Asset Misappropriations: Taking It Personally

Tom Westwood could charm the paint off the side of his house. But as the controlling shareholder of a large car dealership he also could find ways to misappropriate company funds to repaint that same house.

Tom Westwood was the personification of a cliché: the self-made man. He began his career as a car salesman. When he moved to Grand City, he had very little capital. He opened Grand City Motors in a vacant building where the previous vehicle dealership had failed. Even though he was new to Grand City, in less than a decade he built the entity into the largest and best-known dealership in the surrounding region. The business had a minority shareholder, but Tom operated the business.¹  

Tom had a gift for dealing with people. He had the uncanny ability to make each person feel like the most important individual that Tom had talked to that day. Whenever a salesperson couldn’t close a sale, he would refer the potential purchaser to Tom and most of the time he closed the deal. An articulate and polished man, he appeared on radio and television as the dealership’s spokesperson. Even in newspaper ads, the enterprise was billed as Tom Westwood’s Grand City Motors.

Through the years, Tom must have decided that he could do whatever he wanted with his business. He succumbed to the temptation of concealing the use of corporate funds for purely personal purchases. Through-out my career as an investigator and auditor with Revenue Canada (Canada Customs and Revenue Agency), I was involved in many investigations of corporations. Most of those investigations centered on shareholders or managers misusing business funds to pay for items that were strictly personal.

Fraudulent Invoices and Losses for All

In a misappropriation, the individual in authority labels a personal expense or asset as an expenditure of the enterprise. He’ll set up a corporate asset or charge a corporate expense. In many cases, the person involved in misappropriations will obtain fraudulent invoices to disguise the true nature of the transactions. The fraudster would regard this use of business funds as valid because he really is the driving force behind the business’s success. However, false expenses artificially reduce the profit of an enterprise because the money wasn’t laid out to earn income. In the case of a personal asset charged to the business, the assets of the entity would be overstated.

In Tom’s case, the money losers were the federal and provincial governmental taxing authorities, trade creditors, banks, the credit arm of the vehicle manufacturer, and the minority shareholder. In any misappropriation case, a smaller corporate profit means smaller dividends and the security of the creditors and financial institutions is lessened.

A payment by the entity for a personal item of the shareholder (or manager) isn’t wrong by itself. The proper treatment of such a payment is a charge to a salary account, to a bonus account, or to a shareholder loan account. However, business operators can charge this type of payment to a corporate expense account or asset account. In many cases, they obtain and use fraudulent invoices to help cover up the defalcation.

Why would suppliers issue a fraudulent invoice? Suppliers may rationalize by maintaining that they really have no control over the manner in which invoices get used. One contractor, referring to just such an invoice he issued to Grand City Motors, stated “It’s up to Tom how he handles it in his books.” A person operating an entity may use intimidation to get a supplier to prepare a false invoice. Tom told Dave, a self-employed tradesman, that his invoice should show that the work was done for Grand City Motors and not for a project at Tom’s residence. Dave truly felt that he wouldn’t be paid in a timely fashion unless he did as Tom had requested. As a small businessperson, he really needed the money right away. So he addressed the billing to the company and described the work as Tom directed.

Short-cut Test

As the income tax auditor reviewing Grand City Motors, I needed to find a short cut to test for personal items without analyzing each and every account of the business. The accounting system for an automotive dealership is normally voluminous. The accounting was even more complicated at Grand City Motors. There were many suspense accounts that were labeled to resemble the normal general ledger accounts. These suspense accounts were only temporary and would at some point be folded into the regular accounts.

I knew I could find hidden personal payments by scanning cheques and highlighting those issued to businesses that a vehicle dealership might not normally deal with daily. However, scanning cheques may not yield good results when there are a large number of them. The task is tiring, and it’s easy to overlook something significant.

