Trust us... we wouldn't lie to you

An accounting firm took on a new client from the advice of a good friend, but it didn’t conduct proper due diligence. Big mistake. During an inventory, the client’s CEO repeatedly lied to the author — a fraud examiner — and the external auditors he worked with. Here’s how to avoid fraudulent clients and keep your sanity.

Inland Distributors was a new client of Shipman Calabrese, a regional public accounting firm where I worked as a manager. Josh Addision, a well-respected banker with Family Bank and a good friend to Shipman Calabrese, had recommended that the owners of Inland Distributors, who were seeking new auditors, contact our firm. Shipman Calabrese had a great reputation with Josh and Family Bank.

According to Josh, the owners of Inland, a large distributor of machinery with annual revenues of approximately $25 million, were in discussions with him to restructure the company’s financing and potentially move their borrowing and banking relationships over to Family Bank.

Sam Forde was president and chief executive officer and a primary shareholder of Inland. Brad Crossman was chief financial officer. Evan Bowers, working under Brad, was the controller.

I was a “utility player” with significant forensic and fraud examination experience at Shipman Calabrese. Our engagement partner would frequently add me to traditional audit teams for risky or new engagements to complement skills and experience.

Growing distribution

Inland Distributors maintained a primary headquarters with a large warehouse for receiving and shipping machinery and a second satellite warehouse about five miles from the main building. Inland shipped many orders directly to customers or end users from the satellite warehouse. According to information provided by Josh, past sales were strong, and Inland was growing. Inland’s management was seeking additional financing because of its sales growth.

The new client

Based on Josh’s recommendation, Shipman Calabrese accepted Inland as a new client late in the year. David Kirkham, the partner in charge at Shipman Calabrese, performed little independent due diligence. Because Inland had a December year-end, Kirkham quickly assembled an audit team to begin planning for the upcoming audit. The firm asked me to help out the audit team.

Kirkham held a planning meeting at Inland with Sam, Brad and Evan. One of Kirkham’s biggest concerns was coordinating the physical inventory that Inland’s staff had to conduct at the end of the year because its inventory, in large part, collateralized its financing.

Inland’s executives identified their need for audited financial statements to obtain financing from Family Bank and told us they needed the complete statements within 60 days of their year-end close (Dec. 31). That timing would be tight even for a recurring client with a history at our firm, but for a brand-new audit client with a known reliance on financing, completed within 60 days during tax season — the busiest time for any accounting firm — was insane. Still, Kirkham scheduled the audit, met with our team and we proceeded with the audit.

Sam instructed Brad and Evan to plan, schedule and oversee the physical inventory and ensure the company followed procedures to provide sufficient audit evidence to meet our standards. Shortly after our planning meeting, Inland scheduled the inventory and sent our firm a copy of the inventory instructions provided to its staff.

On the day of the inventory I drove to Inland’s main location with another Shipman Calabrese auditor, Jeff Coyle, to observe the inventory and perform test counts. I knew little about the company or its inventory, but I learned what I needed on the ride out. As we pulled onto Inland’s property, Jeff told me to park in the front visitor’s lot. He said Kirkham instructed him to park in front and use Inland’s main entrance, where someone would meet us.

We entered and, after signing in, were escorted to a large conference room. Shortly after, Sam, Brad and Evan joined us, introduced themselves and began discussing Inland’s physical inventory, which they said was underway.

I asked them three questions:

• Is any of the inventory obsolete?
• Is any of the inventory owned by anyone other than Inland?
• Will there be any movement of inventory (shipping or receiving) while the counting is being performed?

They assured us Inland owned the entire inventory, machines turned every three to four months (resulting in no obsolete inventory) and the company made no inventory movements until it completed the counts. Sam provided the green light to resume normal operations, which was just what an auditor wants to hear from its client.

Sam, Brad and Evan left the meeting. As Jeff and I headed out to the warehouse, we saw another meeting in another conference room. It looked like another team of auditors was meeting with Sam and Brad. Curious.

We entered the warehouse to find staff counting and tagging machines and other inventory. I asked one of the employees where we should start observing the counting, and they told me the inventory directly in front of me didn’t belong to Inland but to the other company. I looked over at Jeff and asked myself, What other company? Senior management had just told me that Inland owned the entire inventory. Strike one.

Senior management had just told me that Inland owned the entire inventory. Strike one.

The employee told me the counting had just started, and it would be more efficient if we started observing and performing our test counts at the remote warehouse first. He said the staff across town had started much earlier in the morning, and because of the smaller size of the warehouse, they might even be finished with their counts.

Jeff and I headed across town. As we walked in, we saw that the satellite warehouse was segregated into areas designated with letters — A through K. We saw the count teams were working in the G area and tags were fixed on the inventory in the A through G sections.

