Something's Fishy at Jones Company: Classroom Case Takes Auditors from Investigation to Confession

The authors have designed this fictitious case to illustrate in courses or seminars some of the more important aspects of the fraud examination process. Of course, the authors have simplified the process to provide a more concise classroom example. Teaching notes and an accompanying DVD with video segments (not produced by the ACFE) are available at no charge from Martin Coe.

Custom Parts Inc. (CPI) of Chicago is a large original equipment manufacturer (OEM) of vehicle parts in the automotive industry. CPI has grown exponentially in the past 10 years because it purchases smaller OEMs that have an established customer base.

Though CPI typically allows the companies it purchases to continue their sales and production offices, it administers all other functions from its corporate headquarters. CPI’s financial analysis group periodically scrutinizes each company or “segment.” The group became concerned during an analysis of one of its newest acquisitions – the Jones Company.

Jones Company sells its own manufactured OEM parts and those it buys from other companies. Also, Jones doesn’t have equipment to manufacture some of its in-house parts, so it outsources them to local machine shops.

In addition to the OEM relationships, Jones holds several patents that allow its gross profit margin to be about 40 percent of sales because patent holders can charge higher prices until their patents expire. So when the gross profit margin for Jones dropped to 25 percent, CPI’s financial analysis group took a closer look at Jones’ segment data. The group then asked the internal audit manager, Barb Reynolds, to investigate further.

AUDITORS INVESTIGATE 

Reynolds assigned the review to a new staff auditor, Chad Collins, who had been hired to perform operational audits. She provided Jones’ segment financial data to Collins (See Figure 1) and asked him to look for anything that might be causing the reduced profit margin.

Collins noticed an upward trend in consulting fees, so he reviewed the underlying source transactions, which indicated that all the consulting fees had been paid to a Ted Jones. CPI still had a consulting contract with Jones, the former owner. Collins contacted him to explain the increase.

“You’re barking up the wrong tree!” Jones told Collins. “You can only analyze the results by looking at the job reports.”

Collins ran a job summary report because Jones Company uses jobs to keep track of the revenue, costs, and profit for each order. A review of the report (See Figure 2) indicated that 12 jobs had negative profit margins.

Collins ran a detailed job report (See Figure 3) for those 12 jobs. He noticed that the jobs had large charges for outsourced machining, so he ran a line-item report that listed the source transaction detail for all the outsourced machine operations on the jobs. The majority of those charges were associated with the same vendor – Smith Company. Collins went back to Ted Jones.

“I have never heard of Smith Company,” Jones said. “Furthermore, for what they are charging, the company would be better off buying the machine and doing the work in-house!”

Collins was proud of his analysis; he told Reynolds the company should bring this machining operation in-house so the profit margin could improve. But Reynolds was cautious. She said it would be prudent for Collins to first find out the firm to which Jones Company had outsourced this machining operation before it used Smith Company; the previous vendor might have been cheaper. She also asked Collins to examine Smith Company’s vendor file.

Collins discovered that the vendor Jones Company used before Smith Company charged 50 percent less than Smith Company for the same machining operation. He also found that Jones Company had paid Smith Company more than $2 million for outsourced machining the previous year. The vendor file contained all the necessary documentation to establish Smith Company as a valid vendor; however, Smith Company had been added as a vendor after CPI purchased Jones Company. After Reynolds reviewed this information, she told Collins to perform a public records search on Smith Company.

Collins found Smith Company’s articles of incorporation. The articles listed Tony DeMarco as an officer of Smith Company. DeMarco is Jones Company’s production manager and Reynolds recalled seeing in the audit paperwork that DeMarco had approved payment of invoices submitted by Smith Company.   She knew immediately that the problem was worse than she’d originally thought, and fraud might be afoot. The next step was for her and Collins to interview DeMarco.

AUDITORS INTERVIEW PRIME SUSPECT 

Collins had never interviewed a fraud suspect before, so Reynolds, who had interviewed several, gave him some pointers. Reynolds warned him they probably didn’t have enough evidence this early in the investigation to obtain a confession from the suspect, but she said there was plenty to warrant an interview.

She explained to Collins that an investigative interview is a non-accusatory meeting for gathering factual information through open-ended questions and studying behavioral cues that might indicate deception. An admission-seeking interview requires more of an accusatory approach in which the interviewer asks assumptive questions to obtain admission that corroborates the evidence.

The auditors knew that Smith Company had charged exorbitant fees to Jones Company for the outsourced jobs. They also knew that DeMarco is an officer of Smith Company and that he approved the payments to Smith Company. DeMarco had failed to report this relationship (related party disclosure) to CPI. Further, based on the opinion of the previous owner, Jones Company could have purchased a machine to do the work done by Smith Company at a much lower cost. However, the auditors needed evidence that the production manager substantially benefited from the overcharges on the jobs billed to Jones Company to prove fraud.

