Adrianas Jewelry Stores was founded in 2000 that operates 22 retail jewelry stores located throughout the MidWest United States. Adrianas tailors its product line to middleclass shoppers, and specializes in engagement and wedding rings. Each store offers a large variety of jewelry with a fairly narrow price range ($60 to $3,500). Although sales increased rapidly during the first years of Adrianas operations, sales during the last three years were flat. In an effort to increase sales, Adrianas recently initiated its own credit card program.

The credit card program required new manual and new IT systems. Among other things, a credit department was established and an accounts receivable (AR) IT program was installed. The credit departments responsibilities include approving customers for the companys credit cards, following up on past-due receivables, and determining when customer accounts should be written off. The credit department has two employees: a credit manager and an AR clerk.

Customers credit card requests are initiated by the customer completing an online application in any of Adrianas 22 retail locations. The online application requests the customers name, address, current monthly income, and Social Security number, among other information. Once the credit application is completed, the IT system automatically interfaces with an independent credit bureau. If the information included in the customers application matches the information in the credit bureaus database, and if the customer has a credit score of in excess of a predetermined minimum score, the customer is extended a credit limit equal to 10 percent of his/her current monthly income. Higher credit limits require the approval of the credit manager.

The AR IT system interfaces with the companys point-of-sale system, automatically posting sales transactions that occur at the companys stores to the AR trial balance. Customers payments are received at a lockbox, posted to the companys bank accounts daily by the bank. Copies of customer checks and remittance advices are received by the Credit Department, where the AR clerk posts them to customers accounts. Monthly customer statements are automatically generated by the IT system. Each month-end, a report of all customers with past-due balances is generated by the IT system. The credit manager reviews the report and instructs the AR clerk to follow-up on specific customer accounts.

Based on the results of the AR clerks follow-up activities, the credit manager determines which accounts should be written off, and processes any necessary adjustments through the IT system. The credit manager meets quarterly with Adrianas CFO to discuss any particularly problematic accounts or unusual write-offs of customer accounts.

Before accepting a position with Adrianas Jewelry, the credit manager was employed by Freds Fashions in a similar position. Freds owner decided to discontinue Freds credit card program and eliminated the credit managers position. The credit manager purchased a new home just prior to being laid off. The night prior to being laid off, the credit manager got engaged, promising that he and his new fiance would soon shop for an engagement ring. Even though the position at Adrianas paid $20,000 less than the position at Freds, the credit manager was assured by Adrianas president that as long as the companys credit card program went well, the credit manager was sure to receive raises that would soon make the salary comparable to his former salary. In addition, the credit manager was looking forward to taking advantage of Adrianas employee discount program when purchasing his fiances engagement ring.

The credit manager selected a $3,500 ring for his fiance, which with his employee discount cost $2,900. The purchase was financed on an Adrianas credit card, by the credit manager overriding the company policy of granting a credit limit of 10 percent of a customers current monthly salary. The credit manager quickly fell behind in his required credit card payments. Although his account began to show up on the AR past-due report, the credit manager avoided directing the AR clerk to perform follow-up procedures for several months. When he learned that the companys auditors would be visiting his department soon, he wrote his remaining account balance off using the IT system, fully intending to repay the balance when he receives his promised raise.

Requirements:

1. What are the red flags present that suggest the possibility of fraud? Are there conditions present suggested by the fraud triangle that may facilitate fraud? Are there IT-related issues that could facilitate fraud?
2. How would the fraud impact the financial statements? What accounts would be misstated
3. How might the fraud be detected? What audit tests might be performed on the processes and IT systems to detect the fraud?
4. In light of your findings, what recommendations might you suggest to improve both manual and IT system internal controls?