Mastering Internal Controls and Fraud Protection

MASTERING INTERNAL CONTROLS AND FRAUD PROTECTION SOLUTIONS TO HOMEWORK EXERCISES

Section 1–HOW DISHONEST EMPLOYEES STEAL INVENTORY

1. Match the description on the left with the type of theft on the right. 1. Most common type of noncash theft a. Fraudulent write-off 2. Goods shipped to an accomplice b. Unconcealed larceny 3. Altering physical inventory counts to cover theft c. Falsified shipping or receiving report 4. Goods are stolen, then a receiving document is created d. Fraudulent shipment showing fewer goods received 1. b. 2. d 3. a. 4. c.

2. Match the description on the left with the type of theft on the right. 1. In a restaurant, the kitchen does not prepare a dish until a a. Analytical review sales order is entered in the computer 2. An electronics shop employee physically counts items on a b. Physical safeguard random basis and compares the count to the perpetual inventory record 3. Sales orders are written by salespeople who have no access c. Segregation of duties to the goods, which are released only by warehouse personnel 4. The warehouse is always locked and access is limited to d. Established system for authorized persons who have keycards storing and counting inventory 5. A graph of each month’s gross margin percentage for the e. Proper documentation last year is reviewed monthly monitored properly 1. e. 2. d 3. c. 4. b. 5. a

3. A convenience store is suddenly running out of soda syrups much too fast. The store is usually staffed by a single clerk. What internal controls would you recommend? To combat theft of sodas, a common problem for convenience stores, many stores account for the cups, requiring that the number of cups equal the number of soda sales rung up. However, this does not prevent shoppers from using their own cups. If soda is being stolen or given away, the most conspicuous control may help—a well- publicized electronic surveillance system. When employees and customers believe that activity around the store—including the soda machine—is on tape, soda and other items are less likely to disappear.

Homework Solutions 1 Mastering Internal Controls and Fraud Protection

4. Waiters in a small restaurant write each order on a pad of prenumbered order sheets, then turn it in to the kitchen. Later, the patron hands the sheet to the cashier with payment. At the end of the day, the owner puts the sheets in numerical order and investigates missing ones. List each internal control the restaurant uses and the kind of control it is (e.g., “physical safeguard”).  Prenumbered order pads that wait staff hand to the kitchen, and that patrons hand to the cashier, is proper documentation properly monitored  Having wait staff take orders and a cashier collect money is segregation of duties. Proper documentation properly monitored. Prenumbered order sheets prevent wait staff from ordering food without filling out an order sheet, or from filling out an order sheet, then throwing it away. Requiring that each sheet to be handed to the cashier with payment ensures that all sales are entered in the cash register. Because each order pad has a separate sequence, the owner knows whom to ask if there is a problem. Segregation of duties. Having wait staff take orders and a cashier collect money prevents collusion between kitchen and wait staff to give away food. For example, a cook cannot have wait staff deliver food without an order sheet. Similarly, wait staff cannot order food without an order sheet. But this does not eliminate theft of foods that do not go through the kitchen, such as desserts, pastries, beverages, etc., sold at the front of the restaurant. Also, kitchen staff can give away food at the back door without the wait staff’s knowledge. A third internal control that does not fall into a neat category is physical control of cash in one employee’s hands: the cashier (often the owner) at the cash register.

5. A shipping employee is shipping goods to an accomplice and writing up fictitious sales orders to justify the shipments. Which of the following red flags would or would not likely reveal this theft? Explain why in each case. a. An increase in cost of goods sold as a percentage of sales Would indicate theft b. Frequent customer complaints about shipment shortages Would indicate theft c. An increase in the number of uncollectible accounts Would indicate theft d. Merchandise is shipped, but there is no evidence of a sale Would indicate theft 6. A shipping employee is shipping goods to an accomplice and creating fictitious sales orders for the shipments. Which category of internal controls is being violated? Specifically, which missing control in each category permits these thefts?  Proper documentation properly monitored and within this category:  Not requiring matching of all shipping documents to sales tickets  No investigation of shipping documents not associated with a sale

 Segregation of duties, and within this category:  No procedure for authorizing sales  No control of inventory disbursement

