Chapter 6

1. Chapter 6 Employee Fraud and the Audit of Cash "Rather fail with honor than succeed by fraud." --Sophocles (496-406 BCE) ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Presentation Outline • An Overview of Fraud • Cash Collections and Disbursements • Audit of Cash ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

3. I. An Overview of Fraud • Fraud Opportunities • Definitions Related to Fraud • The Elements of Fraud • Red Flags: Employee Fraud • Fraud Prevention ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

4. A. Fraud Opportunities ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

5. 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. B. Definitions Related to Employee Fraud ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

6. 1. Motive 2. Opportunity High Risk 3. Rationalization C. The Elements of Fraud 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. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

7. 1. 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 ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

8. 2. 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. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

9. 3. 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. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

10. Missing documents. 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. Alterations on documents. Duplicate payments. Employees that cannot be found. Dormant accounts that have become active. Common names or addresses for refunds. D. Red Flags: Employee Fraud ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

11. E. Fraud Prevention • Managing people pressures in the workplace • Counseling services • Hotlines • Control procedures and employee monitoring • Integrity by example and enforcement ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

12. II. Cash Collections and Disbursements • Cash as the Most Susceptible Asset • The Processing of Cash Receipts • Key Control Activities Over Cash Collections and Disbursements ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

13. A. Cash as the Most Susceptible Asset • 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 ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

14. B. The Processing of Cash Receipts(Refer to Exhibit 6.2 on p 212) • 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 ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

15. C. Key Control Activities Over Cash Collections and Disbursements:(Also refer to Exhibits 6.3 and 6.4) • 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 • Dual custody over cash • Unused checks secured • SEGREGATION OF DUTIES ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

16. III. Audit of Cash • Cash on Hand and on Deposit • Bank Reconciliation • Standard Bank Confirmation • Check Kiting • Proof of Cash ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

17. A. Cash on Hand and on Deposit • 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. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

18. B. Bank Reconciliation • Balance per bank • CONFIRM directly with bank using a standard 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 ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

19. B. Bank Reconciliation (Continued) ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

20. C. StandardBank Confirmation(Refer to Exhibit 6.8 on p. 221) In addition to corroborating cash and loan balances, a STANDARD BANK CONFIRMATION INQUIRY also requests information about contingent liabilities and secured transactions. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

21. D. Check Kiting • KITING is a fraud that occurs by reporting cash simultaneously in two different bank accounts. • A Schedule of Interbank Transfers is generally useful in detecting KITING. • See Exhibits 6.9 and 6.10 on pages 223 and 224. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

22. E. 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. • See Exhibit 6.11 on p. 225. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

23. Summary • Fraud includes elements for motive, opportunity, and rationalization • Overview of cash receipts processing • Controls over cash in the form of bank reconciliations and bank confirmations • Check kiting and proof of cash ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.