LEARNING OBJECTIVES

After completing this section, you should be able to do the following:

•     Recall typical controls in the cash disbursements cycle.

•     Identify various forms (electronic or paper) used in the cash disbursements cycle.

•     Recall the processes in the cash disbursements cycle's various phases.

•     Identify various types of errors or fraud that can occur if the cash disbursements cycle does not have adequate procedures or adequate segregation of duties in the ordering, receiving, and warehousing phases.

RETAIL STORE EXAMPLE

A retail store's largest volume of cash disbursements is for purchases of inventory. A retail store's purchasing department orders inventory from approved suppliers. A sequentially numbered purchase order is sent from the purchasing department to the vendor, receiving department, and accounts payable. For illustrative purposes, assume all goods are shipped FOB shipping point.² When received by the retail store, the receiving department will inspect and count the goods, complete a numerically sequenced receiving report, and forward a copy of the receiving report and packing slip (exhibit 2-1) to accounts payable.³ The packing slip contains information as to the items that were shipped, items on backorder, shipping address, billing address, customer purchase order number, and vendor contact information.

The accounts payable department receives invoices (exhibit 2-2) from vendors which contain, among other items, payment terms (such as 2/10, Net 30⁴), a list of goods that were shipped, purchase discounts (if any), and total amount due. An employee in the accounts payable department matches the appropriate purchase orders, packing slips, receiving reports, and vendor invoices. This provides evidence that the purchase was authorized and the goods were received. The vendor's packing slip and invoice also provide evidence as to the quantity of goods that were shipped. The accounts payable department then forwards copies of the invoices to the general ledger department to update the accounts payable control accounts. The accounts payable department then updates the accounts payable subsidiary accounts based upon a review of all documents.

In many formal payment systems (such as those used by government entities), a formal voucher packet is created for all disbursements, including purchases from vendors. The numerically sequenced voucher packet for purchase of vendor goods typically contains the purchase order, receiving report, packing slip, and vendor invoice. A voucher form on the front of the voucher packet includes information such as the relevant purchase order number, account distribution, method of payment (check, direct deposit, EDI, and so on), vendor invoice number, and approval signature. An example of a voucher form is contained in exhibit 2-3.⁵ As in the non-voucher system discussed previously, the accounts payable department will forward a copy of the invoice to the general ledger department to update the accounts payable control account.

Many companies do not maintain a separate accounts payable account for each vendor because they pay by invoice, not by vendor statement. The total of all outstanding invoices by vendor would equal total accounts payable. Some companies maintain both a file of outstanding invoices by vendor and an accounts payable file for each vendor, as well as a related accounts payable control account within the general ledger.⁶ An accounts payable account for each vendor allows the retail store to review all transactions with each vendor, including purchases, payments, discounts taken, and more. Periodically, the balance of all subsidiary accounts payable accounts should be reconciled to the accounts payable general ledger account. Any differences should be resolved by appropriate personnel.

Most vendors send monthly statements that contain their customers' beginning balances of accounts receivable (accounts payable for the buyer), transactions that occurred during the month, and ending balances of accounts receivable. Accounts payable (of the buyer) should reconcile their balance of accounts payable with the balance of accounts receivable contained on the monthly statement provided by the vendor. Note that the companies that do not have a subsidiary or control account for accounts payable will find this reconciliation to the vendors' statements difficult to perform. Without a control account, the reconciliation process is typically a manual process as all of a particular vendor's invoices need to be added to create the accounts payable balance for each vendor.

In the example of the retail store, the accounts payable department forwards an approved voucher package to the cashier and a copy of the voucher form to the general ledger department. Note that the accounts payable and general ledger departments report to the controller. The cashier reports to the treasurer. The cashier will prepare a check based upon the information on the voucher package. The voucher package and check are sent by the cashier to an authorized employee in the treasurer's department who will review the documentation that supports the check.⁷ This authorized employee will sign the check and the check will be mailed by another employee. Checks over a certain dollar limit should require dual signatures. To prevent paying the same invoice twice, the voucher package is cancelled by the check signer and returned to the accounts payable department. A payment notice is sent from the check signer to the general ledger department to update the accounts payable control account.

