help me develop a fraud hypothesis based upon the following information

Internal Controls for Brainiac Toys:

You are an internal auditor for Continental Holdings Corp., a holding company that owns controlling shares in many businesses. While Continental holds a controlling interest in its subsidiaries, it has led individual companies to manage operations and accounting functions independently. Each subsidiary submits a quarterly report with financial results to Continental. Continental has had a strong track record over the past several years in picking winners out of the various business entities for sale. It has grown past the funding limits of its private partners and is taking the steps needed to go public within the next several months. As part of this process, Continental is reviewing the operations of each of its subsidiary companies. The biggest concern is to ensure that each of the subsidiaries has a clean set of books and accounting procedures. When a company goes public, its financials are open to increased scrutiny, so Continental wants to be sure that there are no "skeletons in the closet." You have been assigned the task of overseeing the review of Brainiac Toys. Your teammate, Jill, has conducted the interviews and gathered other information for you to review. Below is the information she has collected for you to aid in the report. Brainiac Toys Brainiac Toys started operations in the Hans Schuler garage in 2008. Hans noticed that his kids were bored with simple games and puzzles, so he created more challenging activities for them. As his kids started showing their friends what he had made, Hans received requests from parents around the neighborhood. Hans soon had a lucrative part-time job on his hands. Over the next few years, Hans rented space in a local manufacturing facility to produce toys and games at a faster pace. He purchased the rights to other products and expanded his product line. Fast forward to 2018. Hans, now working full-time for the company, had a thriving production facility with over 50 products. He distributed the products through various retail stores in the region. He decided it was time to increase his market reach by developing a website and selling products online. Hans recognized that he did not have the capital needed to invest in an online infrastructure. Brainiac Toys was already organized as a private corporation, so he started looking for a corporate partner. Continental Holdings was interested, but only if it could hold a majority ownership interest in the company. Continental assured Hans that he would be retained as the company CEO for at least 10 years, at which point Hans would likely want to retire anyway. Hans swallowed hard and decided to sell. Brainiac Toys currently has a production division and a sales division. Corporate headquarters houses the accounting department, human resources, central IT, and research and development. Accounting Department The accounting department for Brainiac Toys handles the accounting functions for the whole corporation. While the company has grown overall, the accounting department is still a relatively small operation. Hans was not an accountant by trade, so he decided to offload most of the accounting work to his CFO, Barry Black. Barry was a local CPA used by Hans to file his taxes when he started the company. After a few years, the work Barry was doing became complex enough that Hans hired him to be the full-time two-company accountant. Barry was later named the CFO when Brainiac Toys started as a private corporation. Barry was a CPA for 20 years before starting to work full-time for Brainiac Toys. He set up the company's accounting system and expanded it as the company grew. The accounting staff consists of Barry, the CFO; Angela, the controller; Jose, who is the accounts receivable manager; Julie, who is the accounts payable manager; and two clerks, Larry and Maria, who handle data entry and other tasks. Barry developed accounting procedures as the department grew. At first, he handled all the accounting functions, with the authority to disburse all checks. Barry started writing down accounting procedures as they were needed. Old procedures were removed only when new ones superseded them.

The following are some of the rules regarding accounting functions.

1. All disbursement checks must have two signatures from among the following positions: CEO, CFO, controller, accounts receivable manager, or accounts payable manager. A. The CFO has a signature stamp from Hans that was used periodically before the accounting staff grew to a sufficient size to allow others to sign checks.

2. All disbursements must be authorized by one of the following positions: CEO, CFO, or controller.

3. All incoming mail must be opened by two employees, with one of them being either the CFO, the controller, or the accounts receivable manager.

4. The monthly checking account statement needs to be reconciled within five business days of receipt by either the CFO, the controller, or one of the clerks.

5. The accounts receivable manager is responsible for matching up all checks received against the A/R records detailing which customers have outstanding balances.

6. Incoming checks are either deposited nightly by two employees in the bank's night depository or are locked in the safe in the CFO's office until the next business day.

7. The CFO is the only person authorized to have a key to the safe in the CFO's office.

8. Customers who order products online must pay for the product before it is shipped.

9. The accounts receivable manager will receive an electronic file of all online customer payments daily. This file needs to be matched against shipping records to ensure all payments were received prior to shipment. This reconciliation can be delegated to one of the clerks.

10. The accounts payable manager will receive invoices for the delivery of raw materials and supplies as well as bills of lading. These need to be matched up with the receiving report created by the receiving department and the original purchase order.

11. All payments for raw materials and supplies should be made within the cash discount period, if applicable.

12. Inventory of raw materials and finished goods should be counted at least quarterly.

13. A petty cash fund of no more than $500 is kept for non-standard expenses. Only the petty cash custodian keeps a key to the lockbox.

