Digging Deeper… Field Examiner Uncovers Fraud
When a field examiner discovers inconsistencies upon her review of a modular home manufacturer applying for an increased line of credit, she ultimately uncovers fraud.
Freed Maxick’s Michael Boeheim and Rosie O’Brien describe how this case underscores the importance of due diligence to confirm all material facts before entering into a significant financial transaction with a customer.
A bank headquartered in the Midwest requested an on-site field examination for one of its customers. Mobile Offices, Inc. (MOI) had been in business for five years, manufacturing and selling temporary classrooms, churches and a wide variety of single-family homes. It specialized in job site offices.
The units were manufactured in a large modern factory the width of a football field, and twice as long. MOI used four assembly lines, each connected by railroad tracks. Each unit was created as two separate sections (sides A and B), and the sections were joined after transporting the completed unit to a building lot. The basic manufacturing process took about five days; customization took longer.
A year before this examination, MOI had applied for, and received, a $5 million revolving line of credit from its bank. When the company requested an increase to $10 million, the bank asked for an on-site field examination before approving and funding the loan.
The borrowing base for the loan included raw materials, work in process and finished goods. The raw materials included lumber, plumbing and electrical supplies, carpeting and cabinets. Any unit in the manufacturing process was considered work in process. For example, a unit might be 20% complete after day one, 40% complete after day two and so on. Finished goods comprised the completed units in the factory lot that awaited customer financing and job site readiness. These processes might take anywhere from two days to one month to complete. The advance rate for finished goods inventory was 70%.
The field examiner contacted MOI, introduced herself and presented a list of records needed to complete the exam. She was assured that all relevant documents would be ready when she arrived, and they were. Because the company’s controller was “unavailable” during the examination, the examiner worked with MOI’s owner.
The examiner noted that MOI claimed average monthly sales of $2 million, or about $24 million annually. The average monthly A/P balance was $2 million, the average monthly inventory balance was $7 million, gross margin averaged 30% and inventory turnover averaged 152 days. Initially, none of these figures raised any red flags.
The first day of the exam passed as expected. The examiner spent the day reviewing an enormous amount of reports, including A/R aging and activity, sales, collections, returned merchandise, credits, reductions and inventory records. On the second day, however, the examiner noted some issues with the company’s records. First, fixed assets were included in the company’s raw materials inventory. For example, including a forklift in the inventory report made no sense because it was not for re-sale.
Second, MOI’s cost accounting system was woefully inadequate. While company records might indicate that a unit cost $10,000 to build, there was no breakdown of the cost — none of the components, such as walls, cabinets and fixtures, had been itemized.
Finally, the company used an inventory system that did not provide up-to-date records of either the inventory or the cost of goods sold. At the end of each month, the company would simply shut down production and count everything it had. Month-end physical inventory counts were taken for work in process and finished goods. Had MOI used a perpetual inventory system, it would have recorded the sale or purchase of inventory in near real-time, providing a highly accurate perspective.
As the exam continued, other inventory irregularities began to emerge as well. While invoices showed that the average selling price per completed unit was $25,000, the inventory listing showed a cost of $25,000 per unit side. By recording the inventory cost as the selling price, MOI had significantly overstated the value of its inventory. Additionally, valuing items per unit versus per unit side would overstate inventory even more. Based on a unit cost of $17,500 — adjusting the invoice amount by the 30% gross margin — there needed to be substantially more units in the factory to support finished goods values.
When the examiner presented this discrepancy to MOI’s owner, his first response was, “Oh, that has to be a bookkeeping error. I’m sure the purchase order was for $25,000 per unit side. Let me look into this. Thanks for finding this mistake for us!”
At this point, the examiner could have concluded the examination and accepted the explanation that this “bookkeeping error” was an anomaly. But further review of the company’s records indicated that this “error” was not an isolated case; the examiner found dozens more. When she showed these to the owner, he said, “Well, we certainly did not agree to such a low selling price! I’ll see that we bill our customers immediately for another $25,000.”
The examiner contacted the bank’s loan officer, saying she suspected that inventory was significantly overstated, and there was a possibility of fraudulent inventory reporting. The initial conversation, and subsequent discussions with the loan officer, did not go well. Intent on accommodating the client, the loan officer aggressively disputed the examiner’s findings and evidence.
At this point, the examiner took matters into her own hands and contacted the bank’s chief credit officer (CCO), with whom she had extensive dealings on previous matters. The loan officer reported to the bank’s CCO. Disappointed by his loan officer’s behavior, the CCO told the examiner, “Please work with me directly on this situation — you and I can take it from here.”
The examiner and the CCO went a step further and contacted some of the customers listed on the suspicious MOI invoices. The customers confirmed that both the purchase orders and the invoices represented an entire unit, not just one side of the unit. Additionally, the customers indicated that the company’s owner was absolutely aware of the true unit pricing. The owner was responsible for company sales contracts, including terms and conditions.
The request for an increased line of credit was denied. In her final report, the examiner found that the company’s inventory had been overstated by $4 million. MOI could not cover all its debts and was ultimately liquidated. It was able to sell assets and inventory and collect on receivables, leaving the bank with a loss exceeding $3 million.
One possible explanation for the fraud was the owner’s need to maintain a certain lifestyle and status in the community, as well as the ongoing liquidity requirements for his company.
This case underscores the critical importance of due diligence to confirm all material facts before entering into any significant financial transaction with a customer. The bank’s lending standards are developed from experience and must be adhered to. The field examiner might have accepted the company owner’s explanation that the bookkeeper had made an error, and the exam might have ended there. But because the examiner took the time to dig deeper, she not only uncovered fraudulent activity, but may have saved the bank from an even larger write-off.
This case also raises a number of questions. Had MOI committed fraud earlier? At what point did the company’s practices become dishonest? Could the situation have been uncovered early on if the bank’s due diligence had been more thorough? Could valuable information have been gleaned by reviewing industry publications to gain a sense of where MOI stood in relation to its competitors? We will never know. But we can be sure that a fraud uncovered in the early stages of the fraud life cycle will mitigate loan losses.
Company names and locations have been altered to ensure confidentiality.
Michael A. Boeheim is a director in Freed Maxick’s Asset Based Lending Practice. With over 30 years of experience in the ABL industry, he is responsible for staff supervision, quality control and developing and maintaining lender relationships.
He also has experience in portfolio acquisition due diligence and forensic examination assignments of troubled loans involving fraud. He served as an instructor and developed fraud programs for the CFA Fraud Awareness Workshop and the European Fraud and Audit Conference and has been a speaker for a number of organizations on various fraud-related topics. A graduate of the State University of New York at Buffalo, Boeheim is a Certified Internal Auditor and Certified Fraud Examiner.
Rosie O’Brien is a senior manager at Freed Maxick, where she is responsible for staff supervision, quality control and developing and maintaining lender relationships. O’Brien has been involved in field exams involving discovery of fraud and misstatements. She has instructed numerous financial institutions on fraud education and awareness techniques. She has been with Freed Maxick ABL Services for 18 years. Her prior experience includes working for eight years at HSBC Bank as an ABL manager. She holds a BS degree in Accounting from St. John Fisher College in Rochester, NY.