8: Knottyville Country Club: Asset Misappropriation Srinivasan Ragothaman, Ph.D., C.A. University of South Dakota LEARNING OBJECTIVES After completing and discussing this case, you should be able to Evaluate misappropriation risk factors. Evaluate internal controls. Design new control. Understand governance in non-profit sector. Analyze materiality decisions. Apply SAS 99, PCAOB AS5, and SAB 99. Perform cost benefit analysis. KNOTTYVILLE COUNTRY CLUB: AN INSTRUCTIONAL CASE ON ASSET MISAPPROPRIATION There was a stunned silence in the courtroom as the Circuit Judge was about to announce the sentence. "You are sentenced to 15 years in prison for grand theft. Your abominable conduct ran long and deep, and it is now time to pay for it," said the judge. The judge also suspended an additional 25 years in prison time for Fancy Rockbottom. One of the members of the country club cold Fancy that she was trusted as a family member by the patrons of the club and that trust was betrayed by Fancy. OVERVIEW OF THE CLUB: Knottyville Country Club (the Club) caters to the desires of its 1,800 dues-paying full members, 800 associate members and their guests. It also rents out its halls and ballrooms for weddings, reunions, and other gatherings. Built on the banks of the Missouri river, Knottyville Country Club offers a variety of exciting, fun-filled activities for its members. The Club was established in 1944 with a nine-hole golf course and an outdoor swimming pool. Since its opening, the Club has steadily continued to expand. It now (in 2007) has one of the most impres- sive 27-hole golf courses in the upper Midwest, six tennis courts, a spectacular clubhouse with lovely views, two swimming pools, an indoor basketball court, beautiful dining rooms with chandeliers, a restaurant, a bar and other opulent amenities. The Club facilities were in great demand and there was a six-month waiting time to book the halls for company picnics, banquets, family reunions, wedding receptions, and the like. There was also a waiting period to gain full membership. Knottyville Country Club is a member-owned, private country club. The seven member board of directors is elected every two years by the members. It includes four officers the president, vice president, secretary and treasurer-and is responsible for the day-to-day management of the Club. The board has broad powers to borrow money and to enter into contracts necessary for the normal operation of the Club. The Club has five committees - membership commit- tee, the finance committee, the nominating committee, the construction and maintenance committee and the special events committee. The finance commit- tee has three members elected from the membership at large and the treasurer is an ex-officio member of the finance committee. The finance committee met just twice a year. The Club was taking in approximately $8 million each year in membership fees alone. In addition, the restaurant, the bar, banquets, rentals and a variety of other programs brought in an additional $18 million each year. The president of the club was a friendly, jovial fellow and treated eveyone with great warmth. He had no accounting or finance background. He was very trusting of people, in general and considered all employees and members as belonging to one big happy family. SHENANIGANS OF THE GENERAL MANAGER: Fancy Rockbottom was employed by the Club in a variety of capacities for twenty-two years including the bookkeeping function. The last six years she served as the general manager and continued to serve as the bookkeeper for the Club. Fancy was also in charge of ordering all supplies. The Club policy required two signatures on each check. As the general manager, Fancy had check signing authority. The other signature had to come from another employee, Sarah or from Robert, who is on the board of directors and is the treasurer. Fancy often asked Sarah to sign blank checks in advance so that she can pay the bills on time and does not have to wait for the second signature. Unsuspecting Sarah would readily oblige and would sign several blank checks from time to time. As the bookkeeper, Fancy was in charge of maintaining the accounting records. She did the monthly bank reconciliation as well. Every three months Fancy would meet with the finance committee of the board and report about the financial situation. She would prepare simple profit and loss statements and a balance sheet. Working with the treasurer, she also presented the annual budget to the finance committee for its approval. Because Fancy was in charge of ordering supplies, she would often insist that they buy alcoholic beverages from a particular supplier who was her college classmate. Members of the Club were allowed to charge their meals and drinks and pay for them later when the monthly statements are mailed to them. Fancy would charge a few dollars extra to some members' monthly restaurant/bar bills. If the members did not notice the extra charge, she would keep the money. If the members complained that they did not order that item or were not at the club on that day, she would apologize, blame it on clerical error and give credit to the complaining members. She would then accuse the server of punching in the wrong member number and take small amounts of money ($50, $36, $84 etc.) out of the paychecks of servers. Fancy's argument was that the servers had to pay for the mistakes they made. The amounts taken from the servers were quite small when compared to the gigantic amount stolen. Fancy has been spotted by her co-workers at various video lottery parlors over the years. There is a rumor that she had a mild gambling addiction. She had acquired a couple of expensive sports cars in recent years and has taken several expensive vacations to exotic places including the French Rivera, Bangkok, and the Bahamas. It was revealed in court that Fancy had paid off large personal credit card debts of her family using the stolen money. The grand theft ocurred evenly over a six-year period from 2001 to 2006. Ironi- cally, it was a bank official who got suspicious about some transactions and alerted the president of the club. The bank official did some investigation when he found out that the business account of the Club was overdrawn. His investigation revealed that Rockbottom was depositing high dollar amounts from her personal account to take care of the balance. Alarm bells rang. He blew the whistle by informing the Club president about his suspicions. The Club terminated Fancy's employment in February, 2007 and ordered an internal investigation. A month later, the Club also filed a police complaint about the grand theft. When Fancy was sentenced to 15 years in prison, she had already paid back $400,000 of the $1.2 million she had embezzled. She has sold her home and other assets to pay back this money. The Club is unlikely to get any more money from Fancy and the remaining $800,000 is gone. This whole episode has made many club members rather uneasy and 400 of them have already quit the club. The debt is mounting for the Club and its future looks rather bleak. Note: Only a few of the facts mentioned in this case actually occurred in a real life situation. Several more fictitious information pieces were added to enhance the learning objectives of this auditing case. All names are fictitious. You can consult a couple of documents readily available in the public domain: COSO framework for auditing internal control for small companies and a fraud checklist from the Association of Certified Fraud Examiners. 1. 2. 3. List in detail the various internal control weaknesses and weaknesses in the monitoring system that existed at the Knottyville Country Club. You are hired as an expert CPA to institute effective internal controls and monitoring systems at the Knottyville Country Club. What controls and monitoring systems would you recommend? List them in detail. The Knottyville Country Club wants to construct an $8 million addition to the clubhouse. They have approached ABC Bank. The bank required the Club to get an external audit done by a CPA firm for years 2005 and 2006. You have been hired as the external auditor. Hint: Read SAS No. 99 first. A) List the risk factors (red flags) for asset misappropriation that are pres- ent in this case. B) What audit procedures would you perform to make sure that there was no embezzlement at the Club and that its financial position is fairly stated? List them in detail