14. Employees are allowed two weeks of vacation annually, with unused balances required to be cashed out after one year.

15. All documents need to be filed in the central office filing room within two weeks of month-end closing.

16. Passwords to the IT system should be changed every three months. Passwords should not be reused.

17. All official company correspondence should use the company letterhead. It looks more professional and carries more authority that way.

Interviews Interview With Hans, the CEO

Jill: Congratulations on building such a successful company. At Continental, we have been delighted with the positive returns on our investment.

Hans: Thank you. At first, I was skeptical about giving up my ownership interest, but Continental has been true to its word about being a "hands-off" owner. We wouldn't be in as great of shape today without the added investments from your company.

Jill: I see that you oversee product development and are very active in the production side of the business. How have you managed the company's financial aspects and demands?

Hans: I was very lucky to have a great CPA to do my taxes during those first few years. Barry has been wonderful to work with. I trust him entirely to run the finances. He has never let me down. As you can attest, he has led us forward with great profits.

Jill: How often do you review financial statements?

Hans: I receive a monthly report with estimates of our profit and a quarterly report that I go over together with Barry.

Jill: Does this happen every quarter? Do you sign off on the results?

Hans: I don't need to sign anything official. We are not a publicly traded company, so Barry says we don't need to follow the SOX rules or whatever they are called.

Jill: Do you still review the disbursement requests and sign checks?

Hans: Oh, I haven't done that regularly in years. I do fill in occasionally when Barry or Angela is sick, but I don't think I have had to do that in several months now.

Jill: I noticed in the accounting procedures that there is a signature stamp for you that Barry has used in the past. Is that still in use?

Hans: We needed that when there were only the two of us, and I was too busy to sign the checks in a timely manner. But we do not use it anymore. I do not even know where that stamp ended up. I believe the last time I saw it was a couple of years ago when we were still using Flecker Supplies.

Interview With Barry, the CFO

Jill: Barry, how long have you been with the company?

Barry: I joined the company full-time about ten years ago. Before that, I was a practicing CPA for 20 years. 4

Jill: How did you develop the accounting system at Brainiac Toys?

Barry: I started with a simple accounting system using QuickBooks. When we outgrew that system, I had a custom system developed for us by an accounting software company. It is flexible, and we can add modules to it as needed.

Jill: One of the policies states that you are the only one with a key to the safe in your office. What happens if you are sick or out of town?

Barry: I give the key to my daughter Julie. She is very trustworthy and can get whatever is needed from the safe.

Jill: Do you keep the signature stamp with Hans's signature in the safe in your office?

Barry: I guess it is in there. That's where I always kept it, but I don't think I've seen it for a while now.

Jill: Who prepares the financial statements for the company?

Barry: Angela, the controller, does that for us. She downloads the information from the accounting system and organizes the data into a more user-friendly reading format.

Jill: Does anyone work with her on that task?

Barry: No, it's pretty easy to do. The accounting software generates the basic format. She just needs to add the relevant information that's not officially entered into the accounting system to get the statements to represent what actually happens here.

Interview With Angela, the Controller

Jill: How often do you reconcile the checking account?

Angela: I only do it when there has been a high volume of activity, typically around the holidays. Otherwise, I assign it to one of the clerks. I think Maria has been doing it recently.

Jill: Where are the company letterhead and other pre-numbered documents kept?

Angela: I keep those supplies here in my office. Jill: Under lock and key? Angela: Only the pre-numbered checks. Who would want to steal company letterhead or invoices?

Jill: I understand from Barry that you prepare the financial statements that are regularly sent to Continental Holdings.

Angela: That's right. I downloaded the basic information from the accounting software and adjusted the data for other relevant events. 5

Jill: Could you give me an example of one of these other events?

Angela: Sure. We all know that research and development costs need to be expensed for tax purposes as they are spent. However, why are we really spending that money? To benefit future revenues. So, I increased the assets on the balance sheet and reduced the expenses on the income statement to show this reality.

Jill: But that's a violation of GAAP principles.

Angela: Yes, but that's ok in this case. We don't put these entries into the accounting system, so the taxes we file using the software are still correct. Since we are not a publicly traded company, we don't have to follow all the GAAP rules anyway. This method better reflects economic reality.

Jill: You do understand that you will be a part of a publicly traded company in a few months, right?

Angela: Yes, I do. I guess we will have to stop making those adjustments to the statements at that point.

Interview With Jose, the Accounts Receivable Manager

Jill: As manager of the accounts receivable, what do you do on most days?

