Ethics or Employment?

Editor’s note – With the exception of Frank, the per diem accountant, the author has changed the identities of the individuals and companies involved in this case.  

My surprise first encounter with fraud began with a search to find a better job. It ended with losing my new position, but keeping my integrity and CPA license intact.

The job opportunity looked great. It was a finance manager position with an airline food catering company (AFC) that was publicly traded in the United Kingdom. Essentially I would be the chief accountant of the company’s U.S. subsidiaries (AFC Subs), which consisted of six entities. It would be more money, closer to home, and the work hours wouldn’t be too bad. All the things a guy with a growing family could want. In the interview, AFC Subs management seemed pleasant, and the consolidated financial statements of the subsidiaries appeared to be in good health. The decision was easy. I accepted their offer.

I joined the company just in time to close the books for October. Obviously, I requested the prior month’s financial statements, but, surprisingly, the controller couldn’t produce the balance sheet. Consequently, we had to construct the October income statement using estimated financial data gathered throughout the operation. We were able to publish a monthly flash report – or profit and loss statement – to the U.K. parent just in time. Well, I should’ve known by this point that something was drastically wrong. As an accountant it was apparent to me that AFC Subs didn’t maintain the most basic accounting records – a sure sign that the internal control structure at AFC Subs was nonexistent.

Financial Statement Fraud 

Over the next few months, with the help of an outside computer consultant who specialized in the accounting software used at ACS Subs, we began reconstructing the financial statements. The software was a cumbersome DOS-based application and was probably the reason why I didn’t receive a balance sheet when I asked for it. The consultant recommended that we use compatible software that would allow me to extract the period-ending balances by general ledger account and by entity, and download them into a spreadsheet. After several days of scripting the macros to extract the data, we were able to compile the consolidated financial statements for all six entities.

After about an hour or so of reviewing the financial statements, I went into shock. The inter-company accounts didn’t balance with each other. Most of the cash balances were negative and the accounts receivable control account didn’t reconcile to the subsidiary ledger. There also was an excessive amount of other unsubstantiated asset and deferred asset accounts with large balances.

To make matters worse, AFC Subs was heavily laden with debt, tens of millions of dollars in municipal development bonds – not to mention the insignificant revenues and substantial losses that led to a large accumulated deficit.

As discouraged as I was with this revelation, I tried to stay focused and think positively. “That’s why they hired me,” I thought to myself, “to help them straighten this out.” So I proceeded in my usual routine to compile data from the operations, estimate the unrecorded liabilities, and record the accruals, which generated what I felt were reasonably accurate numbers.

However, that’s when I began to see management’s penchant for creative accounting. The controller, Jack, presented my monthly financials to Randy, a longtime AFC employee who had come over from the United Kingdom to serve as vice president of operations and sales for the subsidiaries. Upon looking at my numbers, Randy commented, “These profit margins can’t be right. We should be at approximately 46 percent, not 39 percent. Did we record those sales for TSC Airways?”

“Yes,” I replied. “I reviewed the sales invoices and sales accruals with Betty, the accounts receivable manager.”

But Randy insisted that we weren’t capturing all the transactions in the month. He demanded that adjustments be recorded to reflect what he felt was an accurate picture of the month’s financial status. Needless to say, none of the adjustments he suggested had supporting documentation, or, for that matter, any factual basis. These adjustments included:

• prematurely accruing sales that occurred subsequent to month’s end. (Randy rationalized that the goods were ready to ship the next morning after preparing the month’s end.);
• deferring current-period expenses, recording them on the balance sheet in other asset accounts, and not reversing or relieving them in the following month; and
• prematurely recognizing vendor credits and applying them against cost of goods sold before receiving agreements from the suppliers (to lower the cost of goods sold incurred for the current month).

That’s when it dawned on me that Randy was expected by his peers over in the United Kingdom offices to meet certain earning levels, or, at the very least, minimize the losses. As I examined prior profit and loss statements, it became apparent that AFC Subs was unable to generate income or positive cash flow. Randy’s attempt to salvage or prolong the operation’s existence was through these fraudulent alterations to the financial statements. Local management’s integrity and ethical values had been severely confined and negatively impacted by the head office’s unrealistic expectations to achieve goals. Even worse, AFC Subs had only one person who ultimately was in charge of making decisions – another element that made the environment ripe for fraud.

As Randy’s financial tales got longer, my patience grew shorter. Consequently, I was cut out of the month-end review process. Instead, Jack came into my office and told me that we had to make some last-minute adjustments. When I asked him for the supporting documentation, he just gave me one of Randy’s longer stories. I knew the journal entries were fictitious, so I firmly told Jack, “ If you want to record these entries, you’re going to have to do it yourself.”

I left the office that evening without recording the entries. The following morning Jack approached me and indicated that he had recorded the adjustments and left the revised financial statements on my desk. I noticed that the $500,000 loss from the prior evening’s financials was now only $200,000.

