Vendor Fraud: Finding Deals Gone Awry

Fraud examiners, working with teams of diverse staff members, can discover deceitful vendors by conducting regular audits. 

The company's reputation was good. There were no complaints from the product's users. Everything was looking good until... "Walt" stared at the vendor's 1099 tax forms. Here was incontrovertible evidence that the vendor was defrauding his company - with inside help! A pipe dream? Hardly. It can happen when fraud examiners perform careful vendor audits.

Just a decade ago, most companies never even thought of auditing their vendors. Times are changing. With the advent of new complex pricing arrangements such as time and materials, cost-plus, and list-less agreements, even purchasing departments are recognizing the need to verify critical vendor data. When vendors promise to build a warehouse for a fixed percentage over their cost of materials and labor hours, who verifies the underlying data? When a vendor agrees to sell goods at a fixed markup over cost, who verifies the real cost? Even experienced purchasing executives find themselves feeling like teenagers in a used-car dealership. Today, more executives are relying on fraud examiners to verify contract compliance through quick, hard-hitting vendor audits.

Right-to-audit Clause 

On first exposure to vendor auditing, most fraud examiners wonder how to persuade vendors to allow audits of their transactions. The answer is simple. Your company's purchase order must contain a "right-to-audit" clause. Carefully examine one of your company's purchase orders. Look on the back as well as the front. The language is often buried in the "Terms and Conditions" language printed on the back of many purchase order forms. (See sidebar at right.) If the right to audit is already contained in the purchase order "boilerplate," you're in luck. If not, you'll need to introduce the concept to your purchasing, legal, and senior management.

Teamwork, Teamwork, Teamwork! 

It may sound trite, but a good vendor audit should involve close teamwork. Sooner or later, most fraud examiners discover that using a team not only reduces the workload, it improves "buy-in" from other departments. Who should you include on your audit team? Representatives from the purchasing and user departments are your best candidates. Each brings a different perspective and skill set to the project.

By including purchasing personnel in the audit process you improve your knowledge base. When fraud is found, the effect on the outlook of the purchasing staff can be quite dramatic. Most purchasing agents tend to take vendor representations at face value. Once a buyer participates in the discovery of a purchasing fraud, his or her outlook usually becomes more cautious.

In my experience, vendor comfort and support improves dramatically when the primary contact throughout the project is from the purchasing department. Let your purchasing participant make the audit arrangements with the vendor, introduce you and your staff to the vendor's representatives, and generally act as the liaison between the vendor and other company personnel. The vendor will feel less threatened when dealing with a familiar face from the purchasing department and the purchasing department will have a better sense of control over the project.

Other aspects of the vendor audit improve when the purchasing department is included in the audit. Purchasing personnel are usually quite familiar with the relevant contracts and may have questions of their own. Asking for their suggestions when planning the audit often results in useful contributions. Don't be surprised if, after a few successful audits, the purchasing department presents its own list of audit prospects.

User departments may surprise you with their observations. "Ron," a machinist for a small company started out on a vendor audit with open misgivings. What could he contribute to the efforts of a fraud examiner? Within minutes of arriving at the vendor's shop, Ron noticed the equipment that the vendor used to make a critical part was capable of operating faster than the billed rate. Four times faster! The vendor was grossly overcharging for the machine time used to make dozens of expensive parts. Taking the finding to the vendor's president brought a sheepish response - and an immediate offer to refund the overcharge. Ron suddenly realized the value of his background in the audit, touring the plant, and poring over specifications and blueprints. By the end of the day, a long list of similar overcharges had piled up. The purchasing department representative, stunned and incensed by the vendor's fraudulent behavior, immediately demanded a full refund and cancelled all future business. Without a team approach to the audit, the fraud examiner would likely have missed many of the items that Ron found. Without the presence of the purchasing department's representative, the response wouldn't have been as rapid and decisive. Teamwork made the difference.

Common Features in Vendor Audits 

How do you discover fraud with a vendor audit? Much depends on the type of vendor and the kind of goods or services purchased. However, many vendor audits have common features that any fraud examiner can perform with only reasonable effort. Try to include the following in your vendor audit.

