What you see is what you get

What you see is what you get – detection of fraud in a newly acquired company

Courtenay Thompson

Simple tools, like a telephone book and criss cross directory, helped one internal audit department save the company $2.35 million.

XYZ company was engaged in an aggressive acquisition program. The recent purchase of ABC Manufacturing had been engineered to provide entry into a business area where the company had no direct operating experience.

XYZ’s standard procedure required internal auditing to perform a post-acquisition audit about nine months after the deal had closed. The key purpose of the audit was to facilitate integration of the acquired entity. Due to the relatively high risk associated with this unfamiliar business, however, the internal auditors initiated the post-acquisition audit of the ABC purchase somewhat earlier.

During the audit planning phase, Audit Supervisor Dan Wood quickly identified an obvious problem: sales to the two largest customers had virtually disappeared within six months after the change in ownership. These two customers had accounted for approximately 40 percent of total sales and 45 percent of gross profits prior to the acquisition.

When asked about the “disappearing sales,” the former owner, who had been retained as a consultant, contended that XYZ just didn’t know enough about the technical side of the business to sell effectively to these customers. The sales representatives assigned to these accounts relayed a different story, however. They had been told by purchasing agents at both companies that XYZ’s product was far from competitively priced. In the past, the purchasing agents had been instructed by their management to buy from the company in spite of the inflated prices, but that policy had apparently been abandoned.

Wood looked at the margins on sales made to these two customers before the acquisition. His review confirmed the points made by the purchasing agents. The two customers were the sole purchasers of a specialty product, which had always been priced substantially above the prevailing market. In addition, the existing supply contracts had been set up so that it was impossible for the acquired company to sell this particular product at the prevailing market prices.

Wood quickly recognized the red flags associated with fraud. The audit team immediately began an in-depth review to determine if questionable payments had been made prior to the acquisition.

KICKBACK #1

As an experienced auditor, Dan started with ABC company’s general ledger account for “consulting services.” Not surprisingly, two series of repetitive monthly payments appeared.

The first series of payments, in the amount of $7,000 per month, extended back for approximately two years and ceased just before the acquisition closing date. The payee was a company called “Eve Industries.”

For the preceding two-year period, which would have been years three and four prior to the acquisition of ABC, the same $7,000 monthly amounts were recorded in the general ledger, but the payee was different. The mailing address, however, was the same as that used for Eve Industries.

Reference to a criss cross directory of city telephone numbers and addresses showed that the address was the domicile of a “John Adams.” When this information was compared to one of the Dun & Bradstreet Reports obtained on the two major customers, John Adams was listed as the company president of the larger of the two firms.

KICKBACK #2

The second stream of payments was not quite so easy to trace. For the four years prior to the acquisition, a monthly amount of $6,200 had been paid to various companies – a different company each year.

The first breakthrough in the investigation surfaced from ABC’s sales department’s correspondence file for the second major customer. In examining the correspondence from the company, Staff Auditor Casey Young found the name of the Director of Technical Processes, Research, and Development. In discussion with the XYZ sales representative responsible for the account, Casey determined that the functional responsibility of this individual was “technical gatekeeper;” in other words, he qualified all items for use in production.

Casey obtained this individual’s home address from the telephone book and compared it to the accounts payable name and address files for the series of $6,200 payments. For the first two years, payments to the company were sent to the same address as that of the technical director. Although a different company name appeared on payments after the first year, the address remained the same.

For the third year, payments were sent to the post office box address of yet another company. The monthly invoices displayed the name of the new company but listed the same street address as that of the previous payees.

No obvious connection could be made for those payments one year prior to the acquisition, but Casey was resourceful. Posing as an office supply salesman, he called the technical director’s listed home phone number. He discovered that the “company” whose name was used for the series of payments in the final year was domiciled at the same address and phone number as the technical director. It was clear that the ultimate recipient of payments over the four-year period was the technical gatekeeper.

The questionable nature of all payments and the reason for the disappearing sales were quite clear. based on the lack of disclosure of material facts, XYZ’s attorneys were able to obtain a $2.35 million reduction in the purchase price of ABC.

LESSONS LEARNED

* As a result of this deception, internal auditing is now involved in the due diligence process, especially in searches for questionable payments. In addition, explicit verification of the identity of all consultants and commission agents and the nature of their services is now required.

* XYZ’s experience emphasizes the importance of reviewing internal records and support and comparing them to external records, documents, and information.

* This case demonstrates the simplicity and efficacy of the telephone book and its cousin, the criss cross directory. In an experienced internal auditor’s hands, these basic tools and other standard external information sources, such as Dun & Bradstreet and state records of incorporation, can provide the external information necessary to determine the true identity of payees and their relationship to the organization.

COPYRIGHT 1998 Institute of Internal Auditors, Inc.

COPYRIGHT 2004 Gale Group