Category Archives: Occupational Fraud

The Unsanctioned Invoice

Of all the frauds classified as occupational, one of the most pernicious encountered by CFEs is the personal purchase with company funds scam. I say pernicious because not only is this type of fraud a cancer, devouring it’s host organization from within, but also because this basic fraud scenario can take on so many different forms.

Instead of undertaking externally involved schemes to generate cash, many employed fraudsters choose to betray their employers by simply purchasing personal items with their company’s money. Company accounts are used by the vampires to buy items for their side businesses and for their families. The list of benefiting recipients goes on and on. In one case a supervisor started a company for his son and directed work to the son’s company. In addition to this ethically challenged behavior, the supervisor saw to it that his employer purchased all the materials and supplies necessary for running the son’s business. As the fraud matured, the supervisor purchased materials through his employer that were used to add a room to his own house. All in all, the perpetrator bought nearly $50,000 worth of supplies and materials for himself and various others using company money.

One might wonder why a purchases fraud is not classified by the ACFE as a theft of inventory or other assets rather than as a billing scheme. After all, in purchases schemes the fraudster buys something with company money, then takes the purchased item for himself or others. In the case cited above, the supervisor took building materials and supplies. How does this differ from those frauds where employees steal supplies and other materials? On first glance, the schemes appear very similar. In fact, the perpetrator of a purchases fraud is stealing inventory just as s/he would in any other-inventory theft scheme. Nevertheless, the heart of the scheme is not the taking of the inventory but the purchasing of the inventory. In other words, when an employee steals merchandise from a warehouse, s/he is stealing an asset that the company needs, an asset that it has on hand for a particular reason. The harm to the victim company is not only the cost of the asset, but the loss of the asset itself. In a purchasing scheme, on the other hand, the asset which is taken is superfluous. The perpetrator causes the victim company to order and pay for an asset which it does not really need in the course of business, so the only damage to the victim company is the money lost in purchasing the particular item. This is why purchasing schemes are categorized as invoice frauds.

Most of the employees identified by the ACFE as undertaking purchase schemes do so by running unsanctioned invoices through the accounts payable system. The fraudster buys an item and submits the bill to his employer as if it represented a purchase on behalf of the company. The goal is to have the company pay the invoice. Obviously, the invoice which the employee submits to his company is not legitimate. The main hurdle for a fraudster to overcome, therefore, is to avoid scrutiny of the invalid invoice and to obtain authorization for the bill to be paid.

As in the many cases of shell company related schemes we’ve written about on this blog, the person who engages in a purchases scheme is often the very person in the company whose duties include authorizing purchases. Obviously, proper controls should preclude anyone from approving her own purchases. Such poorly separated functions leave little other than her conscience to dissuade an employee from fraud. Nevertheless, CFEs see many examples of small to medium sized companies in which this lapse in controls exists. As the ACFE continues to point out, fraud arises in part because of a perceived opportunity. An employee who sees that no one is reviewing his or her actions is more likely to turn to fraud than one who knows that her company applies due diligence in the attempt to detect all employee theft.

An example of how poor controls can lead to fraud was the case where a manager of a remote location of a large, publicly traded company was authorized to both order supplies and approve vendor invoices for payment. For over a year, the manager routinely added personal items and supplies for his own business to orders made on behalf of his employer. The orders often included a strange mix of items; technical supplies and home furnishings might, for instance, be purchased in the same order. Because the manager was in a position to approve his own purchases, he could get away with such blatantly obvious frauds. In addition to ordering personal items, the perpetrator changed the delivery address for certain supplies so that they would be delivered directly to his home or side business. This scheme cost the victim company approximately $300,000 in unnecessary purchases. In a similar case, an employee with complete control of purchasing and storing supplies for his department bought approximately $100,000 worth of unnecessary supplies using company funds. The employee authorized both the orders and the payments. The excess supplies were taken to the perpetrator’s home where he used them to manufacture a product for his own business. It should be obvious that not only do poor controls pave the way for fraud, a lack of oversight regarding the purchasing function can allow an employee to remove huge amounts from the company’s bottom line.

