The Spinster and the Dubious Investment

Small organizations: Beware of those longtime employees who have their hands in every department. They could be like alpha executive Francine Gordon, whose fraud gave her company headaches and grief. Learn lessons from this tale of misplaced trust, faulty internal controls and lack of segregation of duties.

This article is excerpted and adapted from the “Financial Statement Fraud Casebook: Baking the Ledgers and Cooking the Books,” edited by Dr. Joseph T. Wells, CFE, CPA, published by John Wiley & Sons Inc. ©2011 Used with permission. Names in this case are fictitious.  

All financial statement frauds are not in the billions of dollars. They only need to be big enough to be material to the financial statements.

Francine Gordon was a highly intelligent, model employee of Small Town Federal Credit Union (STFCU). She had been STFCU’s controller for more than 15 years, but she also managed the data-processing systems. When the data-processing clerk was sick or on vacation, Gordon would step into the position to make sure that the processes ran efficiently. Many employees at the credit union — including Gordon — believed she knew more about the IT systems than the data-processing clerk.

She was not the typical “that’s not my job” employee. For years, she helped out in many other departments and led several projects. Susan Wren, STFCU’s CEO, and many employees tolerated her somewhat dictatorial manner and moody temper because she was so valuable to the credit union. Few employees ever challenged Gordon about credit union issues.

As with many small financial institutions, the credit union had not separated duties because of finite resources and extremely tight budgets. Gordon had some unthinkable duties and responsibilities. Her primary responsibilities as controller were creating financial statements, preparing budgets and forecasts and reconciling STFCU’s lengthy and often complicated bank statement.

In addition to supervising the data-processing department, she was responsible for the accounting — and the management — of STFCU’s investment portfolio. This allowed her to make purchase and sales decisions about investments, although intelligent investment analysis was not one of her strengths. So, Gordon relied on the advice of the credit union’s three approved brokers. Her control of so many of STFCU’s areas created a “witch’s brew” for bad decisions and lax internal controls.

Her compensation was good but not comparable for those working in the upper tier in credit unions of similar size. Regardless, Wren granted Gordon more authority and autonomy throughout the years.

Gordon frequently worked long hours and weekends. She was not married, did not have a significant other or children, seldom visited her faraway family and was not close to other employees and had few friends. Gordon did gravitate toward Steven Edwards, one of the credit union’s investment brokers. Edwards, an older distinguished gentleman with a silver tongue, always was impeccably dressed and manicured. He would send flowers to Francine on her birthday and visit her regularly.

Though the credit union had three approved brokers, it consistently awarded Edwards about 90 percent of its investment business. Because it was a small financial institution, STFCU relied on its brokers to analyze investments and to detail how individual investments and the total portfolio fit into the credit union’s balance sheet and future goals. However, Edwards did not provide these analytics and did not appear to have a solid understanding of how to manage an investment portfolio. In fact, he did not seem to understand financial institutions very well. Apparently, his skills were more social than financial.

NOT SLY ENOUGH

STFCU, located in a northeastern state, had 22 employees, two locations (a branch and main location), approximately 30,000 members (customers) and $110 million in assets. As with most small financial institutions, taking in deposits and granting loans was STFCU’s primary business. However, due to spare loan capacity, the credit union’s investment portfolio was vital to earning a reasonable return on excess funds. Typically, credit unions and small financial institutions follow the SLY principle of investing — safety, liquidity and yield. However, financial institutions must know what they are investing in so they can implement all aspects of the SLY principle.

WITHIN THE MATRIX

When I started working at STFCU I had a wide range of duties, including internal audit and financial accounting. As a CPA, I was concerned about the overlaps in duties, but I was pleased to be working at a credit union. My grandfather had founded a small credit union; I grew up in the industry and was happy to be out of public accounting and back in the field I had been a part of from a young age. A regular schedule, not often found in public accounting, and the ability to focus on moving one organization forward was truly appealing to me.

Approximately six months into my tenure, Wren asked me to start reviewing and preparing the bank reconciliation. I was surprised by the volume and the relative complexity of the transactions. I jumped into the project, but it took some time to learn the nuances of the transactions flowing through the cash account. After a couple of months, I was relatively comfortable with the transactions and did not need Gordon’s direction and explanation of the reconciling items.

While I was conducting the third-quarter reconciliation of the bank statement, and preparing the financial statements and the quarterly 5300 Call Report (a U.S. regulatory financial and statistical report), I noticed a significant reconciling item that affected both cash and member shares (deposits at a credit union). Time was of the essence because the credit union’s regulators were also on-site conducting their annual review. I was concerned about submitting the Call Report and financial statements without understanding the $130,000 entry, so I decided to question Gordon about it. The transaction had her employee ID attached to it, which meant she recorded the entry. She gave me a flustered, circular explanation that did not make sense and said we had to quickly prepare financial statements for the regulators. Unsatisfied with Gordon’s explanation, I met with Wren. Wren was the closest to a friend that Gordon had in town; Wren was also concerned about submitting the Call Report and financial statements to the regulators in a timely manner.

