McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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

6-2

Learning Objectives
1. 2. 3. 4. 5. 6. Define and explain the differences among several kinds of employee fraud that might occur at an audit client. Identify and explain the three conditions (i.e., the fraud triangle) that often exist when a fraud occurs. Describe techniques that can be used to prevent employee fraud. Describe the control activities over the receipt and disbursement of cash. Describe the types of substantive procedures that are conducted during 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.

7.

6-3

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

The Fraud Triangle

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

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

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

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. Im 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

Fraud Prevention
A strong control environment and tone at the top
Can have a pervasive effect on fraud prevention

Managing people pressures in the workplace

Counseling services Anonymous hotlines Ethics officers

Internal control activities and employee monitoring

Segregation of duties and responsibilities for transaction authorization, record keeping, custody of or access to assets, and reconciliation of actual assets to the accounting records.

Integrity by example and enforcement

Accountability Codes of conduct Background checks prior to hiring

6-9

Cash Receipts: Process 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

6-10

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

6-11

Audit Evidence Used to Test Cash

Cash receipts journal Cash disbursements journal Bank reconciliations Cancelled checks Year-end bank statement Cutoff bank statement

6-12

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 TRACE to cash receipts journal VOUCH to CUTOFF BANK STATEMENT VOUCH to cash disbursements journal TRACE checks cleared from cutoff bank statement Inspect bank credit/debit memo and audit for reasonableness. Examine relevant supporting documentation. FOOT the entire reconciliation for mathematical accuracy TRACE the amount to the trial balance

Add deposits-in-transit

Subtract Outstanding Checks

Add/Subtract other Debit/Credit Memos

Balance per books

6-13

Confirmation of Bank Balances

Standard Bank Confirmation Inquiry
Must be mailed under auditors 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) Can improve the control of both delivery and receipt of the confirmation request Allowed by professional auditing standards

6-14

Other Fraud Detection Procedures for Cash

Count the petty cash twice in one day Carefully examine endorsements on canceled checks Audit general journal entries Retrieve customer checks Use marked coins and currency Measure deposit lag time Examine documents such as bank statements for alteration Covert surveillance

6-15