Belding Party Store Lottery Fraud Introduction Elizabeth Amelia, CPA, works for Hovey \& Jackson, CPAs, [H \& J] a Detroit-based Litigation Support firm. She supervised you on an engagement to examine a potential fraud involving a Michigan State Lottery ticket vendor. Amelia and you should determine whether a fraud had occurred and, if so, estimate the extent of damages. The ticket vendor in question is the Belding Party Store [hereafter, Belding] that Samuel Mason owns. Belding is a typical local, Mid-Michigan convenience and grocery store. Besides traditional convenience and grocery items, Belding sells various types of lottery tickets. Mason is experiencing difficulty reconciling his lottery-related cash flows. He asked H&J to examine his books, determine the nature of the problem, and assess the extent of financial loss. The following is background information that Amelia has developed to help understand the situation. Michigan State Lottery System Public Act No. 239 of 1972 (hereafter, the Act) set up the Michigan Lottery to help fund public education, deriving over $23.4 billion in revenues since then. This Act requires the Michigan Auditor General or an independent accounting firm to audit biannually the Michigan Lottery Commission (MLC). The Act does not require individual retailers to provide audited financial statements or any other CPA-associated financial statements. Over 10,500 Michigan retailers sell lottery games, all of whom must obtain state licenses, pay appropriate fees, and follow strict guidelines. Among such, they must keep current and accurate records of all lottery operations. Retailers caught disobeying these rules could lose their state lottery license and face severe civil and criminal penalties. The MLC offers four major types of lottery games, whose costs range from fifty cents to $30 : (1) draw games, (2) Instant Ticket, (3) Pull-Tab, and (4) Insta-Tab. In traditional draw lottery games, customers can select their own lottery numbers or have the MLC system randomly select them. The MLC periodically holds random drawings to choose the winning numbers. Customer scratch off latex coverings to reveal symbols to determine if they won Instant Ticket game prizes. They also can play Pull-Tab games by pulling on perforated tabs to reveal winning tickets. Insta-Tab games combine Instant Ticket and Pull-Tab games. Customers must both scratch latex off the eard and pull on a perforated tab to see if they won a prize. Retailers receive lottery tickets on consignment, which hold no value until the retailer activates them. Upon activation, the retailer must remit the proceeds for the entire roll of tickets. based upon their face values. Thus, they must make up any differences for tickets sold below face value and may not sell lottery tickets for over their face value. Retailers can return damaged tickets to the MLC for full credit. Exhibits la-ld show how these documents flow. Retailers must report lottery tieket thefts to the MLC and local or state police authorities and absorb the costs of all stolen or lost tickets. Depending on an investigation's outcome, the retailer could receive refunds for some stolen ticket costs if they properly accounted for the stolen tickets and reported the theft. All licensed retailers can redeem prizes below $601, and generally, automatically redeem prizes under \$26. Winners can redeem prize amount between $601 and $50,000 at a Lottery regional office, bank claim center or Secretary of State branch office - or by mail. Winners must claim those over $50,000 at the MLC headquarters. Retailers must validate winning tickets before redeeming cash prizes, requiring that: - The customer scans the ticket, and if it is a winner, the customer hands the ticket to a retailer who, using a separate scanning machine that is located on the ticket seller's side of the sales counter, scans and confirms the winning lottery ticket. - Upon confirmation from the second scan, the MLC receives such information as whether the ticket won, as well as the following: time of the event (to the tenth of a second); the ticket's denomination; and the scanning store's location. - Next, the retailer collects the ticket, writes their unique retailer number on the ticket, and defaces the validation number so the ticket may not be redeemed again. - The retailers will then normally hold the redeemed tickets to balance their records and later submit the tickets to the MLC as part of the monthly reconciliation processes. Retailers earn 6% commissions on tickets sold plus 2% on cash prizes over $600 paid to individuals They must also use separate lottery transactions bank accounts and authorize electronic funds transfers (EFT) to and from the accounts. The MLC runs lotteries daily from Monday to Sunday. At the end of each week, retailers receive invoices for the total tickets sold. The retailers' bank account uses EFT to remit lottery ticket proceeds less earned commissions to the MLC. While retailers need not pay out cash prizes, they are expected to do so if they are able. Lottery Sales at the Belding Party Store Based on a vendor's prior lottery sales, the MLC decides when to mail lottery tickets to retailers. Mason scans arrived tickets to confirm their receipt and places them in a storage Lottery Sales at the Belding Party Store Based on a vendor's prior lottery sales, the MLC decides when to mail lottery tickets to retailers. Mason scans arrived tickets to confirm their receipt and places them in a storage cabinet until they are needed. When the demand arises, he activates the new lottery tickets and displays them for customers to view and buy. All employees can sell and validate tickets and redeem winning tickets - but they cannot activate tickets mailed to the store. Upon a lottery ticket sale, the Belding employee should record the purchase in the cash register using a special register code. Customers receiving the tickets will normally scratch off the latex covering or otherwise ascertain if they have a winning ticket. They would then or later redeem winning tickets and discard losing ones. A customer will give the winning ticket to Belding (or any other vendor) to confirm the paid amount, and the MLC records the scan times for both the buyer's and seller's (redeemer's) scans. Usually, a few minutes occur between both scans. Cases where MLC records show only the time for the seller's scans (and no times for the buyer's