Auditing &

Assurance
Services,
6e

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Chapter 06
Employee Fraud and the
Audit of Cash
"Rather fail with honor than succeed by fraud."
--Sophocles (496-406 BC)

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Learning Objectives
1.
2.
3.
4.
5.
6.
7.

Define and explain the differences among several kinds of employee fraud
that might occur at an audit client.
Identify and explain the three conditions (i.e., the fraud triangle) that often
exist when a fraud occurs.
Describe techniques that can be used to prevent employee fraud.
Describe the control activities over the receipt and disbursement of cash.
Describe the types of substantive procedures that are conducted during the
audit of cash.
Discuss actual cash fraud cases and describe how the schemes were
uncovered.
Describe some extended procedures for detecting employee fraud schemes
involving cash.

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Employee Fraud Overview

Fraud consists of knowingly making material misrepresentations of fact with

the intent of inducing someone to believe the falsehood and act upon it and
thus, suffer a loss or damage.
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.
Errors are unintentional misstatements or omissions of amounts or
disclosures in financial statements.
Direct-effect Illegal Acts are violations or government regulations by the
company, or its management or employees that produce direct and material
effects on dollar amounts in the financial statements.

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Employee Fraud Red Flags

Observation of changes in a persons habits and lifestyles may reveal
some red flags. Fraudsters may exhibit these behaviors:

Experience sleeplessness
Drinking too much
Take Drugs
Become irritable easily
Cant relax
Get defensive
Cant look people in the eye
Sweat excessively
Go to confession
Find excuses and scapegoats for mistakes
Work standing up
Work alone
Work late frequently

6-5

Characteristics of Fraudsters

Has education beyond high school

Is likely to be married
Is member of a mosque, temple, or church
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
Unfortunately, they look like most everybody else
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The Fraud Triangle

There are three conditions that are likely
to be present when a fraud occurs.
They are:
Motivation
Opportunity
Rationalization
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Exhibit 6.1
Fraud Elements

6-8

Motivation
A motive is some kind of pressure a person
experiences and believes to be unshareable with
friends and confidants
Actual or perceived need for money (Economic motive)
Habitual criminal who steals for the sake of stealing
(Psychotic motive)
Committing fraud for personal prestige (Egocentric
motive)
Cause is morally superior, justified in making others
victims (Ideological motive)
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Opportunity
An opportunity is an open door for solving
the unshareable problem by violating a
trust.
Weak internal controls
Circumvention of internal controls
The greater the position, the greater the trust
and exposure to unprotected assets.

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Rationalization
When people do things that are contrary to their personal
beliefs outside their normal behavior they provide an
argument to make the action seem like it is in line with
their moral and ethical beliefs.
Some of the most frequent rationalizations are:

I need it more than the other person.

Im borrowing the money and will pay it back.
Everybody does it.
The company is big and will never miss it.
Nobody will get hurt.
I am underpaid, so this is due compensation
I need to maintain a lifestyle and image.

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Fraud Prevention
A strong control environment and tone at the top
Can have a pervasive effect on fraud prevention

Managing people pressures in the workplace

Counseling services
Anonymous hotlines
Ethics officers

Internal control activities and employee monitoring

Segregation of duties and responsibilities for transaction authorization, record
keeping, custody of or access to assets, and reconciliation of actual assets to the
accounting records.

Integrity by example and enforcement

Accountability
Codes of conduct
Background checks prior to hiring

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Be Aware of Exceptions
o
o
o
o
o
o
o

Missing documents.
Alterations on documents.
Photocopied documents.
Second endorsements on checks.
Unusual endorsements.
Old outstanding checks.
Unexplained adjustments to
accounts receivable and
inventory balances.
o Unusual patterns in deposits in
transit.
o General ledgers that do not
balance.

o Cash shortages and overages.

o Excessive voids and credit
memos.
o Customer complaints.
o Common names or addresses for
refunds.
o Increased past due receivables.
o Inventory shortages.
o Increased scrap.
o Duplicate payments.
o Employees that cannot be found.
o Dormant accounts that have
become active.

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Cash Internal Control

Considerations
Cash is highly liquid, easily transportable,
and not easily identifiable, and therefore is
a primary target for employee thieves.
Some strong internal control activities:
Dual custody of cash at all times
Lockbox arrangement
Fidelity bonds

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Exhibit 6.2 - Cash Receipts Processing

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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
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Cash Receipts and Disbursements:

Key Control Activities

INFORMATION PROCESSING
Voucher packet (Purchase requisition, purchase order, receiving report, invoice) matched
prior to cash disbursement authorization
Deposits reconciled to amounts credited to accounts receivable ledger
Bank reconciliation

PHYSICAL CONTROLS OVER THE SECURITY OF ASSETS

Deposit cash and checks daily and intact

Lock box account
EDI transactions
Dual custody over cash
Unused checks secured
Check imprinting machine

SEGREGATION OF DUTIES
Separate custody, authorization, recording, execution

PERFORMANCE REVIEWS
RECONCILIATIONS

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Exhibit 6.3 Tests of Controls for Cash

Receipts

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Exhibit 6.4 Tests of Controls Over Cash

Disbursements

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Audit Evidence Used to Test

Cash

Cash receipts journal

Cash disbursements journal
Bank reconciliations
Cancelled checks
Year-end bank statement
Cutoff bank statement

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Exhibit 6.5
How to Read a
Cancelled Check
and Endorsement

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Exhibit 6.6
Small Business
Bank Statement

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Audit of Cash
The first procedure in an audit of cash is to obtain a bank reconciliation
for each cash account and audit them in the following manner:

Balance per bank

Add deposits-in-transit

VOUCH to cash disbursements journal

TRACE checks cleared from cutoff bank statement

Add/Subtract other Debit/Credit Memos

TRACE to cash receipts journal

VOUCH to CUTOFF BANK STATEMENT

Subtract Outstanding Checks

CONFIRM (STANDARD BANK CONFIRMATION) directly with bank

Agree amount to CUTOFF BANK STATEMENT

Inspect bank credit/debit memo and audit for reasonableness. Examine relevant supporting
documentation.

Balance per books

FOOT the entire reconciliation for mathematical accuracy

TRACE the amount to the trial balance

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Exhibit 6.7
Bank
Reconciliation

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Confirmation of Bank Balances

Standard Bank Confirmation Inquiry
Must be mailed under auditors own control.
Used to confirm deposit balances and loan balances
Also can be used to request information about contingent
liabilities and secured transactions.

Electronic Confirmation Requests

Many banks now only complete confirmation requests
electronically (e.g., confirmations.com)
Can improve the control of both delivery and receipt of the
confirmation request
Allowed by professional auditing standards

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Exhibit 6.8
Bank
Confirmation

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Check Kiting
Is the 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.
Advances in technology and bank scrutiny has
decreased this possibility in recent years.
A Schedule of Interbank Transfers is generally
used by auditors to detect check kiting.
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Proof of Cash
A proof of cash would be used in situations where
controls over cash are weak.
It essentially combines two bank reconciliations,
reconciling all transactions that occurred during the
period to the clients Cash Receipts Journal and Cash
Disbursements Journal.

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Exhibit 6.9
Illustration of Proof of CashFirst National Bank

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Other Fraud Detection Procedures

for Cash
Count the petty cash twice in one day
Carefully examine endorsements on canceled
checks
Audit general journal entries
Retrieve customer checks
Use marked coins and currency
Measure deposit lag time
Examine documents such as bank statements for
alteration
Covert surveillance

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