William J. Burns, CPA, Attorney at Law

This rolling discussion will have periodic updates highlighting current events involving accounting improprieties, both potential and actual, and how businesses can avoid becoming victims.

29 July 2011

Montreal Clinic

On July 29, 2011, the Montreal Gazette reported that “Montreal's largest private breast-cancer clinic has cut about a quarter of its staff after it was unable to recover most of the nearly $1.5 million that its former chief financial officer is accused to have siphoned from the company since 2005.”  This amount does not appear to include forensic accounting costs or amounts due to tax authorities.  See http://www.montrealgazette.com/news/Montreal+cancer+clinic+cuts+staff/5175303/story.html.  While the article does not speak of the specific acts giving rise to the allegations raised in the article, the article does give rise to the inference that the clinic did not have a strong internal audit program.  An internal audit function serves as a deterrent to some fraud or defalcations, but does not provide a guarantee that it will prevent or detect such acts.  A company can hire an internal audit staff or it can outsource the function.  While the function adds overhead cost, it also serves as a sort of insurance policy that, if functioning properly, does not appear to yield any dividends.  Yet, a properly performing internal audit function may have prevented this particular clinic from suffering losses such that 25 people lost their jobs.  Depending upon the size of the organization, for as little as $10,000 per year, a small to mid-size organization can have a streamlined exam performed to ensure compliance with policies and procedures, and perhaps, prevent and/or detect fraud and defalcations.



11 July 2010

On July 13, 2010, the Montreal Gazette.com reported a detailed scheme of “pre-billing” and “embezzlement.  (See http://www.montrealgazette.com/news/Suit+alleges+details+billing+scam/3269876/story.html).  The scheme allegedly involved a high-ranking city-government employee, an outside businessman and companies involved with providing the city with goods and services.  The government employee purportedly told certain city vendors that in order to help the city balance its budget, the vendors should bill the city for services the vendor had not yet provided in order to ensure the invoice fell within a certain city-budget period.  To pay back the pre-billed invoice, the vendor had to pay services the vendor received from other participants in the scheme.  The independent businessman worked as a contractor to the city government and the independent businessman purportedly billed the vendors for goods and services never provided to the vendor.  Vendors also had to reportedly pay a “tax” on the value of the actual contracts received in order to “help the city balance certain budgets.”  The scheme for some vendors came to an end when a city employee asked for evidence of service for pre-billed invoices.  A scheme such as that described relies on collusion which may makes it more difficult to detect.  Several failures occurred, however.  First, most cities have internal auditors which appear to have failed to detect the scheme.  Second, most cities have external auditors which appear to have failed to detect the scheme.  Finally, the vendors themselves appear to have turned a blind eye to this most unusual form of transferring cash: paying back a pre-billed invoice through paying vendors for goods and services never received.  To detect this scheme, the city only had to perform a simple test: substantiate invoices received prior to paying.  This simple and prudent procedure would not only detect the scheme, but also deter it.  Such a lack of fundamental procedures may indicate a weak internal control environment such that more schemes may exist.

2 February 2010

On July 13, 2010, the Montreal Gazette.com reported a detailed scheme of “pre-billing” and “embezzlement.  (See http://www.montrealgazette.com/news/Suit+alleges+details+billing+scam/3269876/story.html).  The scheme allegedly involved a high-ranking city-government employee, an outside businessman and companies involved with providing the city with goods and services.  The government employee purportedly told certain city vendors that in order to help the city balance its budget, the vendors should bill the city for services the vendor had not yet provided in order to ensure the invoice fell within a certain city-budget period.  To pay back the pre-billed invoice, the vendor had to pay services the vendor received from other participants in the scheme.  The independent businessman worked as a contractor to the city government and the independent businessman purportedly billed the vendors for goods and services never provided to the vendor.  Vendors also had to reportedly pay a “tax” on the value of the actual contracts received in order to “help the city balance certain budgets.”  The scheme for some vendors came to an end when a city employee asked for evidence of service for pre-billed invoices.  A scheme such as that described relies on collusion which may makes it more difficult to detect.  Several failures occurred, however.  First, most cities have internal auditors which appear to have failed to detect the scheme.  Second, most cities have external auditors which appear to have failed to detect the scheme.  Finally, the vendors themselves appear to have turned a blind eye to this most unusual form of transferring cash: paying back a pre-billed invoice through paying vendors for goods and services never received.  To detect this scheme, the city only had to perform a simple test: substantiate invoices received prior to paying.  This simple and prudent procedure would not only detect the scheme, but also deter it.  Such a lack of fundamental procedures may indicate a weak internal control environment such that more schemes may exist.

