Plum Street Dialogue #4 – Some Fraud Schemes Involving Cash

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 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.

[As we join our friends in the shade of Glenn’s patio, Terrie is talking about one of her recent cases specifically as well as cash fraud schemes in general … she’s saying that there are numerous schemes that employees use to defraud organizations. The schemes generally involve cash, accounts receivable, inventory, purchasing, investments and fixed assets, as well as the manipulation of payroll and personal expenses.]

Terrie:  Cash defalcations, like the case I’m currently working on, are probably the most common of all employee embezzlement schemes. Since most companies keep relatively good control over cash, the schemes are frequent but rarely material.  A little more complex scheme involves kiting. Kiting is the process where two or more banks are used to create artificial deposits. Checks written on one bank are deposited in the other and then cash is removed from the second bank. In order to keep the checks from being returned, the fraudster writes new checks periodically. All kiting schemes require banks to pay on unfunded deposits.

Alex: In your experience, Terrie, what’s the best way to go about detecting cash frauds?

Terrie: I use several basic techniques to detect cash frauds. Classically, they include bank reconciliations, cut-off bank statements, surprise cash counts, investigation of customer complaints, journal entry review, and the review of historical sales and cost trends.

Alex: I just finished working a case involving accounts receivable.

Glenn: What do accounts receivable schemes look like?

Alex: There are about four that I’m aware of: lapping, fictitious receivables, diversion of payments on old written-off accounts, and borrowing against the receivables.

Glenn: Define lapping …

Alex: The term is used to describe a method of concealing a defalcation where cash received from a customer is misappropriated by the employee, and at a later date cash received from another customer is credited to the first customer’s account. The second customer’s account is credited still later by cash received by a third customer, and so on. These lapping schemes are usually detected when the scheme becomes too difficult to conceal, when an employee makes a mistake by not crediting the right account, or the customer subsequently complains (which they almost always do). Old or written-off accounts receivable are almost always vulnerable to theft by cashier and accounts receivable employees. Because few controls exist on written-off accounts receivable, subsequent payments can sometimes be diverted. That’s exactly what happened in the case I just finished.

Fictitious accounts receivable are also a common way businesses attempt to artificially inflate their assets and income. They are also sometimes furnish motive for salesmen and others to meet quotas and receive commissions.

Glenn:  According to the speaker at one of our Richmond Chapter’s recent training events, employees will even use the company’s accounts receivable as collateral for their own personal loans.

Alex:  Just as there are four basic schemes, there are four basic detection methods for accounts receivable frauds. They include matching deposit dates, customer confirmations, accounting cut-off analysis, and trend analysis on written-off accounts. Account receivables frauds can be prevented through the adequate segregation of duties. The collection of cash, posting of accounts receivable, and the writing off of old uncollectible accounts receivable should all be done by different personnel if possible. Also, some customer receipts can be made to a lock box rather than to the company’s normal mailing address. This allows the customer to make payments directly to the bank and therefore eliminate time delays.

Terrie:  Don’t forget inventories …because so many companies carry large inventories, these assets are particularly susceptible to abuse. The most frequent inventory scheme concerns the theft or appropriation of the company’s items. The theft of scrap sales proceeds is also pretty common. Because the amounts are generally insignificant to the company, scrap sales are usually not well controlled and good inventories aren’t kept.  In some instances, since inventory accounts are not generally reconciled until the end of the year, embezzlements can be charged to these accounts.

Alex: And how do you detect it? …

Terrie: Most inventory fraud is detected through missing financial documentation, physical inventory counts, or analytical review. If the company’s cost of sales has risen significantly from one period to the next, this could either be because of legitimate reasons or because embezzlements in significant amounts are being charged to the inventory accounts.

Glenn: And purchasing! …

Terrie: Right.  Don’t ever forget purchasing!

Glenn:  The purchasing function of a business is particularly vulnerable to employee abuses. Typical schemes involve fictitious invoices, over-billing, checks payable to employees, and conflicts of interest. Purchasing fraud doesn’t necessarily require collusion with another employee or an outsider, although it often occurs.  I recall a case where a vendor opened up a credit card account for the personal use of a client company’s purchasing officer.

Alex:  That’s a good one and, I would imagine, hard to detect.  Fictitious invoices are one of the most common red flags of employee fraud. They normally involve purchases for goods or services not delivered or rendered. An over-billing scheme is a method where the fraudster submits an artificially inflated invoice to her company for payment. The amount of the overpayment is then diverted or paid to the employee or an accomplice. In a few instances, employees simply make out checks to themselves, deposit the checks in their personal bank accounts, and then destroy them when they are returned in the company’s bank statement. Purchasing or accounts payable employees can also have duplicate payments issued for the same item. Conflicts of interest in purchasing occur when an employee, manager, or executive has an undisclosed interest in a business that supplies goods or services to his employer.

Glenn:  So, the bottom line, how are purchasing schemes generally detected in your experience?

Alex: By analytical review in some instances.  Going over the various general ledger accounts might reveal unusual or unexpected items.  The fraud examiner can also use the computer to facilitate analytical review of timing of bids, patterns of bids, amount of work, patterns of new vendors, and similar trends.

Terrie:  Duplicate addresses in the vendor file. And also addresses that look like addresses that match, like they are different companies, but they end up going to the same P.O. Box. That’s definitely one to look for. And going to a drop box. You know how you get situations where the address is let’s say 100 Warren Street, Suite 150. Well, that’s a drop box for post office box 150. You have to look for things like that. Vendors with post office boxes. You know you can have a post office box and have a check come to you. You should always have a street address. You should know for sure that’s a real street address or real company or just take the time to look it up.

[A pizza delivery man bearing two large boxes and an invoice appears at the edge of the patio and clears his voice…]

Glenn: Well, I see that dinner has arrived and we’ve only touched the surface … we can continue this discussion, if you want,  the next time we choose to meet.

Terrie:  Sounds like a plan!

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