We talked with staff about their progress. They said they started their counting in section D and figured they needed another hour or so to finish through area K. I asked why the items in sections A through C had inventory tags on them if staff members didn’t count them. An employee said section C contained items that hadn’t been moved in the past year, section B had items that had been there for several years and section A had items that never moved. They laughed when they told us the inventory tags were from prior years, and only the dates were updated. Once again I looked at Jeff and thought back to the senior management’s assertions that the entire inventory was current and none was obsolete. Strike two.

The counting was well documented, our test counts revealed no exceptions and — other than the fact that sections A through C contained obsolete items — the inventory looked well done. We headed back to Inland’s headquarters. When we arrived I decided to drive around the back of the building. We saw a tractor-trailer behind the warehouse loading machinery from the shipping area. I parked, and I asked the truck driver where the machines were heading, and he gave me the customer’s name. He said a similar truck had left about an hour earlier. I asked him what he thought the approximate value was of the machines on his truck, and he estimated it was about $150,000. I asked him about the earlier truck, and he said it was about the same. I thought about senior management’s statement and memo that there was to be no product movement in or out during the inventory. I even had the memo indicating that. Now I know why they wanted to control where we went on their property. Strike three.

Whom can you trust?

I wondered what Jeff wanted to do now that we knew that senior management had lied in response to the three questions I’d asked them. I asked Jeff how much he knew about Inland, their financial situation, their need for an audit and if he knew why Inland needed a new auditor this year. Jeff didn’t have the answers because Kirkham had been the primary contact for Inland’s leadership.

I decided we needed to have another meeting with Sam, Brad and Evan to see their reactions to our discoveries and their inaccuracies. First, we summoned Brad to the shipping area. He was surprised to see us there and acted flabbergasted to see any activity in the shipping area. He told us he would get to the bottom of it. His acting was worthy of an Oscar.

Then Evan asked us to join him, Sam and Brad in the conference room. They had long looks on their face and didn’t make eye contact. I asked them about the well-known obsolete inventory at the warehouse across town and why they said this morning they didn’t have any. Sam said he hadn’t taken into account the machines and parts in those areas because they were planning on disposing that inventory from the warehouse as part of the audit. I didn’t believe him, and I knew they could tell.

I asked them whose inventory was immediately outside in the main warehouse — the same inventory they claimed was entirely owned by Inland that morning. Sam said a second, related company had commingled its inventory within the machines and parts throughout the warehouse. He said the inventory I was talking about shouldn’t have been part of our observation because a second group of auditors from another firm should’ve been observing those areas of the inventory. I again shot a look over to Jeff — what other company, and what inventory belongs to whom?

I asked Sam how we’d be able to differentiate inventory that belonged to Inland and inventory that belonged to this other related company. Sam said he and Brad would show us what belonged to each entity. I thought, sure, of course, I can trust these guys. They were completely honest with us this morning, so certainly they’ll keep telling the truth.

Sam asked us what we needed to finish the inventory and proceed with the audit. I left that question for Jeff because I believed that we should gather our files, walk back to our car and drive away from Inland as fast as possible. Jeff, however, suggested that we speak with Kirkham about how to proceed. Sam, Brad and Evan left us, and from the looks on their faces, they were happy to get out of that uncomfortable meeting after we’d caught them in their lies.

Jeff called Kirkham and shared the issues we discovered at Inland. Kirkham identified procedures for us to perform to complete our audit requirements over the inventory observation. I was amazed that we didn’t simply withdraw from the engagement.

Later that day I walked out the back door of the warehouse and saw close to a dozen trailers parked in the lot plus two out-buildings. The trailers and both buildings were locked. I told Jeff I was going to get Brad and Evan, and if they wouldn’t open the trailers and buildings I’d cut the locks. Otherwise, I was leaving and would tell Kirkham that the client had refused to open the trailers and buildings that could contain material amounts of inventory.

Brad met us at the loading area and said the trailers were empty, but the company was storing older machines in the buildings. Great, I thought — more old inventory they hadn’t told us about. Brad eventually found someone who had a key to open the trailers. They were indeed empty. Finally, Inland had told the truth — a first for this new client.

Justice isn’t always served

Jeff and I completed the day’s observations. I documented everything that occurred, including our observations and the client’s inaccurate responses about inventory. On the way out, I saw the other auditors in the second conference room working away at their computers.

In the car, I asked Jeff what he thought of his new audit client; he was much more understanding than I was and tried to find explanations for the inaccuracies. The next morning we met with Kirkham and shared in detail our experiences. Kirkham thanked me for my efforts in assisting Jeff with the inventory and told me I could return to my regular forensic work. Kirkham said he and Jeff would complete the audit and meet with Sam, Brad and Evan to get a better understanding of what happened.

Later that day, Jeff told me Kirkham had called Josh at Family Bank to determine how well Josh knew the company and the executives, as well as how much due diligence he’d performed.

Nothing replaces good due diligence prior to accepting a new client.

In the next few weeks, Jeff led his audit team through the required audit procedures — as identified in large part by Kirkham — and created a preliminary draft of Inland’s financial statements. Jeff confided in me that he felt the firm should withdraw from the engagement without issuing a financial statement for Inland.

