Question

Gamma Construction Company builds and furnishes hotels for third parties. Some of its largest clients include the Helton and Sheradon Corporations. While its construction projects take place throughout the world, its project accounting is centralized in one location. This requires fairly sophisticated accounting information technology systems. For example, to purchase materials for a project, a project supervisor enters a purchase requisition (PR) electronically at the job site. The PR includes a description of the item(s) to be purchased, the vendor from whom the purchase is to be made, and the purchase price. Because of its geographically disbursed operations, the company has approximately 1,500 authorized vendors.

The PR must be electronically approved by the Accounting Department before the Purchasing Department may initiate the purchase. If the PR is for a purchase from an authorized vendor and is within the project’s budget, it is approved electronically by the corporate controller. If the PR does not include an authorized vendor or is not within the project’s budget, the controller determines whether the chief financial officer’s (CFO’s) approval is needed. If needed, once the CFO’s approval is obtained, the controller adds the vendor to the list of authorized vendors—including the vendor’s contact information—or revises the project’s budget estimate. The PR is then sent electronically to the Purchasing Department, where the goods are ordered. Depending on the urgency of the goods, the order is placed by mail, phone, or Internet. The project supervisor receives an email stating that the order has been placed. Once the goods have been received at the project site, the Accounting Department receives an electronic notification from the project supervisor which serves as the final authorization to pay. The CFO signs all checks. Checks in the amount of $100,000 or more also require the president’s signature.

The CFO and controller have both been with the company for in excess of five years. The controller’s spouse recently obtained a degree in construction management and was hired by Gamma to be a project supervisor.

The controller’s daughter was recently diagnosed with a rare disease. The disease is curable, but requires extensive treatment and hospital stays, much of which is not covered by insurance. The controller’s spouse has finally graduated and is now working, but student loan payments are coming due. The controller expects to be promoted to CFO within the year, and a large increase in pay comes with the promotion. This means that money issues are likely only temporary.

As a way of receiving a much needed ‘‘advance’’ on his salary, the controller suggests that his spouse, a project supervisor, place a fictitious order for goods needed on her project in the amount of $99,500. The controller also makes sure that the fictitious order is associated with a start-up project so that the PR will not result in the project being over budget. The order should be placed with the company, American Products—a fictitious vendor with a name very close to one of the company’s authorized vendors, American Projects.

The controller authorizes the fictitious PR after updating the approved vendor list to include American Products and its contact information (a post office box established by the controller). The order is placed by mail in the Purchasing Department. The controller’s spouse, as project supervisor, sends an electronic notification of the goods receipt to the Accounting Department. The Accounting Department processes the payment. The CFO signs the check. The check is mailed to American Products post office box, where the controller picks it up and deposits it.

Questions to Consider:

What are the red flags present that suggests 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?

How would the fraud impact the financial statements? What accounts would be misstated?

Answer 1

Financial statement red flags provide the warning signs that the investors should take note of. They do not necessarily indicate an occurrence of financial statement fraud, but merely signal that further in-depth research is required or must be conducted to assess the validity of the corporate documents.

Red flags Present in this case:

In this case, the relationship between Gamma and their project supervisor is a red flag. They already have a pre-existing relationship and should have never became a client or handled with another person. When the period ends, they should have seen that there was a start-up company that should have not been approved. A red flag is having PO Box on an order.

Fraud Triangle in this case:

In the fraud triangle, there is opportunity and pressure that both could facilitate in this fraud. Opportunity is from his spouse being from one of their project supervisor. This gives them the opportunity to plan this out. Pressure is from their daughter who is being diagnosed with a rare disease and for that they need money. Without this occurring, they might not consider taking money.

IT-related Issues:

They have everything sent by electronics which could be easily facilitate fraud. It also is only sent to three people: the CFO, the controller and the purchasing department. This causes the segregation of duties to not spread enough especially after 5 years. And this gives more space for frauds.

Impact on Financial Statements:

There would be more expenses due to this fraud. There will be presence of fictitious order that will show more expenses on their income statement. This would make their income statement incorrect.

It would also understate their profit. Also, the balance sheet will be affected as there is outflow of cash.

Accounts that would be misstated are:

Purchases Accounts, Income Statement and Balance Sheet would be misstated.