For obvious reasons, cash is the asset most often stolen by dishonest employees. Fraudsters typically target cash as it enters or leaves the business. Thoroughly understanding the controls and procedures in place for processing cash flowing through a business is of primary importance when conducting a fraud examination. Inadequate cash flow controls, especially over substantial amounts, allow dishonest employees to divert cash into their own pockets. Understanding these controls allows investigators to generate ideas, known as fraud theories, that describe how someone could steal cash from the organization without getting caught. These ideas can be categorized as either on-book or off-book fraud schemes.
Historically, law enforcement and financial investigators are reluctant to investigate off-book fraud schemes due to their lack of direct, documentary evidence. The case study below illustrates various methods effectively used to detect and investigate off-book fraud schemes. Such indirect methods include financial statement analysis, undercover surveillance, invigilation, and admission-seeking interviews.
On-Book and Off-Book Fraud Schemes
Cash larceny involves the theft of cash after it has appeared on a company's books. Such schemes are called on-book frauds because an examination of the victim company's records can easily reveal the cash shortage. Here, the company typically knows that a theft has occurred. On-book frauds can be categorized as billing, payroll, expense reimbursement, check tampering, or register disbursement schemes.
Skimming is an example of an off-book fraud, which involves theft of incoming cash before it enters the accounting records. Thus, no record of the fraud exists on the company's books. Skimming typically entails selling goods or services to a customer, collecting the customer's cash payment, and making no record of the sale. The victim generally does not know that a theft has occurred. Off-book frauds cannot be detected by examining the company's books and records and generally are categorized as skimming, unrecorded sales, understated sales and receivables, or theft of checks through the mail.
Case Study: Northern Exposure
Northern Exposure (all names in this case study have been changed) was a gentleman's club featuring exotic dancers. Its primary revenue sources were cover charges and food, beer, and liquor sales. A recent local ordinance outlawed the type of entertainment offered by Northern Exposure. The club's manager, however, successfully petitioned the city council to obtain an exemption, and Northern Exposure was allowed to continue operations in a competition-free environment. The substantial effort by the manager on the club's behalf earned her the owner's trust and loyalty. In the initial fraud investigation interview, the owner said that anyone could be a suspect-except the manager.
Because of the exemption, the club's profit potential was enormous. Northern Exposure generated huge amounts of incoming cash, because no credit cards or checks were accepted. However, a huge risk existed that employees would figure out a way to divert incoming cash into their own pockets.
Larry Swenson, Northern Exposure's owner, was not satisfied with the 10% margins being realized. He engaged two certified fraud examiners to determine why the club was not generating the 35% margins he had expected. They embarked upon a typical fraud examination, whose steps include understanding cash controls, generating fraud theories, collecting and evaluating evidence, estimating losses, assisting in filing claims or bringing charges, and making recommendations.
Understanding Cash Flows
By interviewing Swenson and other personnel, the fraud investigators learned that cash flowed into the business as follows:
Customers paid a $6 cover charge to enter the club. No receipt was given, nor was a head count made. Customers placed orders for food or beverages with the servers. …