Collins and Reynolds decided to meet DeMarco in his office for the interview. If this had been an admission-seeking interview, the meeting would be at a more “neutral” location.

They began the interview by trying to develop a rapport with DeMarco. He seemed to be working too hard to be accommodating and cooperative. He commented that he was “glad to answer any questions” they had, and he even suggested lunch after the meeting.

The auditors played along with small talk for a few minutes, but then something caught Reynold’s eye. On the wall was a picture of DeMarco holding up a fish on the back porch of a cabin. Another man was standing next to him in the photo. Reynolds asked about the photo and DeMarco gladly told her the story of how he caught the fish on a recent trip to his cabin. The other man in the photo was his brother-in-law, Joe Thompson. Reynolds recalled that Thompson was another officer listed in the articles of incorporation for Smith Company and was further able to determine two other important facts from the interview: the cabin was recently constructed and DeMarco had an expensive new boat.

Reynolds mentioned that she knew Thompson was an officer of Smith Company, and that she and Collins noticed DeMarco was also listed as an officer. She then asked DeMarco about his involvement with Smith Company. DeMarco sensed trouble. He tried to convince the auditors that his involvement was limited to helping his brother-in-law get the company started and that he didn’t even realize he was listed as an officer.

Reynolds then asked if he had been compensated for this work, and DeMarco tried to brush it off by saying he had been paid a small amount and really didn’t do much to earn it. Reynolds asked if DeMarco would mind if they contacted his brother-in-law to take a look at some of the records at Smith Company.

DeMarco knew he was in trouble because he and his wife had been receiving “dividend checks,” which totaled more than $1 million, from Smith Company for the previous two years. He responded by claiming he didn’t deal with Smith Company anymore and didn’t see the point in bothering his brother-in-law.

DeMarco promised to contact his brother-in-law, but he made no promises that the auditors would be allowed access to Smith Company records. After the interview ended and the auditors were outside, Reynolds told Collins, “I think he’s lying. We need to see those records before they get a chance to destroy them.”

The auditors, based on DeMarco’s behavior in the interview, had reason to believe that a review of Smith Company’s records would show that DeMarco substantially benefited from the overcharges. They now needed to call in law enforcement and the county prosecutor to subpoena bank account and payroll records at Smith Company. CPI’s corporate security department, with Reynolds’ and Collins’ assistance, convinced law enforcement to initiate an investigation.

CHOOSING THE RIGHT INTERVIEW APPROACH 

The subpoena allowed them to search Smith Company’s records. Detective Brian O’Shea, who was assigned to the case, discovered that Smith Company issued several checks to Tony DeMarco and his wife in the previous two years. These payments, totaling $1.2 million, were recorded as dividends.

The auditors and O’Shea had a compelling case – with or without DeMarco’s admission of guilt – because of the gross overcharges on jobs outsourced to Smith Company and DeMarco’s conflicting testimony that his role at Smith was insignificant. Obviously, the case would be easier to prosecute with a confession, so O’Shea was now prepared to conduct an admission-seeking interview of DeMarco with Reynolds’ assistance. (We now refer to O’Shea and Reynolds as “the interviewers.”)

The interviewers could have used two possible admission-seeking techniques. A direct-accusation approach is confrontational and probably would push DeMarco to deny the fraud. The interviewers would have stated the issue, provided innuendo of evidence, and then directly accused the subject. The intent would have been to overpower the subject up front. Though the evidence was very good and could support a direct approach, the investigators chose an alternative method using an introductory statement.

The introductory-statement approach requires the investigator to deliver a monologue during which he or she:

• Verifies the subject’s background
• Establishes rapport
• Introduces the fraud topic
• Tells the subject how the interviewers know of the fraud and how it was detected
• Establishes credibility in the investigation

This method normally eliminates any hope the subject might have of evading responsibility and could identify other frauds. Interviewers using a direct-accusation approach might not be able to find additional fraud because the subject tends to be locked into denial.

The introductory-statement approach is sometimes ineffective on subjects with strong personalities. DeMarco certainly fell into that category so the interviewers were playing the odds, but the benefits outweighed the risks.

Two key aspects of the introductory-statement approach include identification of a rationalization and the ability of the interviewer to show understanding. The interviewers believed the introductory-statement approach would work well because they had a good idea of DeMarco’s motive: he had been in line to buy Jones Company when the owner had a change of heart and sold it to CPI. (The interviewers discovered this after they had interviewed the former owner again.)

DeMarco probably felt the company had cheated him despite his many years of loyal service and hard work. The company essentially had demoted and humiliated him. He now reported to a bureaucrat in the home office instead of being the man in charge. The interviewers surmised that DeMarco had decided to “take what he is owed.” Anybody would understand why he did what he did – at least that’s what the interviewers would try to convey to DeMarco during an admission-seeking interview.