Not all fraudsters are free to approve their own purchases. Those who cannot must rely on other methods to get their personal bills paid by the company. The chief control document in many voucher systems is the purchase order. When an employee wants to buy goods or services, s/he submits a purchase requisition to a superior. If the purchase requisition is approved, a purchase order is sent to a vendor. A copy of this purchase order, retained in the voucher, tells accounts payable that the transaction has been approved. Later, when an invoice and receiving report corresponding to this purchase order are assembled, accounts payable will issue a check.

So in order to make their purchases appear authentic, some fraudsters generate false purchase orders. In one case, an employee forged the signature of a division controller on purchase orders. Thus the purchase orders appeared to be authentic and the employee was able to buy approximately $3,000 worth of goods at his company’s expense. In another instance, a part time employee at an educational institution obtained unused purchase order numbers and used them to order computer equipment under a fictitious name. The employee then intercepted the equipment as it arrived at the school and loaded the items into his car. Eventually, the employee began using fictitious purchase order numbers instead of real ones. The scheme came to light when the perpetrator inadvertently selected the name of a real vendor. After scrutinizing the documents, the school knew that it had been victimized. In the meantime, the employee had bought nearly $8,000 worth of unnecessary equipment.

Purchase orders can also be altered by employees who seek to obtain merchandise at their employer’s expense. In one instance, several individuals conspired to purchase over $2 million worth of materials for their personal use. The ringleader of the scheme was a low-level supervisor who had access to the computer system which controlled the requisition and receipt of materials. This supervisor entered the system and either initiated orders of materials that exceeded the needs of a particular project or altered existing orders to increase the amount of materials being requisitioned. Because the victim organization had poor controls, it did not compare completed work orders on projects to the amount of materials ordered for those projects. This allowed the inflated orders to go undetected.

Another way for an employee to get a false purchase approved is to misrepresent the nature of the purchase. In many companies, those with the power to authorize purchases are not always attentive to their duties. If a trusted subordinate vouches for an acquisition, for instance, busy supervisors often give rubber stamp approval to purchase requisitions. Additionally, employees sometimes misrepresent the nature of the items they are purchasing in order to pass a cursory review by their superiors.

Instead of running false invoices through accounts payable, some employees make personal purchases on company credit cards or running accounts with vendors. As with invoicing schemes, the key to getting away with a false credit card purchase is avoiding detection. Unlike invoicing schemes, however, prior approval for purchases is not required. An employee with a company credit card can buy an item merely by signing his or her name (or forging someone else’s) at the time of purchase. Later review of the credit card statement, however, may detect the fraudulent purchase.

As with invoicing schemes, those who committed the frauds were often in a position to approve their own purchases;, the same is often true with credit card schemes. A manager in one case, reviewed and approved his own credit card statements. This allowed him to make fraudulent purchases on the company card for approximately two years.

Finally, there is, the fraudster who buys items and then returns them for cash. A good example of such a scheme is that in which an employee made fraudulent gains from a business travel account. The employee’s scheme began by purchasing tickets for herself and her family through her company’s travel budget. Poor separation of duties allowed the fraudster to order the tickets, receive them, prepare claims for payments, and distribute checks. The only review of her activities was made by a busy and rather uninterested supervisor who approved the employee’s claims without requiring support documentation. Eventually, the employee’s scheme evolved. She began to purchase airline tickets and return them for their cash value. An employee of the travel agency assisted in the scheme by encoding the tickets as though the fraudster had paid for them herself. That caused the airlines to pay refunds directly to the fraudster rather than to her employer. In the course of two years, this employee embezzled over $100,000 through her purchases scheme.

