Opening Pandora's Box

Town Mark Ltd. of India retained this accountant and fraud examiner to document and streamline the information systems in preparation for ISO certification. But like the proverbial Pandora's Box, when he and others lifted the lid off the accounts, scores of errors and issues tumbled out. See how he and the auditors found a fraud based totally on manipulation of a computerized management information system and the lessons they learned.  

 

This article is excerpted and adapted from "Computer Fraud Casebook: The Bytes that Byte," edited by Joseph T. Wells, CFE, CPA, to be published at the end of 2008 by John T. Wiley & Sons Inc. 

 

Managing Director Paul Right was the brain and the face of Town Mark Ltd. From meeting distributors, dealers, shopkeepers, mall managers, and suppliers, to interacting with shareholders, he was at the forefront of all business interactions. 

 

Always immaculately dressed, he loved ostentatious ties with equally flashy tie pins, often with a red ruby or a green emerald in its center. His wardrobe was impressive, with a different suit for every day of the week. Paul never looked ruffled - he dyed his hair and gelled it neatly into place. He worked hard for the company and loved to sacrifice his time, his earnings, and his future for its welfare. A day wouldn't pass without him declaring this to an audience - whether to employees in a staff briefing, to visitors in a chance encounter, or to the directors in a board meeting. He seldom spoke about his family but always had a good word to say about the business. 

 

Town Mark Ltd. is a well-known and respected consumer goods public company in India with eight branches, 12 depots, and five main distributors. It grew from its early beginnings in a remote factory in the middle of nowhere by using outsourced production facilities spread across the major regions in the country. The company has a network of dealers within and outside India. 

 

Paul had always been the key figure in Town Mark. He had been loyal to the promoters and owners - the house of "Maharaja Ishwarchand." With a lineage dating back more than 200 years, they had sprawling properties in the district of Chandnagar, India, where the factory was located. Everything was built on a massive scale including the factory, the residential quarters, the staff colony, and the school for the employees' children. Many of these were built in the times when Maharaja himself ran the company. The company now rested on past laurels, but its sheer scale and size kept it going. 

 

Dinesh Singh, the son of Maharaja, followed by Dinesh's wife, Mayawati, and now their son, Rahulji, fresh from business school, ran the affairs of the company. 

 

During Dinesh's tenure, he had brought in Paul Right as an executive assistant in his office. Paul was then a young man who wanted to show his mettle. He quickly earned the trust of his boss and became a reliable retainer of the family. After Dinesh's untimely death, his wife, Mayawati, took charge. But within two or three years, she succumbed to an attack of falciparum malaria that she had contracted during one of her trips to the factory. 

 

The company's burden now was on shoulders of Rahulji- Dinesh and Mayawati's son - a soft-spoken, business-school alumnus. He soon became dependent on Paul for guidance, support, and practically everything else. Rahulji never met anyone without Paul, be it lawyers, employees, branch managers or, for that matter, even the company's shareholders. Paul was at his side during every board meeting or the annual general meeting. Paul boasted about how the company had seen glorious days in the times of the "Maharaja" and how he'd single-handedly struggled to keep the company alive since then. 

 

THE INITIAL MEETING 

I'm a practicing accountant who handles system audits and investigates fraud. Town Mark called me in as a systems auditor. The company was attempting to earn ISO (International Organization for Standardization) 9001:2000 certification, an international designation of the quality management system of an organization. Town Mark's ISO consultant, Ravi Kumar, had suggested that an expert document and streamline the information systems. Nari Mehta, the company's cost auditor, knew me well and recommended me for the position. That's how I found myself sitting face-to-face with Paul in April. He looked at me with his brown eyes framed in gold-rimmed reading glasses; in a firm voice he said he wanted quick results. 

 

"To tell you the truth, we're quite happy with our system. But our ISO consultant, Ravi Kumar, feels we need to improve and streamline our information system. That's why you're here. Please do what you can to satisfy Ravi. You can call me or meet me personally anytime you want, but on a regular basis you can meet our accountant, Goldie Jhaveri." 

 

I soon met with Goldie, his juniors, the system administrator, and a few other staff members, who briefed me on the company's past. Though it had potential, Town Mark hadn't shown good results for a while. It had experienced a perpetual resource crunch - a funds problem - and was plagued with bad debts because it couldn't control its debtors. 

 

Paul had been struggling to revive Town Mark. His remuneration was a fixed amount plus a commission on profits, which surprisingly he didn't accept for a few years because he felt the company hadn't made enough profits. He wanted to make this personal sacrifice because he was under pressure to perform. 