The Tour: Upon arrival at a vendor's location, ask for a tour. Why? First, the vendor is probably proud of his or her business. The vendor will relax and appreciate the opportunity to show off the facility. Second, the fraud examiner has a golden opportunity to see the facility and ask questions. The results of this simple exercise can be quite surprising. "Greg," a fraud examiner working for a manufacturing company, stopped during a tour to ask one of the vendor's hourly employees how long a particular machining operation typically took. The employee replied, "Oh, about 15 minutes at the most." Greg noticed that the vendor's president who was conducting the tour appeared to become agitated at this point. Curious at the response, Greg began examining the bills and associated time records for this machining operation. In each case, the vendor had billed Greg's employer for a minimum of four hours of machine time! Busted!

"Paul," a CFE conducting an audit of an equipment manufacturer, was surprised to find that the vendor wished to have the audit performed over a weekend. He and his team arrived at the vendor's site to find an impressive and well-equipped building. The president of the vendor's firm took him on a tour of the facilities and all questions seemed to be adequately answered. Still not satisfied, Paul asked to go through the facilities again. This time he noticed that letterhead on several desks had the correct street address but a different company name. Paul was concerned and returned to the site on a weekday. Imagine how startled he was to find that his vendor only rented an office from the building's owner, who had agreed to let him place a sign on the corner of the building with his office entrance! The "vendor" was only a "shell," without equipment, facilities, or employees. Further investigation and another tour found that the shell company's owner was working with an insider at Paul's company funneling orders from a known manufacturer at highly marked-up prices. If Paul had neglected to tour the facilities three times, his company might yet be suffering the financial consequences.

Tax Filings: In the U.S., companies paying $600 or more to an individual must issue a form 1099, reporting that payment to the Internal Revenue Service. It isn't unusual for companies wishing to disguise bribes or kickbacks as "consulting agreements" to issue a 1099 for such payments to avoid committing serious tax violations. Fraud examiners should review the vendor's list of 1099s against a list of the names, addresses, and social security numbers of the customer's employees. One fraud examiner whom I spoke with reported finding the names of two key operating personnel on a vendor's 1099 list, which finally explained why the two had pressured the purchasing department to enter into a long-term contract with the company. Each of the criminals was receiving a percentage of the long-term service contract. Their "consulting services" were merely thinly veiled kickbacks.

Expense Reports: Before starting the audit, smart fraud examiners will ask for the names of the vendor sales representatives assigned to service the fraud examiner's company. Early in the audit, the fraud examiner should ask for and review the sales representatives' expense reports. "Ellen," a fraud examiner working for a company that prided itself on its employee ethics policy, was shocked to find that several of her company's key employees were guests of the vendor at a resort. Expenses for the junket were funneled through a salesman's expense report. After taking the information back to her company's president, both the employees and the vendor's contract were terminated.

General Ledger Accounts: Other evidence of graft may appear in the company's general ledger. Ask the company's controller for a chart of accounts listing all the general ledger accounts. Look for accounts with captions such as, "Promotional Expense," "Sundry Expense" or "Entertainment Expense." Ask to review the activity in these accounts for your test period. It's not unusual to find evidence of kickbacks and lavish entertainment in such accounts. Occasionally, such corruption is accomplished using cash from the owner's own pocket. However, many businesses record even the most inappropriate transactions often to claim a tax deduction for the expense.

Freight Invoices and Bills of Lading: Does your vendor supply you with tangible goods? If so, they'll require transportation to your company. Select a sample of deliveries to your location and ask to see the invoices, bills of lading, or proofs of delivery supporting those deliveries. Many vendor frauds involve billing for undelivered merchandise. Corrupt customer employees are paid a portion of the fraud's proceeds to sign receiving documents for undelivered merchandise. Rarely, though, does a vendor go to the trouble of actually shipping an empty container let alone one of the correct weight (and shippers often record and charge by weight). Checking for evidence of a shipment at the vendor's location can uncover most delivery frauds. A fraud examiner in a manufacturing company discovered that a vendor was unable to support almost half of the transactions involving shipment of mechanical parts to his employer's plant. Further investigation found that a single employee had signed for every one of the missing freight transactions. Upon questioning, the employee admitted that he was paid a "commission" of 10 percent of the value of each false receiver that he signed. Both the employee and the vendor were terminated.

