Fraud's fertile breeding ground

Any economic disruption leaves businesses vulnerable to fraud both from within and outside an organization. Here we look at how today’s bottlenecks along global supply chains are creating the potential for financial wrongdoing in the coming months and what fraud examiners and auditors should know to prevent it.

Logjams of container ships circling the port of Los Angeles, empty supermarket shelves in the U.K., medical labs running out of supplies and restaurants struggling to find food for their customers. These are all signs of global supply-chain disruptions and labor shortages that have impacted consumers and companies across industries around the world — and it could get worse before it gets better.

While stock markets flirted with or broke new highs for most of 2021 as corporations beat earnings estimates, problems over sourcing vital equipment and goods to keep businesses running had been brewing for some time. And as year-end approached, they were starting to broadly impact people’s everyday lives and organizations’ bottom lines.

The situation was so serious that U.S. President Joe Biden set up a Supply Chain Disruption Task Force and put the issue at the top of his agenda as he headed to the G-20 meeting in October. (See “Biden to discuss intensifying supply chain challenges with G-20 leaders,” by Amanda Macias, CNBC, Oct. 29, 2021, and “Fact Sheet: Biden-Harris Administration Announces Supply Chain Disruptions Task Force to Address Short-Term Supply Chain Discontinuities,” White House release, June 8, 2021.)

Getting the global manufacturing machine restarted quickly post-COVID amid the sudden labor shortage and a surge in consumer demand has clearly been tough and taken its toll on what was an already fragile supply chain. Severe weather conditions and Brexit-induced trade upsets haven’t helped either. (See “The Supply-Chain Mystery,” by Amy Davidson Sorkin, The New Yorker, Sept. 26, 2021.)

There is a huge unknown in the cost of shipping right now, which is leading to huge unknowns in management decisions, which could be a risk of fraud.

As 2022 dawns, CFEs and auditors see this extraordinary confluence of events as a potential breeding ground for the emergence of all sorts of fraudulent activity in the months ahead, and they are advising vigilance.

“When you have a situation where the goods that are necessary to keep your company going are very hard to procure, you get some desperation,” says Clay Kniepmann J.D., CFE, CPA/CFF, a senior manager in the forensics and litigation services group at Anders CPAs + Advisors in St. Louis, Missouri. “When that happens, the opportunity for fraud is out there.”

Warning signs

Businesses throughout the U.S. are feeling the impact, and images of the logjam of container ships idling off the California coast perhaps best drive home how the cogs of global trade have jammed in recent months. In October, up to 100 ships were anchored off the port of Los Angeles, waiting to offload their much-needed cargo. While that number fell later in the year, the bottleneck left many businesses scrambling to get product to meet heightened demand. To circumvent the backlog some of the larger firms have even resorted to chartering private cargo ships and aircraft to obtain vital components and inventory. (See “Record number of container ships waiting to enter ports of Los Angeles, Long Beach,” by Jade Hernandez, ABC 7, Oct. 19, 2021, and “‘Containergeddon’: Supply crisis drives Walmart and rivals to hire their own ships,” by Lisa Baertlein, Jonathan Saul, Siddharth Cavale, Reuters, Oct. 7, 2021.)

Against that backdrop, an increasing number of CFOs and other experts have been warning that difficult economic conditions were likely to last into the end of 2021 and beyond as imbalances in the labor market and disorder along the supply chain created a domino effect among interconnecting industries.

“Unfortunately, once the bottleneck eases up at the ports, we will immediately face a new bottleneck with trucking. When the product moves from the ports to the local warehouses, the widespread trucking issues will further prevent products from making it to the shelves and to the American consumers,” says Jeff Rossi, CFE, CPA, co-leader in the manufacturing and distribution industry practice at advisory firm CohnReznick.

“I have a lot of clients in logistics and trucking. They’re willing to buy more trucks and hire more drivers, but they can’t because they are not available. There are multiple levels of supply-chain issues that are compounding the problem. It may take another six to 12 months to get these delays corrected.”