 

Rahulji also wanted to assert himself and use his own knowledge and experience more effectively. The company appeared to have great potential, but it was stagnating. The accounts were taking too long to finalize and the management information system (MIS) reports weren't readily forthcoming. 

 

Paul brought in a new team, which re-energized Town Mark; sales rose and profits soared. Among the new managers were a chief operating officer and a chief financial officer. Paul also put new systems in place, which included a quality management team. The company now had regular reporting, MIS, and internal and external audit mechanisms. Paul also introduced a system of budgets, and the computerized MIS information now comprised budgeted figures with actuals and variances presented with the cause of variations. Accounts were being finalized within a week of the yearend. Shareholders and top management, including Rahulji, were pleased with the improvements. Most importantly, for the first time in years the company was in a position to give higher dividends because the profits had nearly doubled. Everyone was happy. It did seem a bit unusual for a managing director to be self-sacrificing forever especially with the company's revival and growing profits. I began to methodically study the systems and document each process - purchasing, stores, sales, marketing, delivery and dispatch, receipts and payments, accounting, etc. I was making progress. 

 

THE INVESTIGATION 

It was a Monday in June, a few months after I had begun working with Town Mark, when I drove to its administrative offices. The sky was overcast after a heavy downpour. I parked and looked up at the glass-fronted building that housed the company's offices. The reflection of the dark angry rain clouds in the large window panes looked ominous and depressing. I entered the office and asked for Paul. 

 

"He's not in," said his secretary, Seema Gomes. 

 

"When can I meet him?" I asked. 

 

"He's been away for a week; I have no idea," she said, offering a smile. 

 

"Can I meet Mr. Goldie Jhaveri then? I've finished documenting the information system, the network of computers in the company, and want some clarification," I added. 

 

"I am afraid Goldie is not in either. He's on leave for a month in order to sit for an examination to become a certified accountant." 

 

"What about Mr. Roy, the company secretary?" 

 

"He just put in his papers yesterday," she said. "Why don't you have a cup of coffee? It's raining and cold. I'll fix you a cup," she said, going to the pantry. 

 

I was feeling a bit lost and wondering what to do next when Nari, my cost auditor friend, walked in. I said I was concerned because the three top executives' absence could slow my project. Nari had his own share of difficulties. The previous week, he'd discovered that the cost records hadn't matched the financial accounts and balance sheet. There was an entry of stock of product destroyed in the cost records, valued at $500,000, which wasn't reflected in the financial accounts. He thought it was a simple omission because a reconciliation of cost and financial records wasn't a regular practice. 

 

After the coffee break, we met with the junior accountant, Sheila Gole. Sheila was having a tough time handling bank auditors who had dropped by to verify stock. Goldie normally handled these matters. The auditors seemed to be agitated about the discrepancy in the stock of finished goods relating to the remote depots furnished to the bank. Sheila assured them that she'd give them a proper explanation as soon as the accountant was back. Her answer seemed to satisfy them and the bank auditors left. 

 

Nari and I took seats opposite Sheila, whose long, black, shining hair hung well below her shoulders. She was remarkably impressive, carried herself well, and was considered close to Paul. Apparently, she could get any papers approved or voucher signed with ease. I told her that I needed information to finish my project and any delay would affect my timelines. I wanted details on the procedures for reporting of financial information and accounts. Sheila was disturbed but promised to help. 

 

"The MIS is drawn up in an Excel sheet where the information is extracted from the entries in the accounting package," Sheila said. "However, the data is manually entered in the Excel sheet and not directly exported from the package due to formatting difficulty. The accounts package is a commercial off-the-shelf solution and the reports are not customizable. The company has its own formats and style of reporting due, which is why data entry was necessary." Sheila explained that Goldie prepared these sheets, with her help, and sent them to company executives and the board of directors. 

 

Nari then asked about Paul's sudden absence especially because he had a meeting scheduled with him. Sheila confided that after the current year's balance sheet was finalized a week earlier, Paul had left the company for better prospects. There was some whispering among the staff that suggested he had differences of opinion with Rahulji on policy matters, she added. Rahulji had started questioning some of his decisions, which had annoyed Paul. This had surprised Sheila and many other employees because everyone in Town Mark felt that it was the managing director's initiative that had helped turn around the company's fortunes. At the same time, the company secretary had left for better prospects and Goldie, the accountant, had gone on a long leave to pursue further studies. The company was looking for a replacement for him. 

