Separating Cats from Dogs: A Case Designed to Enhance Students' Abilities to Identify Incompatible Duties and Employee Red Flags
Developed by a graduate student and leveraging his experience with a family owned business, this case provides an interesting scenario addressing – and integrating – a number of factors relating to fraud, including incompatible duties, the fraud triangle, psychological factors, and “red flags”. Results from an under-graduate AIS course support the case's efficacy as a student assignment. Student performance on the case closely corresponded with other assessment of learning measures, supporting the use of the case for evaluation purposes. The case also increased student interest and motivation. Most importantly, use of the case resulted in measured enhancement of students' abilities to recognize problems in an accounting system. A spreadsheet was developed to increase the efficiency of grading the case.ABSTRACT
INTRODUCTION
When it comes to exploiting weaknesses and avoiding detection, serial killers and fraudsters are interestingly alike. How do we make such a bold comparison? Serial killers avoid detection by exploiting weaknesses in the police investigation. For example, police require a motive to link a suspect; serial killers often have no apparent motive and, hence, no starting point or reasons for a detective to even consider the perpetrator at hand. In a similar fashion, an alarming number of fraudsters avoid detection by exploiting weaknesses in internal controls, mainly improper separation of duties. They both commit the fraudulent act and then conceal it.
Without a motive and without the proper separation of duties, respectively, police detectives and auditors alike have difficulty in catching the very people they are trained to detect. In both events, a relatively low detection rate exists but the rate increases the more times the perpetrator repeatedly commits the crime. Also, these criminals of interest generally walk like us, talk like us, and look a lot like us. According to the ACFE's report on fraud detection and external audits,
“Such audits were the most commonly implemented control in our study; however, they detected only 3% of the frauds reported to us, and they ranked poorly in limiting fraud losses. While external audits serve an important purpose and can have a strong preventive effect on potential fraud, their usefulness as a means of uncovering fraud is limited.” (ACFE, 2012)
Many times when the general public thinks of auditors, they think of detecting fraud. Yet, the ACFE study indicates that external auditors account for an extremely limited amount of fraud detection – mainly because external auditors are the last line of defense. What can management, internal and external auditors do to improve their detection skills?
We identify one basic tool and skill set to consider: the proper understanding of the concept of separation of duties. Under this concept, at a bare minimum, separate the authorization of a transaction (the decision about whether or not to engage in the transactions, the specific details of the transaction, such as dollar amounts, etc.) from the execution of the transaction (physically meeting the company's obligation under the contractual agreement). Also separate the recording of the transaction (in the accounting records) from the custody of the assets (including inventory, cash, etc.). Failure to maintain this separation generally provides the opportunity for a single individual to both engage in fraudulent behavior and to avoid detection of the fraud, at least for a period of time. The probability of undetectable fraudulent activity is reduced by separating these incompatible duties (authorization from execution, and recordkeeping from custody).
We identify a second skill: the ability to evaluate and assess the control environment. Preventing and deterring employee fraud can be enhanced if management evaluates the risk factors associated with the employee responsibilities (opportunity) and their personal and work backgrounds (pressure/motivation and rationalization). The interaction between the job duties and the personal and work backgrounds in many cases assembles the three components of the fraud triangle. In order to assess the control environment, one needs the ability to recognize those combinations of environmental elements which constitute the proverbial “red flag”.
Although red flags do not necessarily signal fraud, they can indicate the need for attention, careful consideration, and further investigation. Just as any good detective should understand his or her environment, an auditor should also fully consider the people involved and the opportunities or motives related to fraudulent acts – in short, the control environment as a whole.
A deep conceptual understanding of why and how internal controls reduce the opportunity for undetectable fraud, and a comprehension of how red flags relate to the possibilities of fraud generally comes with experience. Thus, a classroom exercise which emulates a real world scenario can provide some small measure of “experience” or pseudo-experience for students. A case study based on a real life business scenario provides a richer educational opportunity.
