Employee Fraud and Cash Auditing Lecture Notes

Overview of Fraud and Distinctions

• Fraud Definition: Fraud consists of knowingly making material misrepresentations of fact with the intent of inducing someone to believe the falsehood and act upon it, thus resulting in the victim suffering a loss or damage.

• Management Fraud: This is an intentional deception orchestrated by management. It is specifically designed to injure investors and creditors by providing materially misleading financial information.

• Employee Fraud: Defined as the use of fraudulent means to take money or other property from an employer. It involves three distinct phases:

  • The fraudulent act itself.

  • The conversion of the money or property to the fraudster’s personal use.

  • The cover-up.

• Embezzlement: A specific type of fraud that involves employees or non-employees wrongfully taking money or property that has been entrusted to their care, custody, and control. This act is frequently accompanied by false accounting entries and various forms of lying or cover-up.

• Errors: These are unintentional misstatements or omissions of amounts or disclosures in financial statements.

• Direct-effect Illegal Acts: These are violations of government regulations by the company, its management, or its employees that result in direct and material effects on the dollar amounts reported in the financial statements.

Behavioral Red Flags of Employee Fraud

Observations of changes in a person's habits and lifestyle can reveal red flags. Fraudsters may exhibit the following behaviors:

• Experiencing sleeplessness.

• Drinking too much alcohol.

• Taking drugs.

• Becoming easily irritable.

• An inability to relax.

• Becoming defensive or argumentative.

• An inability to look people in the eye.

• Excessive sweating.

• Seeking out confession (e.g., visiting a priest or psychiatrist).

• Finding excuses and scapegoats for mistakes.

• Choosing to work standing up.

• Working alone.

• Working late frequently.

• Not taking vacations.

Characteristics of a Typical Fraudster

While a fraudster often looks like anyone else, common characteristics include:

• Education level beyond high school.

• Likely to be married.

• Member of a mosque, temple, or church (religious affiliation).

• Age range from teens to over $60$ years old.

• Socially conforming behavior.

• Employment tenure ranging from $1$ to $20$ years.

• No prior arrest record.

• Acts alone in $70\,\%$ or more of reported incidents.

The Fraud Triangle: Conditions for Fraud

There are three conditions likely to be present when fraud occurs, forming what is known as the Fraud Triangle:

• Incentive/Pressure: The motive behind the act.

• Opportunity: The ability to carry out the act.

• Attitude/Rationalization: The justification for the act.

Motivation: Incentive and Pressure

In the context of fraud, a motive is a pressure a person experiences and believes is unshareable with friends or confidants. Types of motives include:

• Economic Motive: An actual or perceived need for money.

• Psychotic Motive: A "habitual criminal" who steals simply for the sake of stealing.

• Egocentric Motive: Committing fraud for the sake of personal prestige.

• Ideological Motive: A belief that the cause is morally superior, justifying the victimization of others.

Opportunity for Fraud

Opportunity is the "open door" that allows a person to solve their unshareable problem by violating a trust. Factors include:

• Weak internal controls.

• Circumvention of existing internal controls.

• Position levels: The greater the position held in a company, the greater the trust and exposure to unprotected assets.

Attitude and Rationalization

When individuals act contrary to their personal beliefs or normal behavior, they develop arguments to align the action with their moral code. Frequent rationalizations include:

• "I need it more than the other person."

• "I’m just borrowing the money and I will pay it back."

• "Everybody else does it."

• "The company is big and will never miss it."

• "Nobody will get hurt."

• "I am underpaid, so this is just due compensation."

• "I need to maintain a lifestyle and image."

Fraud Prevention Strategies

• Control Environment and Tone at the Top: A strong ethical culture has a pervasive effect on prevention. Management must establish a commitment to integrity through example, accountability, codes of conduct, and hiring/firing policies.

• Managing Workplace Pressures: Utilizing counseling services, anonymous hotlines, and ethics officers.

• Internal Control Activities: Implementing segregation of duties—specifically separating transaction authorization, record keeping, custody of assets, and reconciliation of assets to records.

• Personnel Policies: Conducting background checks prior to hiring and the active prosecution of fraudsters.

Documentation and Transaction Exceptions

Auditors should remain alert for the following exceptions which may indicate fraud:

• Missing, altered, or photocopied documents.

• Second or unusual endorsements on checks.

• Old outstanding checks.

• Unexplained adjustments to accounts receivable or 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.

• Common names or addresses used for refunds.

• Increased past due receivables.

• Inventory shortages or increased scrap.

• Duplicate payments.

• Employees who cannot be found.

• Dormant accounts becoming active.

• Transactions recorded at unusual times or associated with unusual locations/branches.

• Unusual numbers or dollar amounts of transactions (either very large or very small).

• Round dollar amounts.

Audit of the Cash Account: Reports and Data

Key documents used in the audit of cash include:

• Cash receipts journal.

• Cash disbursements journal.

• Bank reconciliations.

• Canceled checks.

• Bank statements.

