Billing Schemes, Part 2: Pass-Throughs

THE FRAUD BEAT

Auditors should scrutinize steep fluctuations in the cost of goods sold.

Billing Schemes, Part 2:
Pass-Throughs

BY JOSEPH T. WELLS

This is the second article in a four-part series on identifying false invoices and their issuers. July’s and August’s columns focus on billing schemes involving shell companies criminals set up to facilitate fraud. Articles in the September and October issues will explain how to detect and prevent two scams that employ other, completely different phony-bill strategies. This month’s case study shows auditors and CPAs how to recognize the pass-through billing schemes crooked purchasing agents and others sometimes use to illegally line their pockets.

en, a recent accounting graduate, was on his first real auditing assignment at a West Virginia manufacturer of prepackaged cement. Because Ben was a rookie, his supervisors naturally assigned him tasks they didn’t want to perform. That explains why he was standing atop one of the company’s seven huge cement silos on the morning of December 31, his teeth chattering in the cold wind as he observed employees taking inventory. As workers sounded, or measured, each silo’s contents, Ben watched dutifully and then double-checked every measurement they made.

Later that day, he reported the inventory tallies to Julia, his audit supervisor, and vouched for their accuracy. But on January 3, Julia called Ben into her office to talk about the cement manufacturer’s expenditures for raw materials; they were much higher than in previous periods.

MAKING SENSE OF THE NUMBERS
“Are you sure these inventory counts are correct?” Julia asked. “The client’s total spending on raw materials soared last year. So, I expected a roughly proportionate increase in inventory. But the numbers you reported are only slightly different from the prior period’s.”

Ben nodded affirmatively, but hoped he had not made any kind of egregious error. He was mindful of his lack of experience and had been careful, gazing into each silo and confirming every sounding.

Julia frowned. “Well, if the ending inventory is correct, then we need to look at what the client is paying to manufacture cement. Maybe the unit cost of raw materials has gone up sharply. Let’s go talk to the client’s purchasing department.”

Soon Ben and Julia were sitting across a desk from Lincoln, the manufacturer’s chief purchasing agent. He confirmed the cost of limestone—a key ingredient in cement—had jumped nearly 50% in the last year. As they were about to leave, Lincoln volunteered something that caught Julia’s attention: “I don’t know why the price increased so much last year, but it’s probably temporary.”

As soon as the two auditors were out of earshot, Julia pulled Ben aside. “Something’s fishy about this,” she said. “If anyone in the company should know why the cost of limestone has jumped so much, it’s Lincoln. And since he didn’t know why the price went up, how could he know it’ll go down?”

How to Sniff Out Phony Vendors
CPAs can help prevent false billing schemes by establishing good controls over their employer’s or their clients’ vendor-approval processes.

Ensure those involved in purchasing cannot approve vendors.

Before approving a new vendor, evaluate its legitimacy by

Obtaining its corporate records and other relevant documents.

Checking its credit rating.

Confirming that it is listed in telephone directories.

Contacting its references from clients and others.

Being particularly cautious about a vendor with a post-office-box address or a name composed entirely of initials.

Determining whether its business address matches any employee’s home address.

Once the company approves a new vendor, the CPA should closely monitor the account by

Watching for increases in the amount or frequency of billings.

Observing variances from budgets or projections.

Comparing its prices with those charged by other sources.

SIFTING FOR CLUES
All weekend, Ben and the rest of the audit staff pored over the company’s limestone purchase invoices. By Sunday night, they had a pretty good picture of what was happening. For one thing, about a year ago, Lincoln had personally authorized the addition of a new limestone supplier—Majors and Co.—to the company’s list of approved vendors.

The audit’s documentation also reflected that—within just a few months—Majors had become the company’s sole source of limestone, at prices approximately 50% higher than the company had been paying elsewhere.

Close-Up on False Billing

Source: Occupational Fraud and Abuse, by Joseph T. Wells, Obsidian Publishing Co. Inc., 1997.

Julia came right to the point: “I think we might find Lincoln is connected to Majors and Co., which may be buying limestone from someone else, marking up the price and reselling it to the cement company.”

On Monday morning, carrying a large stack of invoices from Majors and Co., Julia met with the company president, who listened to what she had to say. After a few minutes, the president said: “I wonder if Lincoln is trying to get back at us. About a year ago, the board of directors passed him over for a promotion to vice-president.”

POURING THE FOUNDATION OF A CASE
Julia, a CPA and certified fraud examiner, explained to the president how she could expand the current audit to detect any fraudulent business practices or transactions. The president quickly authorized the additional work.

As proper evidence-gathering procedures require, the audit team collected every original invoice from Majors and Co. along with the vendor file showing Lincoln’s approvals. The team prepared a log describing each document and its source. They photocopied them and stored the duplicates at their offices.

Next, Julia assigned Ben to take a close look at Lincoln’s personnel file. In it he discovered a name that stood out like neon: Linda Majors—Lincoln’s wife. Other members of the team turned up even more evidence: Majors and Co. was legally incorporated, and related documents from the Secretary of State’s office bore the signatures of both Linda Majors and Lincoln as corporate officers.

Finally, the team obtained price quotes from five nearby limestone suppliers. On average Majors and Co. charged 60 percent more than its competitors. Julia was satisfied she had enough documentary evidence to prove the existence of a pass-through billing scheme.

COMING CLEAN
Julia arranged a face-to-face meeting with Lincoln that began with an exchange of pleasantries. As Ben watched, Julia posed carefully constructed, point-blank questions. (For examples, see ‘“Why Ask?’ You Ask,” JofA, Sep.01, page 88.) She also showed Lincoln a copy of Majors and Co.’s articles of incorporation, which bore his name and signature.

Lincoln’s face fell. For a few minutes he acted as if he didn’t understand, but gradually he admitted everything, encouraged by Julia’s low-key technique. Not once did she show any disapproval of Lincoln or what he had done. Instead, Julia was personable and professional throughout the two-hour interview, allowing Lincoln to present his side of the story. In this unthreatening setting, Lincoln told a classic tale of revenge, revealing all the details of his pass-thorough billing scheme and why he set it up. Sure enough, the whole thing started about 18 months ago when Lincoln realized the company wasn’t going to promote him to vice-president. He saw this as a betrayal of his more than 10 years of service.

Like many purchasing agents, he was a constant target for temptation—vendors made it no secret they’d be glad to pay him under the table for favorable consideration when the company awarded business contracts—but he had never accepted.

LESSONS LEARNED AND IGNORED
Ben’s participation in this audit and investigation taught him never to judge the significance of current findings without examining prior-period results and looking for suspicious changes that could indicate fraud.

But the client company was interested only in getting its money back. In just over a year, Lincoln’s “take” had been a cool $1.3 million, which he had saved to finance a new business for himself. In exchange for his returning it all, the company agreed—against Julia’s advice—not to prosecute Lincoln. Even worse, the company kept quiet about his transgression, enabling him to move up to a better job—ironically, as chief purchasing agent for a limestone vendor.

JOSEPH T. WELLS, CPA, CFE, is founder and chairman of the Association of Certified Fraud Examiners in Austin, Texas, and professor of fraud examination at the University of Texas. Mr. Wells’ article, “So That’s Why They Call It a Pyramid Scheme” (JofA, Oct.00, page 91), won the Lawler Award for the best article in the JofA in 2000. His e-mail address is joe@cfenet.com.