Homework Solutions 2 Mastering Internal Controls and Fraud Protection

Section 2– HOW TO PREVENT OR SPOTEMPLOYEE THEFT

1. A key to preventing employee theft is hiring the right employees. Many companies perform background checks on applicants, especially those who will be in a position to steal. List five ways to prevent hiring the wrong employee and how each measure helps to accomplish this. 1. Check past employment. Knowledge of problems with prior employers can help avoid the cost of hiring someone who is likely to be fired for cause. 2. Check criminal convictions. Knowledge of prior convictions for job- or nonjob- related crimes can help avoid hiring an ex-offender for a position where assets are at risk. 3. Drug testing. Addictions often create money pressures that lead to theft. 4. Check references. Never assume that references must be good or the applicant would not offer them. Thieves count on this assumption. Call everyone. 5. Verify degrees, certifications, and licenses. Again, never assume that these are valid or an applicant would not present them—thieves count on this assumption.

2. An audit for possible fraud can uncover employee theft or wrongdoing. Who can perform a fraud audit? Who should not perform the audit? A fraud audit can be performed by the owner, owner’s spouse, outside bookkeeper or outside CPA. The key requirement is that the audit NOT be performed by an employee who handles the accounts being audited.

3. State whether each of the following statements about fidelity bonds (bonding) is correct or incorrect. Explain why in each case. a. A fidelity bond covers unexplained losses of inventory even if there is no indication of how the losses occurred. Incorrect. The burden of proof is on the insured company to provide a suspect in the loss. b. In theft insurance, subrogation means that the insured is liable for amounts not recovered from employees who have stolen. Incorrect. Subrogation in a theft policy means that your right to recover from or take action against an employee passes to the insurer covering the loss. c. A company may recover more than the policy amount. Correct. The insurer may sue for the entire loss, insured and uninsured. Recovery in excess of the policy limit goes to the company.

Homework Solutions 3 Mastering Internal Controls and Fraud Protection

4. There are many signs of employee inventory theft (workbook page 18). Describe the method of theft indicated by each of the following signs: a. An increase in past-due accounts. Indicates fictitious sales orders that lead to fictitious A/R that will not be paid, increasing the number of past due accounts (unless the employee has a way to alter A/R). b. Multiple payees with the same mailing address. Indicates fraudulent shipments sent to one or more accomplices at the same address. c. Files containing copies of invoices rather than originals. Copies are a red flag of altered documents. A supplier’s invoice may be altered to match a false receiving report resulting in underpayments and supplier complaints. This kind of theft may go undetected for some time. d. An unexplained increase in sales returns. Goods are sold to a confederate at a greatly reduced price—or an employee only pretends to ring up sales to an accomplice, who may keep the goods or return them for cash.

5. A spouse’s involvement may be helpful in internal controls. a. Give specific ways this involvement can help A spouse who hears the owner discuss daily business operations will pick up internal control problems of which the owner is not aware. Spouses tend to be more suspicious of employees than owners—especially those of the same sex as the spouse. b. What are the potential risks to internal controls if the spouse becomes an employee? Spouses who become employees work under few or no controls because they are the owner’s husband or wife. So if the spouse leaves the company, the relaxed controls are unintentionally passed on to the replacement who can then easily steal.

Homework Solutions 4 Mastering Internal Controls and Fraud Protection

Section 3–CHECK FRAUD

1. Of the five general categories of check fraud: a. Which two are the most common? The two most common types of check frauds are checks drawn on closed accounts or checks written on accounts with insufficient funds. b. Which are committed by employees rather than customers? Forging company checks or stealing checks that the company receives.

2. What features make a counterfeit traveler’s check difficult to pass at a vigilant firm? Watermarks, holograms, micro printing, and ultraviolet ink.

3. To help minimize customer check fraud, which form of personal identification should a retailer require for a personal check? How can checking personal IDs hurt the business it is designed to protect? Employees should require: 1. valid identification—a valid driver’s license or valid state identification with a recent photograph signed by the customer. 2. 2 photo IDs. The employee should not accept Social Security cards, business cards, birth certificates, library cards, organizational membership cards, unsigned credit cards, bank books, work permits, insurance cards, voter’s registration cards, learner’s permits, or letters. Employees must examine each piece of customer identification, no matter how monotonous this practice becomes. The problem: These procedures slow down sales transactions and may offend honest customers.

