instead of the altered $7,374.93, and (4) they can notice the skip in the numerical sequence not noted by the bank's double asterisk (**) used to indicate a skip (this is the place the paid check was erased). Also, the "low bank balance" figure of $2,374.93 gives it away. CAULCO, INC. Bank Reconciliation (Corrected) February 28 Balance per bank .................................................................................................... Deposit in transit .................................................................................................... Outstanding Checks: Number Date 2239 2240 Feb 26 Feb 29 Total Outstanding Reconciled balance General ledger balance Feb 28 Cash overstatement, Check #2233 not recorded Payee Alpha Supply L.C. Stateman Amount 500.00 254.37 (754.37) $ 2,718.25 $ 7,718.25 $ 5,000.00

$ 2,374.93 1,097.69

6.51

Investigating a fraud If the company is local, visit the location to determine if the company exists. Obtain the checks used to pay the vendor to determine the bank used by the vendor (information should be on the back of the check). Match the vendor invoices to receiving reports to determine if product was received. Match the invoices to purchase orders and purchase requisition to determine if purchase orders exist and that material was requested. If purchase orders or requisitions come from the same person, check the bank used by that person (from the direct deposit information or the back of their paycheck) to see if it is the same bank as the vendor (or maybe even the same account). Check the county court house for information on the business. Other procedures may also be valid.

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6.52

Audit Simulation: Purchasing Fraud a. It is likely that a purchasing agent has created a shell company (K.A. Supplies) and is awarding bids to the shell company. Once the bid is award, someone purchases the necessary materials and sends them to Big Builders at a marked up price. We might obtain information about the bank account used by K.A. Suppliers. This information would be available on the back of the checks we used to pay K. A. Suppliers. We may wish to do an analysis of the business we do with K.A. Supplier. The receipt and recording of bids may be segregated from the purchasing function. In addition, a requirement that all bids be attached to the purchase order may provide senior management in purchasing opportunity to see that the lowest bids is the bid being accepted. The bidders should have to be on the approved vendor list and an inspection of the vendor facility by someone outside of purchasing should be required for adding a company to the list.

b.

c.

6.53

The Perfect Crime? The ingenious scheme was a perfect crime for a long time. Only the greed of the embezzler finally tipped off the managers, who commissioned a special investigation to learn why expenses were high, profits low, and cash flow small. Ordinary everyday control activities for detection: 1. Someone else taking over the embezzler's duties at vacation time might have been less willing or able to dig out the documentation to support payment of "past due" amounts, thus leading to suspicion and maybe discovery. The embezzler avoided the problem by clearing all the vendor payments a month before his regular vacation. The treasurer might have been more diligent about remembering earlier payments of amounts later submitted as "past due," but she had other more important assignments. (In fact, the documents were just scanned and the checks were signed with a mechanical signature plate.) Someone in charge of investigating budget variances (when they occurred) might have been more in tune with "thinking like a crook," but several people in several departments were not that careful. The variances were not very large after the first two years (although some larger ones began to show toward the end when the embezzler got greedy.)

2.

3.

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6.53

The Perfect Crime? (Continued) Extensive detection efforts: The embezzler was caught because he was too greedy--adverse cash flow alerted the business owner, and an investigation started. 1. 2. 3. 4. The investigator spent a long time reviewing the expense accounts and studying documentation. He noticed fairly frequent payments of "past due" balances. In the course of repeated interviews with the company president, he learned about the company's policy of paying bills on time to obtain trade discounts. The president was surprised to learn of the numerous incidents of past due bills. More searching by the investigator led to notice of five "quarterly payments" in an expense account for the rental of a photocopy machine. This was the first obvious sign of a duplicate payment. The investigator asked the bank to send copies of the checks for the five payments. One proved to be payable to the embezzler. This discovery led to requests for access to all the company's canceled checks, and the investigator then was able to find numerous checks payable to the embezzler. The physical differences in the company's own checks and the embezzler's private stock were small, but they were noticeable. Charges were filed. The district attorney subpoenaed the embezzler's bank account records, and the bogus checks were matched with deposits.

5.