The credit union and Wren had a cordial but often tense relationship with the regulators. Wren, an STFCU employee for the past 25 years, had worked her way up from teller to CEO and often treated the credit union as her personal, privately held business. This attitude was clear to regulators and made them uneasy. In addition, Wren often responded to regulators’ recommendations about issues such as internal controls with resistance that bordered on hostility.

With Gordon’s “explanation” and Wren’s direction, I prepared the financial statements and call report so the regulators could move forward with their examination. Surprisingly, the regulators accepted Gordon’s explanation about the reconciling item; I figured it must have been valid if it passed their review. I moved forward with my other duties and did not give it much more thought. The regulators left the credit union in early November and presented their findings — none were significant, and none related to the $130,000 reconciling item.

In mid-December, I began the closing process for November. I was surprised to find the same reconciling item from the September quarter-end. It seemed to me that the reconciling item should have cleared and become a non-issue by now. I again took the reconciling item and entry to Gordon for clarification, and she became flustered again. She told me she was extremely busy and would get back to me by the end of the week. I did not realize that would be the last time I would ever see her.

CHANGE IN PLANS

The next morning Wren came into my office and handed me a piece of paper. It was Gordon’s resignation. Considering she had a 15-year career at STFCU, her note was short and to the point: “As of December 16, I resign. Thank you, Francine Gordon.” I quickly thought but did not say aloud, “Well, happy holidays.”

Knowing that Wren was shocked and worried about losing Gordon, I asked how long she would be around to train and help with the transition. Wren said that she had called Gordon, but her phone was disconnected. Wren checked Gordon’s office, and her few personal items were gone. Gordon’s years of experience and knowledge of the credit union’s systems had vanished.

I made the logical conclusion that Gordon’s abrupt departure was related to the reconciling item. Wren was even more shocked after I told her, but she could not argue with the strong circumstantial evidence. We agreed that analysis of the reconciling item was a priority.

Approximately a week later, Susan promoted me to CFO and tasked me with quickly determining the source of the reconciling item. With little solid information I set out to piece the puzzle together and prepare accurate year-end financial and regulatory reports. I was curious to review the regulator’s work papers related to cash. However, I determined that the investigation should move forward in-house because of our lack of knowledge about the situation and the tenuous working relationship with the regulators.

HOLIDAY PRESENTS FOR ONE AND ALL

With snow falling and temperatures dropping, I began reconciling and often reconstructing various accounting records related to the $130,000. Unfortunately, the level of detail and explanation typically related to adjusting entries did not exist with the transaction. However, I quickly noticed the accounts related to the item were cash, investments and customer deposits — all accounts with significant balances and voluminous and occasionally complicated transactions. A $130,000 change in any of these accounts was not unusually large. After about a week of reviewing online and hard-copy records, my eyes hurt, but I determined that the entry originated approximately three years earlier and pertained directly to investments.

Four-and-a-half years earlier, Gordon had purchased a mortgage-backed investment from, not surprisingly, Steven Edwards, the investment broker. The investment was purchased at a significant premium and paid principal and interest on a monthly basis. The principal payments were based on the principal repayments of the underlying mortgages associated with the security. Because of this, the premium would have to be amortized on a monthly basis based on the principal repayments.

Gordon, although highly intelligent, did not appear to clearly understand the investment, and she was only amortizing the premium on a consistent basis over the projected life of the mortgage security. The projected life of the security and the actual life were not the same and when interest rates on mortgages dropped, consumers refinanced their mortgages and large amounts of the principal were paid back to the credit union. This should have resulted in increased amortization or expensing of the premium; however, it appeared that Gordon realized that proper amortization of the premium would have resulted in a net loss for the year. Instead of amortizing the premium correctly, Gordon continued to amortize it on a straight-line basis, and then she created a “reconciling item” for the remainder and used accounts such as cash, investments and deposits to record the entry. This had the effect of inflating net income for the initial year and equity for the subsequent years. The reconciling amount remained consistent, but the accounts used changed monthly. For three years, the $130,000 oscillated among accounts and passed CPA and regulator audits. It was not possible to determine, but it would have been interesting to know if Gordon’s explanation of the item remained constant or changed with time.

Although we were never able to contact Gordon, the picture of what happened and how it was concealed slowly became clear. This was not the holiday present I originally wanted, but it brought closure to the issue.

It was also clear that Gordon’s overly close relationship with Edwards allowed him to sell her and the credit union inappropriate investments that management barely understood. After further analysis and discussion with other brokers, I realized that Edwards’ commission was highest on these types of investments. Not only did Gordon purchase them for the wrong reasons, but I now found it difficult to find buyers for them. Therefore, many of the investments were held to maturity even though they were not a good fit for the credit union’s balance sheet.

In my new position as CFO, I attempted to understand how the investments fit into the credit union’s balance sheet, but Edwards was never able to clearly explain their benefit. Much like Gordon’s explanation of the reconciling item, Edward’s explanation of investments was circular and illogical. I decided to embrace my limited understanding of exotic investments and ensure that all future purchases made sense to me and fell under the SLY principle.

