Lecture Notes for
How to Steal $500 Million
These notes will be in the form of questions that you should try to answer
while watching the video. The purpose is to make certain that you are
paying attention to what has happened and to assist you in figuring out why.
After watching the video, you should be able to answer the following
questions:
1. Who were the individuals involved in the fraud?
a. Chief Executive Officer
b. Chief Operating Officer
c. Chief Financial Officer
d. Accounting Manager
e. Controller
2. How big was the fraud at the following points in time?
a. June, 1989 (before using exclusivity fees)
b. June, 1990
c. June, 1991
3. Why was PharMor losing money originally?
4. Where were the true numbers kept?
5. How were the cash shortfalls covered?
6. How did PharMor hide the inflated inventory numbers from their auditors
(there were two things they did)?
a.
b.
7. What two critical errors did the auditors make in verifying inventory?
a.
b.
8. What happened to first alert David Shapira to the fraud?
9. What precipitated the discovery of the fraud?
10. What did Mickey Monus suggest that Pat Finn do about your answer in
8?
Lecture notes for:
Corporate Cons
This video covers internal fraud schemes (as opposed to management trying to defraud
investors - like the other two videos)
Internal fraud schemes:
• Cash
• Accounts receivable
• Inventory
• Expenses
• Purchasing
• Payroll
Cash frauds. Easy to steal and hard to trace.
Methods of embezzling cash:
1. Skimming
2. Under-ringing and voiding sales
3. Trading checks for cash
4. Alterations of cash receipts documents
5. Fictitious refunds and discounts
Video Store case (Pam)
Failed to ring up sales. She felt that she was underpaid (this is frequently the case
with small time fraudsters) (numbers 1 and 2 above)
This was an OFF-BOOK fraud in that she did not modify any documents or
journals. There would be no audit trail (no documents to indicate the fraud).
These are typically proven by circumstantial evidence.
Auto Parts store (Tony)
Also felt that he was underpaid
Fictitious refunds and discounts (forged refund slips)
This would be an ON-BOOK fraud since the accounting records are being
changed. The modified documents leave an audit trail that proves the fraud.
One theme that seems consistent is that the fraud seems to build. It
starts out small and then gets out of hand.
Detecting Cash frauds:
1. Bank reconciliations
2. Cut-off bank statements (a bank statement mailed directly to the CPAs
with accompanying checks)
3. Surprise cash counts
4. Customer complaints
5. Altered or missing documents
6. Financial trends (for larger frauds)
Evidence square:
Paper and physical evidence is always preferred to observational or
witness evidence.
Accounts Receivable fraud
John Faulkner - borrowed against other peoples’ life insurance policies
Four main account receivable frauds:
1. Borrowing
2. Lapping
a. Delay the posting of accounts
b. Take one payment on A/R - post the next payment to that account, etc.
3. Creating fictitious receivables (customers) - mainly for:
a. Commissions
b. To make income look better than it is (window dressing)
c. Premature recognition of legitimate orders
4. Write-offs of accounts receivable
Most every fraudster intends to pay the money back ------ at first!
Detecting Receivables fraud
1. Match deposit dates and customer payment dates
2. Trends in write offs
3. Dual endorsements required on all cash receipts
4. Confirmations of accounts receivable
In general, detection of internal fraud is obtained by:
1. Complaints and tips
2. Discrepancies in the books
3. Control weaknesses that indicate “possible” opportunities for frauds
4. Lifestyle changes of employees
Inventory fraud
Kaye Lemon
The fraud was to write checks to herself and then when paying legitimate
vendor bills, she would write down a larger number in the check register
than the check that she wrote for the merchandise. She balanced the
checkbook.
Inventory fraud is typically one of four types
1. Theft of inventory
2. Misappropriation of inventory for personal use
3. Selling inventory and pocketing the money
4. Charging cash embezzlement to inventory (this was what Kaye did)
Typically large inventory frauds are caught by tracking Cost of Sales and
ending inventory numbers.
