Auditing - Chapter 6

Test 3, November 3 2026

Primary target for fraudsters

Cash, because of liquidity

can a person commit both employee and management fraud?

yes. steal cash, then alter documents to cover up

Management fraud

Intentional deception by management to injure investors and creditors

Employee fraud

Misappropriation of assets, usually involves false doc

Employee frauds consists of

1. The fraudulent act

2. The conversion (of assets)

3. The cover-up

Direct-effect Illegal Acts

violations of laws or government regulations by the company, or its management or employees

Employee Fraud Red Flags

• Experience sleeplessness.

• Drinking too much.

• Take Drugs.

• Become irritable easily.

• Can’t relax.

• Get defensive, argumentative.

• Can’t look people in the eye.

• Sweat excessively.

• Go to confession (example, priest, psychiatrist).

• Find excuses and scapegoats for mistakes.

• Work standing up.

• Work alone.

• Work late frequently.

• Don’t take vacations.

Employee frauds red flags are not conclusive proof, so auditors should

make specific inquiries of management regrading change in employe’s demeanor and lifestyle

Fraudsters are also called …

white-collar criminals

Characteristics of a Fraudster (white-collar criminals)

• Has education beyond high school.

• Is likely to be married.

• Is member of a church, temple, etc.

• 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 (70 percent or more of incidents). bc collusions are harder to pull off

Fraud Triangle (three conditions that are likely present when a fraud occurs)

• Incentive/Pressure.

• Opportunity.

• Attitude/Rationalization

Fraud Triangle - Incentive/Pressure

Motive: reason to commit fraud, that is unsharable
Have to meet specific expectations for bonus

Psychotic motive

“Habitual criminal” who steals for the sake of stealing

Economic motive

Simply in need or desire (make payments or high lifestyle)

Egocentric motive

Committing fraud for personal prestige

Thinks their cause is morally superior, therefore stealing is justified

Fraud Triangle - Opportunity

Open door: weak internal controls

The greater the position, the greater the trust and exposure to unprotected assets, the grater the opportunity for large frauds.

Fraud Triangle - Attitude/Rationalization

Do things contrary to their personal beliefs (outside their normal behavior) so they provide an argument to make the action seem like it is in line with their moral and ethical beliefs or self-image
• I need it more than the other person.

• Everybody does it

• I am underpaid, so this is due compensation.

Fraud prevention

• Manage people and pressure in the workplace

• Enforce internal control and employee monitoring

• Set a strong tone at the top

Fraud prevention - Manage people and pressure in the workplace

• Ethics officers
  Employees can talk to over ethical dilemmas. They are not usually psychological counselors

• Anonymus hotlines
  For reporting ethical problems (also required by SOx to be anonymous)

• Counseling services
  When dealing with substance abuse, mental health problems, family issues, etc. Not guaranteed to prevent fraud, but can have positive impact on organisations.

Fraud prevention - Enforce internal control and employee monitoring

To take away opportunity for a fraudster to commit fraud: segregation of duties

Auditors should Be Aware of Exceptions

Separation of duties and responsibilities

1. Transaction authorization

2. Record keeping

3. Custody of access to assets

4. Reconciliation of assets to the accounting records

Be Aware of Exceptions

• Missing documents.

• Photocopied documents.

• Common names or addresses for refunds.

• Unusual endorsements.

• Old outstanding checks.

• Unexplained adjustments to accounts receivable and inventory balances.

• Unusual patterns in deposits in transit.

• General ledgers that do not balance.

• Cash shortages and overages.

• Excessive voids and credit memos.

• Customer complaints.

Fraud prevention - Set a strong tone at the top

• Upper management to demonstrate integrity and high ethical standards

• Hiring policies: background checks and accountability

• Termination policies: accountability

Reports, Documents, and Data files used to Audit the Cash Account

• Cash receipts journal: records cash received

• Cash disbursements journal: records cash spent

• Bank reconciliations.

• Cancelled checks: to find fraudulent checks

• Bank statements.

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.

primary target for employee theft

cash, because: highly liquid, not easily identifiable, easily transportable

Internal Controls Over Cash Receipt

• Dual custody of cash at all times.

• Lockbox arrangement.

• Fidelity bonds: insurance policy that covers embezzlement losses

Tests of Internal Controls over Cash Receipt

• Existence: does the cash exist?

• Valuation: inspect monthly balance

• Presentation and disclosure: cash properly disclosed

Controls Over Cash Disbursement

Segregation of duties:

• Custody (of blank checks)

• Authorization (who can sign)

• Recording (payments)

• Reconciliation

Test of Controls Over Cash Disbursement

• Inspect supporting documentation for mathematical accuracy, classification, approval, authorization and date

• Sequence (look for missing numbers) and duplicates

• Is the bank reconciliation prepared on a timely basis

Substantive tests over Cash

• Existence: confirm bank balance with each financial institution

• Valuation: trace monthly foreign cash translation

• Presentation and disclosure: did the client disclose in their footnotes

Audit Evidence Used to Test Cash

• Cash receipts journal

• Cash disbursements journal

• Bank reconciliations: Year-end bank statement, Cutoff bank statement, Deposit in transit

• Bank confirmations.

• Schedule of interbank transfers.

Extended Procedures to Detect Fraud

• Schedule of Interbank transfer: check kiting

• Proof of cash

Check kiting

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.”

to detect kiting, auditors checks the …

Schedule of Interbank Transfers: use cutoff bank statement to make sure the cash really exist

Extended Procedure to Detect Fraud - Proof of Cash

Combines two bank reconciliations, reconciling all transactions that occurred during the period

to the client’s Cash Receipts Journal and Cash Disbursements Journal

Other Extended Procedures for Detecting Fraud Involving Cash

• Count and recount petty cash on the same day.

• Examine endorsements on cancelled checks.

• Covert surveillance: auditors observe activities without being seen

• Net worth analysis: calculate a suspect’s net worth, and if it matches with their income