DECISIONS AND CONSEQUENCES

The clear solution was to adjust for the reconciling item by reducing equity. Although STFCU had adequate equity on the balance sheet, the adjustment was nevertheless painful. Equity was a valuable tool in keeping regulators content with the credit union’s often stagnant financial and market position. It was also necessary for Wren to contact the regulators and notify them of the situation. They were not pleased, obviously, but they treated us fairly, most likely because they realized they had also missed the error during many audits.

Gordon did not financially benefit from her fraud. Her motivation was to save face by not admitting she had chosen an imprudent investment. Wren said that she would have ranted and yelled at Gordon, but she would not have fired her for the string of errors.

Because of the nature of the fraud, disclosure to law enforcement officials — other than STFCU’s regulators — did not seem necessary or beneficial for STFCU. However, due to the significant nature of the crime it was necessary to notify the credit union’s bonding and insurance company. This arduous process of filing forms and meeting with bonding investigators fell to Mandy Stevens, the credit union’s human resources manager. Stevens and Gordon had worked together for a number of years and Gordon’s bullying and condescending style had not gone unnoticed. Although Stevens was professional, she viewed the process of removing Gordon’s bond as a late holiday gift. The removal of her bond would effectively prevent Gordon from ever working in another financial institution — the only industry she ever knew. With no formal education beyond high school and a tainted work history, Gordon’s options for future employment were slim and few.

Part of the bond removal process allows the accused the opportunity to respond to allegations and provide contradictory evidence. Kurt Marshall, the insurance and bonding company’s investigator, told us that Gordon never replied to notices.

No one at the credit union has heard from Gordon since. There were rumors that she moved out of state and attempted to gain employment at a new credit union. When that failed it was also rumored she took an entry-level retail position. Although her bullying made her an unsympathetic figure, Gordon’s career ended unfortunately, and her motivation was not the typical American greed story.

LESSONS LEARNED

Having well-trained, versatile and intelligent employees is important; however, the segregation of duties is not an abstract theory only applicable in textbooks. Segregation of duties needs to be continually evaluated and understood in organizations of all sizes. Since the Sarbanes-Oxley (SOX) Act, larger organizations have done this, but small organizations are not subject to SOX requirements. Also, this case demonstrates that fraud does not always occur for financial reasons. Although Gordon may have been concerned about losing her job and her income, it appears that her primary motivation was to not appear incompetent and to continue being viewed as the alpha employee of the organization. Not admitting her error was a significant motivator for her.

It was also interesting that Gordon left the total amount of the reconciling item throughout the years. My assumption would have been that she would try to chip away at it over the years with the hope of eventually eliminating the item and moving forward. However, she did not do so, and I wondered if she thought it was easier and simpler to continue moving around one large reconciling item rather than breaking it into many small, monthly, unsubstantiated entries. This procedure might have increased the likelihood of being caught because there would have been more transactions for someone to question. It was also possible that after passing the first couple of audits, she believed it would be easy to continue the fraud into perpetuity, which she thought would remove her need to eliminate the item.

Because of this on-the-job training, I learned my limitations regarding exotic investments. After I took over the CFO position, conservative investment principles guided me. Although my investment strategy resulted in reduced investment income to the credit union, I was able to sleep at night. Plus it allowed for proper balancing of risk for the credit union.

It is also interesting and important to note that the vacuum created by the fraudster’s permanent absence revealed this fraud and not an internal control system or audit. The situation could have continued for some time because of Gordon’s intelligence, the credit union’s less-than-optimal internal controls and her ability to lie about the $130,000.

RECOMMENDATIONS TO PREVENT FUTURE OCCURRENCES

Gordon rarely went on vacation, and when she did it was usually for less than a week. All employees should be required to take an annual vacation of at least a week. In addition, organizations should cross-train all employees in duties. This can be difficult for small organizations, but another employee should be at least familiar with each supervisor’s work. Although this might not have prevented Gordon’s fraud, it would have decreased the likelihood of it continuing.

All organizations should provide resources for detecting fraud. In tough financial times it is often difficult to allocate funds away from revenue generation; however, this approach is shortsighted and can be extremely costly in dollars and reputation. Analyzing fraud risk and segregation of duties should be continuous — not a one-time activity. Also, remember that fraud can be perpetrated for a number of reasons, and they do not always include direct financial reward to the fraudster.

Firms that do not separate the components in the cash, investments and reconciliation process will face an intolerable level of risk.

All reconciling items — material or not — should have a cogent explanation and be verified by an employee who is independent of the person initiating the entry. It is easy to take a person’s explanation of a situation at face value, but reconciling items should be well-founded and balanced or cleared in a reasonable amount of time. A recurring reconciling item for the same amount is a concern and presents a high risk to the institution.

Follow these lessons and you could save your small (or large) organization grief and loss from a too-important employee who needs to save face.

Eric Sumners, CFE, CPA, has approximately 20 years of professional audit experience in an array of industries, including financial services, manufacturing, not-for-profit and governmental. He also has published a number of articles about auditing issues.

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