4. Evaluate each internal control below and describe whether it is cost-effective for a high-volume store such as BigCo Health Foods or a low-volume store such as SmallCo Jewelers. a. A rigorous identification requirement This is more cost effective for a low-volume store selling high-ticket items, such as jewelers. b. A bank verification system Because this process is time-consuming and expensive, it is unlikely to be cost effective for a high-volume low-ticket retailer, but crucial for a low-volume high-ticket store, such as a jeweler. c A limit on the amount accepted by check This could be a fatal requirement for a jeweler, but practical for a food store. d. A detailed examination of the check itself This is time-consuming and works better when done out of the customer’s sight. Such a policy is more feasible at a low-volume, high-ticket retailer.

Homework Solutions 5 Mastering Internal Controls and Fraud Protection

Section 4–CREDIT CARD FRAUD

1. A home-entertainment store sells high-end equipment ($5,000 and up). Orders are written up, then taken to the back office with the customer’s credit card. What specific procedures should the store use to examine the credit card? Closely examine the hologram, the micro printing under a magnifying device and hidden logos under ultraviolet light. 2. Match the description on the left with the fraud scheme on the right. 1. A hot iron applied to a valid credit card a. Counterfeit card 2. Causes the highest losses b. De-emboss/re-emboss 2. A razor blade applied to a valid credit card c. Fraudulent advance payment 3. A bad check and subsequent cash advance d. Shave and paste 1. b. 2. a 3. d. 4. c.

3. Match the description on the left with the type of credit card on the right. AMEX Visa MasterCard a. A 15-digit acct, number starting with “37” X b. A 3-D flying-dove hologram X c. Four-digit card identification number above X the account number on the front inside the scrollwork d. The last four digits of the account number X are printed in reverse italics on the back of the card e. First four digits of account number printed X on the card just below the embossed number

4. Match the description on the left with the type of credit card on the right. AMEX Visa MasterCard a. A 16-digit account number starting with “5” X b. A centurion is visible under black light X c. The entire account number is on the back X d. A globe hologram X e. A 3-digit verification number on the back X X

5. Match the description on the left with the credit card fraud on the right.

1. A new credit card intercepted in the mail a. Skimmer 2. Multiple blank sales slips are filled out using the card b. True name fraud 3. A stolen driver’s license is used to open a new credit card c. Nonreceipt fraud 4. An electronic device transfers data from magnetic strip d. Merchant scam 1. c. 2. d 3. b. 4. a.

Homework Solutions 6 Mastering Internal Controls and Fraud Protection

Section 5–HOW VENDORS CHEAT YOU

1. An employee has certain legal obligations to the employer. Describe these obligations and how bribery violates them. Employees act as the employer’s agent and therefore owe the company their loyalty, are legally required to act in the employer’s best interest and may not further their interests at the employer’s expense. Taking a bribe—accepting something of value in return for choosing a vendor with higher prices or inferior products—is the most blatant violation because it benefits the employee at the employer’s expense.

2. Describe how using local vendors helps avoid vendor fraud. Vendor frauds are generally telemarketing scams. Using a vendor that has a local outlet (or national reputation) dramatically lowers the risk of being defrauded because this kind of retailer relies on its local reputation. Using local (or well-known national) vendors or buyer’s clubs also helps avoid being scammed by phony buyer’s clubs. For example, advertising material scams and toner and paper scams are unlikely to work if a company can return inferior products to a local store. Similarly, you can ask other businesses about local vendors before accepting a loan, purchasing products or employing internet or other services.

3. Describe how limiting advance payments helps prevent vendor fraud. In many scams the profit is the advance payment because nothing is ever delivered. The scammer simply takes the money and runs. For example, a loan scam does not work if you refuse any payments until the loan is in your hands and buyer’s club scams work only when you shell out a large membership fee up front. Advertising materials scam cannot work if payment is refused until the product is received and approved. Paper and toner scams do not work if you require not only that the goods are delivered but that their quality is adequate.

4. What are four resources for checking out a vendor’s legitimacy?

The FBI’s common fraud schemes website The Better Business Bureau (BBB) The National Fraud Information Center website The Federal Trade Commission’s consumer response center

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