In October, Duke University’s Fuqua School of Business and the Federal Reserve Banks of Richmond and Atlanta released their third-quarter survey of corporate executives across the U.S. The mood, while not somber, was certainly less upbeat than months past. And supply-chain and labor shortages were at the top of their minds.

Three-quarters of the firms surveyed said supply disruptions had resulted in production and shipping delays, reduced availability of materials and increased prices. (See “Cost Pressures Mount Amid Widespread Supply Disruption and Labor Shortages,” news release, Oct. 14, 2021, Federal Reserve Bank of Richmond.)

“The actions that these companies are taking to manage supply chain disruptions are costly and hence increase the pressure on companies to increase prices,” John Graham, a Fuqua finance professor, was quoted saying in response to the survey. “What is more, these supply chain challenges are shaving 5% off their revenue growth, on average.”

Watching for fraud risks

In the months ahead both company executives and auditors will have to be attentive to the underlying risks, including financial statement and other kinds of fraud, as businesses struggle with circumstances beyond their control.

“Anytime there is an economic disruption it’s a fertile field for fraud, and I think the supply-chain disruption could be one of those fertile fields. Some companies that aren’t getting their supplies on time perhaps have financial incentives that might mean they fudge the books in some way,” says Janet M. McHard, CFE, CPA, founding partner of the McHard Firm, which specializes in forensic and investigative accounting.

“As fraud examiners we have to watch out for the pressures that might cause management to resort to fraud.”

At the end of last year, auditors were busy preparing for a critical fourth quarter — a time when companies look back on the fiscal year and focus efforts on achieving goals and results. This means performing interim procedures, such as revenue testing; inventory sampling; and updating clients’ internal controls, policies, and procedures. Assessing fraud is also key, including determining whether any misstatements in the financial statements are intentional or not. [See “AU-C Section 240, Consideration of Fraud in a Financial Statement Audit” (formerly Statement of Auditing Standards #99, SAS 99) AICPA.]

With everything from microchips to railcars to paper in short supply and prices rising as a result, large and small businesses have had to reassess their financial projections and estimates. That can be difficult when CFOs don’t know when goods will arrive or the ultimate costs of transporting them across the globe. (See “Why Is Everything More Expensive Right Now? Let This Stuffed Giraffe Explain,” by Alana Semuels, Time magazine, Sept. 8, 2021, and “2021 Supply Chain Chaos – Pulp, Packaging, and Freight…Oh My!” Smith Corona.)

“There is a huge unknown in the cost of shipping right now, which is leading to huge unknowns in management decisions, which could be a risk of fraud,” says McHard.

Contending with the crisis

National and multinational companies including Pepsi, Whirlpool, Procter & Gamble and supermarket chain Albertsons have been finding ways to contend with the extraordinary economic conditions, but also warn that supply-chain disruptions, labor shortages and rising prices could impact financial numbers in coming months. (See SEC 10Q filings for third quarter for the above companies.)

In late October 2021, Apple — a perennial favorite for investors — saw its stock tumble after it missed Wall Street earnings estimates for the first time since 2016. CEO Tim Cook blamed the poor financial numbers on supply constraints due to worse-than-expected chip shortages and COVID-induced manufacturing delays. These problems cost the company $6 billion in sales in the fourth quarter alone, and Cook warned that their impact on sales could be worse over the year-end holidays. This comes after what had been a stellar fiscal year for the tech giant. (See “Apple sales miss expectations, Tim Cook says supply issues cost company $6 billion,” by Kif Leswing, CNBC, Oct. 28, 2021.)

Yet those bigger companies may be better prepared to meet these challenges than the smaller firms farther down supply chains. According to the Duke University and Federal Reserve survey cited above, large firms are more likely than small firms to take some action by reconfiguring supply chains, moving production closer to the U.S. or changing shipping logistics. Small companies, on the other hand, have less room to maneuver and are more likely to wait for these issues to resolve themselves. (See “Cost Pressures Mount Amid Widespread Supply Disruption and Labor Shortages,” news release, Oct. 14, 2021, Federal Reserve Bank of Richmond.)

