CASE STUDY NO. 2 ROCKY MOUNTAIN ELECTRIC

Rocky Mountain Electric is an electrical wholesaler with two locations--0ne in Denver, and another in Aspen that just recently opened. The audit senior stayed in Denver to do the audit at the main store, and a staff accountant was sent to the Aspen (cross-state) store.

The staff accountant returned after a week and said that everything was fine at the Aspen store, which was good, thought the senior, because the audit fee had been cut from the previous year, and the audit team was under time pressure to finish the job.

One of the first things the senior did was look at the audit differences, and she noticed an adjustment in excess of $100,000-a debit to sales and a credit to accounts receivable. "To adjust the general ledger (GL) to the accounts receivable trial balance at the cross-state store" is how the description read. She asked the staff accountant how an error that big could happen, and he told her the store manager said they had some problems installing the accounting system at the new store.

The senior thought the adjustment was proper, since the general ledger balance was now in agreement with the subsidiary ledger. A little while later she was reviewing the analytical procedures and noted that the gross margin percentages at the cross-state store were quite a bit lower than the margins at the main store. In the workpapers was the explanation, "Per store manager, prices were reduced at cross-town store to attract customers in a new location."

The next day, the senior was talking to the controller at the main store, and she mentioned how it looked like there had been a few problems at the Aspen store, but they were working them out. "I guess those price reductions you had earlier in the year really worked to attract new customers," she said.

"Price reductions?" said the controller. "What price reductions?"

The company was a wholesale distributor-they didn't have sales like one might find in a retail store. The senior then brought up the problem the company had in installing the accounts receivable system at the Aspen store. The controller said that the senior must have been mistaken because no problems had ever been reported by the store manager.

The senior realized something wasn't right, and after consulting with the manager and partner, the auditors discussed their concerns with the controller and company owner. The client and auditors agreed to investigate the situation further, so the auditors expanded their procedures, tracing customer payments for the Aspen store back and forth from the subledger to the GL.

That expanded testwork led to the discovery that the manager at the Aspen store was stealing payments by customers on accounts. That's why the subledger was out of balance with the GL. To cover it up, the manager debited the sales account, which was why the gross margins didn't make sense.

1.Is this an example of fraudulent financial reporting or misappropriation of assets?

2.What created an opportunity to commit the fraud?

3.What was the "trail" created by the fraud, that is, what circumstances tipped off the auditors that a fraud might have occurred?

4.The staff accountant originally missed these warning signs of fraud. What were some reasons why the signs were missed?