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Fraud: Do You Know When You See It?

The subject of employee dishonesty is a delicate one. Owners generally want to trust their employees, and given all the other battles owners fight on a daily basis, they are often not as vigilant as they can or should be. Vigilance requires an investment of time and money in return for an uncertain payoff. So let’s look at a typical fraud scenario.

Lou Spencer’s CFO, Marty Jacks, had been with Lou’s company for 15 years. While Lou reviewed company financial reports and often the accounts receivable aging report, he let Marty handle the day-to-day financial operations. To say that Lou was surprised when one of his vendors mentioned that he’d run into Marty on the floor of a Las Vegas casino at 4:00 a.m., would be an understatement. As far as Lou knew, Marty spent every weekend at home or camping with his family.

Rather than confront Marty on his way out the door to play golf, Lou casually asked his golf partner (a CPA who happened to also be a Certified Fraud Examiner) about employee theft.

The CPA listed more ways to steal than Lou could imagine, but Lou did remember:

• Creating fictitious vendors or employees.
• Stealing inventory.
• Giving one’s self undisclosed and unauthorized pay raises.
• “Lapping” or taking payment from one customer and applying it to another’s account.

The CPA also explained to Lou the three conditions present in any fraud situation: motive, opportunity and rationalization. “Has anyone run into financial difficulties,” he asked. “Maybe a sick kid? The unemployment of a spouse or even the readjustment of payments on a home loan?” Lou couldn’t think of anyone in those situations.

Lou understood the “opportunity” factor immediately. He admitted that he’d trusted Marty implicitly so he just wasn’t reviewing every report carefully. If opportunity was at issue, Marty certainly had it.

Rationalization: Lou was fairly confident that his employees — including Marty — were satisfied with their salary and benefit packages. Except for an occasional afternoon of golf, Lou believed he worked as hard as any of them.

The CPA suggested that Lou retain a fraud analyst to conduct a fraud audit, but, at a minimum, that he look at his financial statements again, and this time, rather than focusing on the decline in revenues, look for any anomaly or anything that “bucked the trend.” Lou returned to an empty office to do exactly that.

What Lou discovered caused him to call his golf buddy the next day to schedule a meeting about a Fraud Deterrence Audit. Lou swallowed hard as he signed for an audit that would cost his $20M company between $20,000 and $25,000.

After several weeks of review, the CPA laid out the situation for Lou. Marty had a gambling habit (motive). Over the past 18 months, Marty had set up numerous bogus vendor accounts and had siphoned off almost $1 million to these accounts (opportunity). When Marty started pulling small amounts of cash out without Lou noticing, Marty decided that since Lou didn’t miss the cash, Lou could do without it (rationalization).

Armed with the facts, Lou fired Marty. There was no way to recover the money, so Lou and the Fraud Examiner concentrated instead on implementing ways to prevent this scenario from happening again.

We asked Edward Bortnick, a CPA, Certified Fraud Deterrence Analyst and Certified Financial and Forensic Accountant, and Certified Valuation Analyst from Rockville, Maryland to share with us what Lou, and every owner, can do to prevent fraud. Bortnick suggests the following:

“First, look for any anomalies in the company’s financial reports. Are there exceptions to trends over time?” To do this, Bortnick suggests preparing two Excel worksheets.

• On the first spreadsheet, enter the last five years’ income statements expressed both in dollars and as a percentage of gross revenues. Using that report, investigate any significant changes in income as well as significant changes in the expenses as a percentage of income.
• On a second spreadsheet enter your company’s balance sheets for the past five years. Using this report, compute the accounts receivable turnover and collection days for each year as well as inventory turnover and again, investigate any significant changes.

“Second, change the schedule for running and reviewing reports. Lou’s new CFO (hired only after a thorough background check) should provide Lou with reports on a weekly, rather than monthly basis.”

“Third, owners should carve out time to carefully review those reports without distraction.”

“Fourth, owners should ask their CPAs to conduct a quick ‘Financial Statements 101’ course,” says Bortnick. Lou thought he knew how to read them, but he learned what to look for and what the numbers could tell him. Most importantly, he learned what ratios to look for and what changes in those ratios might mean.

“Finally,” Bortnick explains, “Fraud Examiners will propose a number of changes tailored to the particular company and can follow up periodically to make sure that all changes have been implemented and that no new opportunities for fraud have opened up.”

“These are a few of the tools,” says Bortnick, “that can be used to monitor your operations and help detect whether anomalies are due to employee dishonesty or changes in your company's operations. I suggest that owners contact their accountants (or forensic accountants) to help develop systems and forensic tools that owners can use to deter fraud and manage — financially — business operations.”

“If an owner sees anything he or she does not understand or that seems unusual,” concludes Bortnick, “dig deeper. Doing so could save the company.”

Subsequent issues of The Exit Planning Review™ discuss all aspects of Exit Planning. The provider of this Newsletter (Paul Honeycutt) offers you unbiased information about what you may need to know — How To Run Your Business So You Can Leave It In Style™.