Jorhat distributor: one man, one ledger, one lapping fraud
Kalita Brothers is a family-owned hardware distributor in Jorhat with turnover of ₹4.5 crore and 40 employees. Purchases above ₹20,000 need only the proprietor's oral approval; there is no purchase order system and no goods received note. Sri Das, the cashier, receives cash and cheques from salesmen, prepares the pay-in slips, deposits money, maintains the debtors' ledger and prepares the monthly bank reconciliation. The proprietor signs cheques but signs whatever is placed before him without comparing the supporting bills. Stock is counted once a year, on 31 March, by Sri Das alone.
During the year it emerged that a customer's payment of ₹40,000 received in June was posted to that customer's account only in September, when another customer's payment came in - the September receipt was deposited and the June cash was retained. Sales invoices are pre-numbered, but 18 invoices are missing from the file and the bound book cannot be traced. Bank reconciliations for seven months were prepared only after the auditor asked for them.
1. Classify the control weaknesses by type (authorisation, segregation of duties, documentation, physical, reconciliation) and identify which weakness or combination made the ₹40,000 fraud possible.
Read the worked answer
| Weakness | Type | Risk |
|---|---|---|
| Oral approval of purchases, no PO or GRN | Authorisation / documentation | fictitious, overpriced or duplicate purchases; no audit trail |
| One person receives cash, deposits it, keeps the debtors' ledger and prepares the BRS | Segregation of duties | cash can be withheld and the record adjusted to hide it |
| Proprietor signs cheques without supporting bills | Authorisation without verification | payments without valid liability |
| Annual count by the storekeeper alone, no perpetual records | Physical / independent check | stock losses undetected for a year |
| 18 missing invoices, no invoice register | Documentation | unrecorded sales, understated revenue |
| BRS delayed by seven months | Reconciliation | errors and misappropriations survive for months |
The fraud was possible because of the combination of custody (receiving cash), record-keeping (the debtors' ledger) and reconciliation (the BRS) in one person. The missing invoices and the delayed reconciliations are symptoms of the same problem: no independent check operated during the year. A single weakness - for example, no purchase orders - would not by itself allow cash to be abstracted.
2. Distinguish internal check from internal audit, and state with reasons whether the statutory auditor can reduce substantive testing on the strength of this control system.
Read the worked answer
Internal check is built into routine recording: the work of one person is automatically checked by another as part of the day-to-day process (custody separated from recording, one clerk's totals verified by the next). It is not a separate department and it operates continuously.
Internal audit is a separate, independent appraisal function that examines and reports on the adequacy of the controls and the reliability of records, usually after the event, and usually on a sample basis.
Which is needed first here? Internal check. The firm's problem is that duties are combined, not that nobody reviews; an internal auditor reviewing a system with this much concentration of duty would have very little to test. Once duties are split, a part-time internal audit or periodic proprietor review becomes worthwhile.
Can the auditor rely on the controls? Only after tests of control. Here the evidence points the other way: a known fraud, missing pre-numbered invoices, reconciliations performed only on request, and no evidence of independent checking mean control risk is high. So reliance cannot be reduced and substantive procedures must be extended - positive debtor circularisation at an interim date and at year end, detailed testing of receipts to pay-in slips and bank statements, sequence testing of invoices, attendance at the stock count, and cut-off testing. The fraud itself is evidence of a breakdown that cannot be cured by sampling a few more vouchers.
3. Explain how the lapping fraud worked, the audit procedures most likely to detect it, and how it should be reported.
Read the worked answer
Mechanics. Cash from A (June) is retained and A's account is not credited. In September, cash from B is banked but credited to A's account; B's account stays open and is later covered by a further receipt. The cash shortfall stays roughly constant while every customer's ledger balance looks correct, and the fraud grows with turnover - the classic 'teeming and lading' or lapping scheme. Because the same person receives cash, keeps the ledger and reconciles the bank, the discrepancy never surfaces.
Detection procedures
- Positive confirmation of debtors at the year end and at a date before the year end; compare replies with the ledger.
- Compare the date of each receipt in the debtors' ledger with the date on the pay-in slip and the bank statement; investigate delays.
- Trace subsequent credits in the ledger to identify payments applied to the wrong account.
- Examine accounts with credit balances, round-sum credits and old uncleared balances.
- Surprise cash counts and direct receipt of the bank statement by the proprietor.
Reporting. Under SA 240 the matter must be communicated promptly to the proprietor in writing, with the facts and the amounts; the loss must be reflected in the accounts, and the control recommendations communicated. Document the work done and consider whether the fraud indicates a risk of material misstatement requiring a modified opinion if uncorrected.