Detecting Circular Cash Flow
Healthy doses of skepticism and due care can help uncover schemes to inflate sales.
Following an initial customer confirmation request with no response, a first-year auditor mails a second and third request, all under the supervision of the auditor-in-charge assigned to the account. Field work begins on the audit, but there is still no response from the customer. Another auditor scanning the cash journal from the beginning of the year through the current date notes that all outstanding invoices have subsequently been paid from this customer during this period. Customer check copies are provided, and remittances indicate that payment has been received in settlement of all outstanding invoices at fiscal year-end for this customer. But has the existence of accounts receivable from this customer at fiscal year-end really been established?
Fraudsters have been creating increasingly complex and sophisticated schemes designed to rely on potential weaknesses in the execution of audit procedures surrounding key assertions such as existence. A financial statement auditor can use his or her professional judgment while carrying out audit procedures to detect such a scheme.
Given the difficult economic times of the past year, special care should be given to consider fraud while performing audit engagements. One fraud scheme that has been encountered with increasing frequency involves the inflation of accounts receivable and sales through the creation of a circular flow of cash through a company to give the appearance of increasing revenue and existence of accounts receivable. This article addresses this fraud technique when used to materially overstate assets and inflate borrowing capacity under an asset-based revolving line of credit. This article also points out red flags that may help uncover such a scheme.
BACKGROUND
A typical asset-based revolving line of credit allows a company to borrow funds for working capital. The borrowing limit is based on a formula that takes into account various working capital assets and related advance rates. A typical availability formula allows for loan advances equal to a set percentage of asset balances.
This article focuses on an accounts receivable- backed line of credit, an asset that is prone to manipulation in this specific fraud scheme. Typical advances against accounts receivable range from 75% to 85% of eligible accounts receivable. Items excluded from eligible collateral would include invoices aged over 90 days, affiliate receivables or any other invoice that would create a nonprime receivable from the lender’s perspective. The loan agreement in an asset-based loan facility requires management to submit an availability calculation periodically. This allows the lender to monitor collateral levels and exposure. A generic accounts receivable availability calculation is illustrated in Exhibit 1.
By design the availability calculation allows a lender to focus on maintaining a fresh, collectible accounts receivable collateral base.
Accounts receivable are closely monitored by the lender through various parameters including dilution (percentage of an invoice that is ultimately not collected due to the issuance of credits, discounts, etc.) and turnover in addition to sales trends. When managers begin to look for opportunities to defraud lenders, they are familiar with lender diligence procedures and are aware that, if they fail to remove an invoice in a timely manner, the invoice will eventually show up in the ineligible past due aging bucket or, if the invoice date can be reset within the accounting software, turnover will show significant slowing trends.
As these parameters are calculated based on a rollforward of the receivables balance from period to period, the lender should be aware of all credits issued and cash received during periods under review. This allows for easy detection of many old-school fraud schemes such as simple crediting of previously issued bogus invoices. To avoid either a spike in dilution or a significant deterioration in turnover, management must clear invoices in line with normal payment trends, requiring cash to be received and applied against the fictitious invoice.
Once fraudulent invoices have been assigned to the lender, management must devise a way to create cash flow, which is often accomplished through cycling existing cash through a depository account to create the appearance that an invoice has been paid. This is typically done by transferring cash to a third entity that then must relay the cash back to the original company, either directly or indirectly, to clear the fictitious invoice. The third entity is typically a related party (unbeknownst to the lender) or an unrelated party that is paid an arranged amount for assisting with the scheme.
Exhibit 2 outlines what the expected cash flow would be in a typical asset-based revolving line of credit facility. Exhibit 3 outlines what the cash flow would look like when a circular flow of cash is present. The following fictitious case study, based on our experience with numerous actual cases, shows how one company can use a circular flow of cash to artificially inflate its collateral balance, prompting advances from a lender that are not adequately supported by working capital assets.
CASE STUDY
Ricardo Mox was the CEO of a middle-market company, Moxie Alloys, which maintained an asset-based lending facility with a local bank, Fourteenth Federal. The credit agreement allowed Moxie Alloys to receive loan advances based on 85% of eligible receivables. Mox felt that after all his years of hard work, he deserved a payout greater than his six-figure salary. To achieve this, he decided to inflate sales and collateral to create loan availability to fund additional payouts to himself. He instructed the controller to create a bogus invoice for $85,000 and assigned this invoice as collateral for the loan, receiving $72,250 (85% advance rate) the following day from Fourteenth Federal.
After 60 days, Mox realized that this invoice would soon become ineligible for borrowing purposes, reducing his collateral base in 30 days. So he devised a plan to circulate cash through Fourteenth Federal prior to the close of this 30-day window through the creation of another fictitious invoice, this one for $100,000. The $85,000 advance ($100,000 x 85%) received as a result of this invoice’s assignment was then forwarded by Mox to a shell company acting as a vendor, which in turn sent an $85,000 check in settlement of the first invoice to Moxie Alloys’ lockbox with Fourteenth Federal. The delivery of this $85,000 check into the Fourteenth Federal lockbox reduced both collateral (accounts receivable) and the loan balance by $85,000, with the net effect of increasing the borrowing capacity under the revolving line of credit by $12,750. Mox used this scheme with increasing frequency (that is, he had multiple bogus invoices outstanding at a single time) to continually increase the amount of funds siphoned from Fourteenth Federal.