The cashier and the check signer will account for the numerical sequence of the voucher packages. The accounts payable department will account for the numerical sequence of cancelled voucher packages.

A flowchart of the cash disbursement cycle (where no voucher payable system is maintained) is presented in exhibit 2-4.⁸

KNOWLEDGE CHECK

1.     The accounts payable and general ledger departments should be under which division?

a.     Treasurer.

b.     Controller.

c.     Chief Executive Officer.

d.     Chief Legal Officer.

2.     What document is forwarded from the accounts payable department to the cashier?

a.     Voucher package.

b.     A completed check, except for signature.

c.     A sales order.

d.     A bill of lading.

OTHER CONTROLS

Some additional controls that are relevant to the cash disbursements process not included in the flowchart include the generation of a check register for all issued checks and the periodic reconciliation of the bank account by an independent employee.

In the retail store example, all goods are shipped to the retailer FOB shipping point. This means that the sale occurs at the point the goods leave the vendor's dock. In order to provide assurance that the retail store's accounts payable is not understated at year-end, the retail store should perform purchase cut-off procedures. These procedures require the retail store to examine all numerically sequenced receiving reports for several days after year-end to assess if the received goods were shipped on or before the year-end date. This information should be contained on the bill of lading that is provided by the common carrier. The bill of lading should be attached to the receiving report. The retail store should record a liability (increase accounts payable) and increase inventory for all goods that were shipped FOB shipping point on or before the year-end date for those purchases that had yet to be recorded.

Exhibit 2-1 Packing Slip

Exhibit 2-2 Vendor Invoice

Exhibit 2-3 Voucher Example

Exhibit 2-4 Cash Disbursements

SEGREGATION OF DUTIES

Segregation of duties (using the example retail system) exists between bookkeeping, access to assets, independent reconciliation, and authorization of transactions. These duties are segregated as follows:

•     Bookkeeping — Performed by the accounts payable and general ledger departments. These departments are under the controller's division.

•     Access to assets — Checks are prepared by the cashier's department. Checks are signed by an approved check signer. Checks over a certain dollar amount require an additional signature by an appropriate employee. Checks are mailed either by the check signer or his or her subordinate promptly after they are signed. Both the cashier and the check signer are under the treasurer's division.

•     Authorization of transactions — All transactions are approved both by the requesting department and the purchasing department. A list of approved vendors is maintained and purchases may only be made from vendors on this list.

•     Independent reconciliation — Periodically, the subsidiary accounts payable is reconciled to the control account. The bank account is reconciled by an independent employee.

OTHER CONTROLS

In addition to separation of duties, there are numerous other controls present in the various cash disbursement systems presented previously. These controls include the following:

•     Accounts payable matches the vendor's invoice with the respective receiving report, purchase order, and packing slip.

•     The accounts payable department updates the subsidiary accounts payable account based upon a review of the receiving report, purchase order, vendor invoice, and packing slip.

•     A copy of the voucher form is transmitted to the general ledger department so that the accounts payable control account can be updated.

•     The cashier prepares a check based upon a review of the voucher package received from the accounts payable department.

•     The cashier and the check signer account for the numerical sequence of the voucher packages.

•     The check is recorded in a check register.

•     The check signer signs the check after a review of all supporting documentation.

•     The voucher package is cancelled by the check signer and returned to accounts payable.

•     A payment notice is sent to the general ledger department to update the accounts payable control account.

•     The subsidiary accounts payable is totaled and the total is compared to the amount in the accounts payable control account.

•     The vendor's statement is compared to the balance in the subsidiary accounts payable account. Any differences are reconciled.

•     Purchase discounts are taken based upon the terms of the discount and company policy.

There are additional controls surrounding checks which should be incorporated into a cash disbursements system. These controls include the following:

•     Checks should not be made payable to cash.

•     Checks should not be signed in advance of preparation of the check. (No signing of blank checks.)

•     Long outstanding checks should be investigated by employees independent of the accounts payable and cash disbursements functions.