6.54

Select Effective Extended Procedures These procedures are offered without explanation of the information that might be discovered. For each one, a confirmation of the suspicion might arise. One definite instance is enough to justify proceeding with an investigation (real fraud examination), but failure to find confirming evidence can mean (1) nothing wrong is going on, or (2) the crook is too clever for the auditor. All of these procedures should be conducted with care not to impugn falsely the integrity of the people under investigation. a. Count the petty cash fund on Friday morning in the presence of the supervisor and custodian of the fund. Then, perform a second surprise count Friday afternoon before the custodian leaves work for the day. Ask the local Better Business Bureau for reports on the eight new vendors. Ask the local Chamber of Commerce if they are members. Look them up in the telephone book. Telephone them, asking about business hours, product availability, and other matters. but not in a way to arouse suspicion of investigation. Visit the business location (telephone book address) to browse. Go to the local tax assessor-collector office files to look up the owner of the property where the businesses are located. If any of the new vendors are professional people, look them up in state licensing agency directories (e.g. CPAs, attorneys, doctors). Go to the state secretary of state office and look up the corporate charter to see if the purchasing agent is shown as an incorporator, officer, or director (if a large company, you can use the Standard & Poor's Register of Corporations, Directors, and Executives) . Look them up in the state or county "assumed name" files for real names. Write a check to each business, and use the canceled check to identify the businesses' banks; then get one of the purchasing agent's canceled payroll checks to see whether they all bank at the same place. (This is circumstantial evidence that needs more work, but it would be an unlikely coincidence in most cases if all of them had accounts at the same bank.) Avoid approaching the chief purchasing agent with inquiries about the new vendor approval process because you might alert the person to the investigation.

b.

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6.54

Select Effective Extended Procedures (Continued) c. Select the people who have quit and determine their termination dates. In the payroll records, find the identification of their last paychecks (check number), then find the canceled checks and examine the endorsement, looking for two endorsements, one of which might be the payroll supervisor. Contact the terminated employees on the pretext of an exit conversation, and inquire whether they received all their paychecks, being sure to identify the last period or severance pay provision for them. Add the customers' subsidiary accounts and compare to the general ledger control account. If clerks are giving customers proper credit in their subsidiary accounts but not depositing the money and enabling the accounting system to credit the control account, they may be out of balance. If you can identify suspicious accounts, ask the customers to give you originals or copies of their canceled checks so you can examine the endorsements to see whether they appear to have been negotiated by a company employee. Use the cash receipts journal date and the deposit date at the bank to see whether there is a pattern of delay that could indicate the cashier is holding the deposits. Last resort is a surprise cash count at the cashier's desk to see whether cash on hand is actually on hand.

d.

e.

6.55

FORENSIC ACCOUNTING ASSURANCE ENGAGEMENT 1: Expenditure Analysis FORENSIC ACCOUNTING CONSULTING ENGAGEMENT 1 Known Expenditures: House payments Mercedes payments Nissan Maxima payments Audio and video equipment Household expenses Total estimated expenditures Known Sources: Beginning bank balance Take-home pay 12 @ $2,950 Ending bank balance Total known sources Expenditures financed by unknown sources $ 3,462 35,400 (2,050) $ 36,812 $ 33,820 12 @ $ 1,377 12 @ $ 2,361 down + monthly 12 @ $900 $ 16,524 28,332 9,444 5,532 10,800 $70,632

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6.56

FORENSIC ACCOUNTING ASSURANCE ENGAGEMENT 2: Net Worth Analysis FORENSIC ACCOUNTING CONSULTING ENGAGEMENT 2 END YEAR ONE ASSETS: Residence Stocks and Bonds Automobiles Certificate of Deposit Cash Total Assets LIABILITIES: Mortgage Balance Auto Loan Total Liabilities Net Worth Change in Net Worth TOTAL EXPENSES* Increase in Net Worth + Expenses KNOWN INCOME FUNDS FROM UNKNOWN SOURCES * Includes some principal payments on debts. $ 100,000 30,000 20,000 50,000 6,000 $ 206,000 90,000 10,000 $ 100,000 $ 106,000 END YEAR TWO $ 100,000 30,000 20,000 50,000 12,000 $ 212,000 50,000 -0$ 50,000 $ 162,000 $ 56,000 30,800 $ 86,800 40,000 $ 46,800 END YEAR THREE $ 100,000 42,000 40,000 50,000 14,000 $ 246,000 -0-0-0$ 246,000 $ 84,000 28,000 $ 112,000 42,000 $ 70,000