When You Assume

by Rumbi Petrozzello
2018 Vice President – Central Virginia ACFE Chapter

On November 8, 2007, in the small town of Constantine, Michigan, 11-year-old Jodi Parrack was reported missing. Residents from the surrounding region volunteered to search for the missing girl, including Ray McCann, a police reservist. During the search, Ray suggested to Jodi’s mother, Valerie, that they should search for Jodi in the local cemetery. Valerie and Ray did so and, tragically, found her daughter there; she had been murdered.

Almost immediately, Ray came under suspicion. His reaction to Jodi’s death appeared to some of the investigators to be suspicious and why had he suggested that he and Valerie go to the cemetery, of all places, to look for Jodi? Then, during their subsequent investigation, the police found Jodi’s DNA on Ray’s body; according to Ray this was because he had pulled Valerie away from Jodi when he and her mother discovered the child’s body.

For years, Ray was under suspicion. He was brought in for questioning by the police on multiple occasions, and his answers, as far as the police were concerned, were not particularly convincing. He claimed to have been in one place and the police said that there was proof that he was not there. Seven years after Jodi’s murder, Ray was arrested and charged with perjury, related to the answers he had originally given the police; this seems to have been a tactic the police employed to hold him while they continued to try to gather enough evidence to charge him with Jodi’s murder.

While Ray was being held and facing from two to twenty years behind bars, another girl was attacked; she fought back, escaped and led the police to another man, Daniel Furlong. It turned out that Furlong’s DNA had been found on Jodi’s body during the original investigation as well as Ray’s and yet, the police had persisted in focusing solely on Ray. It was also revealed that the authorities were not honest when they told Ray that they possessed evidence Ray was lying. All the police really had was a deeply held conviction that Ray was being deceptive, leading to their determination to somehow develop evidence to validate that feeling.

By the time Ray was released after spending 20 wasted months of his life behind bars, he had lost his job, his family and the trust of the community in which he lived and which he had hoped someday to serve.

As Fraud Examiners and/or Forensic Accountants, we are engaged to investigate alleged wrongdoing and to follow up on leads as we work to resolve often confusing and contradictory matters. As we seek evidence, interview people and try to figure out what happened and who did what, it can be all too easy to make the mistake of viewing a red flag as somehow constituting proof. If someone giggles when they’re telling you they know nothing; if a person taps her foot throughout an interview, or if someone is extremely helpful, none of those things in themselves means anything definitive in resolving the question as to whether or not they have done anything wrong, let alone illegal.

Professional skepticism is a CFE’s tendency not to believe or take anyone’s assertions at face value, a mental tendency to ask every assertion to “prove it” (with evidence). The inevitable occurrence of confusion, errors and deception in all situations involving actual or suspected fraud dictates this basic aspect of professional skepticism. Persuading a skeptical CFE or forensic accountant is not impossible, just somewhat more difficult than persuading a normal person in an everyday context. Our skepticism protects the Ray McCann’s of this world because it’s a manifestation of objectivity, holding no special concern for preconceived conclusions on any side of an issue. Skepticism is not an attitude of being cynical, hypercritical, or scornful. The properly skeptical investigator asks these questions (1) What do I need to know? (2) How well do I know it? (3) Does it make sense?

Professional skepticism should lead investigators to appropriate inquiry about every clue involving seeming wrong doing. Clues should lead to thinking about the evidence needed, wringing out all the implications from the evidence, then arriving at the most suitable and supportable explanation. Time pressure to complete an investigation is no excuse for failing to exercise professional skepticism and bias and prejudice are always unacceptable. Too many investigators (including auditors) have gotten themselves into trouble by accepting some respondent’s glib assertion and stopping too early in an investigation without seeking facts supportive of alternative explanations.

A red flag means only that further investigation is warranted; it definitely does not mean that the examiner should shut down all other avenues of investigation and it certainly does not mean that an attempt should ever be made to make the crime fit the person. In the sad case of Ray McCann, the police continued to pursue him to the exclusion of all others even though they had found someone else’s DNA on Jodi’s body. They never appeared to be even looking for any other suspect. Even when Daniel Furlong subsequently confessed to murdering Jodi, the local authorities still persisted in implying that Ray was somehow connected to the crime; in the face of all contradictory evidence, the police still stubbornly refused to let go of their original hypothesis.

