Question

Francisco Fernandez recently invested in a small 26-room motel and café in a remote tourist area in Southern Utah. Francisco lives in Northern Utah, some five hours from the motel, and only plans to visit the motel periodically.
Francisco hired a young couple to manage the motel and café. They will live on-site and will have complete control over daily activities and record keeping.
Francisco is concerned about having little control over the operations of the motel and café. He has requested help in identifying possible ways the business could be defrauded and in establishing creative internal controls to deter such fraud.



Instructions to solve the case study
This case represents “Establishing Effective Internal Control in a Small Business”
It will help you as a student to understand types of frauds that can occur in a small business environment due to the lack of effective internal controls.
Also, to help you apply general business knowledge, reasoning abilities, and understanding of internal controls to identify controls that would be effective and efficient in reducing risks of material misstatements due to fraud.
You have to do the case individually.




Answer the following questions in details:
1. What are your two biggest concerns relating to possible fraud for the motel part of the business?
For each concern, generate two or three controls that could effectively reduce risk related to
your concerns. Use common sense and be creative!
2.What are your two biggest concerns relating to possible fraud for the café part of the business?
For each concern, generate two or three controls that could effectively reduce risk related to
your concerns. Use common sense and be creative!


3.Describe the impact each proposed control would have on the efficiency of running the
business. Are the controls you generated both effective and efficient?


4.Describe the potential impact of your proposed controls on the morale of the [4] couple in charge of the day-to-day operations. How might Francisco deal with these concerns?

Answer 1

Sol 1.

The two biggest concerns relating to a possible fraud for the motel part of the business are:

1. Asset Misappropriations - Broadly speaking, asset misappropriation is the taking of assets, and it can be done through many ways.

Asset misappropriation can be broken down into eleven categories: skimming, cash larceny, billing, expense reimbursements, check tampering, payroll, cash register disbursements, misappropriation of cash on hand, and non-cash misappropriations.

To prevent asset misappropriation:

• Conduct thorough background checks on the employees.
• Implement checks and balances.
• Separate the functions of check preparer and check signer.
• Conduct random audits of accounts.
• Don’t pay commission performance has been appraised.
• Keep checks in a locked cabinet and destroy voided checks.

2. Corruption & Conflict of Interests - Corruption is defined as, “any scheme in which a person uses his or her influence in a business transaction to obtain an unauthorized benefit contrary to that person’s duty to his or her employer”. Corruption can be committed by: conflicts of interest, bribery, illegal gratuities, and economic extortion.

To prevent and detect bribery and corruption:

• Have a strong code of ethics and ensure everyone in the company, from the top down, knows what it says and puts it into practice.
• Discipline employees who breach the company’s code of ethics.
• Conduct due diligence on all third parties your company does business with.
• Look for Unusually high numbers of repairs or replacements or other supplies.
• Conduct a risk assessment to look for areas to watch more closely
• Train all employees on bribery and corruption prevention
• Reward employees for ethical behavior

Sol 2.

The two biggest concerns relating to a possible fraud for the cafe part of the business are:

1. Vendor Fraud - Vendor fraud can be committed by employees acting alone or in collusion with vendors. Examples of vendor fraud are: Personal Purchases, Overbilling, Kickbacks, Price Fixing etc.

To prevent and detect vendor fraud:

• Implement checks and balances on payments to vendors.
• Separate the functions of check preparer and check signer.
• Conduct random audits of vendor files.
• Conduct due diligence when setting up vendors by verifying:
• Compare vendor details with employee details.
• Review the vendor master file to check that volume of billing is reasonable and consistent.

2. Payroll Fraud - Payroll fraud schemes include:

Ghost Employee Schemes - A fake employee or ex-employee is kept on the payroll with pay being diverted to the fraudster.

Advance Fraud - An employee requests a payroll advance and doesn’t pay it back.

Timesheet Fraud - An employee falsifies timesheets to inflate hours, an employee clocks in and out for another employee in his or her absence or a payroll employee manually inflates hours on an employee’s timesheet.

Paycheck Theft - One employee steals another employee’s check and cashes it.

To prevent and detect payroll fraud:

• Reconcile balance sheets and payroll accounts each quarter.
• Require managers or supervisors to approve timesheets and overtime claims.
• Institute mandatory vacations for payroll employees.
• Perform data analytics on payroll records to look for matching addresses, names, bank accounts, etc.
• Check payroll records to ensure terminated employees have been removed from the payroll.
• Separate tasks of preparing payroll checks and reconciling payroll account.

Sol 3.

The control methods proposed are both efficient and effective.

This can be explained with the help of the impact of the proposed control methods on the efficiency of the business: -

• Establish Protocols and Procedures - By creating internal controls, small business owners establish protocols and procedures their staff and consultants must follow. Small business owners inform their employees of these protocols and expect that they follow them as they perform their day-to-day work duties. These established protocols help bring order and cohesiveness to companies, as everyone knows what's expected, as outlined in the internal controls.
• Prevent Fraud and Theft - Establishing internal controls can help companies prevent or reduce fraud and theft within their organizations. Internal controls can include activities such as reconciling bank statements and internal audit reviews, which can uncover whether the company's money is being misappropriated by management or employees.
• Separation of Duties - Internal controls separate the duties employees have, ensuring that there's a system of checks and balances. For example, a company's internal controls might make sure that an employee who does the company's accounts receivable doesn't also do the company's accounts payable. This can also help reduce internal fraud and theft.
• Organize Financial and Management Information - Internal controls can help your small business keep its financial and management information organized. Organized data can increase productivity and better prepare your business if you need to produce documents for litigation or if you need to grab information for compliance reviews or audits. This might include giving each employee his own password to access files and data on the company's computer, or creating a system for filing client data and financial documents, online or offline.
• Reduce Errors Through Training - Internal controls can help companies reduce errors, which can help them save money and protect their reputations. Employee training is an example of an internal control that can reduce errors. By training employees on processes and procedures, and updating them on new ones, employees are less likely to make mistakes.

Sol 4.

The Internal Control Methods may adversely affect the morale of the management as they might get a feeling of distrust & therefore their motivation to work may decline.

In order to deal with the following concerns, Internal control Methods must be accompanied with :

• Skill Development Initiatives
• Resources & Strong Audit Team
• Incentives to Reinforce employees’ drive to ethical excellence with appropriate incentives and rewards.
• Strong Human Resource Policies
• Delegation of Responsibility with Authority