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6.57

Employee Embezzlement via Cash Receipts and Payment of Personal Expenses Objective: Obtain evidence to determine whether expenses paid from the extra bank account were for legitimate school business. Auditors cannot ignore informants' tales. Control: Cash disbursements should be authorized by responsible officers of the organization to be for valid business purposes. It is not unusual for a business manager to have the authorization responsibility. Tight control would call for disbursement review (at time of check signature) by another responsible person (superintendent), and this control was not always observed. Cash receipts should be listed by the person initially in control (cafeteria manager), deposited by another person (business manager), and a responsible person (superintendent, internal auditor, external auditor) should compare the initial control record to the deposit to note any differences. Test of Controls: Forewarned by the informant, the auditors could make inquiry: "Does the school district have a fund for which individual disbursements are not approved by the school board?" and "Does the business manager have responsibility for this fund?" Answers to both questions directed to the superintendent would be "yes," and the auditors can then concentrate initial attention on the particular account records. The next question is: "Does the cafeteria manager make a record of the daily receipts?" Answer by the superintendent: "I don't know, ask her." Luckily, it turned out that the cafeteria manager, without direct instructions, made notes on a calendar of the amount of money sent forward to the business manager for deposit. Procedure: Compare the amounts from the cafeteria manager's calendar to the deposits in the account. Audit of Balance: The "balances" being audited are the expense accounts that received the debits from the extra bank account. However, it is efficient to go to the bank account records as a starting point for the investigation. Obtain the bank statements and supporting documents for cash disbursements. Study them for evidence of (1) improperly authorized payments, (2) payments of personal expenses on the school district's VISA account, and (3) payments to unauthorized persons or to "cash" for unauthorized purposes. Discovery Summary: After finding payments to American Express and VISA, auditors asked the superintendent about the credit card used by the school and learned that the school used only VISA. Inquiry at American Express revealed the business manager as the owner of the account number found on receipts in the supporting documents. (Actually, by this time the business manager had confessed, but identification of the account might have been harder.) Study of the items and dates on the VISA charge slips showed items (e.g. hosiery) not used at the school and dates that did not match business periods. Review of the checks identified the son as payee on some. During this review, the auditors found checks dated out of numerical sequence and a missing block in the most current month. This was a sign of having blank checks signed, so the superintendent was asked, and he admitted doing so. The missing block was in the business manager's a desk drawer, already signed. Comparing the cafeteria manager's notes of cash receipts showed shortages in numerous deposits. The business manager admitted taking the cash.

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6.58

Kaplan CPA Exam Simulation: Audit objectives for cash C A B The confirmation of cash balances at year-end will provide assurance that cash on the balance sheet is owned by Harrison. Cut-off procedures will provide assurance that all cash amounts owned by Harrison at year-end appear on the balance sheet. An analysis of the relationships between cash and investments will provide assurance that cash balances are properly described and presented in the financial statements. Reviewing the minutes of the meetings of the board of directors will provide assurance that Harrison has authorized all long-term debt at the balance sheet date. Examining lease agreements for potential capitalization will provide assurance that all long-term debt at the balance sheet date is identified and recorded. Testing the reasonableness of interest expense and accrued interest payable will provide assurance that long-term debt at the balance sheet date is properly classified. Reviewing debt agreements for interest rates, restrictive covenants and assets that have been pledged will provide assurance that long-term debt is properly presented in the financial statements and related restrictions, regulations, guarantees, interest rates, pledged assets and commitments are adequately disclosed.