SMALL BUSINESS EMPHASIS
Educators often remove extraneous distractions from the learning environment when attempting to develop a set of skills and abilities. Once students have learned the skill or ability, however, educators can reintroduce the real-world distractions and complicating factors to provide a more realistic scenario. For this reason, illustrations, exercises and cases involving small business vignettes are widely found in accounting education. Small business situations frequently contain a level of complexity necessary for full understanding and comprehension but exclude the complexities inherent in large multi-site corporate environments. Once the students understand the fundamentals of the skill or ability, the educator can then introduce the large business complexities.
We also used the small business environment in this case because for most small businesses, their small workforce often precludes the needed separation of duties of employees to tasks which the owner sees as unproductive, e.g., not directly contributing to the execution of profitable transactions. This includes authorization and recordkeeping tasks. As a result, small businesses often violate the concept of separation of duties due to the cost/benefit dilemma. However, a small business can use a series of checks and balances, and possibly the implementation of compensating controls, to provide at least some level of separation of duties and reduce opportunities for fraud.
In the current case, the small number of employees allows the inclusion and consideration of diverse human vagaries, personalities, backgrounds, and other issues, but at the same time limits the breadth of those issues to a manageable number. With less than a dozen employees, an instructor can contrive and manipulate the range of personalities, personal backgrounds, individual work settings, and potential motivations to provide the needed variety to exercise student skill without the overwhelming complexity found in larger corporate environments.
Thus, the small business environment offers an optimum background on which to build an educational case addressing a combination of concepts relating to separation of duties, control risks, personalities, personal backgrounds, and red flags.
In summary, graduating accounting students should have the basic abilities to 1) identify areas where employees may have the opportunity to commit fraud, 2) analyze employee responsibilities, 3) distinguish between those that do not allow a highly perceived opportunity to commit fraud and those that do, and 4) identify red flags present in the personal characteristics and backgrounds of those working for an organization. By combining all these aspects and tying their significance to elements of the fraud triangle, students can evaluate the main components of common employee responsibilities in an actual organization. They can then associate the everyday issues faced by companies with opportunity, motivation/pressure, and rationalization, and effectively assess the risk factors present, due to the lack of properly separated duties. This case provides students with these abilities.
GROUP EDUCATIONAL ENVIRONMENT
The educational literature is replete with studies which confirm the effectiveness and efficiency of group learning. Collaborative learning, discussion-based collaborative pedagogy, and other techniques utilizing the group environment for which this case is designed are well documented as effective educational delivery vehicles. Curseu and Pluut (2013), Chiriac, Williams, and Senior (2014), Hamann, Pollock, and Wilson (2012), and Sellitto (2011) are just a few of the numerous studies which addressed the benefits of group work in education, especially the discussion-based analyses inherent in this case.
The accounting education literature over the past two decades is also filled with studies which confirm the effectiveness and efficiency of group learning environments. Ravenscroft and Buckless (1999), Levinson (1999), and Kunkel and Shafer (1997) are three examples. For lengthy bibliographies of studies confirming the efficacy of group learning, one can refer to Ravenscroft, Buckless, and Hassall (1999) or more recently, Norman, Rose and Lehmann (2004).
CASE EFFECTIVENESS
We used the case in three sections of one semester of an undergraduate systems course at one of the co-author's institutions. A total of 84 students, organized into 25 teams of three or four students per team used this case. The case was issued near the end of the semester and students were given a weekend to perform the work – comprehending the complex interaction between the control environment, the internal control system and the elements of the fraud triangle. Each team submitted a written report, after which a half-hour discussion was held in class.
Individuals from four different semesters had 16 similar questions on a final examination. Three of the semesters the students did not participate in the case and the fourth semester the students completed the case as described above. Thirteen of the questions were related to separation of duties / internal control (SOD/IC) and three of the questions related to the fraud triangle (FT). The students' performance was examined by type of question (SOD/IC or FT) as well as combined to see if the learning objectives of the case were achieved. Table 1 reports the results of the students' performance on the exam questions.
