McGraw-Hill/Irwin. Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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1 McGraw-Hill/Irwin Cpyright 2013 by The McGraw-Hill Cmpanies, Inc. All rights reserved.

2 Chapter 06 Emplyee Fraud and the Audit f Cash "Rather fail with hnr than succeed by fraud." --Sphcles ( BC) 6-2

3 Learning Objectives 1. Define and explain the differences amng several kinds f emplyee fraud that might ccur at an audit client. 2. Identify and explain the three cnditins (i.e., the fraud triangle) that ften exist when a fraud ccurs. 3. Describe techniques that can be used t prevent emplyee fraud. 4. Describe the cntrl activities ver the receipt and disbursement f cash. 5. Describe the types f substantive prcedures that are cnducted during the audit f cash. 6. Discuss actual cash fraud cases and describe hw the schemes were uncvered. 7. Describe sme extended prcedures fr detecting emplyee fraud schemes invlving cash. 6-3

4 Emplyee Fraud Overview Fraud cnsists f knwingly making material misrepresentatins f fact with the intent f inducing smene t believe the falsehd and act upn it and thus, suffer a lss r damage. Emplyee fraud is the use f fraudulent means t take mney r ther prperty frm an emplyer. It cnsists f three phases: (1) the fraudulent act, (2) the cnversin f the mney r prperty t the fraudster's use and (3) the cver-up. Embezzlement is a type f fraud invlving emplyees' r nnemplyees' wrngfully taking mney r prperty entrusted t their care, custdy, and cntrl, ften accmpanied by false accunting entries and ther frms f lying and cver-up. Errrs are unintentinal misstatements r missins f amunts r disclsures in financial statements. Direct-effect Illegal Acts are vilatins r gvernment regulatins by the cmpany, r its management r emplyees that prduce direct and material effects n dllar amunts in the financial statements. 6-4

5 Emplyee Fraud Red Flags Observatin f changes in a persn s habits and lifestyles may reveal sme red flags. Fraudsters may exhibit these behavirs: Experience sleeplessness Drinking t much Take Drugs Becme irritable easily Can t relax Get defensive Can t lk peple in the eye Sweat excessively G t cnfessin Find excuses and scapegats fr mistakes Wrk standing up Wrk alne Wrk late frequently 6-5

6 Characteristics f Fraudsters Has educatin beynd high schl Is likely t be married Is member f a msque, temple, r church Ranges in age frm teens t ver 60 Is scially cnfrming Has an emplyment tenure frm 1 t 20 years Has n arrest recrd Usually acts alne Unfrtunately, they lk like mst everybdy else 6-6

7 The Fraud Triangle There are three cnditins that are likely t be present when a fraud ccurs. They are: Mtivatin Opprtunity Ratinalizatin 6-7

8 Exhibit 6.1 Fraud Elements 6-8

9 Mtivatin A mtive is sme kind f pressure a persn experiences and believes t be unshareable with friends and cnfidants Actual r perceived need fr mney (Ecnmic mtive) Habitual criminal wh steals fr the sake f stealing (Psychtic mtive) Cmmitting fraud fr persnal prestige (Egcentric mtive) Cause is mrally superir, justified in making thers victims (Idelgical mtive) 6-9

10 Opprtunity An pprtunity is an pen dr fr slving the unshareable prblem by vilating a trust. Weak internal cntrls Circumventin f internal cntrls The greater the psitin, the greater the trust and expsure t unprtected assets. 6-10

11 Ratinalizatin When peple d things that are cntrary t their persnal beliefs utside their nrmal behavir they prvide an argument t make the actin seem like it is in line with their mral and ethical beliefs. Sme f the mst frequent ratinalizatins are: I need it mre than the ther persn. I m brrwing the mney and will pay it back. Everybdy des it. The cmpany is big and will never miss it. Nbdy will get hurt. I am underpaid, s this is due cmpensatin I need t maintain a lifestyle and image. 6-11

12 Fraud Preventin A strng cntrl envirnment and tne at the tp Can have a pervasive effect n fraud preventin Managing peple pressures in the wrkplace Cunseling services Annymus htlines Ethics fficers Internal cntrl activities and emplyee mnitring Segregatin f duties and respnsibilities fr transactin authrizatin, recrd keeping, custdy f r access t assets, and recnciliatin f actual assets t the accunting recrds. Integrity by example and enfrcement Accuntability Cdes f cnduct Backgrund checks prir t hiring 6-12

13 Be Aware f Exceptins Missing dcuments. Alteratins n dcuments. Phtcpied dcuments. Secnd endrsements n checks. Unusual endrsements. Old utstanding checks. Unexplained adjustments t accunts receivable and inventry balances. Unusual patterns in depsits in transit. General ledgers that d nt balance. Cash shrtages and verages. Excessive vids and credit mems. Custmer cmplaints. Cmmn names r addresses fr refunds. Increased past due receivables. Inventry shrtages. Increased scrap. Duplicate payments. Emplyees that cannt be fund. Drmant accunts that have becme active. 6-13