In turn, that arguably makes these smaller firms more vulnerable to fraudsters who have already been taking advantage of organizations and individuals desperate for components and other goods during the COVID-19 pandemic and now see another opportunity as supply and labor shortages squeeze businesses. As the ACFE 2020 Report to the Nations shows, smaller organizations tend to have higher losses to fraud and often see more fraud than their larger counterparts. (See ACFE.com/RTTN.)

“With the big players in the automotive industry, presumably they would have a relatively sophisticated and stringent internal control structure, but suppliers to those industries may not be in such a position,” says Kniepmann.

“You may have a smaller company which has contracted with GM to supply control modules, and in order to meet the requirements of their contract, they have to source microchips. Due to the semiconductor shortage, they may be forced with a decision to seek out less-than-secure sources to fill that need, possibly subverting any existing internal controls and exposing the organization to fraud risk.”

With chips in short supply, companies have been sourcing them from whomever they can. Often, the sellers are opportunistic scammers who send faulty, fake or counterfeit products to the company.

[See sidebar “Ripple effect of global chip shortages” at the end of this article.]

A U.S-based association called ERAI tracks these fraudulent products and keeps a database of the websites selling them. (See “The supply chain fraud pandemic,” by Alexander Geschonneck, KPMG, May 7, 2020; “What’s Worse Than a Chip Shortage? Buying Fake Ones,” by Stephanie Yang, The Wall Street Journal, July 15, 2021; and “Tech News Briefing,” WSJ podcast, July 16, 2021.)

“Any industry can be susceptible to supply chain fraud, particularly if they lack or have inadequate internal controls, have a complex supply chain, often deal with international or unfamiliar suppliers, and/or are in a position of great pressure,” says Kniepmann.

Supply shortages and financial statement fraud

Aside from monitoring external risks, such as unscrupulous suppliers, fraud examiners and auditors must also keep a watchful eye on internal risks that can result in financial statement fraud. Here are some key questions to assist auditors and fraud examiners when assessing this type of fraud. (1) Why would the audit client commit financial statement fraud? (2) How would they commit financial statement fraud? (3) What key people could embezzle a material amount from the audit client? and (4) How would each person be able to do it?

It’s also worth remembering that management’s attempts to use accounting techniques to make their financial statements look better through so-called earnings management isn’t necessarily fraud. And the discretionary nature of certain accounting rules can make it difficult to tell if earnings management is fraud or not. Even so, the U.S. Securities and Exchange Commission has been clamping down on companies that cross that line. (See “Earnings Management Revisited: Further Suggestions in the Wake of Corporate Meltdowns,” by Pervaiz Alam, Ph.D., CPA; Michael A. Pearson, D.B.A., CFE, CPA; and Stephen D. Makar, Ph.D., CPA; Fraud Magazine, March/April 2004, and “The SEC Continues To Scrutinize Earnings Management Through Its EPS Initiative,” by Jina Choi and Andre Fontana, Morrison Foerster, Aug. 31, 2021.)

“When we start talking about financial statement fraud, we have to be aware that there is a lot of manipulating the books that may fall short of a criminal definition of fraud,” says McHard.

“There is earnings management, some of which is possibly legitimate. But certainly, any time there are incentives for a company to begin changing estimates because of economic pressures you have the ingredients for financial statement fraud."

To understand how and why the current economic environment might push executives to commit financial statement fraud, it might also be useful to examine the three components that make up Donald Cressey’s Fraud Triangle — perceived unshareable financial need (often expanded to mean “pressure”), perceived opportunity and rationalization. (See ACFE.com/triangle.)

Businesses currently face a whole host of pressures, opportunities and rationalization that could result in executives cooking their books. Here are some examples of how those three components might come into play during this time of supply and labor shortages.

Debt dilemmas

Businesses often rely on short-term financing to smooth cash flows, especially when there’s a gap between the time they record sales and receive funds for those sales, or a gap between when they incur materials and labor expenses, and when payment is due. These loans usually contain performance requirements in the form of financial covenants. Covenants may also require a borrower to pay off a line of credit for a stated period before it can draw upon it again.

