Solution manual auditing and services 2e by louwers chap006

By this method, a bank customer utilizes the time required for checks to clear to obtain an unauthorized loan without any interest charge.Auditors can detect signs of kiting by observing

CHAPTER 6

Employee Fraud and the Audit of Cash

LEARNING OBJECTIVES

ReviewCheckpoints Exercises, Problems,and Simulations

1 Define and explain the differences among several

kinds of employee frauds that might occur in an

5 Design and perform substantive audit procedures for

the audit of cash 13, 14, 15, 16, 17, 18 59, 60, 6147, 48, 49, 50, 57,

6 Discuss actual cash fraud cases and describe how

7 Describe some extended procedures for detecting

SOLUTIONS FOR REVIEW CHECKPOINTS

6.1 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 employer’s property that is not entrusted to an employee’s care, custody or control

Defalcation is another name for employee fraud and embezzlement

6.2 Fraud perpetrators look like other people, hence the difficulty in spotting them easily However,

they sometimes exhibit behavioral red flags of odd habits

6.3 (1) If the employees cannot be identified, maybe they do not exist The names are odd All

the first and last names begin with the same letter

(2) If Eloise Garfunkle is a company employee, somehow she cashed a check payable to a

supplier Maybe she is related to the supplier, or maybe she intercepted the check before

it reached the supplier

(3) Somebody is working on holidays! These dates are normal workdays off for most

businesses: New Year’s Day, Memorial day, Independence day, Labor day, Thanksgiving day, and Christmas day (Would students have been able to identify holidays like memorial day and labor day if the other more obvious ones had not been listed?)1.4 Egocentric Motivations

 My father was wealthy, and I need to be wealthy too

 My friends admire cars, and I need to have an expensive one

Ideological motivations

 The company sells tobacco and alcohol, and doesn’t deserve to make a profit

 I can award the government housing grants to best use without the HUD red tape

(Justifying diversion of funds in government housing programs.)Economic Motivations

 Pay college tuition

 Pay hospital bills for a parent with cancer

 Pay gambling debts

 Pay for drugs

 Pay alimony and child support

 Pay for high life style (homes, cars, boats)

 Finance business or stock speculation losses

6.5 Conditions related directly to employee fraud:

 Nobody counts the inventory, so losses are not known

 The petty cash box is often left unattended

 Supervisors set a bad example by taking supplies home

 Upper management considered a written statement of ethics but decided not to publish

one

 Another employee was caught and fired, but not prosecuted

 The finance vice-president has investment authority without any review

 Frequent emergency jobs leave a lot of excess material just laying around

6.6 Rationalizations:

 I need it more than the other person (Robin Hood theory)

 I’m borrowing the money and will pay it back

 Nobody will get hurt

 The company is big enough to afford it

 A successful image is the name of the game

 Everybody is doing it

6.7 Some auditors look at capability as a forth item necessary for committing a fraud They argue that

if a control weakness exists, but you do not have the skills and knowledge to take advantage of theweakness then an opportunity does not present itself Others would argue that these are separate issues and the opportunity exists whether the potential fraudster has the capability or not and, therefore, capability is a requirement that must be present to produce fraud

6.8 Fraud - Prevention Management Style Style Leading to Fraud

Democratic, open-door management Autocratic management

Trust the employees and give them power in

Install controls that don’t make work difficult Install tight, bureaucratic controls

Let people design and manage their jobs and

work

Insist everything be documented with a rule for everything

Decentralize authority Centralize authority in top management

Measure performance on long-run basis Measure performance on a short-term basisHave multiple measures of performance Make profits the only criterion for successMake rewards positive and generous Make rewards punitive, stingy and politicalGive constructive positive and negative

feedback

Give feedback that is always critical and negativeCreate a cooperative workplace Create a highly hostile, competitive workplace

Boss’ exemplary behavior and decisions Boss’ questionable behavior and decisionsMake background checks on new employees Be lax about background checks

Prosecute fraudsters Fire fraudsters without prosecution

6.9 The basic sequence of activities and accounting in a revenue and collection cycle is:

1 Receiving and processing customer orders Entering data in an order system and

obtaining a credit check

2 Delivering goods and services to customers Authorizing release from storekeeping to

shipping to customer Entering shipping information in the accounting system

3 Billing customers, producing sales invoices Accounting for customer trade accounts

receivable

4 Collecting cash and depositing it in the bank Accounting for cash receipts

5 Reconciling bank statements

6.10 It might be easier just to send the cash to the accounts receivable accountants, but (1) that would

delay the bank deposit and the company would lose interest income, and (2) a dishonest

accountant could steal cash while still giving the customer credit (to forestall complaints) The accounting department is a recordkeeping function and having cash would violate the separation

of duties control because the accounting department would also have custody of assets (checks andcash) The accountant could cover the theft by making false debit entries to such accounts as allowance for doubt accounts (account write-offs) or discounts and allowances expense

