Bad Bad Benny: A True Story (Identifying Controls for a System)

In the early 20th century, there was an ambitious young man named Arthur who started working at a company in Chicago as a mailroom clerk. He was a hard worker and very smart, eventually ending up as the president of the company, the James H. Rhodes Company. The firm produced steel wool and harvested sea sponges in Tarpon Springs, Florida for household and industrial use. The company was very successful, and Arthur decided that the best way to assure the continued success of the company was to hire trusted family members for key management positionsbecause you can always count on your family. Arthur decided to hire his brother Benny to be his Chief Financial Officer (CFO) and placed other members of the family in key management positions. He also started his eldest son, Arthur Junior (an accountant by training) in a management training program, hoping that he would eventually succeed him as president.

As the company moved into the 1920s, Benny was a model employee; he worked long hours, never took vacations, and made sure that he personally managed all aspects of the cash function. For example, he handled the entire purchasing processfrom issuing purchase orders through the disbursement of cash to pay bills. He also handled the cash side of the revenue process by collecting cash payments, preparing the daily bank deposits, and reconciling the monthly bank statement.

The end of the 1920s saw the United States entering its worst Depression since the beginning of the Industrial Age. Because of this, Arthur and other managers did not get raises, and, in fact, took pay cuts to keep the company going and avoid layoffs. Arthur and other top management officials made lifestyle adjustments as wellfor example, reducing the number of their household servants and keeping their old cars, rather than purchasing new ones. Benny, however, was able to build a new house on the shore of Lake Michigan and purchased a new car. He dressed impeccably and seemed impervious to the economic downturn. His family continued to enjoy the theater, new cars, and nice clothes.

Arthurs wife became suspicious of Bennys good fortune in the face of others hardships, so she and Arthur hired an accountant to review the books. External audits were not yet required for publicly held companies, and the Securities and Exchange Commission (SEC) had not yet been formed (that would happen in 19331934). Jim the accountant was eventually able to determine that Benny had diverted company funds to himself by setting up false vendors and having checks mailed to himself. He also diverted some of the cash payments received from customers and was able to hide it by handling the bank deposits and the reconciliation of the companys bank accounts. Eventually, Jim determined that Benny had embezzled about $500,000 (in 1930 dollars).

If we assume annual compounding of 5% for 72 years, the value in todays dollars would be about $17.61 million! Arthur was furious and sent Benny away. Arthur sold most of his personal stock holdings in the company to repay Bennys embezzlement, which caused him to lose his controlling interest in the company and eventually was voted out of office by the Board of Directors.

Jim, the accountant, wrote a paper about his experience with Benny (now referred to as Bad Bad Benny by the family). Jims paper contributed to the increasing call for required annual external audits for publicly held companies. Arthur eventually reestablished himself as a successful stockbroker and financial planner. Benny disappeared and was never heard from again.

Requirements

1. Identify the control weaknesses in the revenue and purchasing processes.

2. Identify any general controls Arthur should have implemented to help protect the company.

3. Identify the internal control activities that Arthur should have consid- ered (or implemented) that would have thwarted Bennys bad behavior.