Reconstructing the Crime — Lessons Learned on How to Catch A/R Fraud
Kevin P. Durkin, an experienced instructor with the Commercial Finance Association / Field Examination School, has spent hours plowing through court documents to study accounts receivable frauds and to learn how to better detect these scams in the future. He shares his insights on lessons learned.
In addition to having done forensic work related to accounts receivable frauds for years, I have researched and studied dozens of massive accounts receivable frauds by going through reams and reams of court documents in an attempt to try and better understand how lenders, financial statement auditors and field examiners get duped and what could have been done differently to increase the likelihood of catching these types of frauds in the future. Here is what I learned.
A Well-Designed Fraud
Fraudsters provide the appearance to auditors that legitimate payments are being received from third-party customers who ordered goods that were shipped and accepted. They generally accomplish this by creating a mechanism that gets monies moving through bank accounts. The mechanism at times includes forming fictitious companies where bank accounts are opened and used to create a circular cash-flow between accounts of the borrower and the fictitious companies. Another method used involves check swapping between real companies, where a third-party “friend” will receive into their accounts monies initially originating from the borrower and then disburse monies back to the borrower less a small transaction fee. Without the ability to remove invoices from an aging through a cash-type transaction, invoices would merely age and be questioned by an auditor. If invoices were removed through credit memos, dilution would increase significantly and also be questioned. A well-designed fraud will have receivables performance averages reporting turnover of less than 90 days and dilution less than 5%.
In addition to creating a mechanism to remove receivables from an aging through a cash transaction, the fraudster needs to be able to produce forged or fake documents for auditor test samples. These documents show goods were ordered, shipped, accepted and in some cases paid for. Technology, through electronic imaging software, has given fraudsters a valuable tool. Even experienced and seasoned auditors can be duped by the authentic-looking bills of lading, vendor invoices and customer check copies created.
Lastly, multiple persons are usually involved in executing the scheme, and at times, some are even third parties.
Between the electronic imaging software, the establishment of shell companies for the purpose of creating a circular flow of cash and collusion with third parties, finding a receivable fraud is no easy task.
So how can an auditor even the playing field and make the fraudster have to work harder? Whereas one can debate whether a field examination is designed to identify such a fraud — a debate I choose to stay away from — working within the parameters of the traditional field examination, auditors can improve their effectiveness by changing their mindset and approach to establishing “existence.”
Field examiners and financial statement auditors perform detailed testing and analysis of a borrower’s receivable portfolio, but the performance analysis (aging spreads, dilution, turnover, concentrations) oftentimes outweigh or overshadow the testing for existence (shipping, cash application, verifications). Existence testing needs to be the foundation for the analysis of accounts receivable because if the receivables do not exist, no one will care about their performance.
Let us consider a mindset that significantly reduces an auditor’s effectiveness and results in them getting duped, even when the fraud is not all that sophisticated. While teaching introductory and advanced field examination programs for the Commercial Finance Association, I ask the class participants what the best evidence of a good receivable is. The most common answer: payment.
Realizing one of the major attributes of these large frauds is that no goods were ordered or shipped, and invoices are just accounting entries, by the end of the class, I hope they change their answer to something like: “payment received from the customer who ordered the goods that were confirmed shipped and accepted in the normal course of business.”
It is often engrained in their mindset that once the auditor has accepted that payment occurred, they stop auditing, with the thought process being, “Why would an invoice be paid unless goods or services were ordered and received?” Payment must mean that the earnings cycle has been completed. Fraudsters and their cohorts make their living exploiting that rationalization. Almost every significant overstatement of sales and accounts receivable fraud I have examined or studied involved monies flowing through bank accounts where no goods or services were ever exchanged. The flow of monies through the accounts was used to provide the appearance that invoices were being paid from legitimate sources, when they were not.
That mindset causes more auditors to get duped because they fail to consider the plausibility that payment alone is not good enough audit evidence to have established existence. When auditors accept that payment is end of the earnings cycle, they assume without doing the detail work with the proper level of professional skepticism that goods and or services were ordered, delivered and accepted. When they lower their level of skepticism, it diminishes their effectiveness and the benefits obtained by performing other substantive testing.
Instead of accepting monies received as evidence of a good receivable, changing the auditors’ mindsets and approaches by attempting to establish existence through a four-point approach can significantly improve their personal effectiveness and increase the likelihood of catching the fraudster in a lie. The four points are:
- Goods were ordered by the customer.
- Goods were shipped to the customer and accepted.
- The customer confirmed an invoice is due for payment.
- Monies were received from the customer who ordered and received the goods.
If the auditor can validate that goods were ordered, shipped and the invoice was paid, a good receivable was collected. If the auditor can validate that goods were ordered, shipped and verified, a good receivable will be collected.
Each of these four points helps establish existence of a bona fide receivable. No one point alone is sufficient. As an analogy, I consider each point to be a leg of a stool that provides the foundation of a bona fide receivable. Whereas I can have a stool with three or four legs, two or one is not a stool, and, therefore, usually insufficient to establish a strong foundation for existence. Of course, certain industry exceptions exist.
For auditors to improve their effectiveness, they should be aware of the tools that fraudsters use to prepare forged and fake documents and design a methodology that can best combat the circumstance where the auditor accepts those documents as valid.
One way is to authenticate documents with a third party directly. Send a bill of lading to the company that supposedly produced it. Another way is, instead of picking a sample and waiting in a conference room, ask how the invoicing and shipping records are maintained, and then ask to see those files. Most fraudsters only produce documents for auditor samples. Producing authentic-looking documents for all fictitious accounts receivable would be a monumental task and require some sort of paper mill. Very few fraudsters run paper mills where all fictitious receivables generated can be supported.
If during this verification process, fraudulent documents are discovered, it is at this point that a routine field examination or audit becomes a forensic exam. A fraud has been uncovered and it is now necessary to determine to what extent it permeates.
I recently read about testimony relating to the trial of a former Bernie Madoff employee. The former CFO described that a KPMG auditor wanted to see support for specific trades. As no trades had actually occurred, the employees manufactured fictitious documents evidencing trades. The testimony also revealed that employees went to great lengths to have the physical documents look aged by refrigerating them and then physically tossing them in piles around the office. They were refrigerated because the documents were warm, having just been printed.
I wondered, had the auditor asked to see where all of the trading documents were stored and then selected a sample, if that fraud would have been caught earlier.
Another effective approach is considering the chain of custody of the information being provided to the auditor. Does the auditor have the ability to get the information directly from the source, such as a bank? When looking at supporting documentation for cash application testing, can the information be obtained from a bank directly or is a sample being provided by the borrower? In many fraud cases, a post mortem review showed that what actually went through the bank account or lock box was not what was reflected on the books of the borrower.
The four-point approach to establishing accounts receivable existence will make the fraudster work harder. Authenticating what is purported to be a third-party document with the third party is a powerful tool. Getting information directly from the source when possible, such as banking information online will make an auditor’s evidence more pervasive.
Having the right mindset and a good approach and methodology to establishing existence does not guarantee all frauds will be uncovered, but it increases the auditor’s effectiveness and likelihood of identifying less sophisticated accounts receivable frauds.
Kevin P. Durkin, CPA, managing director, Durkin Group, is an experienced instructor with the Commercial Finance Association / Field Examination School.