Jose: We have two types of customers. The first type is what we have had for years: accounts with the stores and retail outlets that buy our product in bulk. We sell to them on credit, with generous payment terms. We tailor these to the size and importance of each customer. Most of the time, we offer terms of 2/10, net 30, but with some of our bigger customers, we will offer 3/45, net 90. And believe me, some of them take 90 days to pay sometimes.

Jill: What is the other type of customer you have?

Jose: Those are the individual customers that buy from our online website. We don't have to worry about waiting for the money from them, as they usually pay with a credit card. We have had some pay with an electronic check at times. I don't like it when they use that method because, occasionally, their checks will bounce. We still need to match up the payment with the shipping records to be sure we have been paid before the product has shipped. Some slip through from time to time. We then must send out letters asking for payment.

Jill: With your retail customers, what is your history with bad debt? How often do you write off a receivable as uncollectible?

Jose: We really try to work with those customers who have trouble paying for one reason or another. I would prefer that we create a standard time frame before we commence with the write-off, something like 150 days past due. However, Barry asked me to send him the really late ones so he can talk to them personally. I guess his method works because he is successful in getting payment more often than not. 6

Jill: I see that it is company policy to give me two weeks of vacation each year. Does everyone take vacations? What happens if multiple accounting department employees want to take a vacation at the same time?

Jose: That would be a problem. However, Angela hates to take vacations so that she will pick up any slack in the office. I don't think I've ever seen her take a vacation day, in fact. I know I am not that dedicated to my job!

Interview With Julie, the Accounts Payable Manager

Jill: Julie, how long have you been with the company? Julie: I graduated college two years ago. At first, I struggled to find a job, but my dadsorry, Barrylet me know about an opening here. He helped me get through the interview process, and I got the job.

Jill: What was your degree in?

Julie: I graduated with a degree in political science with a minor in history.

Jill: How did you learn how to do this job?

Julie: My dadumm, Barryshowed me what to do. It's really easy to follow the procedures that he wrote down for me. Jill: One of the company policies is to pay all invoices within the cash discount period, if applicable. Does the company always follow this procedure?

Julie: Of course, if we have the money.

Jill: What does that mean?

Julie: Well, I always check the bank account balance before making payments. If there isn't enough money in there, I wait until there is before releasing the checks. Sometimes, that means we miss the cash discount period.

Jill: How do you check the balance? Do you ask Angela what the spendable amount is?

Julie: No, I just go online to the bank website to see what's in the account. My dad has the password and lets me use it. He thinks it's smart of me to be sure we don't bounce any checks.

Interview With Larry, an Accounting Clerk

Jill: What are some of your job functions?

Larry: I always seem to get stuck with matching up the payable documents. It's supposed to be Julie's job, but she doesn't seem to know which document is which sometimes. She's a daddy's girl. If you ask seven me, she gets paid much more than she's worth. How about spreading some of that money around to the people who are really doing the work?

Jill: Sorry to interrupt, but could you describe the process you use?

Larry: Sorry about that. Anyway, I put together the invoice, the purchase order, the bill of lading, and the report from the receiving department. Sometimes, these don't match up, and I have to hunt down the missing information. More often than not, it involves someone in the receiving department not recording the receipt of materials on the clipboard on the desk. "It was missing," they say. They really need to put a string on that thing so it stays in one place.

Jill: Do you have any other job functions that you do regularly?

Larry: Yes, I am the one who files all the documents in the filing room. What a boring job! I have often wondered why we bother. No one seems to look at them once they are filed. The whole room could catch fire and no one would even care, in my opinion.

Jill: Are the documents photocopied or digitized in some way?

Larry: Well, of course, some of them are only in digital form. But the paper ones are the only copies we have.

Interview With Maria, an Accounting Clerk

Jill: What are some of your job functions? Maria: I pretty much help whoever is busy with things. Sometimes, I reconcile the bank account. Sometimes, I match up the online customer payments with the shipping logs. I count the inventory each quarter to make sure it matches our accounting records.

Jill: Are you the only one who reconciles the bank account?

Maria: Mostly. However, sometimes Angela wants to do it herself when there have been a lot of transitions, like around the holiday season.

Jill: I'm told that you are the custodian of the petty cash fund.

Maria: That's correct. Jill: How often does that need to be replenished?

Maria: It depends. Most of the time, it will last two to three months before it almost runs out. But a few times last year, it needed to be replenished after only a week or two.

Jill: Why was that? 8

Maria: Angela had some immediate expenses that needed to be paid and didn't have time to wait for the check disbursement process to be completed.

Jill: Did she provide the proper receipts?

Maria: Of course! Everything was done according to procedure. The expenses seemed to be legitimate to me.