| This is the second article in
a four-part series on identifying false
invoices and their issuers. July’s and
August’s columns focus on billing schemes
involving shell companies criminals set up
to facilitate fraud. Articles in the
September and October issues will explain
how to detect and prevent two scams that
employ other, completely different
phony-bill strategies. This month’s case
study shows auditors and CPAs how to
recognize the pass-through billing schemes
crooked purchasing agents and others
sometimes use to illegally line their
pockets. |
 en, a recent accounting graduate,
was on his first real auditing assignment at a
West Virginia manufacturer of prepackaged cement.
Because Ben was a rookie, his supervisors
naturally assigned him tasks they didn’t want to
perform. That explains why he was standing atop
one of the company’s seven huge cement silos on
the morning of December 31, his teeth chattering
in the cold wind as he observed employees taking
inventory. As workers sounded, or measured, each
silo’s contents, Ben watched dutifully and then
double-checked every measurement they made.
| Later
that day, he reported the inventory
tallies to Julia, his audit supervisor,
and vouched for their accuracy. But on
January 3, Julia called Ben into her
office to talk about the cement
manufacturer’s expenditures for raw
materials; they were much higher than in
previous periods.
MAKING SENSE OF THE NUMBERS
“Are you
sure these inventory counts are
correct?” Julia asked. “The client’s
total spending on raw materials soared
last year. So, I expected a roughly
proportionate increase in inventory. But
the numbers you reported are only
slightly different from the prior
period’s.” Ben nodded
affirmatively, but hoped he had not made
any kind of egregious error. He was
mindful of his lack of experience and
had been careful, gazing into each silo
and confirming every sounding.
Julia frowned. “Well, if the ending
inventory is correct, then we need to
look at what the client is paying to
manufacture cement. Maybe the unit cost
of raw materials has gone up sharply.
Let’s go talk to the client’s purchasing
department.” Soon Ben and Julia
were sitting across a desk from Lincoln,
the manufacturer’s chief purchasing
agent. He confirmed the cost of
limestone—a key ingredient in cement—had
jumped nearly 50% in the last year. As
they were about to leave, Lincoln
volunteered something that caught
Julia’s attention: “I don’t know why the
price increased so much last year, but
it’s probably temporary.” As
soon as the two auditors were out of
earshot, Julia pulled Ben aside.
“Something’s fishy about this,” she
said. “If anyone in the company should
know why the cost of limestone has
jumped so much, it’s Lincoln. And since
he didn’t know why the price went up,
how could he know it’ll go down?”
|
How to
Sniff Out Phony Vendors
CPAs can help
prevent false billing schemes by
establishing good controls over
their employer’s or their
clients’ vendor-approval
processes.
 Ensure those
involved in purchasing cannot
approve vendors.
Before approving
a new vendor, evaluate its
legitimacy by
 Obtaining its
corporate records and other
relevant documents.
Checking its
credit rating.
Confirming that
it is listed in telephone
directories.
Contacting its
references from clients and
others.
Being
particularly cautious about a
vendor with a post-office-box
address or a name composed
entirely of initials.
Determining
whether its business address
matches any employee’s home
address. Once the
company approves a new vendor,
the CPA should closely monitor
the account by
Watching for
increases in the amount or
frequency of billings.
Observing
variances from budgets or
projections.
Comparing its
prices with those charged by
other sources.
| |
SIFTING FOR CLUES
All weekend, Ben and
the rest of the audit staff pored over the
company’s limestone purchase invoices. By Sunday
night, they had a pretty good picture of what was
happening. For one thing, about a year ago,
Lincoln had personally authorized the addition of
a new limestone supplier—Majors and Co.—to the
company’s list of approved vendors. The
audit’s documentation also reflected that—within
just a few months—Majors had become the company’s
sole source of limestone, at prices approximately
50% higher than the company had been paying
elsewhere.
| Close-Up on False Billing
 Source:
Occupational Fraud and Abuse,
by Joseph T. Wells, Obsidian
Publishing Co. Inc., 1997.
| Julia came
right to the point: “I think we might find Lincoln
is connected to Majors and Co., which may be
buying limestone from someone else, marking up the
price and reselling it to the cement company.”