This all could be a difficult balancing act for businesses confronted with labor and supply shortages. Even so, management will likely do all it can to avoid violating debt covenants if it wants to maintain a good standing with its lenders and have continued access to funding. It could request covenant waivers, as companies often do. But banks and other financial institutions may be less accommodating in this environment, especially for those organizations that had already asked for loan modifications during the height of the COVID-induced economic downturn last year. In such cases, borrowers may be forced to refinance the loan through another lender, or worse, pay it down, placing more pressure on already-strained cash flows.

“There are a lot of industries where people took out loans to weather the storm, and now we are at a period where those loans are maturing, and you are not going to get another round of PPP loans to keep things going,” says Kniepmann.

Pressures could mount further for small business owners who have personally guaranteed loans. Lenders could then seize personal assets in the event of a default. Needless to say, no one wants to lose their house if their business goes under.

Supply-chain delays can also seriously impact access to funding in other ways too. Take floor-plan loans, which are like revolving lines of credit for car dealers that allow them to buy vehicles and in turn help them free up cash for other uses. To access those funds, dealers must have the cars sitting in their parking lots waiting to be sold, says McHard. That could prove problematic if new cars are delayed at ports or elsewhere, increasing pressures to commit fraud.

“So, there is a pressure for the dealership — if they need that cash flow — to falsify what cars are sitting on their lot so they can draw more money off their line of credit,” she adds.

Inventory, supply delays and rising prices

The difficulties for companies and the car industry in obtaining inventory provide another good example of the pressures management face and how that could potentially lead to fraud.

With new car lots virtually empty, dealers have told customers to expect a six- to eight-week wait in new car orders. But realistically the backlog is more like three to six months. So, vehicle leasers are purchasing their cars outright at lease end to avoid waiting for new cars. This has caused a ripple effect in the used-car industry, which now has less available inventory. Not only does that lead to fewer sales opportunities, but car prices are soaring as a result. (See “With Car Lots Sparse, Shoppers Drive Home in Their Second Choice, or Third …,” by Tom Voelk, New York Times, updated Nov. 2, 2021, and “Thinking of buying a new car? Supply chain crisis impacts Central Valley auto dealers,” by Gabe Salazar, yourcentralvalley.com, Oct. 18, 2021.)

That’s bad news in more ways than one. Dealers have sales, volume and profitability expectations established with automakers, which may force unprofitable and low-volume dealerships to close — or at a minimum — to cut inventories, which further impacts their sales volume.

Manufacturers and dealers are finding creative ways to revive new-car orders to help make sales goals and keep personnel employed during these difficult times. My local Subaru dealer, for instance, is telling clients that if a Subaru owner has six months left on their lease, they should order the car they want today, so that it will be on the lot when the lease expires. Subaru also now offers an option to extend your lease by six months.

Yet while these tactics help dealers and consumers, an auditor would be prudent to exercise some healthy skepticism and ensure that the revenue associated with pre-order sales is reflected in the proper accounting period, rather than being used to achieve the dealer’s set 2021 sales goals.

Rising prices and a lack of available product could create financial pressures in other ways. Any business that has contractual obligations to purchase inventory committed to existing customer orders will suffer. That’s because the sales price within the customer contracts is fixed, but inventory costs are rising, eroding profit margins on those orders.

“This is specifically troublesome for clients utilizing steel stock, which usually falls under long-term contracts, causing intense pressure all along the supply chain, affecting multiple industry segments,” says Rossi.

Inventory issues are particularly problematic for seasonal business. As Halloween approached last year, retailers were growing increasingly concerned that they’d be unable to secure enough costumes, candy and decorations in time to meet what was expected to be strong demand for the popular holiday.

While those products had been offloaded at U.S. ports, a dearth of truck drivers meant they weren’t being delivered to the stores. How would such businesses make up for annual sales if they receive their inventory after the holiday has passed and who is financially responsible for the costs of goods that fail to arrive on time? (See “US retailers fear supply shortages ahead of Halloween,” by Obey Manyiti and Andrew Edgecliffe-Johnson, Financial Times, Oct. 4, 2021, and “Halloween could be haunted by supply chain shortages,” by Ben Thompson, WHAS11 – ABC, Oct. 4, 2021.)