•     Voided checks should be cancelled and retained.

•     Unissued checks should be safeguarded. (Note that payee positive pay will be addressed later in this course as an additional control.)

•     Journal entries to cash accounts should be reviewed by supervisory personnel.

•     Checks to unknown vendors should be investigated by appropriate personnel.

•     Any check that is to be mailed to a vendor's address other than the address that has been used consistently for vendor payments should be investigated.

•     Checks that are written to employees for other than payroll or expense reimbursement should be reviewed by appropriate personnel.

•     Any out-of-sequence checks should be investigated.

SEGREGATION OF DUTIES

If there is not adequate segregation of duties between the bookkeeping, authorization of transactions, access to assets, and independent reconciliation functions then any of the following could occur (the list is not exhaustive):

If the duties are not separated between the check signer and the cashier, then the cashier could write a check in an amount greater than the amount on the voucher package and mail the check to a valid vendor. The cashier could then receive a kickback from the vendor for the amount paid in excess of the valid amount contained on the voucher package.

The individual reconciling the bank account could detect this fraud, as the amount of cash in the bank would be less than the amount of cash in the bank on the general ledger. This is because the check would have cleared the bank at a greater amount than the general ledger department recorded (because the general ledger account recorded the amount listed on the invoice). If the general ledger department received a payment notice that did not equal the amount on the invoice copy then this would be a red flag that the cashier or check signer had either made an error or perpetrated a fraud.

Additionally, if the person performing the independent reconciliation compared the amount of the check with the amount in the check register then the fraud would be detected. The amount of the check in the check register would be less than the amount contained on the cancelled check.

If the duties are not separated between the cashier and the accounts payable bookkeeper then the person with these combined duties could create a fictitious voucher package (creating a fictitious receiving report, shipping notice, and purchase order) and submit the voucher package and a check to the check signer. The voucher package could have a mailing address that is not the real address for a valid vendor, but rather an address that causes the check to ultimately be delivered to the cashier or accounts payable bookkeeper.⁹ The bank account would reconcile. The general ledger department would receive a payment notice from the check signer for the same amount that is indicated on the invoice copy provided by the cashier or accounts payable bookkeeper.

The fraud might be discovered if the check signer compared the address on the vendor address to the address on the vendor invoice and noticed the differences in addresses. This fraud might also be discovered when a physical inventory is taken and the actual amount of inventory is lower than what is recorded on the books.¹⁰

Assume that the check signer does not promptly mail the check. Rather, the check signer returns the signed check for mailing to the cashier. Additionally, the voucher package is also given to the cashier for cancellation. The cashier transmits the cancelled voucher package to accounts payable.

What could happen? The cashier, after receiving the check and voucher package back from the check signer, could change the valid vendor's name imprinted on the check to a “knock off” name. For example, if the vendor's name was j. H. Amos then the knock off name of j. H. Amostoine could be created by the cashier typing the letters ”toine" after Amos on the check. The check to J. H. Amostoine could have a forged endorsement of J. H. Amostoine and the check could be deposited to a coconspirator's account or cashed (through the use of a second endorsement). Additionally, the cashier would not stamp “cancelled” on the voucher package because it will be submitted a second time for payment as described more fully in the following paragraph.

However, the valid vendor is still expecting payment. The cashier would then resubmit the same uncancelled voucher package to the check signer and then follow proper procedures of mailing the check and transmitting the cancelled voucher package to the accounts payable department and a payment notice to the general ledger department. The bank account would not reconcile as the amount of cash in bank on the books would be more than the actual amount of cash in the bank by the amount of the forged check to J. H. Amostoine. This fraud might also be detected if the check signer accounted for the numerical sequence of all voucher packages and noticed that he or she was approving the same voucher twice.

If duties are not separated between the accounts payable bookkeeper and the check signer then, similar to situation number 1, the perpetrator could create a fictitious voucher package. This fictitious package could include a fictitious invoice that would cause the check to be mailed to the perpetrator or an accomplice. However, unlike situation number 1 mentioned previously, this fraud would not be detected by an independent reconciliation of the bank statement.