On Monday morning, carrying a large stack of
invoices from Majors and Co., Julia met with the
company president, who listened to what she had to
say. After a few minutes, the president said: “I
wonder if Lincoln is trying to get back at us.
About a year ago, the board of directors passed
him over for a promotion to vice-president.”
POURING THE FOUNDATION OF A CASE
Julia, a CPA and
certified fraud examiner, explained to the
president how she could expand the current audit
to detect any fraudulent business practices or
transactions. The president quickly authorized the
additional work. As proper
evidence-gathering procedures require, the audit
team collected every original invoice from Majors
and Co. along with the vendor file showing
Lincoln’s approvals. The team prepared a log
describing each document and its source. They
photocopied them and stored the duplicates at
their offices. Next, Julia assigned Ben to
take a close look at Lincoln’s personnel file. In
it he discovered a name that stood out like neon:
Linda Majors—Lincoln’s wife. Other members of the
team turned up even more evidence: Majors and Co.
was legally incorporated, and related documents
from the Secretary of State’s office bore the
signatures of both Linda Majors and Lincoln as
corporate officers. Finally, the team
obtained price quotes from five nearby limestone
suppliers. On average Majors and Co. charged 60
percent more than its competitors. Julia was
satisfied she had enough documentary evidence to
prove the existence of a pass-through billing
scheme.
COMING CLEAN
Julia arranged a
face-to-face meeting with Lincoln that began with
an exchange of pleasantries. As Ben watched, Julia
posed carefully constructed, point-blank
questions. (For examples, see ‘“Why
Ask?’ You Ask,” JofA, Sep.01, page
88.) She also showed Lincoln a copy of Majors and
Co.’s articles of incorporation, which bore his
name and signature. Lincoln’s face fell.
For a few minutes he acted as if he didn’t
understand, but gradually he admitted everything,
encouraged by Julia’s low-key technique. Not once
did she show any disapproval of Lincoln or what he
had done. Instead, Julia was personable and
professional throughout the two-hour interview,
allowing Lincoln to present his side of the story.
In this unthreatening setting, Lincoln told a
classic tale of revenge, revealing all the details
of his pass-thorough billing scheme and why he set
it up. Sure enough, the whole thing started about
18 months ago when Lincoln realized the company
wasn’t going to promote him to vice-president. He
saw this as a betrayal of his more than 10 years
of service. Like many purchasing agents,
he was a constant target for temptation—vendors
made it no secret they’d be glad to pay him under
the table for favorable consideration when the
company awarded business contracts—but he had
never accepted.
LESSONS LEARNED AND IGNORED
Ben’s participation
in this audit and investigation taught him never
to judge the significance of current findings
without examining prior-period results and looking
for suspicious changes that could indicate fraud.
But the client company was interested only
in getting its money back. In just over a year,
Lincoln’s “take” had been a cool $1.3 million,
which he had saved to finance a new business for
himself. In exchange for his returning it all, the
company agreed—against Julia’s advice—not to
prosecute Lincoln. Even worse, the company kept
quiet about his transgression, enabling him to
move up to a better job—ironically, as chief
purchasing agent for a limestone vendor. JOSEPH T. WELLS, CPA, CFE, is
founder and chairman of the Association of
Certified Fraud Examiners in Austin, Texas, and
professor of fraud examination at the University
of Texas. Mr. Wells’ article, “ So
That’s Why They Call It a Pyramid Scheme ” (
JofA , Oct.00, page 91), won the Lawler
Award for the best article in the JofA in
2000. His e-mail address is joe@cfenet.com
. |
Leases standard: Tackling implementation — and beyond