Drying out Fraud

An anonymous tip alerts auditors to employee theft.

Byron Morgan, CIA, CPA, CFE
Senior Compliance Auditor
Washington University

An anonymous letter was sent to the internal audit department of a natural gas public utility company indicating that something “strange” was happening in the sales department of the company’s specialty division. In addition to providing natural gas service, the organization had a separate division that sold gas appliances under the name the Home Energy Center (HEC). As a public utility, most of the company’s operations were subject to regulation by a state utility commission. However, the HEC sales division operated as a retail outlet and, as such, was a part of the unregulated segment of the company. The letter indicated that appliances were being delivered out of the warehouse using sales contracts that were described as “suspect.” No other details were provided.
Without much information to go on, the internal auditor assigned to investigate the situation began by interviewing the warehouse manager under the guise of learning more about how the warehouse operated. The auditor ascertained that the warehouse used a perpetual inventory system, coupled with monthly cycle counts to compare on-hand quantities to the inventory records. The auditor also learned that a sales contract signed by the customer, the salesperson, and the HEC manager was required before appliances could be removed from the warehouse. The sales contract was a multi-copy document; the original copy stayed in the HEC, another copy was sent to the warehouse to relieve inventory records, and the third copy was sent to accounting for customer billing. The contracts were pre-numbered and controlled by the HEC using a manual log of contract numbers. However, there was no interface among the sales, warehouse, and billing systems. As a result, the sales contracts were not reconciled or accounted for in any way outside of the sales department.
During the interview, the warehouse manager told the auditor that cycle counts had not indicated any discrepancies within the appliance inventory. He also mentioned that the HEC assistant manager had recently resigned, and it was rumored that a dispute had occurred between the assistant manager and manager of the division. The warehouse manager further disclosed that, in the past six months, several sales contracts had been signed by the HEC’s assistant manager, rather than the manager. The warehouse manager had questioned this change, but was told by the HEC manager that the assistant manager had been authorized to sign sales contracts in his absence so that appliances would continue to be delivered on a timely basis to maintain good customer service. The warehouse manager felt that something strange was occurring with these contracts but was not sure how or where to report the information.
Based on the information from the warehouse manager, the auditor obtained a copy of the sales contract control log from the HEC and matched the appliances listed as sold with those removed from the warehouse. He also compared the information to customer billing records. The auditor discovered that, over a six-month period, 72 sales contracts totaling US $35,000 had been submitted to the warehouse for delivery of appliances without a corresponding entry in the customer billing records. The assistant manager signed all of these contracts, and all were coded as “customer pickup,” indicating that a company service department employee did not deliver the appliances. The internal auditor also noted that half of the contracts in question were for electric dryers instead of natural gas dryers, which furthered the auditor’s suspicions. Although the company sold electric dryers, such sales were rare. Moreover, most of these sales were made to employees under an employee discount arrangement allowed by the appliance suppliers.
The names and addresses on the suspect contracts appeared to be fictitious based on comparisons to phone books and city directories. The auditor also learned that the assistant manager had been experiencing financial problems. Based on these findings, the auditor scheduled a meeting with the now former assistant manager.
At the meeting, the ex-employee confessed that she had prepared the fictitious contracts to remove appliances from the warehouse. She admitted that, while she was experiencing financial problems, she discovered that there were no controls to match sales contracts with billing records. She had gone to check on a billing issue in accounting and noticed that accounting only billed for contracts received and did not account for missing contract numbers. Also, she found that the billing system did not interface with the sales or warehouse systems. She realized that she could complete a sales contract using fabricated information, forward a copy to the warehouse, and retain the billing department’s copy.
Because the systems did not interface or reconcile the contracts, the warehouse would release the “purchased” appliance, but the billing department, unaware of the contract’s existence, would not seek payment for the goods. By exploiting these weaknesses, she managed to pilfer thousands of dollars worth of merchandise.
Initially, the assistant manager sold the stolen appliances at a discount to her family and friends. However, as time went on, she discovered how easy it was to obtain the appliances without being questioned. She eventually decided to expand the fraudulent operation by running ads in the newspaper and selling the appliances out of her garage at home.
The former assistant manager also disclosed that the HEC manager was involved in the scheme and received a “commission” for the appliances fraudulently removed from the warehouse. The manager had suspected something was amiss when he noticed a large number of sales contracts being submitted under the assistant manager’s signature. When he confronted her, she told him about her financial problems, admitted to the scheme, and offered to resign. The manager said he would let her continue the practice, but he wanted a “commission” of 20 percent for every fraudulent contract that she submitted. Due to her financial problems, she felt she had no choice and agreed to his offer.
Over time, the manager began to accuse her of shortchanging him on his commission. The accusations became more intense, and the manager became increasingly confrontational. The assistant manager indicated that tension escalated to the point where she could not take the harassment and abruptly resigned. She simply did not report for work and left the manager a voice message explaining that she quit.
At the conclusion of the interview, the auditor and the director of human resources obtained a signed confession from the assistant manager, including a statement about the manager’s involvement. In addition, the employee agreed to pay restitution, and the appliances remaining in her garage were recovered. An investigation was initiated into the allegations that the manager was also involved, and corroborating evidence was obtained of his participation. It was also discovered that the manager had been receiving kickbacks from several vendors. Ultimately, the manager was terminated, but the company elected not to pursue criminal prosecution in either case due to the potential for adverse publicity.
  • A mechanism for reporting fraudulent activity is important in any organization. The manager suspected that something inappropriate was happening but did not know how or where to report the unusual sales contracts. After this incident, a formal fraud-reporting policy was developed, and a fraud hot line was implemented.
  • A formal code of conduct is a key component of an effective fraud prevention program. The company had a written conflict of interest policy that required annual disclosure each year by senior officers. However, due to this incident, a formal code of conduct was developed for the entire company. In addition, all levels of management in both the regulated and unregulated segments were required to certify adherence to the conflict-of-interest policy and the code of conduct.
  • Without adequate reconciliation processes, many frauds continue unnoticed, causing huge financial losses. Following the discovery of the fictitious sales contracts, the company implemented controls and established procedures to reconcile the contracts with inventory and billing records. Also, programming revisions were made to interface the sales, billing, and warehouse systems.
  • Prenumbered sales contracts are an effective control only if missing contract numbers are investigated. Copies of voided contracts should be delivered to the billing system, and accountants should be instructed to inquire about any missing or out-of-sequence contracts. If the assistant manager had known accounting personnel would question her about the missing contracts, she may have been deterred from preparing the fictitious documents.
  • Clearly defined written policies and procedures can help identify and document controls in a business process. If written procedures were in place describing who was authorized to approve sales contracts, or if a different flow for the sales contracts among the sales, inventory, and accounting departments had been established, the warehouse manager, or someone in accounting, would have had a basis for questioning the activity at the onset, thus possibly mitigating the extent of the fraud.

To comment on this article, e-mail the author at bmorgan@theiia.org.


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