As we pursue our work as forensic accountants and fraud examiners, we should be constantly reviewing our hypotheses and assessing our approaches.

• Are we trying to make evidence fit the facts as we initially suppose them to be?
• Are we ignoring evidence because it does not fit the story we’re trying to tell?
• Are we letting a particular person’s behavior cloud a more objective judgment of the totality of what’s going on?

Often, even after a person has been cleared of suspicion in a case, we hear parties involved in the investigation make statements along the lines of, “I just know they are good for something.” Fortunately, our practice is not founded on feelings and gut instincts; our practice, and profession, is one that relies on evidence. As you’re investigating a matter, keep in mind:

• Following your defined process and procedure throughout is paramount to investigative success. Even if someone or some aspect of a case looks totally transparent within the context of the investigation, be thorough and follow your evidence all the way through.

• If your findings do not support your original premise, don’t try to force things. Step back and ask yourself why this is the case. Ask yourself if you need to reconsider your foundational hypothesis.

• Beware of confirmation bias – that is be careful that you are not looking only for data that reinforces the conclusion(s) that you have already reached (and, in so doing, ignoring anything that might prove contradictory).

• Even if your team is determined to work the assignment in a particular direction, make sure you speak up and let them know about any reservations you might have. You may not have the popular position, but you may end up expressing the critical position if it turns out that there is other evidence in light of which the conclusions the team has made need to be adjusted.

In summary, when you feel it in your gut and you are absolutely sure that you are right about a hypothesis, it’s very difficult to look beyond your conviction and to see or even consider other options. It’s vital that you do so since, as the ACFE has pointed out so many times, there is a hefty price to be paid professionally for ignoring evidence which eventually proves to be critical simply because it appears not to corroborate your case. Due professional care requires a disposition to question all material assertions made by all respondents involved in the case whether oral or written. This attitude must be balanced with an open mind about the integrity of all concerned. We CFEs should neither blindly assume that everyone is dishonest nor thoughtlessly assume that those involved in our investigations are not ethically challenged. The key lies in the examiner’s attitude toward gathering the evidence necessary to reach reasonable and supportable investigative decisions.

A Piece of String

stringOne of our local members is a part time adjunct accounting instructor at a community college.  She recently asked if any of her fellow chapter members could supply a teaching example of an occupational fraud that started out simply and then escalated.   Turns out, one of our out of state readers had just such an example and I thought I’d share it with you.

The ACFE tells us that any organization or department is susceptible to occupational fraud. The following example illustrates how important it is for every management to analyze their internal accounting controls continuously as well as those over the general control environments of all their operating departments. Organizations and their management commit a critical error and actually enhance opportunities for fraud by trustingly believing that fraud can’t occur in their organization. Fraud prevention is as much about the awareness of the existence and potential for fraud as it is about the development of key controls to safeguard assets.

Fred Blevins was the manager of the kitchen fittings section of a large, luxury kitchen design and installation company.  The company employed a host of equipment vendors and installation subcontractors.  As the section manager, Blevins was responsible for completion of requisition forms for the purchase of outside resources such as custom fittings, outsourced kitchen installations, parts, supplies, and production consumables. Blevins also developed section cost budgets and approved vendor invoices for payment of items originally requisitioned through the fittings section. Blevins reported to the interior design director, Sally Jefferson, who relied heavily on Blevins’ judgment and honesty in completing the non-design related responsibilities associated with managing her department.

Even though his job at the design company provided a good living, Blevins still found it tough to make ends meet and to sustain the lifestyle to which he had become accustomed. With two sons, both trying to purchase their first homes and a daughter set to enter college, Blevins was beginning to feel the financial burden of the coming higher education and looming mortgage related expenses. Furthering Fred’s financial stress was his fondness for gambling. Fred would regularly tell co-workers of his trips to the casinos in a neighboring state. And while this talk frequently included boasts of gambling winnings, the truth was these trips more often resulted in losses.

