Payroll System and Internal Control - Case Study Example

Payroll System and Internal Control Name: Instructor: Course: Date: Executive Summary This case study explores various aspects of internal controls in the payroll system of Trolley Dodgers, a Los Angeles-based baseball team. Due to ineffective control procedures, the company experienced an employee fraud that cost it substantial amount of money. The case study examines evident characteristics of such frauds, internal control weaknesses, and their assessment based on the Committee of Sponsoring Organizations (COSO). To a larger extent, Campos’ fraudulent activities went unnoticed until Trolley Dodgers experienced financial difficulties because of various internal control weaknesses within the payroll system. Payroll System and Internal Control Characteristics of Employee Fraud Although employee fraud includes various elements specific to each case, there are several characteristics common to all cases. According to Romney and Steinbart (2009), some of the common characteristics to all employee defrauders include: they spend all the stolen money; they enjoy much confidence and trust from the employer; they rely on deception, lack of internal controls, and misrepresentation of financial information; they usually begin defrauding due to desire to meet a pressing financial difficulty and then make it an habit; the urge for more money makes them steal more and more; becoming overconfident and careless with time that leads to the detection of the crime. In the current case, the fraudulent activity in which Edward Campos defrauds Trolley Dodgers manifests several of these characteristics. Once employed in the company, Campos demonstrated commitment to his work, spending most of his time designing the payroll system of the company. As a result, he earned job promotions that saw him become the chief payroll officer after several years. Moreover, his hard work made him earn confidence and trust of his employer to the extent of being recalled when on holiday to handle payroll transactions. Besides, Campos performed almost all the transactions solely, including filling out of the payroll cards for all Dodgers’ employees. This demonstrates lack of internal control procedures to prevent occurrence of employee fraud in the payroll accounting system. According to Todd et al. (1999, p.110), the fact that the payroll system did not “include separation of duties so that one employee cannot both have custody of cash and authorize its removal from the company” motivated Campos to commit the fraud. Being the one who designed the system, he understood the available internal controls effectively, implying that he knew and understood how to maneuver through the internal controls without raising immediate suspicion from his employer. As a result, these elements encouraged Campos to violate professional code of ethics, engaging in fraudulent activities to divert money from the company for personal uses. In particular, Campos engaged in deception and misrepresentation of financial data to conceal his malpractices, which Greenlee et al. (2007) cite as the most prevalent elements of occupational or employee fraud in both profit and non-profit organizations. In collusion with employees from the company, he frequently increased working hours to award them more wages, after which they shared equally the extra money. In addition, he added ‘ghost’ workers into the payroll system in order to divert company money to his bank account. Thus, although he may have started swindling the money from the firm to solve a particular financial issue, it later became a habit. He became reckless in committing the fraud, making it a source he could always rely to earn ‘free’ money for personal use. Eventually, the firm’s controller detected the fraudulent activities when the company started facing financial difficulties. This cost Campos his job, financial charges of about $132,000, and eight years in Jail. Internal Control Flaws To a larger extent, Campos’ fraudulent activities went unnoticed until Trolley Dodgers experienced financial difficulties because of various internal control weaknesses within the payroll system. The major weakness in the case includes lack of separation of the various payroll processing duties among different employees. As a result, Campos did most of the duties alone, which may have motivated him to commit employee fraud. Besides being the one responsible for almost all payroll activities, he also prepared the payroll cards for all employees in the company every week (Knapp 2011, p.213). He was also responsible for processing the payroll, with the filling of the cards implying that he also permitted the payment claims of all the employees. As such, this demonstrates absence of internal controls to meet the objective of ensuring validity of recorded transactions concerning payroll. Since Campos performed the activities alone, he could not rectify his own misinformation, which he did intentionally to embezzle money from the company. In addition, although Campos recorded all the transactions he had authorized, the authorization did not follow the correct process as required in payroll systems. Lack of separation of duties allowed Campos to be the recording and authorizing