6.11 The term “lapping” refers to an employee’s stealing the cash receipts of a company and then

covering the amount with a following day’s payment received for another customer’s account A

“lapping” operation is possible when a single employee has access to both cash and accounts receivable records

The auditor is alerted to the possibility of a “lapping” operation when duties are not properly separated Surprise confirmation is the primary means which an auditor can use to uncover such activity Also, details of deposit slips and cash remittance reports can be compared to detect discrepancies

6.12 All vendors should be required to be on an approved vendor list Vendors are placed on this list

with approval from multiple departments (e.g purchasing, engineering, and quality control) In addition, payments should not be made without a complete voucher package including a purchase order and receiving report Since fictitious vendors do not supply product or service, such a fraud would require collusion between purchasing and receiving

6.13 Compare the amount written on the check with the bank’s magnetic imprint of the amount paid by

the bank

6.14 There are several clues that the bank statement has been altered:

 The statement does not add up to the $7,374.93 balance shown

 The font of the “7”s do not match

 The low balance is $2,374.93 (the correct balance) and no transactions occurred after this

point

 There is a space for a gap in the check sequence, but no “**”‘s as with the other gaps

 The statement reports 26 checks, but only 25 are listed

6.15 The cutoff bank statement is a bank statement sent by the bank directly to the auditor, and it is

usually for a 15 or 20 day period following the reconciliation date The basic use of the statement

by the auditor is to determine whether outstanding checks were actually mailed before the reconciliation date and outstanding deposits in transit were actually received in a timely manner bythe bank

6.16 Check kiting is the practice of building up apparent balances in one or more bank accounts based

on uncollected (float) checks drawn against similar accounts in other banks Kiting involves depositing money from one bank account to another, using a hot check Kiting is the deliberate floating of funds between two or more bank accounts By this method, a bank customer utilizes the time required for checks to clear to obtain an unauthorized loan without any interest charge.Auditors can detect signs of kiting by observing in the bank statements:

 Frequent deposits and checks in same amounts

 Frequent deposits and checks in round amounts

 Frequent deposits with checks written on the same (other) banks

 Short time lag between deposits and withdrawals

 Frequent ATM account balance inquiries

 Many large deposits made on Thursday or Friday to take advantage of the weekend

 Large periodic balances in individual accounts with no apparent business explanation

 Low average balance compared to high level of deposits

 Many checks made payable to other banks

 Bank willingness to pay against uncollected funds

 “Cash” withdrawals with deposit checks drawn on another bank

 Checks drawn on foreign banks with lax banking laws and regulations

If these cash transfers are recorded in the books, a company will show the negative balances that result from checks drawn on insufficient funds However, perpetrators may try to hide the kiting

by not recording the deposits and checks Such maneuvers may be detectable in a bank

reconciliation audit

A schedule of interbank transfers can be constructed from the canceled checks and cleared deposits in the bank statements This schedule shows each check amount, the name of the paying bank (with the book recording date and the check clearing date), the name of the receiving bank (with the book deposit date and the bank clearing date) The purpose of this schedule is to see that both sides of the transfer transaction are recorded in the same period (and in the proper period) 6.17 A schedule of interbank transfers shows improper cash transfer transactions when the auditors find

(a) no recording of transfers shown in the bank statement, and (2) dates of bank and general ledgerrecording that are out of order

6.18 A “proof of cash” can reveal unrecorded cash deposit and cash payment transactions when the attempt to reconcile the deposits and payments reported by the bank to the deposits and payments recorded

in the general ledger requires consideration of unrecorded amounts Inspection of the bank statement and comparison to the general ledger (books) will uncover the problem, provided the documents have not been destroyed

6.19 The former petty cash custodian apparently had more expenditures than the new one Maybe the

former one was running false expense claims

6.20 No separation of the duties and responsibilities for (1) transaction authorization, (2)

recordkeeping, (3) custody of, or access to, assets, and (4) reconciliation of actual assets to the accounting records

A supervisor may not take approval responsibilities seriously and fail to perform them (like the supervisor of the petty cash custodian in the text case)

Tight control may be too expensive and simply not performed (like the lack of observation of the laundry money collectors in the text case)

The payroll employee who has responsibility for preparing personnel files for new hires, approval

of wages, verification of time cards, and distribution of payroll checks can “hire” fictitious employees, fake their records, and order checks through the payroll system

