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wish this was a story of crime and punishment, but things didn’t work out quite that way. It began with an embezzler diverting substantial funds from his employer to himself. It ended with several investigators trying to catch him but making big mistakes along the way. I’m one of those people who who were on his trail, and in the following pages, I’ll tell you how this real-life fraudster operated and what we should have done to nab him. Here’s what you the CPA can do to protect your clients against people like him. This is how it happened. Fenwick, the internal auditor for Discount Department Stores, hated traveling. But since he covered all 14 Discount stores in his district, he was on the road constantly. This time he was in Grapevine, Texas. Located near the end of Dallas/Fort Worth International Airport’s seemingly endless runways, the Grapevine store’s windows shook every few minutes as each thundering jet lumbered into the air. As Fenwick silently cursed his assignment, he looked about the store. It was empty except for the piles of financial records surrounding him. The Grapevine operation, which had lost money for three straight years, had closed the previous month, its remaining inventory divided among other Discount locations. The boss’s instructions to Fenwick were clear and simple: Find out what went wrong. Fenwick was about to reach for his latest steaming cup of coffee—filled to the brim—when the earthquake hit. Or so it seemed. The jolt was from yet another jet, the loudest of the day. It had spilled his coffee, which soaked the bank deposit slips on the desk. Fenwick’s groans echoed off the bare walls. | AN ACCIDENTAL DISCOVERY Fenwick got up and spread the dozen or so deposit slips on the carpet to dry. He then cleared the rest of the mess and returned his attention to the stained papers on the floor. Fenwick stacked the slips one by one, glancing at them casually. After looking at just a few, he spotted a distinct abnormality. Fenwick had been around the other stores enough to know that currency and other checks represented about half the money going into their bank accounts; credit card deposits made up the rest. But the documents in his hand were a different mix—three-quarters credit card, one-quarter cash. Although Fenwick didn’t consider himself a fraud expert, he thought he’d uncovered something fishy. Fenwick called the boss. The boss called me. At the time, I headed a firm of fraud examiners. I met Fenwick at the cavernous store, and he showed me what he had. Since Fenwick told me the bank deposits corresponded with the store’s net sales, we turned to gross sales and began to closely examine cash-register tapes. Fenwick spotted it first—a sales refund of exactly $300 on one day’s tape. He picked up the next day’s, which showed a refund of $400 even. Fenwick turned to me and said, “Ordinarily, refunds wouldn’t come in exact, hundred-dollar increments, would they?” Suddenly, neither one of us heard the screaming jet engines above.
| Fraud Examiners Rate the Scams | Schemes | Difficulty | | Extortion | 2.50 | | Illegal gratuities | 2.86 | | Nonfinancial statements | 3.22 | | Other | 3.53 | | Conflicts of interest | 3.54 | | Bribery | 3.65 | | Inventory and other assets | 3.73 | | Other fraudulent disbursements | 3.95 | | Billing | 4.01 | | Payroll | 4.20 | | Skimming | 4.24 | | Financial statements | 4.28 | | Expense | 4.34 | | Register disbursements | 4.35 | | Check tampering | 4.40 | | Cash larceny | 5.04 | 1 = Difficult to detect
7 = Easy to detect Source: Report to the Nation on Occupational Fraud and Abuse, Association of Certified Fraud Examiners, 1996. | | Within half an hour, we’d uncovered the scheme. We attempted to match the refunds on the cash-register tape to the source documentation. We found nothing—no documentation whatsoever. The thief hadn’t even bothered to phony up refund slips. Then we examined more tapes. By the time we’d looked at a few dozen, it was obvious what had happened: Each evening, just before closing all eight registers, someone would ring up a several-hundred-dollar refund on one, remove an equal amount of cash and close out the register for the day. The amounts ranged from $200 to $700. SEEING THE FOREST THROUGH THE TREES I asked Fenwick, “Have you done a horizontal analysis of the income statements to see if refunds are increasing compared with sales?” He looked down at his coffee cup. “Not really,” he admitted without raising his eyes. “We check net sales and confirm that’s how much goes into the bank.” Without my saying anything further, Fenwick knew he had screwed up. A horizontal analysis—a comparison of financial-statement line items from one period to the next—would have revealed the growing number of refunds. While Fenwick documented the losses, I scanned the Grapevine store’s most recent employee list, starting at the top. “Where is the store manager now?” I asked.