purchases) strongly indicate that the sellers scanned the tickets for themselves. The seller's machine will print a confirmation of the winning ticket for the store clerk with the important prize information. The employee will then validate the ticket and provide the customer with their cash prize. At the end of the workday, the employee who closes the store will compile the lottery confirmation slips, register tape summary, lottery machine daily summary, cash, checks and credit card information. While this information is collected daily, periodic reconciliations are not always completed in a timely fashion. Mason will take the checks and cash to the bank the next day and set aside, label and store the other documents to help calculate store sales and otherwise complete his records. Each morning, Mason hand-counts his store's lottery tickets' inventory, recording how many activated tickets remain on display and any inactivated tickets. He also records how many tickets are activated throughout the day. Employees then record the inventory information into an Excel workbook to keep track each week. However, this task is often neglected and could take several weeks to complete, meaning that the Excel files need not be current. The Current Situation at the Belding Party Store Mason purchased Belding nine years ago. His current employees include Carol Clark [his mother], Cindy Wright, Candace McAllister, and Cimarron Zander who help to operate the store. Carol prepares much of Belding's hot foods, and the other three employees work as clerks and cashiers. Two of the three work the store's first shift from 9:00 a.m. to 3:00 p.m., and The Current Situation at the Belding Party Store Mason purchased Belding nine years ago. His current employees include Carol Clark [his mother]. Cindy Wright. Candace McAllister, and Cimarron Zander who help to operate the store. Carol prepares much of Belding's hot foods, and the other three employees work as clerks and cashiers. Two of the three work the store's first shift from 9:00 a.m. to 3:00 p.m., and one works the second shift from 3:00 p.m. to the 10:00 p.m. close. All employees and Mason have access to the cash register and have the authority to make lottery sales. During busy times, often during the second shift, Mason or Carol step in to help the employees. To enhance security, Mason installed closed circuit cameras to monitor the store's activity. However, he rarely reviews these recordings, thus presenting an opportunity for fraud. Installing the cameras did not solve the problem as the shortages persisted, despite the fraudster(s) knowing that the cameras were installed as a control. Earlier in the current year, while reviewing his lottery sales records, Mason noticed a significant increase in lottery sales invoices, but a major decrease in his bank account. Initially he viewed these irregularities as puzzling, but thought they may have occurred due to his accounting for lottery sales or timing differences in remitting lottery ticket proceeds. For example, he could have cashed out several winning tickets that were purchased from other lottery vendors, and due to timing differences, the MLC had not yet credited his account. Since such differences continued for a few more months, he asked his tax accountant to review his lottery sales records. Specifically, Mason asked if some of his unsold lottery tickets were mistakenly included in the MLC invoice report. Comparing Belding's ticket scanner to the active tickets on the MLC invoice revealed no such errors. Mason also consulted with an MLC representative on whether increased sales and timing differences could have caused these problems. The lottery representative agreed that a sudden sales increase could have caused the above average invoice balance and told Mason that the balance should correct itself over time as the payments were made to the MLC. Unfortunately for Mason, the lottery invoice balance did not correct itself and instead continued to increase while his cash decreased. This problem persisted over a five-month period. When realizing that neither the remittance process nor errors caused the cash problem, Mason engaged H&J, who sent you and Amelia to examine Mason's records. After initial meetings with Mason, Amelia has collected and presented you with the following information: - A sample of daily records from the "Buyers' side" ticket scanner; - A sample of daily records from the "Sellers' side" ticket scanner; have caused the above average invoice balance and told Mason that the balance should correct itself over time as the payments were made to the MLC. Unfortunately for Mason, the lottery invoice balance did not correct itself and instead continued to increase while his cash decreased. This problem persisted over a five-month period. When realizing that neither the remittance process nor errors caused the cash problem, Mason engaged H&J, who sent you and Amelia to examine Mason's records. After initial meetings with Mason, Amelia has collected and presented you with the following information: - A sample of daily records from the "Buyers' side" ticket scanner; - A sample of daily records from the "Sellers' side" ticket scanner; -Data from Mason's account with the MLC; - Part of Mason's Bank Statement; - Data from Mason's lottery sales, cash receipts and disbursements records; and - All employee time records for a select number of shifts during the period in question. Case Requirements Please complete the following: 1. Identify the weaknesses in Belding's system of Management Controls over lottery tickets. 2. What inconsistency in store performance should have alerted management to the lottery fraud in a timlier manner? 3. What specific data would be useful in determining if there was ongoing fraud at the party store? What patterns would you look for in this data? 4. How would you separate the duties of the store owner and clerks? 5. What internal controls could the party store implement to stop this type of fraud from happening again in the future? 6. Using available data files, estimate Belding's loss during the first week of June. 7. Using the data in the available files, identify the employee(s) of the Belding Store who committed the fraud during the first week of June. 8. Discuss the strengths and weaknesses of some Belding internal controls, including identifying those that were designed well but were not operationalized properly