Related Parties: Vendors with "cost plus" agreements may be tempted to use fraud to improve their financial performance. One method involves the use of related party transactions to mark up the price of goods sold. For example, a vendor supplying a part under a contract that allows a 10 percent markup may decide to form a dummy company to supply the part to his company. If the dummy company marks up the transaction by 25 percent, then the vendor is now able to pocket a 37.5 percent markup while making the customer believe that he's only paying a 10 percent markup. Fraud examiners should investigate the ownership and background of companies that supply significant quantities of goods used on any project that involves a fixed markup agreement.

One fraud examiner I spoke with discovered that a mechanical contractor with a major contract actually was the owner of a pipe and valve supply company that conveniently provided significant price markups on the project. The fraud examiner was able to justify his salary for more than a year based on that single discovery!

Tricky Pricing: At one time or another, most fraud examiners have heard car dealers advertise cars for, "one cent over the invoice price" or $10 over, or whatever. Do we honestly believe that dealers can cover overhead, salaries and freight at sub-miniscule margins? Of course not! Many invoices that accompany goods are merely a convenient reference point from which a complicated series of rebates, holdbacks, and other adjustments are applied to arrive at a true price. Fraud examiners need to constantly be on the lookout for such arrangements. Never be afraid to press a vendor for answers on pricing and be sure to look in the company's chart of accounts for general ledger accounts used to account for such activity. Making use of such arrangements isn't fraud unless they're concealed from the buyer in a cost-plus agreement.

Fraud examiners can greatly help their employers by conducting vendor audits. Using a team approach to the task leverages the efficiency of the vendor audit and the likelihood that a fraud will be uncovered. It also improves the fraud awareness of both purchasing and user personnel.

David G. Banks, CFE, CIA, is the director of internal audit for Weirton Steel Corporation in Weirton, W.V. 

SIDE BARS 

Right-to-audit Clauses Protect Firms from Unscrupulous Vendors 

Right-to-audit clauses needn't be complicated. Language such as the following is usually adequate:

AUDIT: When, in the opinion of the BUYER, any aspect of the contract between the parties requires financial or other auditing or appraisal, representatives designated by the BUYER shall have the right to examine and copy all writings relating to the contract in the possession or control of SELLER, and SELLER agrees to make them available to BUYER at reasonable times for said purposes. BUYER'S right to audit shall extend for a period of one year after completion and acceptance of performance of the contract. SELLER shall include in all subcontracts a like provision under which BUYER shall have the above rights to audit such subcontracts.

Making a List: Vendor Audit Necessities 

It's impossible to make a "one size fits all" checklist for performing vendor audits. However, your audit should answer the following questions:

• Are the hours charged to a project reasonable and are they sufficiently documented? Can you trace the hours through the payroll system?
• Are there invoices for all materials used? Are they from companies that are independent of the vendor? Do the invoice prices reflect the actual cost to the vendor or are additional factors involved?
• Do company expense reports indicate any bribes, kickbacks, or excessive entertainment?
• Do freight bills support the delivery of materials?
• Are vendor tax filings free of any indications of payments to your company's personnel?
• Do general ledger accounts for "Promotional Expense," "Entertainment," and "Sundry Expense" indicate payments to your company's personnel?
• Do the company's physical facilities appear capable of providing the goods or services being audited?

WANTED: Articles Like the One You've Just Read 

The White Paper needs articles containing clear descriptions of fraud schemes, concise case histories, practical ways to detect and prevent the crimes, and useful tips from fraud examiners. Here's your chance to share your insights and add to the fraud examination body of knowledge. Interested? Contact editor Dick Carozza for the author's guidelines.