Finding procurement fraud red flags

Have you ever been asked to review procurement practices for your organization or as a third party? Procurement is prone to corruption and bribery and can cost large organizations millions of dollars annually. Here I shed light on some of the best tools and techniques fraud examiners can use to combat procurement fraud.

Throughout my 10-year career, I’ve detected and investigated more than 50 cases of fraud and abuse for large private and publicly listed companies. In this column, I cover an example of procurement fraud associated with outsourcing decisions.

Using your CFE knowledge

In one case, a company group’s audit committee and CEO asked me to perform a procurement review for a large factory, which produced oil and gas equipment. I had complete autonomy, which included full freedom and access to information.

Fraud examiners, internal auditors and consultants can often find themselves in such a situation. Your client might give you carte blanche but expects you to achieve solid results. So, it’s important that you utilize the academic knowledge and tools you gained during the process of obtaining your CFE credential and additional continuing education.

From a practical point of view, of course, some of the handiest data you can get is actual payment information for as many years as possible. It’s reliable and overcomes the challenges of using arbitrary and possibly judgmental accounting information. (I suggest using a “flat-table format,” which contains one record per line; it’s great for trend analysis, understanding changes among various vendors and, most importantly, identifying links between various companies and the employees.)

Sort the data according to annual spending and start reviewing from the top down according to amount. You’ll often find big brand names in this section, but I generally avoid them as starting points because the smaller companies are more likely to have internal-control issues. Thoroughly research your vendor base. Try to identify evasive, shady and questionable vendors.

I’ve discovered some of the most vivid red flags of procurement fraud via:

1. Internet profiles. Look for poorly designed websites, lack of internet presence and news searches online. Do a Google search of the organization and try to review as many results as you can. Do you get an impression that the organization is reputable? Does it advertise the products and services it sells to your organization? Who are its other clients? Does the organization exaggerate its success?
2. Incorporation dates. A short time frame from when the company became incorporated and when you started doing business with them is suspicious — particularly if it’s less than one year.
3. Addresses. Hundreds of other organizations registered with the same address as your vendor, of course, could indicate that the vendor has no physical presence and only exists on paper. (Sometimes, an organization might provide its address as the same as your building or a location down the street!)
4. Investigative links. Compile a file with your vendor’s basic information (including names of known directors, employees and owners), and another file with employee data (including former employees). Identify any matches. Although you’ll want to automate this (for example, with IBM’s i2 Analyst’s Notebook, Sentinel Visualizer or Microsoft Excel), it’s worth spending a few extra hours to manually review the data to search for any matches.

These following methods work extremely well in detecting fraud and abuse by outsourced vendors. They’re indicators that the vendor has been set up specifically to do business with your organization.

1. Compare your annual purchases with your vendor’s revenue over several years. One of the vendors in a fraud examination I worked demonstrated an overall 95 percent rate. This means that 95 percent of its revenue was generated from sales to our organization. In practice, it means that you can easily move this service in-house; remove the vendor, hire similar staff and don’t overpay for the services.
2. Check the vendor’s invoice numbering. Almost sequential numbering means the vendor has no or few other customers than you.
3. Use specific interviewing techniques to judge employee behavior. Interview employees in the decision-making chain from the engineer who designed a product to the buyer to the buyer’s manager and the chief procurement officer. Listen closely to the responses to your questions. Don’t follow a prepared questionnaire line by line. Observe and make judgmental notes. Observe whether the interviewed employees are nervous, concoct unreasonable arguments, overreact to certain comments, interrupt the flow of discussion and act unnaturally.

In another procurement case I worked I identified 10 suspicious companies from the payment data, and they all related to the production process of modular oil and gas equipment. I reviewed the contracts with those companies to try to understand the kinds of services they provided.

If you suspect similar fraud at the production level, I strongly advise you to do some additional internet research to find their locations, the owners and main personnel, how long they’ve been in the market, financials, media reports, manufacturing processes, etc. Also visit warehouses and production floors to gather important clues.

In this case, these companies either supplied various component parts for our final product or did some work in the factory itself. In essence, we were dealing with widespread outsourcing.

