Problems on Ethics, Fraud, and Internal Control.

Problems

1. FRAUD SCHEME

A purchasing agent for a home improvement center is also part owner in a wholesale lumber company. The agent has sole discretion in selecting vendors for the lumber sold through the center. The agent directs a dis- proportionate number of purchase orders to his company, which charges above-market prices for its products. The agent’s financial interest in the supplier is unknown to his employer.

Required

What type of fraud is this and what controls can be implemented to prevent or detect the fraud?

2. FRAUD SCHEME

A procurement agent for a large metropolitan building authority threatens to blacklist a building contractor if

he does not make a financial payment to the agent. If the contractor does not cooperate, the contractor will be denied future work. Faced with a threat of economic loss, the contractor makes the payment.

Required

What type of fraud is this and what controls can be implemented to prevent or detect the fraud?

3. MAIL ROOM FRAUD AND INTERNAL CONTROL

Sarat Sethi, a professional criminal, took a job as a mail room clerk at Benson & Abernathy and Company, a large department store. The mail room was an extremely hectic work environment consisting of a supervisor and 45 clerks. The clerks were responsible for handling pro- motional mailings, catalogs, and interoffice mail, as well as receiving and distributing a wide range of out- side correspondence to various internal departments. One of Sethi’s jobs was to open cash receipts envelopes from customers making payments on their credit card balances. He separated the remittance advices (the bills) and the checks into two piles. He then sent remittance advices to the accounts receivable department, where the customer accounts were updated to reflect the pay- ment. He sent the checks to the cash receipts department, where they were recorded in the cash journal and then deposited in the bank. Batch totals of cash received and accounts receivable updated were reconciled each night to ensure that everything was accounted for. Nevertheless, over a one-month period Sethi managed to steal $100,000 in customer payments and then left the state without warning.

The fraud occurred as follows: Because the name of the company was rather long, some people had adopted the habit of making out checks simply to Benson. Sethi had a false identification prepared in the name of John Benson. Whenever he came across a check made out to Benson, he would steal it along with the remittance advice. Sometimes people would even leave the payee section on the check blank. He also stole these checks. He would then modify the checks to make them payable to J. Benson and cash them. Because the accounts receivable department received no remittance advice, the end-of-day reconciliation with cash received disclosed no discrepancies.

Required

a. This seems like a foolproof scheme. Why did Sethi limit himself to only one month’s activity before leaving town?

b. What controls could Benson & Abernathy implement to prevent this from happening again?

4. SEGREGATION OF DUTIES

Explain why each of the following combinations of tasks should or should not be separated to achieve adequate internal control.

a. Approval of bad debt write-offs and the reconcilia- tion of the accounts receivable subsidiary ledger and the general ledger control account.

b. Distribution of payroll checks to employees and ap- proval of employee time cards.

c. Posting of amounts from both the cash receipts and the cash disbursements journals to the general ledger.

d. Writing checks to vendors and posting to the cash account.

e. Recording cash receipts in the journal and preparing the bank reconciliation.

5. EXPENSE ACCOUNT FRAUD

While auditing the financial statements of Petty Corporation, the certified public accounting firm of Trueblue and Smith discovered that its client’s legal expense account was abnormally high. Further investigation of the records indicated the following:

• Since the beginning of the year, several disbursements totaling $15,000 had been

made to the law firm of Swindle, Fox, and Kreip.

• Swindle, Fox, and Kreip were not Petty Corporation’s attorneys.

• A review of the canceled checks showed that they had been written and approved by Mary Boghas, the cash disbursements clerk.

• Boghas’s other duties included performing the end- of-month bank reconciliation.

• Subsequent investigation revealed that Swindle, Fox, and Kreip are representing Mary Boghas in an unrelated embezzlement case in which she is the defendant. The checks had been written in payment of her personal legal fees.

Required

a. What control procedures could Petty Corporation have employed to prevent this unauthorized

use of cash? Classify each control procedure in accordance with the SAS 78/COSO framework (authorization, segregation of functions, supervision, and so on).

b. Comment on the ethical issues in this case.