In handling of assets, the three following activities should be performed by
different entities:
1. Custody
2. Recording transactions for
3. Authorization of transactions for
Expense fraud
McKinley Tabor
Would charge the bank for services expenses (from some bogus provider).
Would take the money that these expenses supposedly cost and
electronically wire it to his own account (by paying off a credit card).
Note that expenses get closed at the end of the year (and all are reset to
zero). That makes this a particularly dangerous fraud.
Payroll frauds
1. Having ghost employees (frequently detected because they forget IRS
deductions, etc.)
2. False overtime
Purchasing Fraud
Paul Cote
Typically, bogus purchases are made to a related party (or bogus party) and
the money is siphoned to the fraudster.
Five types of purchasing fraud:
1. Fictitious invoices
2. Over-billing (real product at an inflated price - requires cooperation of an
outsider)
3. Checks to relatives
4. Conflicts of interest (purchaser owns stock in the vendor)
5. Bribes, kickbacks, and corruption
Management attitude seemed to play an important role in Cote’s fraud as it
seems to in so many of these.
Also, it appears from these stories that it is easy to bury and hide files from
the auditors. They do not seem very tenacious when dealing with intentional
frauds.
Detection of purchase frauds
1. Check addresses and phone receipts of employees
2. Look for missing documentation (through reconciliations)
3. Compare prices of purchases over time and with others in the industry if
possible
4. Keep a watch for new (possibly bogus) vendors.
Corruption
John Edward Thomas
Kickbacks for risky loans (bribery)
This is an off book fraud since all of the paperwork is correct - it is only the
wisdom of authorization that is an issue.
There are three components to every fraud
1. Perceived need
2. Opportunity
3. Rationalization
To reduce the perceived need:
1. Management attitudes towards employees should be supportive
2. There should be support programs in place to help employees that have
true financial difficulties
3. There should be an open-door policy
To minimize opportunity, the company should have:
1. Proactive fraud procedures and policies
2. Good fraud reporting program
Proactive fraud procedures and policies would include:
1. Letting employees know that the auditor is watching
2. Encourage tips
3. Require mandatory vacations
A good reporting program would include
1. Encouraging tips
2. Providing rewards for info
3. Educating employees on fraud
Finally, corporate attitude (control environment) is essential to minimize
“rationalization” of fraud.
1. Corporate conduct (does the business conduct itself ethically)
2. Writen codes of ethics.
In summary:
Fraud causes:
Fraud can be detected by:
Best prevented by:
Frequently caused by excessive
spending
All employees are at risk
Audit clues and discrepancies in the
books
Tips and complaints
Ethical leadership
Proactive fraud policies
Lecture notes for:
Cooking the Books
This video will discuss three cases of fraud: how fraud was perpetrated, how it was
detected, and why it was perpetrated. Pay close attention to how (why) it got started.
There seems to be a similarity between the three cases and to the next video (PharMor).
Most of the notes that are in this document are information that is provided in overheads
shown in the video. These overheads go way too fast to be able to write down - so I am
writing it down for you.
Fraud is defined as the intentional misstatement of information for the purpose of
obtaining some advantage. The importance here is that fraud is misrepresentation. It is
not embezzlement except to the extent that embezzlement involves intentional
misstatement.
The video begins with a discussion of eight common methods of perpetrating fraud.
These are worth knowing:
The first four relate to the overstatement of revenues:
1. Premature revenue recognition (recognizing revenue before it is earned).
2. Improper treatment of sales (for example - recording a consignment as a sale - or
worse - making sales up)
3. Revenue substance versus form (for example - selling to a related party in a bogus
transaction)
4. Percentage of completion accounting (saying that more is earned than actually is)
Four other methods of perpetrating fraud are:
5. Deferral of costs and expenses (holding off recognizing an expense)
6. Improper asset valuation
7. Related party transactions
8. Inadequate disclosures
This list is not very concrete, but it is good to know (you will see it again in auditing)
ZZZ Best
They did a bunch of things to manufacture their fraud. Among these things were:
• Creating false accounts receivable and sales
• Creating false documents (using photocopies of real documents)
• Kiting checks (depositing a check in one bank account from second bank account and
then depositing a check into the second bank account from a third bank account to
cover that first check. Then they deposit a check in the third bank from the first bank
in order to cover the second check, etc.)