After you do your homework about the vendor companies and what they do, you’ll want to understand the rationale for employing these companies. Here are three main questions to ask:

1. Are you outsourcing the core competency? In a case I worked, the production factory outsourced the work it could perform itself. Its workers had nothing to do while subcontractors maintained regular levels of activity. Moreover, the vendor moved the in-house factory workers to a three or four work-day week for several months.
2. Is it really cheaper? Always request production calculations from your finance department and vendors and thoroughly study them. Request supporting documents, such as commercial quotes, technical norms, assumptions and other data and underlying formulas. Organizations typically err in including overhead costs, which shouldn’t be relevant to its decision to outsource. Overhead costs will remain stable whether or not an organization decides to outsource. Challenge key assumptions of the calculation and check the formulas.
3. Who are the vendors? Did the organization place the vendors under a selection and due diligence process? How did the organization find them? Are there any indicators of conflicts of interest? Review the supporting documentation and business correspondence.

To further your investigation of a vendor’s history, speak to the budget holder (the staff member who’s been assigned a budget for a particular activity and is responsible to management for it) for an explanation and background.

In one case, the production director argued that the factory couldn’t do everything, and it needed to outsource one of the least-enjoyable parts of the technological cycle (dirty, high-labor jobs, such as casting, welding and sandblasting) to focus on more technologically advanced cycles (such as design work and assembly).

During the course of my case interview, the production director tried to confuse me with production terminology and laughed when he realized that I wasn’t familiar with basic engineering and welding concepts. But I didn’t need to know everything. What I did understand was the finance behind production. Don’t let the interviewees derail you with unfamiliar terms. Concentrate on the most important issues and fit the unfamiliar terms within your understanding of business concepts.

What I found most suspicious in this case was the lack of documentation around the initial outsourcing decision and the production director’s aggressive behavior. I decided to structure my analysis with two conclusions: Prove the outsourcing wasn’t cheaper and explain the suspicious nature of the vendors.

I did some extra work. I analyzed the previous contractors as far as the systems would allow me. I found a large subcontractor, set up eight years before, and I researched its background information. Initially nothing appeared suspicious until I looked through the ownership changes and there he was — my aggressive production director. He owned the subcontractor that provided the services for our factory at a 25 percent share. What a conflict of interest and fraud!

In my experience as an internal auditor, I’ve seen employees seek rewards beyond salaries by introducing an affiliated company’s business into procurement functions. They become “predator” fraudsters whom organizations can no longer trust.

As a CFE, I’ve also seen past or present employees try to steal parts of businesses or compete with the organizations at which they work. Pay extra attention whenever your company hires a person with previous or current ownership in a business.

What to do about it?

Your organizations will show multiple scenarios and reasons for its procurement fraud. Depending on the circumstances and cooperation with your stakeholders (owners of the business, board of directors, CEO, senior management, etc.), the outcome will be different. However, I suggest taking these key steps to improve the corporate culture and prevent such behavior in the future:

• At a minimum, I strongly suggest immediate dismissal of the people involved in fraud. If the organization doesn’t do that, others will feel they can perpetrate a fraud or steal from the organization with no repercussions. It undermines the very essence of fraud deterrence, fraud remediation and internal auditing. Think about how you might audit the same person a year later. It’s your job to strongly argue for the dismissal of the perpetrators, especially if you work in-house and complete these reviews regularly.
• Potentially prosecute if the case is significant or if it’s relatively easy to prove. For example, bring in law enforcement if you’ve discovered work emails suggesting that your vendor offered a bribe to an employee and they accepted it. However, don’t let your company get involved in a lengthy trial with little potential or benefit to recuperate losses.
• Understand what led to the fraud and review the internal control system accordingly. Consider the range of control activities, segregation of duties, general procurement and sourcing policies, and the minimum vendor selection requirements.
• For outsourcing arrangements, argue for the selection of a cheaper provider or transfer the service or product in house.

Sneaking procurement fraud

Procurement fraud and abuse can sneak up on your organization or clients. Vendors can cut corners, farm out procedures they should keep in-house; your employees can have conflicts of interest and cheat you on prices. Conduct regular reviews of your procurement practices. These anti-fraud measures will give you a start.

Vladimir Chugunov, CFE, ACCA, CIA, CISA, is a partner at Lighthouse Forensic in Sydney, Australia. His email address is: chugunov@lighthouseforensic.com.