The bank account would balance. The general ledger department would receive a payment notice from the cashier that equaled the amount on the invoice copy sent to the general ledger department by the accounts payable bookkeeper or check signer. The accounts payable bookkeeper or check signer cancels and retains the fictitious voucher package.

This fraud might be discovered if the account charged for the fictitious acquisition was reviewed by management personnel for reasonableness. Additionally, an attentive general ledger department employee might notice that the account classification did not correlate with the information on the invoice. A comparison of the vendor with the approved list of vendors by an independent employee might also detect this type of fraud.

If the accounts payable employee was also in charge of the general ledger then the perpetrator could create a fictitious voucher package and cause a check to be sent to either the perpetrator or an accomplice. The fraud could be spread out across multiple general ledger accounts such that no one account would appear to be significantly out of line with expectations.

This fraud could be detected if either the cashier or the check signer compared the payee and payee's address with information on the approved vendors list.

Other types of fraud or errors that could occur that are not due to inadequate separation of duties are addressed in the following list. This list is not exhaustive.

If accounts payable does not match the vendor's invoice with the respective receiving report, purchase order, and packing slip then the entity might pay for goods that were not received or goods that were received that were of a substandard quality. Additionally, the invoice might have a pricing error or a price that is greater than the price contained on the purchase order.

If the accounts payable department updates the subsidiary account based solely upon the vendor's invoice, and the invoice is incorrect due to an incorrect number of items shipped or pricing errors, then accounts payable in the subsidiary and general ledger would be either over or understated depending upon the nature of the error.

If the cashier prepares a check and the check signer signs a check based upon review of an invoice and not a voucher package, then, similar to situation number 2 noted previously, the vendor might be overpaid or underpaid.

If the cashier and the check signer do not account for the numerical sequence of voucher packages then a voucher package might be missing and not found in time to take advantage of cash discounts. Additionally, as noted previously in the separation of duties examples, it might be discovered that the same voucher package is being submitted twice, which might be indicative of internal fraud (check being mailed to the perpetrator for a fake vendor) or collusion with a vendor (kickbacks for duplicate payment).

If a payment notice is not sent to the general ledger department to update the accounts payable control account then the subsidiary accounts will not balance to the general ledger account. In addition, financial statements might be produced that contain material misstatements of accounts payable and cash.

If the subsidiary accounts payable is not reconciled to the general ledger accounts payable control account then posting errors could occur in either the subsidiary or control account and not be detected on a timely basis. This might result in the production of materially misstated financial statements.

If the bank statement is not reconciled by an independent employee then errors in either cash disbursements or cash receipts might not be detected in a timely manner. In addition, an independent bank reconciliation might detect errors and frauds, which were previously discussed in the separation of duties section.

If the vendor's statement is not reconciled to the accounts payable subsidiary ledger then errors in accounts payable might not be detected in a timely manner.

If purchase discounts are not taken then the company might be paying an excessive imputed interest rate for short-term financing.

If checks are made payable to cash, then anyone could cash the check. For example, the bookkeeper, who has access to the checks, could make payments of personal expenses by taking a check, making it payable to cash, and then either cashing the check or giving it to whomever the bookkeeper is indebted. This fraud would be caught if there were a separate independent reconciliation of the bank statement as cancelled checks are typically reviewed by the reconciler. A check made payable to cash would arouse suspicion.

If checks are signed in advance of preparation of the check, as might be done in many small businesses when all check signers need to be absent for a period of time, then a dishonest cashier could take the check and make it payable either to cash, to a fictitious vendor, or to an accomplice. As in the preceding situation, this fraud may be detected by an independent bank reconciliation via review of the cancelled checks by the reconciler.

Long-outstanding checks should be investigated as to why they have not been cashed. For example, the entity might have issued a check to a vendor that states “paid in full” and the vendor may not cash the check as the vendor's books indicate that, in order for the account to be paid in full, the amount of the check should be higher than what is on the check.

Another possible reason that the check has not been submitted for payment in a timely manner is that the check could have been lost or stolen. All long-outstanding checks should have a stop payment order issued to the bank just in case the check had been stolen or lost. If the long-outstanding check is not cancelled then the amount of the check might, depending upon the jurisdiction, be escheated to the state.

