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. 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.

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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.

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Employee Fraud Red Flags

Observation of changes in a person’s habits and lifestyles may reveal

some red flags. Fraudsters may exhibit these behaviors:

• Experience sleeplessness

• Drinking too much

• Take Drugs

• Become irritable easily

• Can’t relax

• Get defensive

• Can’t look people in the eye

• Sweat excessively

• Go to confession

• Find excuses and scapegoats for mistakes

• Work standing up

• Work alone

• Work late frequently

6-5

Characteristics of Fraudsters

• Has education beyond high school

• Is likely to be married

• Is member of a mosque, temple, or church

• Ranges in age from teens to over 60

• Is socially conforming

• Has an employment tenure from 1 to 20 years

• Has no arrest record

• Usually acts alone

Unfortunately, they look like most everybody else

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The Fraud Triangle

There are three conditions that are likely

to be present when a fraud occurs.

They are:

• Motivation

• Opportunity

• Rationalization

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Exhibit 6.1

Fraud Elements

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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)

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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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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

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Be Aware of Exceptions

o Missing documents.

o Alterations on documents.

o Photocopied documents.

o Second endorsements on checks.

o Unusual endorsements.

o Old outstanding checks.

o Unexplained adjustments to accounts receivable and inventory balances.

o Unusual patterns in deposits in transit.

o General ledgers that do not balance.

o Cash shortages and overages.

o Excessive voids and credit memos.

o Customer complaints.

o Common names or addresses for refunds.

o Increased past due receivables.

o Inventory shortages.

o Increased scrap.

o Duplicate payments.

o Employees that cannot be found.

o Dormant accounts that have become active.

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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

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Exhibit 6.2 - Cash Receipts Processing

6-15

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

6-16

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

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Exhibit 6.3 Tests of Controls for Cash

Receipts

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Exhibit 6.4 Tests of Controls Over Cash

Disbursements

6-19

Audit Evidence Used to Test

Cash

• Cash receipts journal

• Cash disbursements journal

• Bank reconciliations

• Cancelled checks

• Year-end bank statement

• Cutoff bank statement

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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

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

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Exhibit 6.7

Bank

Reconciliation

6-24

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)

– Can improve the control of both delivery and receipt of the confirmation request

– Allowed by professional auditing standards

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Exhibit 6.8

Bank

Confirmation

6-26

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.

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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.

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Exhibit 6.9

Illustration of Proof of Cash—First National Bank

6-29

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

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