Tuesday, June 9, 2015

Who Controls the Cash Box? Covering Up Fraud

Most examples of accounting fraud involve theft of assets or some sort of earnings manipulation. The SEC recently reported on a fraud scheme that was far more complex. This fraud occurred because of huge internal control failures over company assets and the accounting records.

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Investing extra cash, margin trading
Katsuichi Fusamae is a senior accounting officer at Molex Japan. Molex is a Chicago-based company with a Japanese subsidiary. In the late 1980s, “he began investing Molex Japan’s excess cash in riskier securities, including substantial trading of equities on margin.”

Well, these transactions bring up a host of issues. Here are just a few:

·      Segregation of duties: No accountant should be involved in any sort of investing of company assets. Segregation of duties dictates that a record keeper (accountant) cannot also have custody of assets. If an accountant has both of these duties, the company is at risk for fraud- exactly what occurred here.

·      Investment policy: All companies should have Board-approved investment guidelines for assets. Few companies would allow securities trading on margin as an investment policy. Margin means that the buyer is borrowing money to buy securities. If the value of the securities declines, the investor is required to deposit more money. This can create a financial spiral: As the securities decline further in value, more money must be deposited.

Using loans to cover trading losses
The accountant starts to accumulate trading losses over time. As the SEC explains: “He concealed the massive trading losses by taking out unauthorized and undisclosed company loans with Japanese banks and brokerage firms, and he used loan proceeds to replenish account balances and engage in additional trading.”

Even more internal control problems here:

·      Segregation of duties: Just as the accountant cannot have access to assets, no accountant should be authorized to sign off on a company loan.

·      Loan policy: Senior management should make the decision about any borrowing. The amount, loan details and the purpose of the loan should fit the company’s borrowing policy.

·      Loan approval: The first thing a commercial banker wants to know is: How will the loan proceeds be used? Obviously, the accountant wasn’t truthful.

Financial statement impact, dormant accounts
The accountant “falsified Molex accounting records and general ledger entries and intentionally utilized dormant general ledger accounts to conceal the unauthorized and undisclosed trading as well as the concealed borrowing.  At the peak of his scheme, Molex Japan had accumulated approximately $222 million in unauthorized loan obligations as a result of Fusamae’s misconduct. (Italics added)” 

The manipulation of accounting records and general ledger entries is common in an accounting fraud. Using dormant general ledger accounts, however, brings up an issue that is often ignored.

What is that account used for?

Everyone is in a hurry. Accountants are under the gun to produce financial statements. Auditors- both external and internal auditors- are trying to perform audit work efficiently. Along the way, people may not pay attention to the chart of accounts.

Hiding in the chart of accounts
The chart of accounts is the listing of all of your accounts. As you might expect, accounts get added, deleted- or simply sit dormant and unused. Now, it’s standard accounting practice to remove accounts that are dormant. They become a distraction and clutter your accounting reports.

The dormant account can be the perfect place for an accountant to “park” accounting activity that they want ignored. If senior management and auditors aren’t used to seeing that account, it might fall under the radar screen for a while. Eventually, if the balance gets big enough, it will get noticed.

The fallout
This was a massive fraud, but it has several key takeways:
·      No accountant should be involved in signing off on investment or loan activity
·      Pay attention to dormant general ledge accounts. Remove them if they aren’t being used

Have you seen an issue with dormant general ledge accounts? I’d love to hear from you.

Ken Boyd
St. Louis Test Preparation
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
 Co-Founder: accountinged.com

David Tarwin, Cash register close up
(CC BY-SA 2.0)