2 February 2010

On February 23, 2010, the Boston Herald reported that the Justice Department charged an employee of a Boston-area hospital with alleged embezzlement of $1 million in funds from patients and vendors.  To effectuate this embezzlement, the employee deposited checks the employee received from patients and vendors into the employee’s own bank account.  This type of situation represents a classic fraud and the lack of proper controls at the hospital allowed the employee to take the funds.  Two issues present themselves in this scenario with the same underlying principal: an employee handling cash.

The first issue has to do with an employee that receives cash from customers.  To prevent an employee from embezzling customer cash the employer could have first assigned a receipt book to each employee that received any type of cash or check from patients.  The receipt book should contain sequential receipt numbers.  It matters not whether a customer pays with a check or cash: each customer should receive a receipt upon remitting a payment.  At the end of each day a supervisor or other employee should tally the amounts in the receipt book and compare it to the cash received.  Any discrepancy should be immediately investigated.  When both parties agree as to the amount received, both should sign the tally sheet in pen.

As an additional control, especially at a health-care facility which may accept co-pays from patients, the number of patients seen should be compared against the cash received.  Occasionally, another employee such as an internal auditor should choose a sample of patients and trace the patient’s payment through receipt to deposit into the bank account.

The second issue has to do with an employee that receives cash from vendors.  An employee that receives rebate checks from vendors can only get away with embezzling this cash when an employer fails to reconcile vendor rebates to cash and credit memos.  Someone other than the employee that receives the vendor rebate checks should reconcile the cash received and credit memos applied to a vendor-rebate statement.

The Herald report leads one to question as to whether the cost of implementing appropriate controls exceeds the benefit to prevent an employee of embezzling $1 million in funds.  While the limited information on this particular case leaves the question open, another question presents itself.  Namely, how much has the hospital lost because it has a weak internal control environment? 

3 August 2008

The August 2-3, 2008, Wall Street Journal relayed that a draft Securities and Exchange Commission report on bond-rating firms revealed that internal Emails for some rating agencies questioned the ratings assigned to securities.  See Aaron Lucchetti, S&P Email: ‘We Should Not Be Rating It.’ Wall Street Journal, August 2-3, 2008 at B1.  Investors rely on firms like S&P, Fitch and Moody’s to rate debt and the rating, in turn, affects the value of the investment and the price investors will pay for the product.  Placing too much reliance on these “independent” rating firms proved wrong and contributed to the volatility in the credit markets.  Most telling, however, an analytical manager at S&P, according to the WSJ Emailed a colleague ‘rating agencies continue to create an even bigger monster – the CDO market.  Let’s hope we are all wealthy and retired by the time this house of cards falters.’  Such a comment while issuing favorable ratings on investments could rise to the level of fraud.  Users of rating agencies should have heeded the advice of the greatest trader of all time, Jesse Livermore.  Mr. Livermore implored people to do their own research.  Rather than hire staff to perform independent analysis and scrub collateralized instruments, investors relied on the rating firms to assess an instrument’s risk and investors in debt have paid for this strategy with deteriorating asset values.  One alternative to hiring staff, hire an outside firm to scrub the items making up a collateralized debt instrument.  Although a more expensive proposition, the cost pales in comparison to the asset value lost for failing to ensure true independent analysis.

23 December 2007

Recently a Wall Street Journal headline screamed that fraud drives wave of real estate foreclosures.  See Michael Corkery, Fraud Seen as a Driver in Wave of Foreclosures, Wall Street Journal, December 21, 2007 at A1.  The article outlined a scam in which a fraudster recruits borrowers with good credit to apply for loans using false income and asset statements.  Then the fraudster finds an appraiser to inflate a home’s value.  A lender then loans the borrower an amount that allows the borrower to purchase real estate and split with the fraudster the excess of the cash borrowed and the price paid for the real estate.  The article described a ring in Atlanta that defrauded lenders of almost five million dollars.  This kind of scam illustrates fundamental weakness in the underwriting of real estate loans.