In searching for a way to address his various financial pressures, Fred opportunely noticed that the accounting controls over the requisition of outside goods and services at his company were extremely weak or, in some cases, nonexistent.  Blevins soon devised a scheme that would allow him to easily circumvent the weak controls that were in place. When functioning correctly, the company purchasing process was fairly straightforward. All requisitions associated with purchasing consumables had to be approved by the requisitioning department’s manager. Once approved, the requisition was submitted to accounting for the issue of a purchase order. Before issuing the purchase order, the accounting department checked that the purchase was within the budgetary constraints for the coinciding expense category and that the vendor was on the approved vendor list. Although the accounting department required that approved vendors provide a company name, address, telephone number, and principal contact, there was no verification or due diligence process associated with establishing an approved vendor in the accounting system – a weakness that Fred found too tempting to resist.

Fred’s scheme began simply enough with a shakedown of the vendors who supplied goods and services to the kitchen fittings section. He knew that these vendors relied on his satisfaction and approval to continue their business relationship with his company. Fred began to take advantage of his authority by requiring that vendors provide him with monetary gifts to remain on his company’s rotation for sales. Vendors that refused to cooperate with Blevins would risk reduction in orders. To maintain business volume, most vendors “played the game” and acquiesced to Fred’s requirement.  Fred’s scheme quickly evolved, and he soon began requiring that vendors pay him a “commission” on all of their sales to his company. The vendors did not report this activity to the company management because of fear of reprisal and the resulting substantial loss of business revenue.

Blevins’ greed soon increased, and he began to favor one vendor in particular, a company owned by a man named Stan Fields. Fields agreed to a larger commission than the other vendors to knock out the competition and get a larger volume of business. Fields obviously believed that the return in revenue and profits was worth the risk of being discovered.

As Blevins’ and Field’s bank accounts grew, so did Fred’s confidence in his ability to continue successfully defrauding his employer. Eventually, he decided to advance the scheme further by setting up his own fictitious vendor with Fields, FBSF Inc., to bilk his employer out of even more money. When Fred submitted the application for FBSF to be approved as a new vendor, the accounting department didn’t even notice that the president of FBSF was the same Stan Fields who owned a competing vendor company. The department also failed to notice that the address listed on FBSF’s application was a post office box. At a minimum, a routine check of the corporation’s standing with the local secretary of state’s office would have quickly revealed that this vendor was a sham.

In a classic example of a pass-through billing scheme, the two men used FBSF to purchase products from Field’s company and resell them to Fred’s company at a marked-up rate. Thanks to the proceeds of what can clearly be defined as occupational fraud, Blevins and Fields were prospering. Over the course of a year and a half, Fred embezzled nearly $300,000 and Fields shared in the excess profits from every transaction run through FBSF.

Fred’s scheme finally unraveled when he became ill and the company was forced to delegate his duties to another employee during his absence. When Fred’s replacement contacted one vendor regarding the purchase of some fittings, the vendor’s response was “it isn’t my turn yet.”  This unusual response led to further inquiry and the discovery of all the kickbacks required by Blevins in his fraudulent dealings with company vendors. As the investigation continued, Fred’s employer uncovered the fictitious vendor he set up with Fields. When confronted, Fred initially denied any involvement in the scheme, but could not explain why his company, FBSF, received checks from his employer. As a result, Fields company lost all of its considerable business with Fred’s employer and was quickly forced to shut down its operations. Fred’s position was immediately terminated. Criminal charges were filed against Blevins and Fields and restitution was sought.

The bottom line is that occupational frauds, if initially successful, almost always escalate and diversify.  There’s an old auditor’s question (something of an adage, really), “How long is a piece of string?”  When applied to fraud examination, it means that there is usually more than one initial scenario to look for in any instance of fraud.  Fred’s scheme started out as a simple shake down of vulnerable vendors and escalated in a relatively short period of time from kickbacks to a full scale fictitious vendor pass through scheme with several sub-schemes thrown in along the way.