14 Cash Internal Cntrl Cnsideratins Cash is highly liquid, easily transprtable, and nt easily identifiable, and therefre is a primary target fr emplyee thieves. Sme strng internal cntrl activities: Dual custdy f cash at all times Lckbx arrangement Fidelity bnds 6-14

15 Exhibit Cash Receipts Prcessing 6-15

16 Cash Receipts: Prcess activities Receive cash and REMITTANCE ADVICE in mail. Prepare REMITTANCE LISTING. Enter ttal frm REMITTANCE LISTING (r REMITTANCE ADVICE) in CASH RECEIPTS JOURNAL. Prepare DEPOSIT SLIP and depsit cash receipts in bank (INTACT and DAILY). Recrd update t SUBSIDIARY ACCOUNTS RECEIVABLE using REMITTANCE ADVICE. Recncile REMITTANCE LISTING, SUBSIDIARY ACCOUNTS RECEIVABLE, and DEPOSIT SLIP daily 6-16

17 Cash Receipts and Disbursements: Key Cntrl Activities INFORMATION PROCESSING Vucher packet (Purchase requisitin, purchase rder, receiving reprt, invice) matched prir t cash disbursement authrizatin Depsits recnciled t amunts credited t accunts receivable ledger Bank recnciliatin PHYSICAL CONTROLS OVER THE SECURITY OF ASSETS Depsit cash and checks daily and intact Lck bx accunt EDI transactins Dual custdy ver cash Unused checks secured Check imprinting machine SEGREGATION OF DUTIES Separate custdy, authrizatin, recrding, executin PERFORMANCE REVIEWS RECONCILIATIONS 6-17

18 Exhibit 6.3 Tests f Cntrls fr Cash Receipts 6-18

19 Exhibit 6.4 Tests f Cntrls Over Cash Disbursements 6-19

20 Audit Evidence Used t Test Cash Cash receipts jurnal Cash disbursements jurnal Bank recnciliatins Cancelled checks Year-end bank statement Cutff bank statement 6-20

21 Exhibit 6.5 Hw t Read a Cancelled Check and Endrsement 6-21

22 Exhibit 6.6 Small Business Bank Statement 6-22

23 Audit f Cash The first prcedure in an audit f cash is t btain a bank recnciliatin fr each cash accunt and audit them in the fllwing manner: Balance per bank CONFIRM (STANDARD BANK CONFIRMATION) directly with bank Agree amunt t CUTOFF BANK STATEMENT Add depsits-in-transit TRACE t cash receipts jurnal VOUCH t CUTOFF BANK STATEMENT Subtract Outstanding Checks VOUCH t cash disbursements jurnal TRACE checks cleared frm cutff bank statement Add/Subtract ther Debit/Credit Mems Inspect bank credit/debit mem and audit fr reasnableness. Examine relevant supprting dcumentatin. Balance per bks FOOT the entire recnciliatin fr mathematical accuracy TRACE the amunt t the trial balance 6-23

24 Exhibit 6.7 Bank Recnciliatin 6-24

25 Cnfirmatin f Bank Balances Standard Bank Cnfirmatin Inquiry Must be mailed under auditr s wn cntrl. Used t cnfirm depsit balances and lan balances Als can be used t request infrmatin abut cntingent liabilities and secured transactins. Electrnic Cnfirmatin Requests Many banks nw nly cmplete cnfirmatin requests electrnically (e.g., cnfirmatins.cm) Can imprve the cntrl f bth delivery and receipt f the cnfirmatin request Allwed by prfessinal auditing standards 6-25

26 Exhibit 6.8 Bank Cnfirmatin 6-26

27 Check Kiting Is the deliberate flating f funds between tw r mre bank accunts t make it appear that mre cash is present and available than is really the case. This practice is als knwn as playing the flat. Advances in technlgy and bank scrutiny has decreased this pssibility in recent years. A Schedule f Interbank Transfers is generally used by auditrs t detect check kiting. 6-27

28 Prf f Cash A prf f cash wuld be used in situatins where cntrls ver cash are weak. It essentially cmbines tw bank recnciliatins, recnciling all transactins that ccurred during the perid t the client s Cash Receipts Jurnal and Cash Disbursements Jurnal. 6-28

29 Exhibit 6.9 Illustratin f Prf f Cash First Natinal Bank 6-29

30 Other Fraud Detectin Prcedures fr Cash Cunt the petty cash twice in ne day Carefully examine endrsements n canceled checks Audit general jurnal entries Retrieve custmer checks Use marked cins and currency Measure depsit lag time Examine dcuments such as bank statements fr alteratin Cvert surveillance 6-30