I had to decide whether to blow the whistle or keep quiet. With little hesitation, I called William, the internal audit director in London, and briefed him on the fictitious numbers. He decided to fly in the following week to visit AFC Subs. He also requested that I compile a spreadsheet of the most recent profit and loss statement reported to London and reduce it by the fictitious journal entries to arrive at the actual financials for the current month.

At this point, I had gained the support of U.K. management to dissect the financial statements to prepare for an upcoming audit to be performed by an outside CPA firm. In prior years, the CPA firm only reviewed AFC Subs’ financial statements; however, this year, quite by coincidence, the firm was performing a full audit. It was time to clean up the financial statements and make things right.

William and I soon discovered that we were unable to support significant amounts of inventory, fixed assets, and other assets. Further examination of the financial records revealed that AFC Subs hadn’t accrued for and was also in arrears in paying port fees amounting to more than $200,000. (Port fees, which are equivalent to taxes and based on gross income, are mandatory for airport-based companies.) Additionally, the inventory pricing didn’t properly reflect the value due to outright price inflation or unadjusted old prices that had since declined. This, apparently, was another tool used to manipulate the cost of goods sold to depict inflated profit margins. The overstated inventory was deducted from goods available for sale to arrive at cost of goods sold.

In a two-year period, AFC Subs management had manipulated the finances to sufficiently cover up more than $2 million in losses, which we later had to write off. If I hadn’t blown the whistle, the deception probably would’ve continued.

U.K. management decided not to reprimand Jack because he was following his supervisor’s instructions, and he continued working for the company. The U.K. offices also decided to keep Randy, but stripped him of his oversight authority on financial statements. From that point onward, I was instructed to have the final word on the company’s finances – a situation that caused quite a bit of tension between Randy and me for the remainder of my time at AFC Subs.

Unfortunately, the lack of integrity among AFC Subs management had set forth the perfect environment for others in the company to commit fraud. Preparing for the company audit, which was about to get under way, opened the proverbial can of worms.

Disbursements Fraud 

As most of the financial records at AFC Subs weren’t properly maintained or monitored on a timely basis, neither was the bank reconciliation. Given the backlog of work, I recruited a per diem accountant named Frank, who had worked for AFC Subs in the past. I asked Frank to work on the bank reconciliation, informing him that we were about three or four months behind.

Frank meticulously verified the thousands of check numbers on the bank statements and examined each canceled check. Soon Frank noticed that one check was missing and asked me if I knew where it was. “I haven’t seen it, Frank,” I replied. “Why don’t you ask the clerks in accounts payable.”

Frank asked Annie, one of the clerks, about the missing check. Annie’s face went blank and her mouth dropped open. She immediately rummaged through her desk, presented the missing check, and confessed to stealing it. She had made it payable to her boyfriend and forged the authorized signature. Annie said she needed the money for repairs to her boyfriend’s car. She anxiously asked Frank not to tell anybody, but he told her he couldn’t do that. So Annie stood up to leave and said, “You know where to find me.” We later sent the police to her house to arrest her. She then admitted to stealing another check. We subsequently examined thousands more canceled checks, but didn’t turn up any additional stolen ones. Annie’s scheme amounted to approximately $10,000: the first check was for $8,000, and the second was for $2,000.

How did Annie commit this fraud? 

She was responsible for vouching the vendor invoices into the accounts payable (A/P) system, selecting invoices for payment, and printing the checks. Due to computer system limitations, Annie had access to the A/P vendor maintenance function, which allowed her to edit the vendor name. Annie would record a fictitious transaction for ABC Corp., a major supplier. Then, between the time of selecting the vendor invoice for payment and printing the check, Annie would change ABC Corp. to J. E. Samsone – her boyfriend’s initials and last name. After printing the check, she would change the vendor’s name back, so the system would reflect a payment to ABC Corp. Because AFC Subs’ purchase volume with ABC Corp. was rather high, the dollar amount of Annie’s altered checks was relatively immaterial. And vendor subsidiary accounts were never reconciled with vendor records, so the fraud probably wouldn’t have been uncovered without Annie’s confession.

In a controlled A/P environment, different employees are assigned to approve transactions, maintain detail ledgers, receive or disburse funds, and maintain custody over collateral. With the exception of signing checks, Annie could dominate a transaction from beginning to end without management’s supervision. She was responsible for:

• Receiving and opening the mail;
• Vouching the vendor invoices to the A/P system;
• Selecting invoices for payment;
• Keeping custody of the check stock;
• Adding and updating vendor names and addresses in the system;
• Printing the checks;
• Presenting checks and vendor invoices to management for signatures; and
• Mailing the checks.