 

The new accountant, Rita Prabhu, was a graying middle-aged woman who had served as a secretary and then as a senior accountant in another large consumer product company. She was a complete contrast to Sheila, her junior accountant, who had an engaging personality and always got her way in the company. But Rita knew the business model, the MIS, and the accounting system quite well. After I had known her for a week, she asked me to come to her office to discuss the system audit and system overhaul. 

 

OPENING PANDORA'S BOX 

After a week had passed, Rita appeared a bit harried. Her face looked tired sans her usual light makeup and gray peeked from the roots of her dyed hair. But the office was buzzing with activity. Statements were being compiled, reconciliations done, accounts made up. 

 

She glanced up from her cluttered desk and said, "There is a difference of over $2 million in the books. There are debtors as per the final accounts that are not reflected in the books. I have gone over the books and extracted a trial balance. It means that figures of sales and debtors in the final accounts presented to the board and shareholders are inflated by two million. The inflation was made in the spreadsheet prepared from the trial balance extracted from the books. All subsequent processing is based on the inflated figures." 

 

Over the weekend, Rita had checked and verified the balances of individual debtors and found the difference. The discovery was delayed because of inadequate circularization of debtors; some were disputed, others not yet reconciled, and some omitted from the list because they never responded in the past and mailing statements to them was considered a waste. Rita also noticed that in the previous four years, the company hadn't obtained confirmation of balances from debtors, which weakened the control on receivables. Rita asked me if I could help. I agreed but requested Nari join me because he was the company's longtime cost auditor and knew most of the old hands in the accounts department, especially Sheila. 

 

The next day Rita, Nari, and I sat down to sift through the papers, wondering where to start. Inflating sales and debtors for window dressing was "old hat." But what about invoices? Dispatch notes? How was the whole scheme tied up? A further search revealed that this was a completely MIS-based fraud. The original books, vouchers, and records were never tampered with. Monthly sales and debtor figures reported to the board and used for MIS were inflated. Figures in the final accounts were also upped by cleverly programming the spreadsheet template, used for preparing MIS and final accounts, to add a fixed sum to both sales and receivables. I remembered that Sheila helped Goldie compile the figures and the spreadsheets. Rita, the new accountant, immediately called Sheila and asked her point blank: "Why did you fudge the spreadsheets? Or did you help Goldie do it?" 

 

"We just followed Paul's instructions. I really don't know where the figures came from," she responded. We knew we wouldn't be able to extract much information from her. Sheila was rattled and left the company a week later. They couldn't hold her for questioning because the company hadn't started a formal investigation. There was no use catching the small fry, anyway, when the real brain in the scheme was probably higher in the hierarchy. 

 

It was an amazingly simple, yet effective, scheme. But the question kept haunting us: Who was behind it and where did the money come from to keep the company running if the sales were inflated? Increased sales meant more profits, more bonuses, more commissions, and higher dividends. The sales could be inflated with higher receivables, but the bonuses, the commissions, and the dividends needed hard cash funds to be paid out. 

 

We kept looking at the sources and the receipt side of the bank book and soon discovered a number of short-term loans and unsecured loans borrowed at a high rate of interest. These were at rates much higher than the market rate ranging from 18 percent to 36 percent per year from associates of the top management. This was the method of bankrolling the operation. It effectively covered up the fact that sales weren't genuine because the company still had enough funds, received by way of these loans, to manage its activities. 

 

We compiled the information: 

• Inflated sales and debtors: $2 million 
• Missing inventory (written off as destroyed in cost and excise records - appearing in books): $0.5 million
• Over-charged interest on borrowings - difference above the market rate over a period of two years: $0.6 million
• Total: $3.1 million 

 

As we sat back looking at the total on the sheet of paper, Rita saw the staggering figure and remarked, "Are we not opening Pandora's Box?" 

 

"We're still not sure who is involved and at what level. Let's look at the figures more carefully," I suggested. 

 

Nari proposed we look at the commission and sales expenses. We found that after the new management team had come in, the distributors and agents' commission claims and charges were at a much higher rate than currently accepted. Someone was making a personal profit at the cost of the company. The difference was staggering - $4 million in the previous two years. 