The teachable fraud prevention moment for the accounting class is that organizations should have a policy regarding new vendor approval that requires due diligence on the part of the accounting department. This process should include verification that the business is a legal business in the state represented, that the entity has a legal federal identification number and proof of liability insurance, and that the potential vendor’s owners are checked against other vendors’ owners and employees of the organization. Finally, when vendors provide a post office box as an address, the firm’s physical location must always be verified.

Plum Street Dialogue #6 – October Light

carved-pumpkinOver the years I’ve been involved in on-going discussions with any number of practicing certified fraud examiners, many of whom have provided me with excellent insights on every aspect of the profession.   Using the notes I’m constantly taking, I thought it might be fun (and instructive) to cast some of their thoughts on actual practice in the form of a series of fictitious dialogues on everything fraud examination.  This third is a discussion on the topic of financial fraud; the dialogue is between three composite fraud examiners, Glenn, Alex and Terrie.  Our three friends meet, as before, after work, in the garden behind Glenn’s house on Plum Street in the Fan District of Richmond, Virginia.

[There’s a chill in the air, stirring the falling yellow leaves from the sidewalk into the gutters as our friends climb Glenn’s front steps to his porch, on through the front door and into their chairs ranged in front of his crackling, living room fire …]

Terrie:  [to Glenn and accepting his offer of a cup of coffee] I see you got the fireplace cleaned … no more wood smoke in the living room!

Glenn: I know, I let the problem go on too long … my bad.  Summer came to an end and I just couldn’t put it off any longer.  Alex, how’s your case going?

Alex: The one Terrie and I were talking about last time? I had a representation about a material point in the case I had to prove is false. And I had to prove that the defendant knew it was false at the time she made it.

Terrie: [sipping her coffee]: This is where we run on the rocks in fraud cases very easily – or relatively easily.

Glenn:   By which you mean?

Terrie: Just that other key elements of most fraud cases are relatively easy to prove, but intent is hard to prove …

Alex: … because, in this case,  I had to prove to the jury what the defendant was thinking when she sold my client that piece of property to which she said she had free and clear title.  In other words, her state of mind at the time of the alleged fraud is the key element to the entire case.

Glenn:  It always seems to turn out that way, doesn’t it?  And that’s sort of ironic because as CFEs and auditors and accountants, we generally think of frauds as being paper cases – debits and credits, columns of numbers. But in its most pure form fraud has nothing to do with numbers; it has to do with behavior and psychology, the reason being that every single fraud case – fraud, bribery, conflicts of interest, embezzlement – all of them ultimately depend on proving fraudulent intent.

Terrie: Right.  If I take some money from you or from your client, that’s not embezzlement unless you prove that I didn’t take it accidentally. If l accept a kickback, it’s not a crime until you prove that it was given to me to corrupt and influence me.

Alex: And, as we were all taught in college so long ago, all fraud or misrepresentation cases include a material false statement; a knowledge of the statement’s falsity; reliance on the false statement by the victim; and, damages suffered as a result of that false statement.  Most clients don’t understand that an actual loss is not even necessary to sustain a criminal case, but most of the time this requirement exists in civil frauds. In all fraud cases, though, the plaintiff must prove that the false statement was intentional and part of a deliberate scheme to defraud.  The intentional part is the hard part!

Glenn: So every single type of fraud has this intentional element that may be extremely difficult to prove. Maybe if Alex’s defendant was close to a colleague of the plaintiff and she cheated her, or maybe if the defendant pulled this same scheme 100 times before, or maybe a relative will testify that the defendant told him what she was going to do, intent would be easier to prove!  But the bottom line is we have to have some sort of proof that the defendant knew that she was lying to her victim.  Because, under the law, there is no such thing as an accidental or negligent fraud.