Inventory pressures such as these may explain why a business would try to commit financial statement fraud, perhaps by recognizing sales revenues earlier than allowed under revenue recognition criteria or using old inventory costs to bolster profit margins (hoping they can avoid detection and absorb these diversions in their 2022 results).

An auto dealer, for example, might recognize the revenue associated with new car sales at the point a deposit is received, even though the customer has six months left on the lease and won’t take delivery until that time. Or a supplier might recognize sales revenue on orders that remain on a cargo ship that were free-on-board (FOB) destination (meaning that the title for those goods won’t pass until the customer receives the goods).

Rationalization for ‘greater good’?

A fraud examiner experienced in auditing financial statements should easily recognize business owners’ rationalizations for committing financial statement fraud in this economic climate. Many organizations are now at the mercy of factors beyond their control, and it’s easy to envision how an owner might rationalize transgressions as a means to achieving what they perceive to be the greater good for the business and its employees. It’s also easy for auditors to be sympathetic to a business owner’s plight and may be tempted to play free and loose with the “materiality threshold” that determines that an audit hasn’t detected a material misstatement. But they must remain vigilant and objective.

Business owners all along supply chains are facing unprecedented conditions and creating serious financial pressures as we head into 2022. Some will attain their goals; others won’t. For those who don’t, how they choose to address their shortcomings will determine whether they’re at higher risk of financial statement fraud.

Fraud examiners and auditors should have candid discussions with business owners and management about fiscal performance, financial pressures and expectations. Talking about risks with clients may provide a deterrent to business owners who aren’t likely to meet expectations or requirements and may have considered fraud as a last resort. My recommendation — as always — is to remain vigilant.

Stephen Pedneault, CFE, CPA/CFF, is the principal of CPA firm Forensic Accounting Services, LLC. Contact him at steve@fasman.com.

Ripple effect of global chip shortages

If you want to understand how supply-chain bottlenecks are impacting companies across sectors and opening doors for possible fraudulent activity, examining the global shortage of chips (not crisps or French fries) may be a good place to start.

Chips or semi-conductors are used in products ranging from cars to computers to a variety of household appliances. Without them, companies are unable to meet demand from consumers who now have money to burn following the worst of the COVID pandemic. (See “Semiconductor chip shortage could extend through 2022, Marvell CEO says,” by Ian Thomas, CNBC, Oct. 3, 2021.)

A lack of chips has hit the car industry particularly hard, causing GM and Ford to temporarily close assembly plants, and it could cost the sector $210 billion in revenue in 2021, according to consulting firm AlixPartners. Nor is the problem expected to go away any time soon. (“Chip shortage expected to cost auto industry $210 billion in revenue in 2021,” by Michael Wayland, CNBC, Sept. 23, 2021, and “ The global chip shortage is continuing to wreak havoc for the car giants,” by Sam Shead, CNBC, Oct. 28, 2021.)

Yet it isn’t only the car industry that has been impacted. Try to order a large kitchen appliance in any store across the country, and you’re likely to find it’s out of stock. That too is because of a lack of chips that help in the functioning of refrigerators and other appliances. (“Global Microchip Shortage Worsens Appliance Delays, May Last Until 2022,” by Annie Cebulski, May 6, 2021, Proremodeler.)

The fallout from the delays in appliances reaches farther than you might expect. In a new neighborhood being built not far from my house in Manchester, Connecticut, the new homes under construction start at $500,000 and many still sit empty despite being completed. Builders can’t obtain certificates of occupancy until appliances are installed, leaving developers unable to book sales. And buyers must stay in existing homes, which in turn delays the sale of that house.

This comes on top of a shortage in building materials, which are in high demand for a variety of factors, including the destruction caused by worsening weather conditions. The dearth of construction materials, combined with shipping delays and shortages from overseas suppliers, leaves the U.S. with inventory levels at an all-time low and near-unprecedented cost increases in the housing market. (See “Construction material shortage triggers delays, soaring prices. How long will it last?” by Michael L. Diamond, Asbury Park Press, Sept. 23, 2021.)