When questioned by Fourteenth Federal about the sudden rise in sales to certain customers, Mox used new shell companies or existing customers to continue to expand the fraud, issuing multiple fraudulent invoices to several customers, each of which then individually comprised an insignificant portion of the receivable balance. He was aware that his financial statement auditors would be interested in confirming balances outstanding with customers as well as reviewing subsequent cash received against prior-period invoices outstanding. To plan for this, he sent written confirmations to shell company addresses that were actually personal residences of inside parties. Additionally, if prompted, he was able to provide customer checks and remittances (drawn on shell company accounts) to further support the legitimacy of accounts outstanding at the end of the prior period. If confirmations came back with negative responses from legitimate customers, he used scanning and editing technology to change figures shown on previously received legitimate customer checks to match deposits for checks drawn on shell company accounts.
This case is a general model for numerous schemes that have unfolded over the several years. Our firm has seen numerous instances where a financial institution avoided losses from the scheme because appropriate due diligence efforts discovered the fraud early on. Unfortunately we have also seen instances when lenders have taken losses in excess of $20 million when the scheme was not identified in a timely manner.
PROCEDURAL EMPHASIS
It is imperative to have a renewed emphasis on certain audit guidelines. In designing a confirmation request, AU section 330.27 states that “the auditor should consider whether there is sufficient basis for concluding that the confirmation request is being sent to a respondent from whom the auditor can expect the response will provide meaningful and appropriate audit evidence.” A key to verifying existence is that the receivable is collectible from a third party customer with whom goods or services were exchanged in the normal course of business. With the advent of SAS no. 99, Consideration of Fraud in a Financial Statement Audit, is it outside the scope of an audit to review and question key customers that are unknown to other industry members, going as far as conducting a background check on questionable accounts that comprise a significant portion of accounts receivable, to validate that the company is indeed selling products or services to a legitimate third party? Although such procedures are not currently required, auditors must rely on professional judgment to determine when additional action may be warranted.
If confirmation procedures do not produce acceptable results, AU section 330 (paragraphs .31 and .32) addresses the use of alternative procedures to reduce the level of audit risk to an acceptably low level. Within these alternative procedures is the examination of subsequent cash receipts (including matching such receipts with the actual items being paid). In completing this review of subsequent receipts, it is important to take care to ascertain that (a) the check copy (and related remittance) provided by management is identical to the check that was deposited into the company’s bank account and (b) the bank account that the check is drawn on is indeed the account of the customer listed on the subledger. The circular flow of cash fraud model often relies on an auditor’s acceptance of inadequate audit evidence and explanations provided by management. Fraudsters will often play to these weaknesses by using scanning software to manipulate information within a scanned image.
What makes uncovering the previously outlined fraud scheme difficult is that (a) the entity making payment is not the same entity as the party being invoiced (if the party being invoiced is a legitimate entity) or (b) management effectively exercises control over the entity that is making the payment (if the entity is a shell company created by management or a collaborating outside entity).
Outside of common attributes of fraud in general, the following red flags may indicate a circular flow of cash scheme, especially if issues are noted during the confirmation process:
- Cash received in settlement of an invoice is drawn on an account different from that of the customer.
- Checks received in payment of an invoice are drawn on an account under a similar but not identical name as a legitimate customer (for example, Davis Inc. vs. Davis LLP).
- Checks that mask the payor identity (for example, official bank checks) are used to settle a customer invoice.
- Unfamiliar customers comprise a significant amount of sales or show increasing sales trends.
- Unfamiliar vendors comprise a significant amount of purchases.
- Unfamiliar customers have addresses similar to vendors or management.
- Purchase orders and shipping documentation do not reconcile to amounts being invoiced; however, payment is received regularly from the customer regardless.
The importance of professional skepticism and due professional care cannot be overemphasized when evaluating a company’s accounts receivable. When reviewing the viability of the customer base and performing accounts receivable confirmation procedures, it is imperative that these attributes come to the forefront of the thought process in order to detect improprieties such as the inflation of accounts receivable and sales through the circular flow of cash.
EXECUTIVE SUMMARY
John F. Monhemius (jmonhemius@durkingroup.com) is a senior manager for the Durkin Group LLC in Cleveland. Kevin P. Durkin (kdurkin@durkingroup.com) is the founder and managing director of the Durkin Group LLC in Parsippany, N.J.
To comment on this article or to suggest an idea for another article, contact Loanna Overcash, senior editor, at 919-402-4462 or lovercash@aicpa.org.
AICPA RESOURCES
Audit guidelines
- SAS no. 99 (AU section 316), Consideration of Fraud in a Financial Statement Audit, tinyurl.com/mecn7d
- SAS no. 67 (AU section 330), The Confirmation Process, tinyurl.com/l2dv9f
Conferences
- Practitioners Symposium, June 7–9, Las Vegas
- Forensic Accounting Conference, Sept. 30–Oct. 1, Boston
For more information or to register, go to cpa2biz.com or call the Institute at 888-777-7077.
FVS Section and CFF credential
Membership in the Forensic and Valuation Services (FVS) Section provides access to numerous specialized resources in the forensic and valuation services discipline areas, including practice guides, and exclusive member discounts for products and events. Visit the FVS Center at aicpa.org/FVS. Members with a specialization in financial forensics may be interested in applying for the Certified in Financial Forensics (CFF) credential. Information about the CFF credential is available at aicpa.org/CFF.
OTHER RESOURCES
Web sites
- Example of actual circular flow of cash fraud (Suprema Specialties Inc.)
- Commercial Finance Association
General fraud examples
- Financial Crimes Report to the Public (2007 cases made known involving the FBI Financial Crimes Section)
- FBI reports involving white-collar crime
- Association of Certified Fraud Examiners, articles related to fraud