When a party decides to purchase real estate, the party typically applies for a loan with the help of a mortgage originator.  The originator will only receive payment for their services upon closing the transaction.  Lenders protect themselves from a variety of risks through a process known as underwriting.  In the underwriting process a lender’s employee verifies a borrower’s loan application, including income and assets and orders an appraisal on the property.  A lender uses an appraisal to ensure that the real estate will adequately protect the lender’s investment in the property.  A closing attorney documents the transaction for the lender and files the necessary paperwork with the appropriate governmental authority.  A competent closing attorney will notify the lender of glaring disparities between a loan amount and the value of real estate.  The scheme in Atlanta relied on collusion with borrowers making false statements on mortgage applications, appraisers knowingly inflating property values and closing attorneys turning a blind eye or actively participating in the scheme.  Lenders also suffered damage through failure to perform due diligence during the underwriting process.  To further exacerbate the problem, lenders typically bundle up notes secured by real estate into securities and sell the debt to investors. 

For protection against such schemes, lenders should regularly have an independent party perform due diligence on a sample of loans.  Further, securities underwriters should also perform due diligence on samples of loans comprising a security prior to packaging and selling the securities to unsuspecting investors. 

Recently a young couple that wanted out of a real estate deal approached this office seeking options to escape a real estate deal.  The couple had put $20,000 down and on the eve of closing realized that they could not afford the home.  Upon reviewing the mortgage application, this office asked how the couple could earn over $100,000 per year when the husband did not have a job and the wife worked as a clerk in a file room for a not-for-profit.  The client responded that the mortgage originator had the couple put on the mortgage application that the wife earned $100,000 per year and not to worry about it.  Unfortunately for the client they signed the mortgage application under the pain and penalties of perjury.  This left little recourse against the mortgage originator and opened the client to a charge of perjury.  Additionally, the closing attorney appeared to know all about the fraud and, at least to this office, seemed an active participant in the fraud.  At the end of the day, the client lost half their deposit to the sellers.  This example demonstrates the need for unsophisticated individuals to obtain the service of an independent attorney; not a bank supplied one.

8 December 2008

Recently Forbes Magazine reported on an algorithm that several academics developed.  Daniel Fisher, F Is for Fudging,  Forbes,  29 October 2007, at 72.  Based on the article it appears that the algorithm incorporates the following variables: (a) sales; (b) receivables; (c) asset growth; (d) employee count; (e) cash sales; (f) cash margin; and (g) book-value multiples, among other things.  The algorithm produces a metric called “F-score” where F means “fudging.”  The term “asset growth,” as used in the algorithm considers: (1) reserves; (2) intangibles; (3) accruals; and (4) leases.  “Cash sales,” as used in the regression means revenue less the increase in accounts receivable.  “Cash margin” means “cash sales” less the sum of cost of goods sold and the increase in inventory divided by “cash sales.”  The article does not discuss the coefficients or all the variables associated with the regression, but the variables identified and examples in the article provide insight as to how income statement and balance sheet relationships and trends could serve as metrics that trigger heightened scrutiny. 

With respect to each variable in the algorithm: (a) Sales measure how effectively an organization uses its assets to generate an economically viable product and the value others attach to the product.  (b) Receivable refers to a sale made for which the seller expects to receive payment at a future date.  (c) Asset growth, as specifically defined above, considers the change or delta in the enumerated variables.  (d) Employee count attempts to incorporate the human element and provides an indicator of anomalies in an organization.  (e) Cash sales, as specifically defined above, attempts to eliminate the effect of accrual basis accounting.  (f) Cash margin, as specifically defined above, attempts to eliminate the effect of accrual basis of accounting.  (g) Book value, usually a conservative measure, attempts to provide a baseline for measurements.  The algorithm incorporates these variables to produce a metric that may indicate improprieties.  The algorithm has logic.

For example, if sales per employee changes significantly such a change should invite heightened scrutiny.  If sales per employee increase significantly, such an increase could indicate fraudulent sales.  Alternatively, if sales per employee decreases significantly, such a change could indicate significant off-book activity such as an officer of a corporation using corporate personnel to engage in other activities.

While one could write a book about how the above variables interplay with each other, a business could use the above variables to identify the expected relationships and investigate the causes of deviations if actual results differ.