Table 1 reflects that students completing the case on average performed significantly better (7.5%, t = 7.4, p < .001) on the 16 questions than students from the prior three semesters. Similarly, students completing the case on average performed significantly better on the 13 SOD/IC questions (7.3%, t = 6.2, p < .001) and on the 3 FT questions (8.3%, t = 4.5, p < .001) than students from the prior three semesters. Additionally, an ANOVA with follow-up comparison of means was performed to analyze student performance by semester on the 16 questions by objective. Table 1 reflects no significant differences (homogenous subsets) for the prior 3 semesters (1, 2 & 3) when analyzed by Mean SOD/IC scores, Mean FT Scores and Mean Combined Scores. However, all 3 prior semesters scores were significantly less (p-value < .05) than the semester (4) in which the case was given, with the sole exception of Semester 3's mean FT score. The results suggest that students completing the case did increase their performance on final exam questions relating to separation of duties, internal controls, and the fraud triangle.
Conclusion and Summary
This case is a quick and easy assignment which illustrates the integration of internal control concepts (specifically the separation of duties) with the concepts of the fraud triangle, and the application of “red flags”. Students who completed this case score significantly better on the examination rubric than comparable students in the course in earlier semesters who did not have the benefit of completing this case, which demonstrates the case's efficacy in enhancing educational achievement.
The Case
Assume PetUs Company, a veterinary clinic located in the Washington D.C. area hires you as the auditor. PetUs Company performs all of the basic functions of an animal hospital including client check-ups, surgeries, grooming, and sales of basic pet accessories. In the past few months, the animal clinic recorded unusually low revenues from both the retail and service sides of the business. This raises the suspicions of the owner of the clinic and he wants you to identify weaknesses in, and potential improvements to, business processes with the goal of deterring and preventing employee fraud.
The owner wants you to map out the various positions and roles of each employee. Create an organizational chart displaying each employee position (include names) and use it as one of your tools for evaluating the control environment of the company. Also, the owner has provided background summaries of each employee, descriptions of employees' key responsibilities, and other factors related to potential red flags both at home and the workplace. The owner also wants you to identify incompatible employee duties and assess the risk factors associated with each employee position. Once you have assessed the risk, rank the employees from highest risk of fraud to lowest risk of fraud in hopes of adjusting the business processes accordingly to deter and prevent employee fraud in the future.
Employees
Groomer, Angela
Angela provides grooming services for clients' pets as well as processing transactions for these services. Angela operates in a separate part of the building with her own cash register although she reports directly to the Office Manager. If a customer chooses to purchase these services, Angela will receive the payment over the counter and enter the transaction into the cash register designated for grooming services. At the end of the day, Angela removes the register tape that records the transactions for the entire day and counts the payments in the register to see if the totals from the register tape and payments on hand match. She then takes the payments and register tape directly to the Office Manager and they both place these in a safe and close out the day. Angela works through both the morning and afternoon shifts and spends a significant amount of time cleaning up her service area before and after close. She believes that she deserves a raise for her excellent services.
Mailroom Clerk, Beth
Beth's main duties take place in a small mailroom located in the rear of the animal clinic. Since this is a small organization with a minimal amount of incoming mail, only Beth works in the mailroom and no cash register exists at this location. She opens the daily incoming mail and retrieves any payments from customers by check. She collects the checks and posts them to customer accounts to show that the customers have sent in their payments. At the end of the day, she collects all of the checks and delivers these to the Office Manager. Then together they place the checks in the safe.
Beth has a happy marriage to a successful lawyer and two healthy children. Due to her lifestyle and stable job, she enjoys a relatively healthy life for her age.
Receptionist, Chris
Chris works the front desk as a receptionist under the Morning and Afternoon Shift Managers. Although he works for both Shift Managers, neither provide much oversight as both managers keep busy handling their own transactions. In addition to answering the phone and making client appointments, Chris has the responsibility for retail items. Except for scheduling appointments, Chris has no involvement in any transactions regarding client check-ups, surgeries, or grooming services. Chris sells all retail items for cash or check. Sometimes Chris is given a check from a customer in payment on the customer's account, although this happens rarely.