Managers can override controls and order people to ship bricks (as in the text case) or manipulate records to create false numbers from a position of accounting authority (inventory falsification textcase)

6.21 Extended procedures are audit procedures performed only when (external) auditors think

something deserves imaginative investigation in the circumstances Usually they are more complicated and expensive than “normal” audit procedures, and they usually suggest a suspicion

of something fraudulent going on The text contains brief explanations of several “extended procedures,” but these may seem “normal” for fraud examiners

6.22 Two endorsements may indicate that the payee of the check is not the party that received the

benefit of the check payment The payee may be fictitious

6.23 Net worth analysis is used when fraud has been discovered or strongly suspected, and the

information to calculate a suspect’s net worth can be obtained (e.g asset and liability records, bankaccounts) The method is to calculate the suspect’s net worth (known assets - known liabilities) at the beginning and end of a period (months or years), then try to account for the difference as (1) known income less living expenses, and (2) unidentified difference The unidentified difference may be the best available approximation of the amount of a theft

Expenditure analysis is similar to net worth analysis, except the data is the suspect’s spending for all purposes compared to known income If spending exceeds legitimate and explainable income, the difference may be the amount of a theft

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

6.24 a Correct Risk is high when the company always estimates the inventory but

never take a complete physical count

b Incorrect Risk is low when the petty cash box is always locked in the desk of the

custodian

c Incorrect Risk is lower when management has published a company code of

ethics and sends frequent communication newsletters about it

d Incorrect Risk is lower when the board of directors reviews and approves all

investment transactions

6.25 a Incorrect Airtight control systems of checks and supervision is not the best

long-run way to stop fraud

b Incorrect Name an “ethics officer” who is responsible for receiving and acting

upon fraud tips is not the best long-run way to stop fraud

c Incorrect Place dedicated “hotline” telephones on walls around the workplace

with direct communication to the company ethics officer is not the best long-run way to stop fraud

d Correct Practice management “of the people and for the people” to help them

share personal and professional problems is the best long-run way to stop fraud

6.26 a Correct Many frauds are motivated by employees who have problems due to

debt, addictions, or family problems Establishing an employee assistance program addresses these issues and may reduce the motivation to commit fraud for some employees

b Incorrect A fidelity bond reduces the risk to the employer for theft since this is a

form of insurance It also provides a background check on employees Neither of these issues addresses employee motivation

c Incorrect Reconciliations are methods of detecting problems that have occurred

While these are good controls and may reduce the opportunities for employees to steal, reconciliations to not address employee motivation

to commit fraud

d Incorrect Audits may detect fraud and even provide a deterrence for fraud

Audits do not address the employees motivation to commit fraud.6.27 a Incorrect An appointment of a chief ethics officer would increase the

effectiveness of the code of ethics

b Incorrect A hot line that allowed employees to report ethical violations would

increase the effectiveness of the code of ethics

c Correct The violation of the code of ethics by senior management would reduce

the effectiveness of the code of ethics since the tone at the top would provide a message to employees that the code of ethics was not important

d Incorrect The posting of the code of ethics and any other means of presenting the

code of ethics to employees in a prominent manner would increase the effectiveness of the code of ethics

6.28 a Incorrect Numerous cash refunds have been made to different people at the same

post office box address is an indicator of cash refund fraud

b Incorrect Internal auditor cannot locate several credit memos to support

reductions of customers’ balances is an indicator of returned goods fraud

c Correct Bank reconciliation has no outstanding checks or deposits older than 15

days is a sign of a good bank reconciliation, a fraud detection technique

d Incorrect Three people were absent the day the auditors handed out the

paychecks and have not picked them up four weeks later is an indicator

of padded payroll fraud

6.29 a Incorrect Overstating sales revenue and overstating customer accounts receivable

balances is a way to misstate financial statements for management fraud

b Correct Overstating sales revenue and overstating bad debt expense does not

misstate income or assets but will hide an employee embezzlement

c Incorrect Understating interest expense and understating accrued interest payable

is a way to misstate financial statements for management fraud

d Incorrect Omit the disclosure information about related party sales to the

president’s relatives at below-market prices is a way to misstate financial statements for management fraud

6.30 a Incorrect Inventory should be counted on a regular basis, therefore, the fraud would be detected.

