Question

Robert Hopkins was the senior office employee at the Griffin Equipment Company. He enjoyed the complete confidence of the owner, William Barton, who devoted most of his attention to sales, engineering, and production problems. All financial and accounting matters were entrusted to Hopkins, whose title was office manager. Hopkins had two assistants, but their only experience in accounting and financial work had been gained under Hopkins’s supervision. Barton had informed Hopkins that it was his responsibility to keep him (Barton) informed on the financial position and operating results of the company but not to bother him with details. The company was short of working capital and would occasionally issue notes payable in settlement of past-due open accounts to suppliers. The situations warranting the issuance of notes were decided upon by Hopkins, and the notes were drawn by him for signature by Barton. Hopkins was aware of the weakness in internal control and finally devised a scheme for defrauding the company through understating the amount of notes payable outstanding. He prepared a note in the amount of $24,000 payable to a supplier to whom several invoices were past due. After securing Barton’s signature on the note and mailing it to the creditor, Hopkins entered the note in the Notes Payable account of the general ledger as $4,000, with an offsetting debit of $4,000 to Accounts Payable. Subsequently, when funds became available to the company, he paid the $20,000 of accounts payable that remained on the books. Several months later when the note matured, a check for $24,000 plus interest was issued and properly recorded, including a debit of $24,000 to the Notes Payable account. Hopkins then altered the original credit in the account by changing the figure from $4,000 to $24,000. He also changed the original debit to Accounts Payable from $4,000 to $24,000. This alteration caused the Notes Payable account to have a balance in agreement with the total of other notes outstanding. To complete the fraud, Hopkins called the supplier to whom the check had been sent and explained that the check should have been for only $4,000 plus interest. Hopkins explained to the supplier that the note of $24,000 originally had been issued in settlement of a number of past-due invoices, but that while the note was outstanding, checks had been sent in payment of all the invoices. "In other words," said Hopkins over the telephone, "we made the mistake of giving you a note for those invoices and then going ahead and sending you checks for them as soon as our cash position had improved. Then we paid the note at maturity. So please excuse our mistakes and return the overpayment." After reviewing the record of invoices and checks received, the supplier agreed he had been overpaid by $20,000 plus interest and promptly sent a refund, which Hopkins abstracted without making any entry in the accounts.

Assuming that an audit by CPAs was made while the note was outstanding, do you think that the $20,000 understatement of the Notes Payable account would have been detected?

Explain fully the reasoning underlying your answer. If the fraud was not discovered while the note was outstanding, do you think that an audit subsequent to the payment of the note would have disclosed the fraud?

Explain. What controls would you recommend for Griffin Equipment Company to avoid fraud of this type?

Answer 1

Detection of the $20,000 understatement in the Notes Payable account during the audit depends on whether auditors confirm notes payable directly with suppliers. Post-payment audit might reveal fraud through a detailed review of altered entries. To prevent such fraud, Griffin Equipment Company should implement robust internal controls, including segregation of duties and regular independent reconciliations.

Step-by-step explanation:

The likelihood of detecting the $20,000 understatement of the Notes Payable account during an audit while the note was outstanding depends on the specific audit procedures employed. If the auditors conduct a verification of notes payable by directly confirming with suppliers, then the understatement should have been detected. Auditors typically send confirmation requests to a selection of creditors and verify the amounts owed as per their records against the company's records. Therefore, the discrepancy should have come to light if the supplier was chosen for confirmation and the auditors diligently assessed the response.

However, if the fraud was not discovered during the note's tenure, an audit subsequent to the payment of the note might reveal the fraud through detailed transaction analysis and investigation of altered entries. Auditors could notice the discrepancy in timings of the initial incorrect entry and subsequent changes if they examine journal entries and supporting documents around the dates of transaction.

To prevent fraud of this type at Griffin Equipment Company, implementing internal controls is crucial. Some recommended controls include:

• Segregation of duties so that no single employee has control over all aspects of a financial transaction.
• Regular independent reconciliations of accounts payable and notes payable.
• Management review and approval of journal entries, particularly for large and unusual transactions.
• Regular internal audits to test the effectiveness of controls and detect any irregularities.
• Direct confirmations of notes payable as a standard audit procedure.

Answer 2

Detecting the fraud described in the scenario would depend on the effectiveness of the audit procedures and the controls in place during the audit. Let's analyze the situation and consider the likelihood of detecting the fraud at different stages.

While the note was outstanding

The audit procedure would likely involve confirmation of the Notes Payable directly with the creditors, in this case, the supplier. The confirmation would be sent by the auditors to the supplier to verify the amount of the outstanding note.

Since the supplier had been contacted by Hopkins and had acknowledged the overpayment, the confirmation response might match the recorded amount, and the fraud could potentially go undetected during the audit.

Subsequent to the payment of the note

After the payment of the note, auditors might perform a detailed examination of the cancelled check, including reviewing supporting documentation and bank statements.

If the auditors noticed any discrepancies in the payment amount, such as a significant overpayment, they might further investigate and could potentially detect the fraud during this stage.

Controls to avoid fraud of this type

Segregation of Duties

Implement a segregation of duties by having different individuals responsible for authorizing, recording, and reconciling financial transactions. This would make it more difficult for one person to carry out and conceal fraudulent activities.

Independent Review

Introduce an independent review process for significant financial transactions. For example, a designated person should review and reconcile the details of notes payable, ensuring that the amounts match supporting documentation.

Internal Controls and Policie

Strengthen internal controls and establish clear policies regarding the issuance and recording of financial instruments. This includes regular reconciliations, mandatory documentation reviews, and approval processes for significant transactions.

Surprise Audits

- Conduct surprise internal audits or engage external auditors periodically to review specific accounts or transactions. This can serve as a deterrent to fraudulent activities and provide an independent assessment of the financial records.

Employee Education and Ethics Training

Train employees, especially those involved in financial transactions, about ethical behavior and the consequences of fraud. Encourage a culture of integrity and transparency within the organization.

In summary, while an audit might not have detected the fraud while the note was outstanding, stronger internal controls, segregation of duties, and additional review processes could help prevent and detect such fraudulent activities. Implementing these controls would contribute to a more robust and fraud-resistant financial environment at Griffin Equipment Company.