6. TOLLBOOTH FRAUD

Collectors at Tollbooths A and B (see figure on next page) have colluded to perpetrate a fraud. Each day, Tollbooth Collector B provides A with a number of toll tickets prestamped from Tollbooth B. The price of the toll from Point B to Point A is 35 cents. The fraud works as follows:

Drivers entering the turnpike at distant points south of Point B will pay tolls up to $5. When these drivers leave the turnpike at Point A, they pay the full amount of the toll printed on their tickets. However, the tollbooth collector replaces the tickets collected from the drivers with the 35-cent tickets provided by Collector B, thus making it appear that the drivers entered the turnpike at Point B. The difference between the 35- cent tickets submitted as a record of the cash receipts and the actual amounts paid by the drivers is pocketed by Tollbooth Collector A and shared with B at the end of the day. Using this technique, Collectors A and B have stolen more than $20,000 in unrecorded tolls this year.

Required

What control procedures could be implemented to prevent or detect this fraud? Classify the control procedures in accordance with SAS/COSO 78.

7. FACTORS OF FRAUD

Research has shown that situational pressures and opportunity are factors that contribute to fraudulent behavior.

Required

a. Identify two situational pressures in a public company that would increase the likelihood of fraud.

b. Identify three opportunity situations that would increase the likelihood of fraud.

Evaluation of Internal Control

Oakdale, Inc., is a subsidiary of Solomon Publishing and specializes in the publication and distribution of reference books. Oakdale’s sales for the past year exceeded $18 million, and the company employed an average of 65 employees. Solomon periodically sends a member of the internal audit department to audit the operations of each of its subsidiaries, and Katherine Ford, Oakdale’s treasurer, is currently working with Ralph Johnson of Solomon’s internal audit staff. Johnson has just completed a review of Oakdale’s investment cycle and prepared the following report.

General

Throughout the year, Oakdale has made both short-term and long-term investments in securities; all securities are registered in the company’s name. According to Oak- Drivers entering the turnpike at distant points south of Point B will pay tolls up to $5. When these drivers leave the turnpike at Point A, they pay the full amount of the toll printed on their tickets. However, the toll- booth collector replaces the tickets collected from the drivers with the 35-cent tickets provided by Collector B, thus making it appear that the drivers entered the turnpike at Point B. The difference between the 35- cent tickets submitted as a record of the cash receipts and the actual amounts paid by the drivers is pocketed by Tollbooth Collector A and shared with B at the end of the day. Using this technique, Collectors A and B have stolen more than $20,000 in unrecorded tolls this year.

Required

What control procedures could be implemented to pre- vent or detect this fraud? Classify the control procedures in accordance with SAS/COSO 78.

7. FACTORS OF FRAUD

Research has shown that situational pressures and oppor- tunity are factors that contribute to fraudulent behavior.

Required

a. Identify two situational pressures in a public com- pany that would increase the likelihood of fraud.

b. Identify three opportunity situations that would increase the likelihood of fraud.

dale’s bylaws, its board of directors must approve long- term investment activity, whereas either the president or the treasurer may approve short-term investment activity.

Transactions

The treasurer made all purchases and sales of short-term securities. The board approved the long-term security purchases, whereas the president approved the long- term security sale. Because the treasurer is listed with the broker as the company’s contact, this individual received all revenue from these investments (dividends and interest) and then forwarded the checks to account- ing for processing.

Documentation

The treasurer maintains purchase and sale authoriza- tions, along with the broker’s advices. The certificates for all long-term investments are kept in a safe deposit box at the local bank; only the president of Oakdale has access to this box. An inventory of this box was made, and all certificates were accounted for. Certificates for short-term investments are kept in a locked metal box in the accounting office. Other documents, such as long- term contracts and legal agreements, are also kept in this box. The president, the treasurer, and the accounting manager have the three keys to the box. The accounting manager’s key is available to all accounting personnel should they require documents kept in this box. Documentation for two of the current short-term investments could not be located in this box; the accounting manager explained that some of the investments are for such short periods of time that the broker does not always provide formal documentation.