 

PANDORA'S MODUS OPERANDI 

Rita, Nari, and I thought that the information and the findings were so significant and sensitive and the implications so far-reaching that it'd be best to talk to Rahulji directly. The three of us met in his office and briefed him. He stared at us for a moment and then said softly, "I think my mother knew it but couldn't do anything. I had suspected that something was amiss, but before I could find out the details, the whole team had left and was replaced." The modus operandi was clear. We showed him a diagram that illustrated the chain of accounting and financial reporting and the cash flow in the company. (See Figures 1 and 2.) 

 

Financial transactions were recorded in the books. Documents and records in respect to the same were preserved. The books of accounts were audited and the resulting assets and liabilities were duly verified. The trial balance was then extracted. The figures were used to generate final accounts, but the sales and debtors were inflated at this stage. 

 

The accounting entries, along with supporting documentation and records, showed the true picture. Using this data, MIS reports were prepared for presentation to management and to the board for decision-making. Once audited, the final accounts statements (profit and loss, balance sheet and cash flow) were also presented to the shareholders, filed with the regulators, and given to relevant stakeholders. 

 

Instead of using the actual figures from the books, figures of sales and debtors were inflated, which resulted in apparently higher turnover and elevated profit. This was done by adding amounts to the corresponding total debtors' cell entry in the spreadsheets used for preparing the statements. 

 

The cell matched the accounting records, but the resultant outputs were inflated by the fixed amount added in the formula. Thereafter, these figures were used for compiling and presenting financial statements for internal decisions as well as external reporting. The cash flow was maintained by taking short-term borrowings to cover the shortfall arising from the inflated debtors. These funds were used to pay increased commissions, margins, interest, and the dividends resulting from higher book profits. The cycle was thus complete. 

 

Except for the inflated sales figures, the others - the higher-than-market rate of interest, the excessive sales expenses, and commissions - were, at best, acts of financial impropriety or irregularity, which could have been caused by a lack of fiscal discipline but wasn't necessarily evidence of direct fraud. Like the proverbial Pandora's Box, when the lid was lifted off the accounts, a whole lot of errors and issues tumbled out. 

 

It appeared that Paul wanted to keep the company going at any cost and so he began shoring up the results. At this stage, the only personal benefits appeared to be the accolades, the respect, the admiration of the employees and the shareholders, and the trust of the owners that he was trying to maintain by showing improved results. But down the line somewhere, he might have been deriving some benefit through overpriced sales margins and the higher-than-normal interest rates. This could also have been his last-ditch effort to keep the company afloat. We had a dilemma: We couldn't discover the truth by direct interviewing and questioning because all key personnel had changed. 

 

The rigged figures made the company look good but couldn't have benefited any single group of executives directly. With no proven motive or direct evidence, we had to consider it a mistake - a costly one that taught the company valuable lessons. But there was always this lurking feeling about the whole episode. Paul appeared to be the mastermind even though he portrayed himself as the ever-sacrificing saint. But was he really the chief instigator? 

 

We felt it was best not to initiate legal action against the suspected perpetrators because of the impact on the company's image and reputation, but we knew it needed to strengthen and improve its systems. 

 

OUT WITH THE OLD, IN WITH THE NEW 

Sheila Gole left the company in a week, joined a competitor, but was relieved from that job for suspected embezzlement. Paul Right joined a competitor and took his accountant, Goldie, along. Three years later, they were caught attempting to sell duplicate products with the Town Mark brand, and they now are facing litigation. 

 

Town Mark took a fresh look at its systems: it cut production and operating costs; installed tighter controls over its operations; and renegotiated sales margins, expenses, and commissions with its dealers, distributors, and sales force. These actions turned the company around. Town Mark is now a leading consumer goods brand and is worth more than $1 billion. Rahulji and Rita are both hoping that with tighter and more efficient systems in place, the company won't face such problems in the future. The learning cost for the company was $7.1 million. 

 

LESSONS LEARNED 

This fraud wasn't initially detected because managerial staff and the internal auditor didn't check spreadsheets of the computerized MIS reports, which offer quarterly, monthly, and annual results (profit and loss, balance sheet, and cash flow statements), before they were sent to top management. The statutory auditors failed to trace the final accounts in depth from balances in the books. Computer-generated MIS reports using spreadsheets, and final accounts generated from spreadsheet software using trial balance, were generally considered reliable, accurate, and acceptable. But that assumption led to figure-fudging, and management, in collusion with the senior accountant, could commit fraud. 