Jeff learned that two companies commonly owned by Sam were working out of Inland’s main building. The inventory we observed at Inland’s main location was divided between the two companies and, despite management’s assertions as to ownership, we had no independent and objective way to corroborate what portion of the inventory was owned by each company. The other auditors we saw during our inventory observation were at Inland to conduct their initial procedures over the second company.

The fact that Sam retained separate audit firms for each commonly owned company operating out of the same location, which used the same inventory and the same personnel, should’ve been reason enough for Kirkham and the firm to withdraw from the engagement.

Kirkham met with Sam to discuss the issues. Sam knew that Kirkham might withdraw from the engagement, so he threatened him and Shipman Calabrese with a lawsuit. Sam told Kirkham that if Shipman Calabrese didn’t complete and issue the financial statements by the agreed-upon date, Inland wouldn’t be able to obtain financing and could suffer a devastating financial loss.

After performing a few additional procedures, Kirkham issued Inland’s financial statements. As a compromise, Shipman Calabrese added a small inventory reserve to the balance sheet for obsolete inventory, but it was nowhere near the amount that should’ve been added — if Inland even owned the inventory to begin with. The reserve was small enough to not interrupt any calculated ratios, and so Kirkham, fearing the lawsuit Sam had threatened, took the risk and issued the financial statements.

Inland successfully obtained the financing and, within a few short months, sold off the second company along with its inventory — whatever portion that might have been. Shipman Calabrese didn’t retain Inland or Sam as a client and, to the best of my knowledge, nothing negative ever came of the actions of Sam, Brad and Evan.

No successor accounting firm called Shipman Calabrese or Kirkham to ask why Inland was no longer a client — something I highly recommended when contemplating a new client. Kirkham failed to perform this step before he accepted Inland’s engagement. Sam probably found yet another audit firm for yet another first-year engagement — a pattern he likely had been perpetrating for years.

Lessons learned

• Nothing replaces good due diligence prior to accepting a new client, especially a client with a tight schedule and pending financing that’s dependent on the audit outcome. Although Josh at Family Bank referred Sam and Inland, Kirkham should’ve performed background and reference checks on Inland, Sam, Brad and Evan. A public records search would’ve revealed Sam’s second company, which likely would have led Kirkham to ask Sam about the second company’s audit and reveal that Sam intended to engage a second firm.
• Kirkham should’ve obtained copies of Inland’s prior financial statements and tax returns, which would’ve revealed Sam’s plans to sell off the second company. Plans were in the works to sell the company once the financial statements were issued because the buyers were waiting for them to make their purchase decisions.
• Accounting firms should have the standard procedure of contacting a potential new client’s past accountants to learn about their experiences. If Kirkham had done so with the Inland engagement, he could’ve, at a minimum, learned whether Inland had paid the prior accounting firm and why Inland had replaced the firm after only one year of service.
• Spontaneous, unplanned, surprise audit procedures often reveal transactions and activity that would’ve gone undetected if the client knew your plan or, worse, dictated the procedures you performed. Ignoring the instructions to park in front and enter through the front door revealed Sam’s deception. The surprised look on Sam’s and Evan’s faces at the time showed they never expected us to go around back — let alone talk with the truck driver. It was apparent to me that Inland’s management controlled previous audits, and they were shocked that we deviated from the expected procedures.

Recommendations to prevent future occurrences

• Perform due diligence. Regardless of how a potential new client is introduced to your firm, perform independent due diligence procedures prior to accepting the client. If you can’t obtain any reliable independent information, don’t accept the client, regardless of the level of service the client is asking you to provide and the associated fees.
• Remain objective. While you want to respect your client’s requests, first and foremost you have to remain loyal to professional standards designed to minimize risks and exposure to you and your firm. Sometimes clients lie to their auditors. Remain skeptical, objective and unbiased during an audit and independently corroborate any information your client provides.
• Don’t let clients control your procedures. Be wary of a client who controls and limits your procedures and the information it provides. Many frauds go undetected simply because accountants didn’t stand up to a client’s evasiveness. Insist on executing the procedures that you objectively designed for an engagement — you might hit the tip of the iceberg.
• Design unplanned and unexpected procedures to find fraud. The steps and measures accountants generally undertake are somewhat predictable, especially for recurring client engagements. Clients with financial personnel who came from public accounting are very knowledgeable of the procedures the outside accountants will perform and can hide fraudulent activity if they want to. By performing unexpected procedures, you might uncover evidence of potential fraudulent activity.
• Remain vigilant. Unfortunately, no one is above the ability to commit fraud when they feel pressure. Many clients perpetrate frauds through violations of friendship and trust; the least suspicious individual is often the perpetrator. When things don’t make sense or add up to an independent and objective eye, consider fraud as an explanation regardless of your relationship with the individual or entity.

Stephen A. Pedneault, CFE, is owner of Forensic Accounting Services, LLC. Reach him at: steve@fasman.com.

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 have been changed.