Accounting Records

The accounting department records deposits of checks for interest and dividends earned on investments, but these checks could not be traced to the cash receipts journal, which is maintained by the individual who normally opens, stamps, and logs incoming checks. These amounts are journalized monthly in an account for investment revenue. The treasurer authorizes checks drawn for investment purchases. Both the treasurer and the president must sign checks in excess of $15,000. When securities are sold, the broker deposits the proceeds directly in Oakdale’s bank account by an electronic funds transfer.

Each month, the accounting manager and the treasurer prepare the journal entries required to adjust the short-term investment account. There was insufficient backup documentation attached to the journal entries reviewed to trace all transactions; however, the balance in the account at the end of last month closely approximates the amount shown on the statement received from the broker. The amount in the long-term investment account is correct, and the transactions can be clearly traced through the documentation attached to the journal entries. There are no attempts made to adjust either account to the lower of aggregate cost or market.

Required

To achieve Solomon Publishing’s objective of sound in- ternal control, the company believes the following four controls are basic for an effective system of accounting control:

• Authorization of transactions

• Complete and accurate record keeping

• Access control

• Independent verification

a. Describe the purpose of each of the four controls listed here.

b. Identify an area in Oakdale’s investment procedures that violates each of the four controls listed here.

c. For each of the violations identified, describe how Oakdale can correct each weakness.

9. FINANCIAL AID FRAUD

Harold Jones, the financial aid officer at a small university, manages all aspects of the financial aid

program. Jones receives requests for aid from students, determines whether the students meet the aid criteria, authorizes aid payments, notifies the applicants that their request has been either approved or denied, writes the financial aid checks on the account he controls, and requires that the students come to his office to receive the checks in person. For years, Jones has used his position of authority to perpetrate the following fraud.

Jones encourages students who clearly will not qualify to apply for financial aid. Although the students do not expect aid, they apply on the off chance that it will be awarded. Jones modifies the financial information in the students’ applications so that it falls within the established guidelines for aid. He then approves aid and writes aid checks payable to the students. The students, however, are informed that aid was denied. Because the students expect no aid, the checks in Jones’s office are never collected. Jones forges the students’ signatures and cashes the checks.

Required

Identify the internal control procedures (classified per SAS 78/COSO) that could prevent or detect this fraud.

10. KICKBACK FRAUD

The kickback is a form of fraud often associated with purchasing. Most organizations expect their purchasing agents to select the vendor that provides the best products at the lowest price. To influence the purchasing agent in his or her decision, vendors may grant the agent financial favors (cash, presents, football tickets, and so on). This activity can result in orders being placed with vendors that supply inferior products or charge excessive prices.

Required

Describe the controls that an organization can employ to deal with kickbacks. Classify each control as preventive, detective, or corrective.

11. EVALUATION OF CONTROLS

Gaurav Mirchandaniis is the warehouse manager for a large office supply wholesaler. Mirchandaniis receives two copies of the customer sales order from the sales department. He picks the goods from the shelves and sends them and one copy of the sales order to the shipping department. He then files the second copy in a temporary file. At the end of the day, Mirchandaniis retrieves the sales orders from the temporary file and updates the inventory subsidiary ledger from a terminal in his office. At that time, he identifies items that have fallen to low levels, selects a supplier, and prepares three copies of a purchase order. One copy is sent to the supplier, one is sent to the accounts pay- able clerk, and one is filed in the warehouse. When the goods arrive from the supplier, Mirchandaniis reviews the attached packing slip, counts and inspects the goods, places them on the shelves, and updates the inventory ledger to reflect the receipt. He then pre- pares a receiving report and sends it to the accounts payable department.

Required

a. Prepare a systems flowchart of the procedures previ- ously described.

b. Identify any control problems in the system.

c. What sorts of fraud are possible in this system?

12. EVALUATION OF CONTROLS

Matt Demko is the loading dock supervisor for a dry cement packaging company. His work crew is composed of unskilled workers who load large transport trucks with bags of cement, gravel, and sand. The work is hard, and the employee turnover rate is high. Employees record their attendance on separate time cards. Demko authorizes payroll payments each week by signing the time cards and submitting them to the payroll department. Payroll then prepares the paychecks and gives them to Demko, who distributes them to his work crew.

Required

a. Prepare a systems flowchart of the procedures described here.

b. Identify any control problems in the system.

c. What sorts of fraud are possible in this system?