b Incorrect Expense accounts are often good places to hide fraud since accounts are

closed at the end of the year Wage expense accounts may be compared

to budget and may be reviewed by department managers that might detect the fraud

c Correct Expense accounts are often good places to hide fraud since accounts are

closed at the end of the year Consulting expense is a particularly goodplace to hide a fraud since no actual product is provided which may be counted or compared to the expense

d Incorrect Property tax expenses would likely be compared to the property tax bill

and any discrepancies investigated

6.31 a Correct The inventory warehouse manager can steal inventory and manipulate

the records

b Incorrect Cashier prepared the bank deposit, endorsed the checks with a company

stamp, and took the cash and checks to the bank for deposit (no other bookkeeping duties) The cashier might steal currency, but needs access

to the records to cover up a theft of customer payments

c Incorrect Accounts receivable clerk received a list of payments received by the

cashier so he could make entries in the customers’ accounts receivable subsidiary accounts Good arrangement because the bookkeeper does not have access to cash

d Incorrect Financial vice president received checks made out to suppliers and the

supporting invoices, signed the checks, and put them in the mail to the payees Fraud would be harder because financial VP would also need to

be able to create fictitious vendors and invoices

6.32 c Correct The cashier would have both custody of cash and record keeping

responsibility, hence could steal money and fix the records without interference by anyone else

6.33 c Correct Kiting involves a mismatching of dates of recording around year-end,

and the schedule of bank transfers is designed to show all the relevant dates so the auditor can see that the entries are in the proper periods.6.34 b Correct Effective control of cash requires that receipts be recorded promptly

For mail receipts, a listing of remittance advices by an employee not performing incompatible functions is a standard control procedure If the customer does not return the remittance advice, one should be prepared at the time the mail is opened If remittance advices are not used, a listing of receipts should still be made when the mail is opened.6.35 a Incorrect A check returned for insufficient funds would make the balance per

bank different than the balance per books and would need to be a reconciling item It would not change any of the information that was provided to the assistant controller

b Correct If the cash received was split into two or more deposits the deposits

would not match the remittances or the payments recorded

c Incorrect Controls over unauthorized access into accounts receivable strengthens

the control indicated in the question since information on the payment report would be more reliable

d Incorrect Having someone else reconcile the accounts payable process adds an

additional person to the control process

6.36 c Correct The individuals with record-keeping responsibility should have custody

of cash Hence, they should use either the remittance advices or a listing of the remittances to make entries o the cash and accounts receivable control account and to the subsidiary accounts receivable records Indeed, having different people make entries in the control account and in the subsidiary records is an effective control

6.37 a Correct Not recording sales on account in the books of original entry is the

most effective way to conceal a subsequent theft of cash receipts The accounts will be incomplete but balanced, and procedures applied to theaccounting records will not detect the defalcation

6.38 a Incorrect The definition of embezzlement involves property that is entrusted to

the employee’s control (as in (d)) This statement refers to larceny

b Incorrect This statement is similar to the definition of management fraud

c Incorrect This statement is similar to a mere error in accounting

d Correct This statement is the textbook and criminological definition of

embezzlement

6.39 b Correct A final review by the treasurer can catch mistakes made in prior

processing

6.40 a Correct The overstatement of cash would be of most concern Cash is

overstated by claiming that the organization has more cash then it does

b Incorrect It is possible that a firm could borrow money to include in a cash count

and, therefore, not have the rights to the cash However, such a scheme

is of lesser concern then if the company claimed cash that did not exist

c Incorrect Since the value of cash is easily discernable this is usually not an issue

d Incorrect Improper cash presentation is of lower risk then the existence of cash

6.41 a Incorrect Since the sources and use of cash can vary greatly from year to year,

balances in prior year are of little use

b Incorrect Management inquiry would provide poor information for use in

performing analytical procedures

c Correct Budgets provided by management provide the best estimates by

management for the sources and use of cash Where cash receipts or cash expenditures vary form the budget by a material amount, a higher level of risk may be assessed

d Incorrect Failure to collect accounts receivable may indicate a problem with cash

sources but would only be one part of an estimate of cash

6.42 d Correct Cancellation (“paid”) of vouchers prevent their use a second time

SOLUTIONS TO PROBLEMS, EXERCISES AND SIMULATIONS

6.43 Tests of Controls over Cash Disbursements

NOTE TO INSTRUCTOR: Procedure #2 below is designed to indicate that work on one sample

of cash disbursements can produce evidence related to several objectives The tasks numbered 2a through 2l all relate to the #2 sample items.

