Read the case of Kay Lemon in Enemies Within. For this case, answer the following questions:

What were the red flags?

How could this fraud have been prevented?

What internal controls should have been in place and working?

Relate the Fraud Triangle to this case.

What form of larceny was committed?

What method was used to conceal the larceny?

Explain your reasoning.

Case:

Regardless of the method or the asset involved, all asset misappropriation has the same effect on the books of account. Take the following actual case as an example: Kay Lemon, a seemingly prim-and-proper grandmother, stole $416,000 from a small Nebraska lighting store where she had been employed for 20 years as a bookkeeper. Lemon spent three years in the Nebraska Womens Correctional Institute after confessing that shed been hitting the books for eight years and had blown all the loot on herself and her family. Lemons crime is typical of the risk to small business: The lighting stores CPA prepared only the companys tax returns, so the business was not audited. Lemon also acted as the stores accounting department. She made deposits, signed checks and reconciled the stores bank account. Although any entry-level accountant could recognize this situation as an accident waiting to happen, the stores owner did not. After 12 years of unrelenting temptation, Lemon finally gave in. Thereafter, for years, she systematically stole money from the lighting store using the same method. She would make out a company check to herself (in her own true name), sign it and deposit the proceeds in her personal checking account. To cover the theft, Lemon would do three simple things: First, shed enter void on the check stub when she wrote the check to herself. Next, she would add the amount of the theft to the check stub when she paid for inventory. For example, if she took $5,000 and was paying a vendor $10,000, she would show $15,000 on the vendors check stub. That way, the cash account would always stay in balance. Finally, when the checks paid to Lemon were returned in the bank statement, she would tear them up and throw them in the trash. In looking at Lemons inelegant scheme from an accounting perspective, one can see that she had her choice of three techniques to cover her tracks: false debits, omitted credits or forced balances. Early Warning Signs of Cash Misappropriation The three principle methods employees use to misappropriate cash can show up early in an organizations books. CPAs should be alert to simple trends when determining a companys risk of material embezzlement. Consider one or more of the following: Skimming redbox.gif Decreasing cash to total current assets. redbox.gif A decreasing ratio of cash to credit card sales. redbox.gif Flat or declining sales with increasing cost of sales. redbox.gif Increasing accounts receivable compared with cash. redbox.gif Delayed posting of accounts-receivable payments. Larceny redbox.gif Unexplained cash discrepancies. redbox.gif Altered or forged deposit slips. redbox.gif Customer billing and payment complaints. redbox.gif Rising in transit deposits during bank reconciliations. Fraudulent Disbursements redbox.gif Increasing soft expenses (for example, consulting or advertising). redbox.gif Employee home address matches a vendors address. redbox.gif Vendor address is a post office box or mail drop. redbox.gif Vendor name consists of initials or vague business purpose. (Employees often use their own initials when setting up dummy companies; for example, JTW Enterprises). redbox.gif Excessive voided, missing or destroyed checks. FALSE DEBITS Lemon chose the most logical (and common) method for covering a cash embezzlement: the false debit. When Lemon credited the bank account for the checks she made out to herself, the corresponding debit was false. Still, from the standpoint of the accounting equation, the books were in balance. Lemon and other embezzlers have two choices concerning the false debit: The transaction can be allocated to an asset account or an expense account. In Lemons case, she added her thefts to the inventory account--an asset. As we CPAs know, that false debit will stay on the books until some action is taken to remove it. In this situation, the lighting stores inventory was overstated by $416,000 over eight years, as the store never performed a physical count of its inventory. As a result, when Lemons crime came to light, a huge writeoff was necessary, almost bankrupting the store. A less obvious move would have been for Lemon to charge the false debit to an expense account, which is written off every year. It doesnt matter what the expense is, although these are some favorites: advertising, legal expense, consulting fees and other soft expenses. Here, the expense for fraud gets written off annually. If the fraud perpetrator can conceal the fraud long enough for the account to be closed to profit and loss, he or she has gone a long way toward avoiding detectionat least on a current basis. OMITTED CREDITS To understand how omitted credits affect the books, imagine Lemon had taken a different tack. Instead of writing checks to herself, she would instead intercept incoming cash receipts before they were posted. Presume further that Lemon would negotiate the checks by forging the endorsement of the lighting store, then endorsing her own name on the checks, subsequently depositing them in her checking account. The net effect would have been that Lemon stole the debit (the cash) and omitted the credit (sales or accounts receivable); in short, she skimmed the money. This is known as an off-book fraud, as evidenced by the omission of the transaction from the accounting records altogether. If Lemon had skimmed from sales, there would be only indirect proof of her crime through falling revenue and/or rising costs. But if she had skimmed from accounts receivable, she would need to create a fictitious entry to credit the customers accounts; otherwise, the books would be out of balance. FORCED BALANCES Another technique to conceal asset misappropriation is not the best choice. Lemon could have attempted to force the balance of the bank accounts and inventory to cover herself. In that situation, she would have forced the bank reconciliation to equal the amount she was stealing by purposely misadding the transactions. But that technique requires constant attention. Unless the company has lots of cash, forcing the bank balance will eventually result in bounced checks. A simple proof of cash thats routinely done in an audit will usually catch this scheme. Thats not what happened to Lemon, though. She had a nervous breakdown because of the pressure from all those years of stealing and covering it up; she came forward and confessed. Her embezzlement points out one real benefit of an audit in a small business: Almost any degree of independent review by a CPA would have uncovered what Lemon was doing. Embezzlements can be uncovered, but more importantly, people like Lemon will be much less likely to steal knowing a CPA will be scrutinizing their activities.