Problem 7 - Accounting

Question

Satchell Company, a communications equipment manufacturer, recently fell victim to an embezzlement scheme masterminded by one of its employees. To understand the scheme, it is necessary to review Satchell's procedures for the purchase of services. The purchasing agent is responsible for ordering services (such as repairs to a photocopy machine or office cleaning) after receiving a service requisition from an authorized manager. However, since no tangible goods are delivered, a receiving report is not prepared. When the Accounting Department receives an invoice billing Satchell for a service call, the accounts payable clerk calls the manager who requested the service in order to verify that it was performed. The embezzlement scheme involves Drew Brogan, the manager of plant and facilities. Drew arranged for his uncle's company, Brogan Industrial Supply and Service, to be placed on Satchell's approved vendor list. Drew did not disclose the family relationship. On several occasions, Drew would submit a requisition for services to be provided by Brogan Industrial Supply and Service. However, the service requested was really not needed, and it was never performed. Brogan would bill Satchell for the service and then split the cash payment with Drew. 1\. Explain what changes should be made to Satchell's procedures for ordering and paying for services in order to prevent such occurrences in the future.

Step-by-Step Solution

Answer

Introduce segregation of duties, enhance vendor transparency, implement independent service verification, conduct regular internal audits, and strengthen the invoice approval process.

Step 1: Segregation of Duties

Satchell should ensure that the responsibilities related to ordering services, approving requisitions, and processing payments are segregated among different employees. The person requesting the service should not have the authority to approve the vendor or verify the completion of the service. Implement checks and balances to avoid conflicts of interest.

Step 2: Establishing Vendor Transparency

Require all employees involved in vendor selection to disclose any familial or personal relationships with vendors. Regularly update and review the vendor list to ensure compliance and prevent nepotism or fraudulent activities by closely examining vendor backgrounds and relationships with employees.

Step 3: Independent Service Verification

Instead of relying on the manager who requested the service for verification, establish an independent verification system. This could involve a separate department or an internal audit team that randomly checks or inspects the completion of services. Maintain documentation as proof of service completion before processing payments.

Step 4: Implement Internal Audits

Conduct regular internal audits focused on billing and service requisitions. Ensure these audits randomly review past transactions, focusing on matching requisitions with completed services and invoices. This will help uncover any discrepancies or patterns of fraudulent activities.

Step 5: Strengthening Invoice Approval Process

Enhance the accounts payable process by instituting a multilayer approval system for invoices related to services. Require additional approval from a senior manager or an independent officer if the invoiced amount exceeds a certain threshold or the vendor is newly approved.

Key Concepts

Segregation of Duties

One of the most effective ways to prevent fraud within an organization is to implement proper segregation of duties. This means distributing tasks and associated privileges for a specific business process across more than one person. For instance, when a service is requested, different people should be responsible for ordering the service, approving the request, and verifying completion of the service. By doing so, this reduces the risk of errors and fraud, since no single employee is in a position to both commit and conceal fraudulent activity. It also introduces checks and balances within the system, ensuring transparency and accountability for each step of the process.

Vendor Transparency

Vendor transparency is crucial in managing relationships with external service providers. Employees should be required to disclose any familial or personal ties with vendors. This is significant to prevent conflicts of interest and ensure decisions are made in the best interest of the company. Updating and reviewing the approved vendor list regularly can assist in identifying any potential red flags. Moreover, scrutinizing vendor backgrounds and examining relationships with employees can help in preventing fraud and ensuring that only legitimate vendors are engaged. Vendor transparency fosters a trusting environment and minimizes risks associated with vendor-related fraud.

Fraud Prevention

Fraud prevention involves several proactive steps that can help protect a company from fraudulent activities. One essential measure is setting up independent verification of services. Instead of relying solely on the manager who requested the service, an independent body or internal audit team should be responsible for verifying service completion. They should maintain documentation as proof before any payment is processed, ensuring the company only pays for services that were genuinely rendered. Additionally, strengthening the invoice approval process by requiring multiple layers of approval for high-value transactions or new vendors can also mitigate the risk of fraud. These preventive steps help safeguard the company's financial health.

Internal Audits

Conducting regular internal audits is a cornerstone for maintaining financial integrity and transparency. These audits should focus on aligning billing with actual service requisitions and payments. By randomly reviewing past transactions, audits can spot discrepancies or patterns indicative of fraudulent activity. This helps ensure that payment matches the services received, confirming the authenticity of transactions. Furthermore, internal audits provide an additional layer of scrutiny over processes and controls, serving as a deterrent to unethical practices. A robust auditing process not only validates financial transactions but also strengthens trust within the organization, as it demonstrates a commitment to honest financial practices.