 

If the statements had been extracted and prepared manually, they wouldn't have been relied upon blindly. Similarly, if the accounting software had generated them directly, the fraud wouldn't have occurred so easily because the statements would've been checked more carefully. It would have also been more difficult to interpolate and inflate the figures because it would have required changing the accounting software program. The fraudsters were able to modify easily the spreadsheet using macros; no one expected these changes. 

 

It's always difficult to establish management fraud beyond a doubt especially when it involves issues of propriety of decisions. The problems in this case could've have been caused by fudging or window dressing (if it was deliberate) or error or carelessness (if it was inadvertent). We couldn't find out the truth by direct questioning or confrontation because the key top managers were no longer employees. They had fled the scene before the temperature rose. 

 

It's easy to be wise after an event. But to prevent and deter fraud it's important to have the vigilance, skill, and expertise to spot the telltale signs of wrongdoing, mischief, and system malfunction. We discovered some weaknesses in the company's internal controls especially in the handling of debtors. A sound review mechanism for aging of debtors and reviewing them for their realizable potential would've prevented, or at least reduced, the fraud's extent. 

 

In fact, the scheme was so simple and so ingenious that it not only yielded personal profits to the perpetrators through higher commissions, bonuses, and interest, but resulted in a higher profit and dividend payout, which made the employees, shareholders, the board, and owners happy. So none of the key stakeholders were in a mood to look at things closely or ask searching, uncomfortable questions. 

 

Top management shouldn't have had blind faith in their executives. They should have incorporated adequate checks and balances through proper systems of internal controls and regular internal audits. They shouldn't have ignored disturbing facts like increasing debtors or liquidity crunch merely because the company was profitable. 

 

RECOMMENDATIONS TO PREVENT FUTURE OCCURRENCES 

• Proper Controls for Final Accounts and MIS
• Proper control systems need to be installed for tracing all MIS and final accounts spreadsheets to books and trial balance in the accounting package. The spreadsheet needs to be periodically verified against book figures and the formulae validated for accuracy. 

 

Executive Ownership of Financials 

The board of directors normally bears the ultimate responsibility for the final accounts, and the company's shareholders eventually approve them at the general meeting. Top executives need to "own" the financial statements of accounts to ensure their accuracy and fairness. The CEO, CFO, and the chief accountant should sign these statements every year, as is now required by Sarbanes-Oxley. Even the MIS now needs to be authenticated to improve the quality of reporting. 

 

Formal Internal Control Manual 

If a formal manual had been written and adopted for internal control, many of the processes would have been in place. 

 

Greater Emphasis on Internal Audit 

Internal audit is often viewed as a supplementary function to statutory audit when, in fact, it has a significant role to play in safeguarding assets and ensuring adherence to systems, policies, and practices. A robust internal audit could've revealed the problem in debtors, the borrowings at high interest rates in excess of normal market rates, and the above-normal commissions and expense margins to distributors on sales. 

 

Review the Appointment of Auditors 

The work of auditors, both statutory and internal, is significant input for the audit committee and board of directors. For effective governance, it's not only necessary to review and consider the auditors' findings but also to communicate with them to identify and analyze the areas of importance and concern. This helps to focus the auditors' attention on issues that can help control deviations in the system. 

 

Appoint a Fraud Officer/Establish a Fraud Helpline 

All large corporations need a specialist to handle potential frauds. Fraud experts - preferably CFEs - should set up controls and systems that can fix responsibility when frauds are discovered. It also helps to improve the success rate in prosecuting fraudsters, apart from preventing frauds and minimizing their impact through early detection. 

 

Human Resources Policies 

Human resources policies should identify: 

• Appropriate recruitment strategies to prevent the wrong kind of people from being recruited, including background checks
• A whistle-blowing policy
• Serious penalties as deterrents
• A checklist to identify fraudsters and their lifestyles 

System Audits 

Computer systems need to be properly designed and continuously monitored and controlled. General internal and accounting controls aren't adequate. Regular system audits are essential to ensure confidentiality, integrity, and availability of correct and timely information for decision making. An auditor's involvement from the beginning might have helped prevent the event. An effective systems audit would have plugged the loophole that allowed inflation of figures at the spreadsheet stage leading to erroneous MIS reports and final accounts. 

 

Vishnu K. Kanhere, Ph.D., CFE, CISA, CISM, FCA, is owner of V.K. Kanhere & Company, Chartered Accountants, in Mumbai, India. 
 

The Association of Certified Fraud Examiners assumes sole copyright of any article published on www.Fraud-Magazine.com or ACFE.com. Permission of the publisher is required before an article can be copied or reproduced.