Cash Receipts: Process Activities

1. Receive cash and remittance advice via mail.

2. Prepare a remittance listing.

3. Enter the total from the remittance listing (or advice) into the cash receipts journal.

4. Prepare a deposit slip and deposit cash receipts in the bank intact and on a daily basis.

5. Record updates to the subsidiary accounts receivable ledger using the remittance advice.

6. Perform a daily reconciliation of the remittance listing, subsidiary accounts receivable, and the deposit slip.

Cash Receipts Processing Roles

• Operations Department (Mailroom): Receives cash and prepares the remittance list (C.R.L.).

• Marketing Department (Salesclerks): Approves discounts and notes approval on the remittance list.

• Treasurer’s Office (Cashier/Cash Management): Prepares the cash deposit and ensures all receipts are deposited intact daily. Sends money and deposit slips to the bank.

• Controller’s Office (Accounts Receivable): Posts to individual customer accounts.

• Controller’s Office (General Ledger): Prepares the cash receipts journal and posts to the general ledger (Accounts Receivable Control and Cash Accounts).

• Internal Audit/Reconciliation: Prepares the monthly bank reconciliation by comparing the bank statement to internal records.

Assertions, Risks, and Internal Controls for Cash

Cash is a primary target for theft because it is highly liquid, easily transportable, and not easily identifiable.

• Key Internal Controls:

  • Dual custody of cash at all times.

  • Lockbox arrangements.

  • Fidelity bonds.

Mapping Assertions to Risks and Controls

• Assertion: Existence:

  • What Could Go Wrong (WCGW): The cash balance may not exist in the company's bank accounts.

  • Internal Control: The CFO performs a detailed monthly review of the bank reconciliation.

  • Test of Control: For a sample of bank reconciliations, reperform the reconciliation and trace items to supporting documentation.

  • Substantive Test: Test reconciliation details for each significant account; confirm bank balances with financial institutions.

• Assertion: Valuation:

  • WCGW: Cash held in foreign countries may not have been translated properly.

  • Internal Control: The treasurer reviews the cash translation adjustment calculation monthly and checks the spot rate used for each currency.

  • Test of Control: Inspect the monthly translation calculation for evidence of the treasurer's review.

  • Substantive Test: For a sample of calculations, trace each foreign currency spot rate to a third-party pricing service.

• Assertion: Presentation and Disclosure:

  • WCGW: Restrictions on the cash balance may not be properly disclosed.

  • Internal Control: The corporate secretary reviews the cash footnote disclosure quarterly to ensure legal restrictions are disclosed.

  • Test of Control: Reperform the corporate secretary's work for a sample of cash accounts.

  • Substantive Test: Examine legal agreements with financial institutions to determine if legal restrictions require footnote disclosure.

Detailed Tests of Controls

Over Cash Receipts

1. Intact/Daily Deposits: Observe mail opening to ensure two employees are present, remittance advice is received, and checks are endorsed. Compare the check listing to the deposit ticket. Verify the deposit date in the bank statement matches the proper period.

2. Reconciliation: Trace a sample of daily postings in the accounts receivable subsidiary ledger to the cash subsidiary ledger.

Over Cash Disbursements

1. Voucher Packets: Inspect supporting documentation for recorded disbursements (purchase requisition, purchase order, receiving report, invoice). Check for mathematical accuracy, classification, approval, and authorized signatures. Compare check dates to the disbursements journal.

2. Sequence Integrity: Scan checks for sequence; identify gaps or duplicates.

3. Timeliness: Review bank reconciliations to ensure they are prepared on a timely basis.

Procedural Audit of Cash

The primary procedure is to obtain and audit the bank reconciliation for each account as follows:

• Balance per Bank: Confirm directly with the bank (Electronic Confirmation); agree the amount to the Cutoff Bank Statement.

• Add Deposits-in-Transit: Trace these to the cash receipts journal and vouch them to the Cutoff Bank Statement.

• Subtract Outstanding Checks: Vouch these to the cash disbursements journal and trace checks that cleared from the Cutoff Bank Statement.

• Add/Subtract Memos: Inspect bank credit/debit memos for reasonableness and examine supporting documentation.

• Balance per Books: Foot the entire reconciliation for mathematical accuracy and trace the final amount to the trial balance.

Bank Confirmations

• Electronic Confirmation Requests: Most banks now use third-party intermediaries (e.g., Confirmation, formerly confirmation.com). This improves control over delivery and receipt and is allowed by professional standards. Used for deposit balances, loan balances, contingent liabilities, and secured transactions.

• Standard Bank Confirmation Inquiry: If manual, it must be mailed under the auditor’s own control.

Extended Fraud Detection Procedures

• Schedule of Interbank Transfers (Check Kiting): Used to detect the deliberate floating of funds between accounts to inflate cash balances. While technology has reduced this risk, auditors still use this schedule to monitor the timing of transfers.

• Proof of Cash: Used when controls are weak. It reconciles all transactions occurring during a period (receipts and disbursements) to the client’s journals, essentially combining two bank reconciliations.

• Other Forensic Procedures:

  • Count and recount petty cash on the same day.

  • Examine endorsements on cancelled checks.

  • Retrieve original customer checks.

  • Use marked coins and currency.

  • Analyze the mix (ratio) of cash vs. checks in deposits.

  • Measure deposit lag time.

  • Document examination and inquiry.

  • Covert surveillance.

  • Horizontal and vertical financial analyses.

  • Net worth and expenditure analysis.

  • Reasonableness tests.