When customers pay for retail items by cash, Chris accepts the cash and rings up the sale in his cash register, placing the cash in the register's cash drawer. He also handles customer complaints that result in returns and voided sales.
For retail sales paid by check, Chris rings up the sale in the register as a check receipt, and immediately calls the Shift Manager. Chris hands the check to the Shift Manager, who scans the check to create a check listing. The Shift Manager keeps the checks. After ringing up the check sale and handing over the check to the Morning or Afternoon Shift Manager, Chris has no further handling of the check.
On those rare occasions when a customer comes in and makes a payment on their account, Chris accepts the check but does not ring it up into the register. Instead, he immediately calls the Shift Manager, and hands the check to the Shift Manager.
At the end of the day, Chris must close out the register and reconcile all cash sales to the cash total on the register tape under the oversight of the Afternoon Shift Manager. The register differentiates the cash sales from the check sales, and Chris and the Shift Manager together count the money and ensure it matches the cash sales total. Together, they both physically place these funds into the safe with the Office Manager also present.
Chris works very hard and seems to work in the office all the time. His dedication to his job has resulted in no vacations taken for the past two years, yet he does not complain about working too much. At home, he has no major issues and lives a relatively comfortable life.
Morning Shift Manager, Debra
Debra works during the morning shift with the assistance of the Receptionist. When Chris (the Receptionist) receives a check from a customer for a retail transaction, he rings up the sale in the register, then directly hands the check over to Debra and she electronically swipes the check to keep a log of all checks collected for the day. If the check was for payment against a customer account (for previous services rather than retail sales), Debra then posts these check payments to the customer accounts. Debra maintains two stacks of checks, one for retail sales, and one for payments against accounts.
Before she ends her morning shift, Debra collects all of the checks received and places the two stacks of checks into the hands of the Afternoon Shift Manager upon his arrival.
Debra lives alone with her healthy German shepherd. As a relatively new hire, she has adjusted very well to her new job. In fact, the Office Manager commented saying that he wished “all his employees could learn as fast as she does”.
Afternoon Shift Manager, Evan
Evan only works during the afternoon shift when business slows down and surgeries for the day have ended. Evan has the same responsibilities as the Morning Shift Manager for checks received. In addition to this responsibility, Evan also handles any write-offs or discounts applicable to customer accounts. At the end of the day, Evan physically places all the checks received during both the morning and afternoon shifts into the safe with the Office Manager present.
Evan, one of the more senior employees, has worked under the owner for quite some time. He was seriously addicted to cocaine in the past but he claims to have quit permanently. Yet, signs of his drug use continue to flood the office talk as his irritability, repeatedly bleeding nose, and other health and financial issues become apparent during the work day. As a senior employee, he blames his problems on being overworked by the Owner and Office Manager.
Senior Technician, Frank
Frank deals with client relations and makes sure that check-ups run smoothly. For the majority of the day, Frank stays in the appointment room and conducts the routine check-ups for the pets with the assistance of the Technician. Frank's other major responsibility deals with the expenditure cycle. He places any purchase orders for necessary items such as pet accessories, vaccinations, medications, medical supplies, and any other required hospital equipment. After creating the purchase order, he sends it to the vendor to order the items. Frank counts the received items. He then compares the quality and quantity of the actual count to the vendor's invoice and signs off to approve that all items were received and he then records this into the inventory journal. After Frank approves the vendor's invoice for payment, he hands the invoice to the Office Manager. The Office Manager then processes the cash disbursement to the vendor for the items received.
Frank is happily married to his stay-at home wife and has three children. Unfortunately, his youngest child has a chronic illness that burdens him both at home and the workplace. He tries to remain professional but his current financial situation makes it difficult to provide the medical care that his youngest child requires. He has asked for a raise in order to afford additional care to his child but the owner regretfully denies him due to the recent drop in profits.