agent of the payroll transactions, meaning some of the recorded transactions concerning the fictions workers and the inflated working hours were inaccurate. Another major weakness inherent in Dodgers’ payroll internal controls is absence of frequent internal audits. Despite presence of financial controller in the company, Campos perpetrated the fraudulent activities for several years before detection. The company did not have an internal auditor who could regularly audit the payroll records to track or identify any misappropriations. As a result, Campos had the opportunity to create fictitious workers and pay them wages, which ended up in his bank account. Thus, the payroll system did not meet the objective of accuracy of payment transactions recorded into the system. He manipulated the records to conceal the fraud since he knew that the company did not have an auditor who could validate the authenticity and accuracy of the distribution of the payroll transactions. The other main weaknesses evident in the concerns the hiring activity within the payroll cycle, including absence of efficient recruitment practice and inefficient recording of human resources within the company. Inefficient recruitment practice allowed Campos to include ghost workers in the employee records and subsequently to the payroll records (Knapp 2011, p.214). On the other hand, absence of or inefficient documentation of the employees and payroll transactions motivated Campos to manipulate number of workers and number of hours worked by the employees for his own benefit. In particular, the regularly extended working hours and number of workers, after which he intentionally and fraudulently paid wages that ended up in his account. These weaknesses saw Dodgers’ internal control procedures fail to meet various objectives. First, the compensations were incorrectly recorded as Campos added fake information to steal money. Secondly, the inclusion of the fictitious information implied that he inaccurately presented or filed the information concerning the transactions. Moreover, the ghost workers lacked identification numbers that would enable them remit their income taxes to the internal revenue service. Therefore, the system could not ensure that the firm complied with policies of government about tax payment and recording of employee compensations. Other objectives the system could not accomplish include effective and efficient execution of activities of the payroll cycle and protection of company’s resources against misappropriation or stealing by employees (Todd et al. 1999). Assessment of Dodger’s Internal Control Problems against framework of COSO The Committee of Sponsoring Organizations (COSO) established an integrated structure comprising of five elements to guide companies in developing and implementing sounding internal controls. The elements include the control culture in the company, evaluation of relevant risks, internal control practices, control technologies, and monitoring activities (Romney & Steinbart 2009). The issues evident in this case of Dodgers are products of absence of some of these components in the company. The control climate involves the efforts the management makes to instill control awareness to the employees. In other words, it includes the control culture within the organization. It may show the extent to which the culture communicates the control ideology of the company, promotes dedication, ethics, and integrity of managers as well as the manner in which the management delegates responsibilities to employees. To some extent, the firm seems to promote a good control environment, as initially, Campos not only executed his duties ethically, but also effectively and efficiently. He was fired when the fraudulent activities were detected, implying that the philosophy of the firm did not condone unethical practices by senior employees. The evaluation of risks lays out the guidelines for determining, evaluating, and managing risks that may arise when preparing and recording payroll transactions. Such risks may occur because of dynamism in the business environment, recruitment of new employees, and adoption of new technologies to support the human resource or payroll cycle activities (Gelinas, Dull & Wheeler 2011). With this regard, the internal control problems in Dodgers can be attributed to lack of this component. The firm did not assess risks present in its environment and its operations to develop and implement effective internal controls. For example, he did not assess potential risks due to its relocation of business operations from New York City to Los Angeles. In addition, its expansion over the years implied recruitment of additional employees, which inevitably introduced risks of inaccuracy and misrepresentation of payroll information. Therefore, it failed to integrate relevant internal controls that could have prevented Campos from mismanaging firm’s financial resources. The firm needs to integrate a risk assessment procedure in its payroll system as a way to internally control relevant threats to the system. This will enable the firm to identify risks and devise control procedures to address the risks effectively. The third element in COSO’s framework includes control practices integrated