22 November 2007

On 29 October 2007, Joseph C. Hubbard, individually and on behalf of others filed a Complaint in a U.S. District Court in Florida against BankAtlantic (“Bank”), one of the largest financial institutions headquartered in Florida.  (See Complaint, Hubbard v. BankAtlantic et al., S.D.FL, Docket No. 07CV61542).  The Complaint alleges, among other things, that BankAtlantic made a $27.8 million dollar real estate loan without obtaining an appraisal while the actual value of the property amounted to $17.1 million dollars.  Because the Bank did not adequately reserve for losses on this loan, the Complaint alleges, BankAtlantic overstated its earnings.  The Complaint details a series of events that allegedly contributed to BankAtlantic booking a loan in which the underlying collateral did not support the full value of the loan.  Namely: (a) 16 June 2005, Eddy Corp. sold “sod property” to Rusty Pot for $7.8 million; (b) 28 July 2005, Rusty Pot sold itself to Capital Force for $17.1 million; (c) 8 August 2005, Rusty Pot sold “sod property” to Steeplechase for $34.2 million; and (d) 8 August 2005, Steeplechase obtained a $27.8 million loan from BankAtlantic.  The following discussion does not does not make any assertions as to the validity of the allegations contained in the Complaint filed against BankAtlantic.  Rather, the fact pattern serves as a basis for discussion without drawing conclusions for either party in the case.

An accounting reserve (sometimes called a contra-asset account) serves to restate an asset at its Net Realizable Value.  Generally, but not always, a posting to a reserve account impacts a company’s earnings.  Failing to establish proper reserves creates opaqueness in financial statements such that investors cannot properly make investment decisions.  An entity may overstate its reserves in good times in order to smooth out earnings in bad times.  Similarly, understating reserves paints a better financial picture than may exist.  Regardless of the reason, failing to properly account for reserves deviates from the primary purpose of accounting: to accurately reflect economic data for decision makers.

Prior to making a $27.8 million dollar investment, any investor such as a bank, should obtain an independent appraisal for the asset supporting the investment.  For real estate, a competent appraiser usually provides an accurate assessment of a parcel’s value.  In the BankAtlantic fact pattern it appears that the same property flipped three times in two months at increasing values prior to the bank advancing against the property.  In such an instance the Bank’s attorneys that documented the loan to Steeplechase should have alerted the Bank as to a potential issue.  While the attorneys will argue they have no duty to issue such a warning, attorneys that respond in such a fashion should not receive future work from a lender.  Finally, a local bank should have knowledge as to local market values to prevent a substantial overpayment for an investment.

Regardless of the outcome of the BankAtlantic case, the fact pattern serves to highlight a series of shortcomings.  Underwriters, appraisers, credit committees, internal auditors, external auditors and regulators need to exercise diligence to prevent the unfair transfer of wealth from a bank to a borrower.

11 November 2007

The Boston Globe reported that the beleaguered town of Randolph's Recreation Department received a subpoena from the Norfolk County District Attorney's office requesting fee collection schedules, payment slips, and employment rosters, among other records dating back to 2003.  The allegations appear to relate to the town's skating rink. Milton J. Valencia, Town records subpoenaed, Globe South, Boston Sunday Globe, November 11, 2007, at S1 and S5.  Note that the following discussion does not mean that any improprieties occurred at Randolph: the subpoena only serves to provide a starting point for discussion.  Fraud can occur in any type of business that lacks proper internal accounting controls.  The District Attorney's subpoena highlights two types of improprieties that can occur.  One deals with revenue and the other deals with expenses.  When an employee receives cash from customers, some sort of monitoring system should exist to inhibit the loss of the cash.  In a pure cash environment like a skating rink, the company should require the presence of two employees when cash changes hands.  One employee receives the cash and the other should hand the customer a receipt or ticket that acknowledges the customer has parted with cash.  The presence of two employees acts on the assumption that collusion will not occur.  At the end of the day, the tally of cash should concur with the number of tickets sold.

The subpoena also highlights another potential fraud: the creation of phony expenses.  When the same person authorizes an expense, like hiring an employee or paying a vendor, also has the ability to pay those expenses, a lack of segregation of duties exists.  All business should attempt to separate the authorization, record keeping and custody functions.  When the same person both authorizes and pays expenses, a business has failed to segregate the authorization and custody functions thereby allowing the creation of phony expenses like ghost employees and payments to non-existent vendors.

In the end, proper internal controls help to inhibit fraudulent transactions.

29 July 2011

Montreal Clinic Defrauded

11 July 2010

City defrauded

2 February 2010

Embezzlement from hospital

23 December 2007

Mortgage Fraud 

8 December 2007

Fraud Algorithm 

22 Nov. 2007

BankAtlantic sued. 

11 Nov. 2007

Town served with subpoena