AUDIT PROGRAM OF TEST OF CONTROLS AUDIT

PROCEDURES

Management Assertion Test of Controls Procedure

1 Observe who has custody of signed checks for evidence of segregation of duties from persons having cash disbursement or accounts payable record-keeping responsibilities and from persons who have cash disbursement authorization responsibilities

Occurrence assertion

Recorded disbursements

are valid and

documented -

representing payment for

goods and services

received

2 Select a sample of cash disbursements recorded during the period, and

2a Compare to the cancelled check

2b Examine for authorized signature and proper endorsement matching payee name

2c Compare recorded amount and check amount

2d Compare recorded payee name and name on check

3 Scan the recorded cash disbursements for large or unusual amounts and perform the same work on these items as in the #2 sample.Occurrence assertion

Cash disbursements are

authorized according to

company policy

2e Examine supporting documents for a proper authorizing signature or initials approving the amount for payment.2f Trace authorizing signature to list of authorized approvers.2g Trace vendor’s name to approved vendor list

Accuracy assertion

Cash disbursement dollar

amounts are calculated

and recorded accurately

2h Recalculate amounts shown on supporting vendor’s invoices and compare to check amount

2i Recalculate cash discount, if any

Classification assertion

Cash disbursements are

properly classified in the

complete-properly summarized and

posted in the general

ledger

5 Foot selected summaries (daily, monthly) of cash disbursements

6 Trace these totals to the general ledger debit and credit entries

7 Foot the general ledger cash account

Cutoff assertion

Cash disbursements are

recorded in the proper

University Books, Incorporated REVOLVING CASH FUND INTERNAL CONTROL QUESTIONNAIRE

1 Is responsibility for the fund vested in one person?

2 Is physical access to the fund denied to all others?

3 Is the custodian independent of other employees who handle cash?

4 Is the custodian bonded?

5 Is the custodian denied access to other cash funds?

6 Are receipts unalterable?

7 Are receipts prenumbered?

8 Is the integrity of the prenumbered sequence periodically accounted

for?

9 Does the seller sign receipts?

10 Are receipts attached to reimbursement vouchers?

11 Are vouchers that are submitted for reimbursement approved by

someone other than the custodian?

12 Are reimbursement vouchers and attachments (receipts) cancelled after

reimbursement?

13 Is the fund used exclusively for the acquisition of books?

14 Is the fund periodically counted and reconciled by someone other than

the custodian?

15 Is the fund maintained on an imprest basis?

16 Is the size of the fund appropriate for the purpose intended?

6.45 Audit Simulation: Test of Controls over Cash Receipts

1 Source of debit entries in general ledger cash

account, other than from cash receipts journal,

should be investigated and supporting documents

examined

1 Since the auditor, using standard procedures, only examined the cash receipts journal, he must investigate the occurrence of all other sources of cash receipts that are not recorded in these journals

2 A surprise examination of cash receipts should be

performed Prior to the accounts receivable clerk

obtaining the cash receipts, the auditor should

make a list of them without the clerk’s knowledge

The undeposited mail receipts should then be

controlled after completion of their preparation for

deposit and postings have been made to the

subsidiary accounts receivable ledger The deposit

slip should be compared to the remittances for

accuracy and totaled Individual items on the

deposit slip should be compared to postings to the

subsidiary accounts receivable ledger The auditor

should then supervise the mailing of the deposit to

the bank The auditor should ask Gutzler to ask the

bank to send the statement containing this deposit

directly to the auditor

2 Since there are no initial controls over cash receipts established prior to the time the accounts receivable clerk obtains the cash, a surprise examination is the only method of determining if cash receipts are being recorded and deposited correctly

3 Postings from the deposit slips should be traced to

the subsidiary accounts receivable ledger Also,

entries in the subsidiary accounts ledger should be

traced to deposit slips

3 Since there is no separation of duties between cash receipts and accounts receivable, the accounts receivable clerk may have been careless in performing her posting duties This procedure may also disclose whether the accounts receivable clerk may have been lapping the accounts

4 Review the subsidiary accounts receivable ledger

and confirm accounts that have abnormal

transaction activity (consistently late payments.)/

4 See No 3 above

5 If Gutzler allows customers to take discounts, the

amount of such discounts and the discount period

should be checked

5 Since there is no separation of duties between cash receipts and accounts receivables the account receivable clerk may have appropriated discounts which could have been but were not taken or may have been careless in checking the appropriateness

of discounts taken

6 Dates and amounts of daily deposits per bank

statement should be compared with entries in the

cash receipts journal

6 Since there are no initial controls over cash receipts established prior to the time the accounts receivable clerk obtains the cash, she may have become careless about prompt deposit of the daily receipts

7 A proof-of-cash working paper should be prepared

which reconciles total cash receipts with credits per

bank statement

7 Since internal control over cash receipts is weak, theauditor should perform this overall check to help substantiate that he has investigated all material items during his detail tests