ADMISSION-SEEKING INTERVIEW COMMENCES 

Because Ted Jones was at Jones Company, O’Shea and Reynolds solicited his assistance to secure a conference room for the admission-seeking interview. They set the chairs so the seated suspect would be looking directly at the seated interviewers three to four feet away. There was no table or other barrier between DeMarco and the interviewers. DeMarco would have his back to the door so he wouldn’t be able to later press a false imprisonment charge. The interviewers’ intent was to create a feeling of intimacy so they could develop a rapport with DeMarco.

Jones and DeMarco still had daily interactions. When DeMarco arrived for work that day, Jones immediately led him to the conference room. DeMarco saw two people in the room: Reynolds, whom he had already met, and a man he didn’t know.

Jones didn’t stay in the room and made no introductions. O’Shea introduced himself and verified DeMarco’s background and then launched into his introductory statement. DeMarco appeared annoyed, but he listened.

O’Shea attempted to develop rapport by asking questions that were unrelated to the investigation, such as DeMarco’s fishing trips. However, DeMarco became agitated with the attempt at small talk and asked what the meeting was really about. At that point, O’Shea described the thoroughness of the investigation and most of the uncovered facts. He made it clear that the interviewers knew that a fraud had occurred. The only question was DeMarco’s motive.

Before DeMarco could deny a fraud took place, O’Shea began discussing his take on DeMarco’s rationalization. After O’Shea had described the case, DeMarco began to deny any wrongdoing. Reynolds quickly cut off DeMarco and said she and the detective knew for certain a fraud had been committed and he had probably done it. Their only remaining question was why; they wanted him to confirm their suspicions about his rationalization.

DeMarco continued to deny the allegations, but the interviewers could see he was shaken. They took turns reminding DeMarco that there was no doubt a fraud had occurred, and they created a sense of urgency by telling him to come clean now so people would think better of him. (This provided an intangible benefit of perceived leniency and encouraged the subject to decide immediately.)

O’Shea tested for submission of guilt by asking an assumptive question (one that presumes guilt): “Did you get other payments as well?” DeMarco responded emphatically, “no!” to which O’Shea responded, “That’s good; we didn’t think you did. So the total we showed you before is about right.” (This was a statement rather than a question.) DeMarco, now more subdued than before, responded with a quiet “yes.” He’d finally submitted.

The rest of the meeting included the interviewers’ further questioning to uncover other fraudulent acts. Finally, Reynolds asked DeMarco to prepare a statement recounting his involvement in the scheme, and he agreed to do so.

INVESTIGATION RESULTS 

Based on the evidence (job cost analysis) and the confession, DeMarco was charged and convicted on 10 counts of fraud. He was ordered to pay restitution to CPI and received a two-year prison sentence. In exchange for a more lenient sentence and to avoid prosecution of his wife, DeMarco testified against his brother-in-law, Joe Thompson. The jury found Thompson to have been the instigator of the fraud,  and he was convicted on all counts. He received a five-year sentence and was also ordered to pay restitution.

Teaching notes for this case are available to instructors from author Martin Coe.

Martin Coe, MBA, Educator Associate Member, CPA, CISA, is an associate professor of accountancy at Western Illinois University in Moline, Ill. 

Jeffrey Coussens, MFA, is an associate professor and director of the Theatre Arts Program at Augustana College in Rock Island, Ill. 

John Delaney, DBA, Educator Associate Member, CPA, CIA is an assistant professor of accounting at Augustana College in Rock Island, Ill.

Suggested Requirements for Students Studying This Case 

This case can be used in a classroom or seminar setting to: 

• Discuss the Fraud Triangle and the importance of symptoms
• Discuss accounting symptoms of fraud
• Perform financial statement analyses to determine if fraud is suspected
• Identify and test a fraud hypothesis
• Analyze an investigative interview
• Analyze an admission-seeking interview
• Draw conclusions and prepare fraud reports

The case requirements include: 

1. Perform horizontal and vertical analyses of the financial statements.
2. Describe other financial statement analyses that the auditor could have performed.
3. Describe a public records search.
4. Analyze this case using the Fraud Triangle.
5. What is the fraud hypothesis in this case?
6. Watch the introduction and interview segments on the case DVD (available from author Martin Coe). Describe the elements of an effective interview and indicate if this interview followed proper interview techniques.
7. What is the difference between civil and criminal as it relates to a fraud examination?
8. Prepare a preliminary fraud examination report that will be provided to law enforcement prior to the admission-seeking interview.
9. Watch the admission-seeking interview segment on the case DVD. (The admission-seeking interview is identified as “Interrogation” on the DVD.) Compare and contrast the investigate interview and admission-seeking interview. Discuss the pros and cons of this particular investigation.
10. Prepare a final fraud examination report that will be provided to CPI management.

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