Obviously having someone else in charge of signing the company checks wasn’t enough to stop this A/P fraud. As businesses, we can’t expect banks to monitor all the signatures on our checks. Most bank clerks aren’t trained to be handwriting experts. In fact, they may not be looking at the signatures at all. To prevent forgeries, companies can:

• Create dual control over the blank check stock by requiring two locks with separate keys in the custody of independent staff and management;
• Independently review the check disbursements by comparing them to the check log to ensure accountability;
• Examine the actual checks to verify that they correspond to the supporting documentation; and
• Restrict A/P records and vendor master files to avoid possible tampering.

Other A/P internal controls include:

• Ensuring the level of system access is consistent with the employee’s job function and responsibility;
• Never returning the signed checks to the staff person who generated them;
• Performing the bank reconciliation in a timely manner;
• Requiring a company officer to periodically review and approve the vendor master file;
• Having a supervisor or independent staff member maintain and review the batch check log for check sequencing to ensure that it’s consistent with the check register (have the person who prepares the log and the person who verifies the entries initial the log);
• Requiring that an independent staff member or manager – not the A/P clerk responsible for preparing the checks – maintain custody of the check stock; and
• Periodically reconciling the vendor subsidiary accounts to the vendor statements, (especially for large vendors).

Payroll Fraud 

A couple of months later, after the company audit had begun, I received an unexpected tip leading to another possible fraud within the company. Maria, a former employee, called to inform me that there was an error on the W-2 she had just received. She said the W-2 reported earnings of more than three months’ wages, but she only had worked at AFC Subs for five weeks. I examined the payroll records to ensure Maria’s statements were consistent with what the books reflected. They were consistent, but my suspicions still grew. I felt the payroll manager was too quick to dismiss Maria as a former employee who didn’t know what she was talking about. I had encountered a fraud like this at another organization years earlier, and I knew something was wrong. I immediately contacted Denise, the personnel manager.

Together we reviewed Maria’s payroll reports, time sheets, and personnel files. The termination date in the personnel file was inconsistent with the ending payroll date. We then examined the canceled checks. All of the checks subsequent to Maria’s actual termination date had signed endorsements on the back that didn’t match the ones on her previous checks. This sent up a red flag for possible forgery. We proceeded to compile a list of all employees terminated within the last year. It was a large list, because lay-offs were frequent in that volatile industry. We used the same methodology to examine the other canceled checks, and consequently, we identified several dozens of forged endorsements!

Alarmed by this discovery, I began looking for the culprit. Rose, the assistant personnel manager, had control over the employee time cards and was responsible for submitting them to Millie, the payroll manager. Rose also was responsible for maintaining personnel files and distributing the paychecks. All these factors made Rose the primary suspect. I advised Randy that this was a sensitive issue that legal counsel should handle. However, with little thought to their approach, Randy and Denise confronted Rose, who at first denied the allegations, but shortly later admitted to the misdeed. Randy fired Rose, but decided not to prosecute her, because she agreed to repay the stolen funds.

Rose confessed that when employees were terminated, instead of notifying Millie, she would intentionally submit false timecards for the terminated employees for several weeks following their termination. Because Rose also was responsible for distributing the paychecks, she would forge the endorsements on the backs of the checks and cash them at a local check-cashing establishment. This fraud resulted in $30,000 to $40,000 of forged payroll checks.

This inadequate segregation of duties was later rectified by implementing an independent payroll distribution. A different accounting department person (outside of the payroll and personnel departments) was selected each week to distribute the paychecks. The new distribution system required that employees present company picture IDs to receive their paychecks.

AFC Subs Finally Sinks 

Once the outside CPA firm concluded its audit, it confirmed what I already knew – AFC Subs was in dire financial condition. As a result of the audit’s findings and the uncovered frauds, U.K. management decided to cut its losses and sell the division’s net assets to a smaller, Chicago-based airline food catering company. It took Jack and me about three months to close the books before the sales agreement was finalized.

In the aftermath, AFC terminated Randy’s employment contract, ending his 22 years with the company. Jack returned to the United Kingdom to find employment elsewhere, and I was left back in the United States without a job. In an ironic twist, the Chicago-based airline services company offered Randy a lower-level position due to his “business savvy.”

It wasn’t entirely negative, however, because my experience at AFC Subs inspired me to become more involved in the anti-fraud field. And, with my newfound investigative skills, I quickly set to work at a new organization performing compliance duties.

As outlined in Statements on Auditing Standards (SAS) No. 78, “the control environment sets the tone of an organization.” This is the most significant lesson to be learned from the demise of AFC Subs. To ensure a company’s financial integrity and safeguard its assets, management must maintain a strong control environment and possess a leadership style that sends a clear message to employees that fraud will not be tolerated. Without these elements in place, the results can be devastating.

Gerard A. Field, CFE, CPA, of Franklin Square, N.Y., is the principal of Field of Accounting PLLC, a firm specializing in fraud investigations. He has 12 years of experience in accounting and auditing in many industries, such as financial services, banking, real estate, manufacturing, and distribution.  

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