So I decided instead to look at some of the miscellaneous invoice files. In the miscellaneous “C” file, I found an invoice for $8,000. The amount was small enough that the external auditor probably didn’t consider it material enough to look at the actual billing. However, the invoice details were intriguing. A cement contractor purported that the amount covered repairs to the parking lot but the lot didn’t appear to have been repaired recently. (The parking lot wasn’t concrete; it was paved. That was the tipoff.) The contractor’s records showed that the $8,000 was just a partial payment for a swimming pool installed at the Westwood residence.

Using my initial finding as a guideline, I decided to examine all the miscellaneous alphabetical files. I also assisted another income tax auditor in doing the audit of another entity in which Tom was involved. We found many items that required closer scrutiny. We called some of the suppliers to examine their files and we obtained search warrants on all the business locations and on Tom’s residence.

A Bad Thing that Got Worse

During the investigation, we found many more examples of shareholder misappropriation. For example, a company issued an invoice to Grand City Motors for a certain number of square feet of ceramic tile and described it as being installed in the dealership showroom. The supplier’s records didn’t contradict the invoice. So without revealing any names, I asked a friend in the tile business how big an area the tile billed in the invoice would cover. He said it would cover the standard size of a bathtub enclosure. I then interviewed the supplier and got him to sign a statement admitting that the work was done at the Westwood residence and that Tom had directed that the work be billed to his company.

In another instance, an invoice from a house builder purported to be for construction of shelves in the parts department of Grand City Motors. Builders usually don’t have tradesmen, such as carpenters, on their payrolls but employ them as subcontractors. When I checked the builder’s records, I found the amount covered a down payment on a condominium purchased by Tom Westwood.

(There are times when the supplier’s records can be very revealing and helpful in establishing the intent behind the misappropriation. In a case unrelated to Grand City, a controlling shareholder of a company took advantage of the fact that a plumber did some work at the company’s office and at the shareholder’s house. When the shareholder received an invoice for work done at his residence, he returned it with this notation: “Al, please bill this to my company.” The plumber sent a revised invoice addressed to the entity, but he kept the returned invoice in his files, where I found it during my investigation.)

Tom Westwood had been getting close to the line in his business dealings, especially with his major creditors. On the day of our searches, representatives of the credit arm of the vehicle manufacturer were doing a regularly scheduled examination of the records of Grand City Motors and found that “the feds” were also doing a search. Eventually, the banks also learned that Tom and the businesses he owned were under investigation. The resulting financial pressure was too much to withstand, and Tom’s businesses declared bankruptcy.

Tom and two of his companies were charged with income tax evasion, and Tom fled the country. (None of his employees were indicted.) However, prior to the bankruptcies, he “sold” vehicles of the entity in a scheme that directed funds to him personally. As a result, he also came under investigation by the Royal Canadian Mounted Police who charged him with fraud under the Criminal Code.

Tom waived an extradition hearing and returned to face the charges in Canada. He was convicted and sentenced to two years for income tax evasion and two years for the criminal fraud. He served the sentences concurrently.

Golden Miscellaneous Invoice Files

There’s always a need to examine for the misuse of company funds especially when the controlling shareholder is also the controlling force in the enterprise. Sometimes the operator of the business may just decide to have the business pay for work being done at his or her dwelling and get the tradesperson to issue a false invoice.

In other cases, it’s a “fraud of opportunity.” During repairs or expansion being done to the physical plant of the enterprise, the person in charge may request that a contractor do some work at a private residence and then bill that work to the business.

When examining expenditures of an enterprise for such fraud, we need to look at the miscellaneous invoice files. Even if there is no obvious discrepancy such as the ceramic tile example above, we need to stop and think about the type of supplier and the service that’s shown on the invoice.

Also, we need to be aware that even if a contractor actually did some renovations or repairs at the business location the billing could also cover work done for an individual. Investigation of the time sheets for the contractor’s employees may also be helpful in establishing where the work was done.

Some directed examinations in entities controlled by a major shareholder often will yield a popular fraud: misappropriations. When you find the fraudsters they may “take it personally” but tell them you’re just doing your job. 

Mel Linington, CFE, is a retired income tax investigator and auditor with Canada’s Department of National Revenue. His email address is mmlinington@yahoo.com.