H E I

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6.59

Kaplan CPA Exam Simulation: Bank Reconciliation 1. A The amount stated on the bank statement should be traced and agreed to the balance provided on the bank confirmation (the bank confirmation should be received directly from the financial institution). Deposits in transit that are listed on the bank reconciliation should be retotaled by P&M to confirm Lakelands calculation. The deposits in transit should be traced and agreed to the cash receipt records for the year being audited (Year 2) since the amounts are already included in calculating the December 31, Year 2 cash balance but are not included on the December 31, Year 2 bank statement balance. The deposits in transit should also be traced to the cut-off bank statement (presumably received sometime in January, Year 3) from the bank to confirm that the amounts were subsequently received. The outstanding checks listed on the bank reconciliation should be re-totaled by P&M to confirm Lakelands calculation. The outstanding checks should be traced and agreed to the cash disbursement records for the year being audited (Year 2) since the amounts are not included (thus, have been deducted) in calculating the December 31, Year 2 cash balance but are included (thus, have not been deducted) in the December 31, Year 2 bank statement balance. Finally, the outstanding checks should be traced to the cutoff bank statement to confirm that the amounts were subsequently disbursed. The erroneous bank deposit should be traced and agreed to the bank cut-off statement to ensure that the amount was subsequently corrected by the bank. The balance of $573,250 should be traced and agreed to Lakelands trial balance or general ledger. Additionally, the balance should be recomputed by P&M to confirm the accuracy of Lakelands total.

2.

C-E-H

3.

C-G-H

4. 5.

H B-C

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Kaplan CPA Exam Simulation: Bank Confirmation 1. 2. False False The confirmed bank balance (cash basis) should be traced and agreed to the balance per bank on the reconciliation, NOT the general ledger (accrual basis). The difference of $25,000, if left unresolved, could result in a material overstatement of liabilities (recall that the overall financial statement materiality is only $20,000). Such a material overstatement of liabilities would result in the overall financial statements being materially misstated, which would not allow for a clean audit opinion. Therefore, further work is required by P&M to resolve the apparent balance discrepancy. Bank confirmations are generally not required to be used when performing a proof of cash. Note, P&M would only perform a proof of cash if there is a material internal control weakness for cash at Lakeland. A reconfirmation of the line of credit balance of $150,000 is necessary to ensure that there was no error on the part of the bank in the original confirmation process. The restricted cash relating to real estate taxes on the property under construction must be disclosed separately in the notes to the financial statements.

3.

False

4.

True

5.

False

6.61

Kaplan CPA Exam Simulation: Bank Transfer Schedule 1. True Disbursement amounts included on a bank transfer schedule should be traced to the clients cash disbursement records to determine if the amount was appropriately included or excluded from the records. Disbursements on the bank transfer schedule should be correctly included or excluded depending on the date when the particular item cleared the bank. All of the information is required to prepare a complete bank transfer schedule. Check #122 is a not a deposit in transit at December 31, Year 2 since it was not disbursed until the following year, Year 3. The procedure helps to detect the overstatement of cash due to kiting.

2. 3. 4. 5.

False True False True

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6.62

Kaplan CPA Exam Simulation: Weaknesses in Cash Receipts To: Partner, P&M From: Manager, P&M Subject: Reportable Conditions, Significant Deficiencies, and Material Weaknesses A reportable condition is a significant deficiency in the design or function of internal control that could adversely affect the organizations ability to record, process, summarize, and report financial data. Significant deficiencies are defined as conditions that could adversely affect the organizations ability to initiate, record, process, and report financial data in the financial statements. The deficiency would provide a more than remote possibility of a misstatement that is more than inconsequential would not be prevented or detected. Examples include: Absence of appropriate segregation of duties. Absence of appropriate reviews and approvals of transactions. Evidence of failure of control procedures. Evidence of intentional management override of control procedures by persons in authority to the detriment of control objectives A material weakness in internal control is defined as a condition that results in more than a remote likelihood of a material misstatement of the financial statements. Before Sarbanes Oxley, AU 325 required us to communicate reportable conditions to the audit committee through a report, either orally (with the discussion documented in the working papers) or in a written letter to the audit committee. In the report, we were not required to identify whether a reportable condition was actually a material weakness. Now, because Lakeland is a public company, we are required to follow the Sarbanes-Oxley act, which requires us to identify significant deficiencies and material weakness and report them in writing to the audit committee.

6.63

Kaplan CPA Exam Simulation: SAS 99 Requirements (AU sec. 110, par. 2): The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not absolute, assurance that material misstatements are detected. The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud, that are not material to the financial statements are detected.

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