If voided checks are not cancelled and retained, then a perpetrator could steal a check and state that it was voided and discarded. This fraud could be detected by an independent bank reconciliation as the bank account balance would be lower than the amount of cash on the books by the amount that is on the “voided” check.

Unissued checks should be physically safeguarded to prevent their theft. A periodic accounting for the numerical sequence of unissued checks should be considered depending upon an assessment of the risk of theft of checks.¹¹

Journal entries to cash should be reviewed for appropriateness by supervisory personnel. For example, a bookkeeper who writes checks and also reconciles the bank statement could steal cash by debiting miscellaneous expense and crediting cash for a check issued to either the bookkeeper or an accomplice.

Checks made payable to unknown vendors should be investigated by appropriate personnel. A control would be to require all vendors be on an approved-vendors list.

Checks should be reviewed to assess if vendors are having checks mailed consistently to the same address. If this is not done then a check could be made out to a valid vendor but intercepted by a perpetrator. The check could also be sent to the perpetrator's address.

All checks written to employees for other than payroll or expense reimbursement should be investigated.

If a cancelled check is not in the bank statement (or a check image is not provided), an investigation should take place. This could be a red flag for fraud.

A failure to mail checks promptly after they are signed might cause the entity to forego early-payment discounts. This also could allow for a kiting scheme.

Out of sequence checks should be investigated to assess if they were possibly stolen from the check stock.

All voided sales should require proper approvals. If a voided sale is not approved by a supervisor then, for example, at a retail store, the cash register clerk could void a valid sale and steal cash that is equal to the amount of the voided sale.

CHECK IMAGES

It should be noted that many entities do not receive cancelled paper checks or paper bank statements. Instead, these entities receive scanned images of checks and electronic bank statements. Auditors and others in the control community should be advised not to rely upon images of checks and bank statements without understanding and testing the system and controls used to obtain and retain the integrity of these documents (such as passwords and other access controls to these electronic documents). These images can easily be modified with the use of software that allows a user to modify PDF and similar files. Bluebeam software is an example of this type of software (see: www.bluebeam.com).

KNOWLEDGE CHECK

3.     According to the Association of Certified Fraud Examiners study, the largest median loss of cash disbursement frauds was due to

a.     Payroll schemes.

b.     Check tampering.

c.     Cash on hand.

d.     Expense reimbursements.

CHECK TAMPERING

Check tampering frauds were listed as a major category of cash disbursement frauds in the Association of Certified Fraud Examiners study. According to this study, check tampering schemes have the highest median loss of fraud and is one of the longest running schemes. Even though there has been an increase in the use of debit cards and electronic banking to pay bills, checks still are used for many consumer-to-business and business-to-business transactions. Many small businesses still use paper checks to pay vendor invoices. Larger entities typically use electronic payment methods, such as EDI, and thus avoid many types of fraud due to check tampering that are discussed in the following paragraphs.

There are numerous ways a perpetrator can steal cash from a business by tampering with checks. Usually check tampering schemes can occur and not be detected if there is not adequate separation of duties in the cash disbursement cycle. For example, an employee who prepares the check, provides the check to an approved signer, mails the check, and reconciles the bank account can write checks to themselves or a fictitious vendor, cash the checks, and not be detected. In this system, the employee could bypass the control that requires an approved signer to sign the check by forging the signer's signature.

Another common check-tampering scheme, mentioned previously, is when a perpetrator prepares a check and related fraudulent supporting documentation for a valid vendor, but provides a payment address that is not the vendor's real payment address—but one used by the perpetrator.

INTERESTING FACTS ABOUT CHECK VOLUME AND FRAUD SCHEME

Various organizations have conducted studies on check volume and fraud payment schemes. Highlights of some of these studies are presented subsequently.

Unlike many consumer-to-business transactions, many businesses still issue paper checks.