Technician, Gwen
Gwen greets the clients when they arrive at the animal clinic for an appointment. She assists the Senior Technician in conducting the check-ups and also guides the clients around the hospital from appointment rooms to surgery rooms and the check-out point. When clients check out, Gwen records any transactions related to the client check-ups and/or surgeries. Since these transactions usually have a relatively higher monetary amount, she uses a separate cash register which is located next to the Receptionist's register. She processes both cash and checks through this register and the register records both of these on the register tape. She receives the payments and enters the transactions directly into this cash register often with the oversight of the Senior Technician.
Gwen also records billings on credit. Once a customer has visited the clinic several times, the Owner/Doctor Wesley will approve the client to have credit extended. Gwen prepares a bill for the customer, and records the accounts receivable in the customer's file and the clinic's accounting records.
At the end of the day, Frank (the Senior Technician) reconciles Gwen's cash and check amounts to the register tape. Then the Office Manager posts the funds and secures the cash and checks in a safe in the presence of the Technician.
Gwen, a single, college student paying her way through college, struggles to make ends meet financially but somehow manages to buy herself nice things such as her new BMW and fancy jewelry. In fact, to an observer, those purchases may seem to be the cause of her financial distress.
Office Manager, Henry
Henry oversees the work of all the employees throughout the course of the day and creates the employee work schedule, coordinating with customer appointments. The Groomer reconciles the cash and register tape herself and brings those funds to Henry to immediately place into the safe in her presence. Henry also has the same duty of locking up all of the Mailroom Clerk's checks received from the mailroom, the Receptionist's funds from the front desk cash register, the Technician's cash register, and all the checks received from both Shift Managers into the safe -- in the presence of the other employee.
For the expenditure cycle, Henry releases the cash disbursements for approved vendor invoices after the Senior Technician has conducted his acquisition responsibilities (refer to Senior Technician employee summary), recording it in the check register.
As the son of an extremely successful heart surgeon, rumor has it that Henry recently inherited a large sum of money. He is a humanitarian and the most loyal and most tenured employee of this animal hospital. He is happily married with one healthy child and has earned the “Employee of the Year” honor multiple years in a row.
Doctor / Owner, Wesley
Wesley conducts all of the surgeries and hires all of the employees. He has the responsibility of making sure that all the employees and business processes operate as smoothly and efficiently as possible. Only Wesley knows the password to the safe, and he empties it every morning before opening the animal clinic. He then leaves it open so that employees can place the daily deposits at the end of the work day and instructs the Office Manager to lock it before closing the store while in the presence of at least one other employee.
Wesley personally takes the contents of the safe to the bank next door before the clinic opens each morning, using a lockable bank bag for security. The bank has a machine which counts the cash, and scans and itemizes the checks, and produces both the deposit slip and the deposit receipt, which Wesley takes back to his office and files.
Student Requirements/Instructions
For this case, assume no collusion exists and that management does not override any employee duties. Use only the information provided as a basis for your answers.
Requirement 1
(5 pts) Use Visio to create an organizational chart (Use Org Chart Template that you will present to the client – make it neat / professional). Print out the Org Chart to submit to your instructor.
Requirement 2
Use the “Student Answers.xls” spreadsheet and do the following:
-
Put your team # in cell E3.
-
(9 pts) Use the dropdown boxes (Cells D5 to D13) to select potential separation of duties issues the employees may have. You should have an answer for each of the positions. Be prepared to discuss these in class. For example, the Groomer (Name) could do both X (Authorize / Record / Custody) and Y (Authorize / Record / Custody) and possibly Z.
-
(18 pts) Use the dropdown boxes (Cells E5 to E13) to rank the employees from 1 (Most Likely to Commit Fraud) to 9 (Least Likely to Commit Fraud) using each number only once. You will see “Fix Duplicates” if you use a number twice. Be prepared to discuss these in class.
Requirement 3
Save the file as your team # (for example “101.xls”) and have at least one member of your team upload your answers to the course management system.
This assignment is worth 32 points and is due at the beginning of class on the due date.