“I understand he had always wanted to open a bait-and-tackle shop on Lake Grapevine,” Fenwick said. “After the Discount store closed, I think he went out there.” I smiled. I knew of many cases where employees had stolen money to start their own businesses. So we went over the entire list of Discount employees. Any of them could have done it, but only the manager seemed to fit. The next day I found my way to his new shop on Lake Grapevine and went inside for a soft drink. The place was practically overflowing with merchandise. Indeed, the only thing missing on that hot Saturday afternoon was customers—except for a lone attendant, the store was empty. CASTING FOR EVIDENCE The following Monday, I telephoned the boss and told him the former manager was my prime suspect. But to prove that he did it, we’d need access to the manager’s personal financial records. I gave the boss three options: Call his lawyer, call the police or call both. Figuring that legal fees would only add to Discount’s losses, he called the police and asked me to work with them. After Fenwick had finished documenting the losses, we took our evidence to Lt. Dale Wilkins of the Grapevine Police Department. He came straight to the point: “Look, this is a very small department and we don’t have any accounting expertise. Even if the manager took the money, we wouldn’t know how to build a case.” But I knew how. Although the key to proving the manager’s scheme was in his bank account statements, we couldn’t get them without a subpoena. Wilkins agreed to subpoena the statements, provided we did the analysis without charging the police and turned over the results to them. When we got the bank statements, we quickly matched the register thefts with unexplained cash deposits in the manager’s checking account. Of the $800,000 stolen in three years, more than $600,000 found its way into the manager’s bank account. He’d spent about $400,000 on the bait shop and the rest on living expenses including a new car and home. We tried to interview the former manager, but he declined.
WHAT WENT WRONG Fenwick and I prepared a report for Wilkins and the district attorney’s office. Later, we all met with a grizzled assistant DA. “This report,” he drawled, “is just numbers and charts and bank account statements. I don’t see anything about eyewitnesses to these thefts.” He eyed us warily. “Look,” I said, “this is a net-worth case. You have a store manager making $150,000 over three years, with another $600,000 in unexplained cash deposits into his bank account.” The assistant DA still wasn’t convinced, even after I pointed out the federal government had used evidence like this to convict Al Capone. The prosecutor, bored with the numbers by now, replied: “Well, this guy ain’t Al Capone and we ain’t the federal government. Around these parts, we’ve never prosecuted a net-worth case, and I don’t see any reason to start now. If you think this guy stole the store’s money, sue him.” Meeting dismissed; prosecution declined. I sat there in stunned silence. Fenwick and I broke the news to the boss. Since criminal prosecution looked like a long shot, I suggested two alternatives: File a civil lawsuit against the former manager for fraud and theft—civil fraud requires a lesser burden of proof than criminal fraud—or notify the IRS of a possible tax fraud. We did both. Including attorney fees and investigative costs, the damages came to $1.1 million. Unfortunately, by then the manager’s bait shop had gone under, so there was no recovery from the civil lawsuit. The boss used our report to file a claim with Discount’s fidelity insurer, which covered the company against such losses. But the policy had a $500,000 deductible, so Discount had to charge that amount to earnings. The IRS, hampered by budget and personnel cuts, has yet to catch up with the manager. THE POSTMORTEM
As it turned out, this fraud case was “dead on arrival,” with plenty of people to share the blame. I was guilty of completely screwing up the presentation of the case to the DA’s office—a fact I woefully shared with my client, the boss. Even though I had been in the antifraud field for more than 20 years, I’d dealt mostly with federal prosecutors and defense attorneys who knew a wide variety of net-worth calculations by memory. And that’s why I presumed—incorrectly—that every prosecutor was equally familiar with these forms of potential evidence. In retrospect, I easily could have made my presentation more visually engaging and simpler. For example, I could have taken photographs of the shiny new car, home and bait shop to show the prosecutor where the money went. And instead of showing him complex spreadsheets and pages and pages of bank statements, I should have prepared simple charts and graphics explaining the scheme. I also could have interviewed a multitude of the manager’s former employees before presenting the case, but in my mind, we easily had enough information to go to the grand jury. However, in many criminal prosecutions, you get only one chance to make your presentation, and I had botched mine. I offered to forfeit my fee, and the boss took me up on it. These lessons were expensive and embarrassing for me to learn, and I never forgot them. Fenwick was also to blame for this debacle. As internal auditor, he was in charge of designing controls to detect and deter fraud including cash-register-disbursement frauds. But Fenwick had always concentrated on net—not gross—sales. He also had the very tools he needed to detect this scheme much earlier, but he didn’t use them. He could have revealed the unmistakable trend of increasing refunds, for example. Finally, the boss had to confess to his own failings. As in many cases, most of the store’s employees knew what was going on. But the company provided no hot line or other means for them to furnish information confidentially, safe from reprisal. Moreover, Discount had no written ethics policies and gave managers and employees virtually no antifraud training. The boss regularly received detailed financial statements from each store, clearly reflecting increasing refunds in the Grapevine operation. But he admitted he and his staff never looked carefully at anything but the bottom line. These turned out to be big mistakes.
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