Question

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 positions—because 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 process—from 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 well—for 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. Arthur’s wife became suspicious of Benny’s 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 1933–1934). 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 company’s 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 today’s 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 Benny’s 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). Jim’s 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.

1. Identify the five control weaknesses in Revenue and Purchase process.

2. Identify the five General controls Arthur should have implemented in the company.

3. From Chapter 13, identify the five internal control activities Arthur should have considered (or implemented) to thwart Benny’s bad behavior.

Answer 1

1. The main control weakness that can be cited from the revenue and purchasing process is that there was no segregation of duties in regards to Benny performing all of the duties and cycles of each process. Benny had unlimited ability to manipulate the accounting records of the company at many different levels. He initiated the purchase of goods from vendors, generated the purchase order, received the goods into inventory, “paid the vendors” when appropriate, closed out the daily bank report, and month end bank reconciliations. There were no checks and balances present to ensure the accuracy of all facets of the purchasing and revenue process. On the revenue side of things, he was collecting the cash from customers, recording the transactions, and depositing the bank deposits. It is no wonder he had free reign to manipulate transactions and falsify vendors and not record all valid transactions. There was nobody with the authority to audit him and make sure that all of the numbers and inventory added up and could be cross referenced to reliable and valid purchase requisitions and bills of lading.

2. Arthur had a strong asset on his side that might have been underutilized. His son Arthur Jr., who had an accounting background, would have been the perfect person to validate transactions and review all fiscal dealings within the company. Arthur should have hired two additional people in each process to ensure the accuracy of the recording of transactions and collections and deposits of revenue. One person in the purchasing process could have been in charge of securing vendors and making purchases. Another person could have been in charge of receiving the raw materials and updating the inventory. While Arthur Junior could have updated the accounts payable ledgers and assist his Uncle Benny in the reconciliation of the bank reports and the daily cash deposits.

I would also implement a cash flow meeting to be held with the top managers of the company (i.e., production manager, Benny the CFO, Arthur himself) on a weekly basis. This would be an added checks and balance for all the managers, for example, Benny made purchases from x, y and z vendor for raw materials to be used in the production process of the goods (compared with production schedules to meet sales demand), and verified against the cash flow statement that revenues have been collected from past sales (A/Rs) and that the right money was being appropriated to pay off the vendors for the new inventory of raw materials (A/Ps).

3. As mentioned earlier the first and most obvious control activity that needs to be implemented is separation of duties for both the revenue and purchasing processes. There should be more than one person in these processes to ensure accuracy, validity, reasonableness, and accountability. If there was even one extra person in each process during the time that Benny was embezzling money, than it would have been a lot more difficult for him to get away with he did. If you provide enough manpower to facilitate a cohesive and effective unit of checks and balances (one person per sub-process), than it would have been almost impossible (especially during the 1930s) to get away with embezzlement.

The second control activity would be to develop an audit trail for the company to refer back to on a quarterly basis with the assistance of an external auditor. If Benny would have had to keep an audit trail from purchase of raw materials through payment to those vendors, then it could have been reviewed by an external member of an organization to ensure accuracy and completeness. Also, any collections made on ARs could have been documented in a journal and ledger cards and reviewed by an auditor when they look at samples of daily bank deposits and monthly bank reconciliations to see that the appropriate funds were flowing and being handled properly.

Finally, the company should have held it in their policies and procedures that any illegal activity (regardless of bloodlines and family members) will be persecuted and/or terminated from the company. It is possible that Benny took his family for granted for his own individual needs and greed. Maybe he figured that since no one stated any policies about how the company is to perform certain processes and procedures that he might as well “wing-it” and by the time he realized what he was doing the thrill and temptation of embezzlement had poisoned his mind to the point of no return. If he would have had the policies and procedure ingrained into his mind from the onset, then there is a possibility that he would have followed them all the way through to an ethical end.