into the payroll system. These involve procedures and policies in place to prevent occurrence of frauds that will inevitably limit the system’s ability to meet the objectives required of an internal control system (Romney & Steinbart 2009). In our case, Campos was principally motivated to commit the fraudulent activities because of inefficient control activities. He carried out most of the activities of the payroll cycle alone. In addition, there were no internal checks to evaluate his work to ensure that it complied with firm’s internal control objectives. As such, the company needs to develop and implement various procedures to limit the ability of Campos’ successors from repeating the crime. The most important of the procedures include separation of job responsibilities by allocating different employees to the different activities of the payroll cycle (Greenlee et al. 2007). The chief payroll officer should only handle the payroll master record and the other tasks allocated to specific employees within the department, who will be answerable to the chief payroll officer. In turn, the officer should report to the financial controller, who should be responsible for reviewing and approving the master file. However, the controller should send copies of the file to the heads of the various departments to review and approve that the information provided in the records is valid and accurate. The company should allow individual employees to fill job and time cards or tickets and the supervisors of the departments to fill similar cards for all employees under them. The supervisors will then compare their records with those of the employees to validate accuracy of the working hours. They should then forward the records to the responsible employees in the payroll department, who will then compile the records and review the records before presenting them to the chief payroll officer for preparation of the master file. In this way, it will not be possible for any one employee to handle all the activities, which will greatly limit the chances of employee fraud (Gelinas, Dull & Wheeler 2011). Another major element in the COSO’s structure includes adoption of technologies to facilitate efficient and effective preparation and exchange of information concerning payroll transactions. This intends to ensure timely distribution of payroll information among concerned employees to help in the detection of errors of omission and commission as well as other forms of misinformation (Greenlee et al. 2007). Dodgers’ had not implemented such technology, implying that it was not possible for other employees (other than Campos and his fellow perpetrators) to know details of the records. To prevent reoccurrence of the same problem in future, the firm should consider developing or acquiring and implementing an accounting information system to make their payroll system efficient. Internal control issues evident in the case partly resulted due to absence of monitoring of the payroll cycle activities, one of the five elements of COSO’s framework. As a result, the firm had no way to evaluate whether the available internal control procedures operated according to the set goals. In addition, it was not possible for the company to identify inherent weaknesses in the procedures that needed improvement. As such, it needs to integrate auditing services within the payroll system. It should require frequent internal and external audits of the transactions to evaluate effectiveness of the controls and possible areas the need improvement. Conclusion From the case, some of the evident elements of occupational fraud include fraudsters enjoy much confidence and trust from the employer; they rely on deception, lack of internal controls, and misrepresentation of financial information; they usually begin defrauding due to desire to meet a pressing financial difficulty and then make it an habit; the urge for more money makes them steal more and more; becoming overconfident and careless with time that leads to the detection of the crime. To a larger extent, Campos’ fraudulent activities went unnoticed for several years because lack of separation of the various payroll processing duties among different employees. Based on the COSO’s framework, Campos was principally motivated to commit the fraudulent activities because of inefficient control activities. As such, the company needs to develop and implement various procedures (notably segregation of responsibilities) to limit the ability of Campos’ successors from repeating the crime. References Gelinas, UJ, Dull, RB, & Wheeler, P 2011, Accounting information systems, 9th edn, Cengage Learning, Florence, KY. Greenlee, J, Fischer, M., Gordon, T., & Keating, E 2007, ‘An investigation of fraud in nonprofit organizations: occurrences and deterrents’, Nonprofit and Voluntary Sector Quarterly, vol. 36, no. 4, pp. 676 -694. Knapp, MC 2011, Contemporary auditing: real issues and cases, 8th edn, South-Western, Florence, KY. Romney, MB & Steinbart, PJ 2009, Accounting information systems, 11th edn, Prentice Hall, Upper Saddle River, NJ. Todd, JD, Welch, ST, Welch, OJ, & Holmes, SA 1999, ‘Insurer vs. insurance fraud: characteristics and detection’, Journal of Insurance Issues, vol. 22, no. 2, pp. 103-124. Read More