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

Image: 

David Tarwin, Cash register close up

(CC BY-SA 2.0)

When Little Things Become Big Things: Internal Controls and Theft

In business, as in life, if we don’t take care of little things, they can become big things. I’ve always remembered a quote from a parenting expert I heard years ago: “As time goes on, the mistakes get more expensive”. This concept is particularly true of internal controls.

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The Hartford Courant reported in May of 2015 that the Ex-Finance Director of Plymouth, David Bertnagel, was sentenced to 30 months in prison. This individual embezzled $808,000 from the city. If you live in any major city, you’ll see an article about business theft every week. This crime is particularly difficult for a governmental entity. The money that was stolen was public funds- a violation of the public’s trust.

So how did it happen?

The theft

The article explains that: “For several years, Bertnagel wrote checks to himself from Plymouth's accounts, and then simply deleted the entries from the accounting ledger.” He was caught when a bank official reported two suspicious checks to the Mayor. The bank noticed that the checks were written to Bertnagel (a city employee) on town bank accounts.

Understanding the purpose of an audit

Here’s another quote from the article:

“Meyer (The Judge in the case) asked how the town's auditors from Blum Shapiro failed to uncover the theft, which included more than 200 checks.

"That's an excellent question. We've asked that question many times," Merchant (The Mayor) replied, saying the town will be changing firms after an ongoing audit is completed.”

This issue is tricky. An audit is designed to determine whether of not the financials are free of material misstatement. By material, we mean an error large enough that would cause the financial statement reader to change their opinion about the entity’s finances.

Most audits now require the auditor to assess internal controls- and here’s where we have the tricky problem: An audit is not designed to detect fraud. However, the reason that this theft occurred is that the internal controls were woefully inadequate. It’s reasonable to expect the auditor to recognize the internal control weakness and point it out.

Segregation of duties

Whenever possible, these three duties should be assigned to three different people in an organization:

·      Custody of assets: Custody refers to the person who has access to the assets. This would include possession of the checkbook, or keys to the company warehouse. In this case, the Finance Director has access to the checkbook.

·      Authority to move assets: Authority means the person who can sign a check (move cash) or who can take equipment out of the warehouse. The Finance Director could sign checks. Generally, accountants should avoid signing checks- because of the other two duties that need to be segregated (above and below this duty).

·      Recordkeeping: If a person has custody of assets or authority to move assets, that person should not post accounting entries or reconcile the bank account. Fortunately, a banker noticed the issue and pointed it out to the Mayor.

Don’t neglect internal controls. As you can see, a lack of segregation of duties can be devastating to an organization. Every entity should have a written set of internal controls and monitor to take sure those controls are being followed.

Have you seen a lack of segregation of duties in your business experience? Tell me about it- 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

(email) ken@stltest.net

 (website) www.stltest.net

Image License: CC0 Public Domain