Auditing CASE - The auditor's consideration of fraud in a financial statement audit

On March 15, 2012, the University of Beckerman (UB) Board of Trustees attended an emergency meeting called by the university's chief financial officer (CFO). The 90 minute meeting, held behind closed doors, was called for the purpose of questioning UB President about allegations of embezzlement in the University's Office of Risk Management (ORM). Specifically, the President and his assistants were asked as to how a supervisor in the ORM could have systematically cheated the University of Nearly One million dollars in false claims over a suspected four-year period.

The Board's concern was undoubtedly about the fact that the scandal in the ORM followed closely on the heels of another instance of unauthorized payments by university employees. Shortly before the ORM embezzlement was uncovered, a series of unauthorized payments had been made to informants who reported irregularities that had occurred in another campus. These unauthorized payments, made to reward whistleblowers without the Board's approval, had also amounted to almost a million dollars.

During the months following disclosure of the ORM embezzlement, UB was the target of criticism in the editorial pages of newspapers across the country. Terms like "outrageous" and "dismal" were used to describe the condition of the ORM's internal control system. Equally critical was the absence of controls in the risk management division and it was as "invitation to disaster", A more detailed description of the highly criticized system and the resulting embezzlement follows.

The System and the Fraud

The University is a multi-campus university with a number of centralized functions. One of those centralized functions is the University's risk management program, which was administered by the ORM. In 2012, the UB risk management program had an annual budget of $113 million in self-insurance funds collected from the various campuses of the University. Of this total budget, annual expenditures for claims had amounted to $58.1 million in the past year.

The ORM reported directly to the office of the president. Within the ORM, the supervisor of property and casualty claims was Mrs. Spaniol. The 47-year-old Spaniol had been claims supervisor for the past eight years. Somewhat ironically, Mrs. Spaniol's primary responsibility was to protect UB assets from fraudulent claims.

In brief, Mrs. Spaniol's job involved the processing and approval of claims made against the University. She could approve any claim for payment out of UB self-insurance funds as long as a lawsuit had not been filed in connection with the claim. Mrs. Spaniol was not required to obtain a review of the claim from attorneys on the staff of the University's general counsel, nor was she required to obtain approval from either her direct supervisor or the President. Furthermore, there was no limit on the amount of claim that she could single-handedly approve for payment.

In the lawsuit that was ultimately filed by the University, Mrs. Spaniol was alleged to have defrauded the University of at least $914,000. Reportedly, Mrs. Spaniol's primary scheme was to create and file fictitious claims against nonexistent University employees who were alleged to have committed offenses including assaults. It appears that she would file those claims with her office and then approve the claims for settlement. To lend credibility to the fictitious claims, Mrs. Spaniol purportedly created fake documentation, including letters from attorneys on the staff of the UB general counsel. She was believed to have used as many as a dozen aliases for purposes of filing the fictitious claims; many of those aliases bore a remarkable similarity to her or her daughter's name.

In one widely reported case, Mrs. Spaniol was alleged to have filed a $175,000 claim on behalf of Diana Harvey. Harvey was supposedly a 33-year-old university employee who was physically assaulted by a professor at UB. in reality, there was no such University professor nor was there an incident of assault against this phantom employee. One report estimated the total amount of such fictitious claims disbursements at $517,000.

In addition to diverting funds through fictitious claims disbursements, Mrs. Spaniol allegedly wrote checks on UB accounts for other unauthorized purposes. Specifically, she was accused of writing 17 checks totaling $439,000 to her daughter Heather. She was also accused of purchasing a $200,000 annuity for Heather, apparently with UB funds. Mrs. Spaniol was believed to use the money from diverted claims payments to take overseas vacations, buy a new sports car, and purchase various pieces of real estate in the area. When asked how Mrs. Spaniol's lifestyle and purchases could escape attention in light of her $60,000 salary, UB officials said she always had an explanation, In one case she reportedly told a co-worker that she purchased her new car with money received from her ex-husband!!!

Discovery and UB's Response-

The discovery of Mrs. Spaniol's embezzlement was a complete accident. The ORM had not been included in the internal audit rotation since 2007, nor was it subject to any other higher-level review. Purely by happenstance, another manager discovered that Mrs. Spaniol had authorized a payment to a fictitious employee of the UB who had supposedly suffered emotional distress.

UB officials' immediate response to the discovered embezzlement was to require external verification of all claims in excess of $1,000, to require more than one signature on checks over $1,000, and to call for placement of a certified fraud examiner on each of the nine UB campuses. Among the numerous other long-term remedies discussed were requirements for regular audits of the risk management section, President's review of settlements in between $25,000 to $50,000, Board's formal approval of settlements over $50,000, general counsel approval of all settlements, and rotation of check-writing authority.

Conclusion

Mr. Spaniol was placed on unpaid leave on April 2012 when the fraud was originally uncovered The University subsequently filed suit against her in an attempt to recover the embezzled funds. Although criminal charges had not been filed, the district attorney's office had anticipated filling such charges by the end of June 2012. Facing a potential prison term, Mrs. Spaniol was found in her kitchen dead from natural gas poisoning in late June 2012.

Discussion Questions General Auditing Topics-

1. According to GAAS, what are the auditor's responsibilities for detecting fraud? What two types of misstatements due to fraud do the standards specifically cover?

2. Do you think the fraud in this case would have been considered material by external auditors? Why or why not? What responsibilities do auditors have for detecting misstatements arising from fraud that are not material?

3. What were some of the specific weaknesses in the control structure in the UB Office of Risk Management (ORM)? Categorize each weakness into one of the five components of control structure.

4. Assuming the misstatement due to this fraud was material; describe several substantive audit procedures that might have uncovered the irregularities.