Terrie: There is recklessness though.  It’s rare but in some circumstances – recklessness is enough. For example, if a new company wants to sell shares of stock to the public and they really have no idea what their financial statements are going to look like, but they just sit around a kitchen table and say, “Gee, maybe we should say we’re going to make $5 million next year; maybe we should say we’re going to make $20 million next year,” and they’re just making it up off the top of their head, they’re reckless. And they disseminate those numbers to the public and the public buys the stock and it collapses, and then they find out that they just made up those numbers. Well, the company might say, “We didn’t know it was false.” But the court will say, “Well, you were so reckless, you were just pulling numbers off the top of your head.”  That’s almost as bad as intentional. So in those rare circumstances, like with securities litigations and things like that, recklessness is enough.

Alex: Good point. Now, the judge in my case will instruct the jury that they can infer intent from all of the facts and circumstances. Again, it’s a real curiosity in the law because intent is the most important element of fraud – it’s the most difficult one to prove. It has to be proven in every case, and yet it is the only element that the judge tells the jury that they can infer.  Why?  Because there’s no way to know what somebody else was thinking.  Defendants aren’t so stupid as to tell you, unless you get a co-conspirator. A co-conspirator will tell you, “I confess … it was all his idea.” And then you’ve got to corroborate even that.

Terrie: So, you can infer it from the facts and circumstances. In a well-organized, simple, clear fraud case it will be apparent. Now, sometimes we get lucky and in addition to the facts and circumstances we find that the defendant did something that is illustrative of intent.

Alex: In my current case she altered a document in the presence of a witness and the witness was willing to testify.

Glenn: The classic way to prove intent in occupational fraud is through repetitive activity.  Every time the embezzler takes money, he intends to pay it back.  One fraudulent action leads to another and another and another.  It’s obvious the embezzler intended to do what he did and why he did it.

[Stretches and yawns].  I don’t know about you guys but drinks and a little dinner sound good to me right now.

Alex: I couldn’t agree more.

Plum Street Dialogue #2 – The Worst Case Hypothesis

patio-set-5Over the years I’ve been involved in on-going discussions with any number of practicing certified fraud examiners, many of whom have provided me with excellent insights on every aspect of the profession.   Using the notes I’m constantly taking, I thought it might be fun (and instructive) to cast some of their thoughts on actual practice in the form of a series of fictitious dialogues on everything fraud examination.  This second is a discussion on the topic of the preliminaries of a fraud examination, especially hypothesis formulation; the dialogue is between three composite fraud examiners, Glenn, Alex and Terrie.  Our three friends meet, as before, after work, in the garden behind Glenn’s house on Plum Street in the Fan District of Richmond, Virginia.

Glenn:  (Switching on the patio floor fan) At least it’s not as humid as it was for our last meeting.  How’s the iced tea?  Anyway, I thought we might talk this afternoon about hypothesis testing.

Terrie: How so?

Glenn: Well, let’s say an allegation lands on your desk that Susie, who works in the purchasing department at XYZ Services, is taking kickbacks from a supplier.  To my mind, the first thing to do is to analyze the available data.  So, what available data would we analyze with respect to Susie?

Alex:  I guess I’d look at all the accounts she’s working on or controls … then, I always try to think like a crook.

Terrie: That’s exactly right.  Management, especially accounting type people, have a particular blind spot.  They don’t think that anybody would be stupid enough to steal money and put it in their own bank account, for example. Well, the only person more stupid than somebody that would put stolen money in their own bank account is the fraud examiner who doesn’t look in that bank account.  So, what we’ve got here in Susie’s case, we’ve got a purchasing official at XYZ Services Company that we suspect may be taking a kickback. And, to investigate, we can do anything we want. What do we do?  As you say, look at her bank account. Then at the accounts on the books and the related documentation her actions affect.