• Compromising the independence of the internal auditors (this is a theme that runs
through EVERY one of the major frauds we will discuss today).
• Create documents that made it appear receivables were being collected.
The video notes that auditors use two primary means of verifying that a company’s
reported Accounts receivable are in fact true:
1. Confirmations (sending a letter to the customer and asking if they do in fact owe
money)
2. Looking for subsequent collection of receivables.
Barry Minkow knew this and created fictitious collections on accounts receivable.
Barry Minkow also compromised the independence of the auditors by “making them feel
good” and diverting their attention from problem areas.
According to the AICPA (American Institute of Certified Public Accountants) Statement
on Auditing Standards (SAS) No. 53, the auditor’s responsibility for finding fraud
include:
1. Understanding the characteristics of errors and irregularities (fraud)
2. Assessing the risk of material (significant) fraud
3. Designing audit procedures to provide reasonable assurance that material fraud will
be detected.
4. Plan, perform, and evaluate the audit carefully.
5. Approach the audit with professional skepticism.
Barry Minkow offered the following as red flags that should alert auditors to an increased
likelihood of fraud:
1. The company is highly leveraged (a lot of debt relative to the assets)
2. A large proportion of the fixed assets are leased (and not owned).
3. Unbelievable growth (if it looks to good to be true, it probably is)
The first and third of these are common threads that run throughout many frauds.
There are two main stages in the auditor’s assessment of the risk of fraudulent financial
reporting:
1. Analyzing the company’s internal and external environment
2. Determining how these environments affect risk.
Note that in the ZZZ Best case, they are in a low-margin industry. How are they growing
so fast? This will also apply to PharMor, Regina Vacuum, and ESM Group.
Internal environment fraud risk factors include:
1. The strength of internal controls
2. The accounting system
3. Management’s attitude towards fraud
4. Administration and Operations
5. Business is dominated by a few individuals
The auditor should consider (in assessing the risk of fraud):
1. Liquidity (how much cash they have)
2. Profitability
3. Ability to borrow money
4. The quality of their receivables
Barry Minkow notes that if growth is essential, this should be a red flag to auditors.
Growth (perpetuating the fraud) is typically essential in a fraud. It may be desirable in a
high growth company - but it is not usually essential!
SAS No. 53 states that the auditor should consider:
1. Recent changes in operations or products (Regina)
2. New production techniques
3. Business with a few major customers (only)
4. Industry trends
5. Assets or inventory with valuation problems
6. Large or unusual adjustments at or near year-end.
For ZZZ Best, industry comparisons would have pointed to anomalies.
Also, past trends analysis would have indicated that something was now quite different.
Regina Vacuum
Premature revenue recognition can happen in several ways:
1. Holding books open past the end of a period (to get some extra sales in)
2. Bill and hold schemes (premature or bogus invoicing for a customer without sending
it)
3. Conditional sales counted as regular sales
4. Delayed posting of sales returns
For Regina Vacuum, sales returns were not posted, they created false invoices, and they
under-reported expenses.
ESM Group
Don’t worry too much about them - the fraud was fairly complicated. There are a few
features of this story that I think are important though:
1. What made them start engaging in fraud.
2. Notice that after they started it escalated to enormous proportions and the “original
reason” was not the only reason it was perpetuated and escalated.
3. Notice how the auditor got caught in a web
a. His independence was compromised
b. He was relatively inexperienced
c. Once he “didn’t catch” the fraud in year 1, he was afraid to turn them in once he
did. This is typical of auditors and employees.