The 2016 Federal Reserve's Payments Study noted the following:

The number of check payments fell to 17.3 billion from 2015 to 2016 with a value of $26.83 trillion, down 2.5 billion or $0.38 trillion since 2012. Check payments fell at an annual rate of 4.4 percent by number or 0.5 percent by value from 2012 to 2015. The decline of checks over the period 2014 to 2015 was slower than previous studies had shown for prior periods since 2003.

Notable in the data for the 2016 study, however, is that the decline in check payments has leveled off somewhat, with the annual rate of decline by number dropping to 4.4 percent from 2012 to 2015 compared with 6.2 percent from 2000 to 2012. The annual number of check payments is estimated to have declined by 0.8 billion per year since 2012, in contrast to the 2000—12 period when check payments are estimated to have declined by about 1.9 billion per year.

While checks start out as paper, since the Check 21 law went into effect in late 2004, check clearing has changed. Checks are overwhelmingly processed electronically once they enter the banking system and are increasingly being scanned and deposited electronically by businesses, often using accounting applications, and individual payees using mobile devices.¹³

A study by Association or Financial Professionals, 2016 Payments Fraud and Control Survey, noted that there was a significant increase in payments fraud between 2014 and 2015 as 62 percent of those organizations surveyed had experienced actual or attempted payments fraud in 2014 and this increased to 73 percent of those surveyed in 2015. Another interesting finding is that there is an increase in Business Email Compromise (BEC) fraud where a perpetrator tricks an employee to make fraudulent payments.¹⁴

CHECK FRAUD CASE

A cash disbursement fraud scheme does not require a perpetrator to use a company check to steal from the corporate bank account. The perpetrator only needs to know the victim's checking account bank routing number and account number. The perpetrator can then input the victim's bank routing number and account number on a form at an online check supply company, such as www.checks.com, and create fictitious checks. Alternatively, the perpetrator could go to a local office supply store, obtain blank check stock, and print their own checks with the victim's bank routing number and account number. See exhibit 2-8 for an example of a fictitious check created from a website.

How does a thief obtain funds from a victim's bank account? One method requires the perpetrator to place the victim's bank routing number and account number along with a fake name and address on the check. The check is then taken to a local retailer who will process the check (run it through a reader and encode the amount) and hand the check back to the perpetrator. The store employee might request the perpetrator to provide an identification card. The perpetrator will then provide a forged identification card with the perpetrator's picture and the same fictitious name and address that is on the check. The victim's bank account is ultimately debited for the amount of the check. If the victim's bank account balance is more than the check amount then the check will clear. The victim or company will not discover the fraud until the entity's bank account is reconciled.

A control that could help mitigate this type of fraud is positive pay.

KNOWLEDGE CHECK

4.     Which fraud scheme uses email to deceive an employee to make fraudulent payments?

a.     BEC.

b.     ATM.

c.     Check 21.

d.     EDI.

Exhibit 2-8 Fictitious Check

WHAT IS POSITIVE PAY?

Positive Pay is an automated fraud-detection tool offered by most banks. Entities send electronic files to the bank which list the checks they have written. When the bank receives the actual checks for processing, the bank matches the account number, payee, check number, and dollar amount of each check presented for payment against the electronic file sent by the entity. If the account number, payee, check number, and dollar amount on the check presented for payment does not match the information in the electronic file, then the bank will not honor (pay) the check.

It is important to note that some positive pay systems do not match the payee information. A seminar participant in Jackson, Mississippi, noted that his company had sent a check to a vendor in the amount of $70,000 and that the company's positive pay system did not match the payee information — just the check number, account number, and dollar amount. One of the vendor's employees intercepted the check, changed the payee information to the perpetrator's name, and absconded with the $70,000.¹⁵

HOW DOES POSITIVE PAY WORK?

An exception occurs when a check is presented for payment that is not preapproved by the bank's customer. Typically, the bank sends a fax or an image of the exception check to the bank customer. The bank's customer will review the exception check and then authorize the bank to pay or return the check.

Due to the high incidences of check frauds, many banks require their commercial customers to use positive pay. If the bank's commercial customers do not use positive pay then the commercial customer will bear the loss of the amount of the fraudulent checks paid by the bank.