Alex: So, now, thinking like a crook. If Susie were taking a kickback from Steve to buy Steve’s merchandise over a period of time, what is Susie going to do with respect to Steve? Is she going to buy more from Steve than anybody else? So one of the things we can do in analyzing data related to her is we’ll look at the trends to see if one type of vendor is getting the business and other vendors are dropping off. That’s one thing we can do with our own books and records. Analyzing data. Why would Steve pay Susie a kickback? He has a better profit on his product. So in other words, let’s say that Susie is in charge of buying widgets, and let’s say on the open market widgets are a $100 a dozen. Is Susie going to be paying Steve a $100 a dozen for her widgets? Nope, I think she would be paying him more.  The market price is $100 a dozen. Why in the world would anyone pay Susie a kickback if they could win her business on the basis of the best product at the lowest price? So if widgets are $100 a dozen and Susie is taking a kickback, then Steve is always going to be charging a minimum of $100 a dozen plus the cost of Susie’s kickback.

Terrie:  In this example, to me, the price of the widgets is very, very important. Because if widgets are $100 a dozen and the vendor is paying a kickback, we’re either paying more than $100 a dozen or not getting the same quality widgets that we would have gotten on the open market. So, the individual red flags are that the company might be experiencing poor quality, higher prices, and poor delivery terms; maybe all three. If we look we’ll probably also find a lack of competitive bids.

Alex: Right.  Before we interview the first person, before we talk to the first person, we analyze whatever data related to them we can. I can’t tell you how many, otherwise well-qualified people, if they get an allegation that Susie is taking a kickback, will call Susie in and sit her down and ask, “Susie, are you taking any kickbacks?” Sure, you have to ask Susie that question eventually but not until you’ve done all your homework by laying the proper foundation for the question; that means document, document, document.

Glenn:  At this point I create a hypothesis and the hypothesis is always the worst case scenario.  My hypothesis is that Susie is taking kickbacks. We can also have a hypothesis that Mary is embezzling money. We can have a hypothesis that Cheryl is paying bribes to someone. We can use the concept of a hypothesis with virtually any kind of fraud case, but it’s always the worst case scenario. By creating and working with the worst case scenario, I don’t have any surprises.

Alex: And the next step is testing it.  To me, testing the hypothesis involves creating a “what if’ scenario. Once the basic hypothesis is tested, the fraud examiner might find that all the facts just do not fit a particular scenario. It then becomes necessary to refine and amend the process going forward. One fact seems to fit most fraud scenarios: fraudsters tend to spend their money.  Take a bank clerk that steals a million dollars.  She and her husband apply to join a country club to go with the new custom home they build with her loot.  The country club can’t understand how a bank clerk can afford the country club’s $100,000 entrance fee and so calls the bank; the bank looks into it and the embezzlement unravels.  Conspicuous spending may be the most important red flag that, sooner or later, trips up most fraudsters. Now, in Susie’s case, Susie works for us and she’s taking a kickback from an outside vendor. Okay, which one is the co-conspirator and which one is the target?

Glenn: Well, it depends on your perspective. If we have to give up one person to make this case, are we going to give up our own employee or are we going to give up the outside vendor? I would certainly give up the outside vendor to get our own employee; probably you guys would as well. And so the outside vendor is going to be the co-conspirator and Susie is going to be the target. But, under the law who do you think is guiltier? It doesn’t matter; under the law they’re both equally guilty.

Terrie:  Most of the time the target is interviewed last, after all necessary facts are obtained. If the accused is culpable of the offense, the examiner’s goal is to obtain a legal, admissible, and binding confession of guilt. The fraud examiner must prove or disprove each and every legal element of the offense under investigation. Most fraud and white-collar crime have common elements, such as intent, disguise of purpose, reliance by the victim, voluntary victim action, and concealment of the offense.

Glenn:  Good point … I think we can wrap it up at that and all go in to dinner.  Just one last thought … a pat on the back for accountants.  It’s a lot easier to teach an auditor how to investigate than it is to teach an investigator how to audit. If you stop and think about the audit techniques that we all use, what do you use more than the interview process as an auditor? What do we use more than that? I can’t think of anything. For that reason, it’s been my experience that accountants in general make outstanding investigators. And that said, lawyers don’t investigate white-collar crimes violations; they have to engage an accountant/fraud examiner for that.