Part 4 of 10, Fraud Inoculation

Part 4 of 10


Egg-shell fragility reigned at this firm for three years after the embezzlement became public. When the initial shock wore off, and forensic accounting issues became less important, I became the Interim CFO and soon interviewed and hired, as another 1099 employee, a skilled, untainted person to do the daily accounting. Because she and my firm both had other clients, we attempted to make our time spent at this firm as efficient and effective as possible.

Though filing for bankruptcy protection remains a possibility today, soon after the discovery of the fraud, the owner president met with the eight main vendors and creditors (those owed more than $50,000 each) offering them a delayed payment plan or pennies on the dollar as no more was available. Their collective immediate response was “no, never.” Yet when the full force of the economic downturn became plainly evident to all, including the questionable survival of many large firms in Arizona, these vendors, lenders and landlords finally started listening to the arguments of this firm’s owner, wrenching though they were.

All told to date, without filing for bankruptcy, major liabilities totaling over a million dollars were settled for either 10 or 20 cents on the dollar or repayment plans were spread over multiple years in the future, usually the distant future. Almost no repayment of large liabilities happened during the first two years after the embezzlement became known, as business survival and a reasonable prison term for the fraud perpetrator were the owner’s two major priorities.

No financial institution would lend money to this firm, therefore we paid a usurious rate of 35% to borrow capital against our credit card receipts to use to republish our main sellers. Even factoring receivables was seriously considered, though not chosen. Somehow, the owner’s Houdini-like contortions proved sufficient, though his time-absorbing actions likely contributed to his marriage failure along the way.

Part 3 of 10, Fraud Inoculation

Part 3 of 10

Fraud Details

For emergencies Ted was a signer on the checking account because the owner and main check signer’s office was 25 miles away in a different city.

Forensic accounting showed Ted signed 73 checks paying $231,299 for various personal bills (mostly personal credit card accounts) over a fifty-seven month period. Additionally, there were 5 automatic payments hitting one checking account. 67 of those 73 checks were manual checks, which manual checks were supposed to be used for emergencies happening outside of normal check run periods. We can only imagine what emergency caused Ted to date the last manual check he signed, payable to one of his credit card accounts, early the morning he flew to Italy!

Towards the end of his embezzlement, one of the creative ways Ted found money to steal was to lock away a number of vendor checks in a file cabinet, to be mailed much later, if ever. When suppliers called looking for their check, they were given a check number, an amount, and a date and asked to be patient waiting for the mail.

In fact, the cash crunch got so bad under his watch, after the company credit line was used up in November, 2007, the former CFO put $12,500 cash of his own money (well, by then was it really Ted’s money?) into the company bank accounts, without telling anyone, then continued his fraud for six more months, until he was confronted, confessed and fired in May, 2008.

The last six months of company business was good enough that the former CFO’s last six months of embezzlement netted him another $55,219.

Where does wealth really come from?

Some Americans falsely conflate wealth with money. Some seem to think that money, as wealth, is created by the Federal Reserve (the Fed). Even some politicians may be confused, encouraging the Fed to push programs like QED1, QED2, and QED3. We are not talking about the source of money, over which, in a mechanical sense, the Fed exerts a large influence. Instead, the real source of wealth creation occurs while growing the capital stock.

Another surprise to many people may be for them to realize that wealth does not actually come from Government spending. Mostly, what federal spending does is “prime the pump.” But money, real money, or wealth, that is, the stuff that makes the economy hum, actually comes from an increase in the capital stock. Let me explain.

Gross Domestic Product

While reading a basic economic textbook, one is almost immediately confronted with the notion of Gross Domestic Product (GDP). GDP is a measurement of economic activity. Economists have agreed that both the income approach and the expenditure approach lead to the same GDP number. The basic calculation is GDP = Consumption + Government Purchases + Investment + Net Exports. But the majority of people end up confused when hearing the factoid “nearly 70% of GDP is Consumer Spending.”

So what? Yes, Consumer Spending, or Consumption IS a component of GDP and a convenient way to measure the short-term direction of our economy. But, consumer spending IS NOT the primary cause of a growing GDP. Instead, Consumption is actually a secondary effect of a growing GDP.

Soft Data

Forget the hard data, look instead at the soft data. One of the best soft data measures of whether the GDP will grow is the Consumer Confidence Index (CCI), measured monthly by the Conference Board. The reason the CCI is important is that potential entrepreneurs often note the “temperature” of the average consumer, (and the CCI is one good attempt to measure that temperature) to determine whether risk-taking can and will be amply rewarded in the current and dynamic investment environment.

One of the senior writers at Fortune magazine, Geoff Colvin, spent years and thousands of words pointing out that the uncertain investment environment was the chief culprit for the eight years of puny recovery that followed the Great Recession. Today, however, Colvin is singing a different tune. The most recent Fortune magazine cover screamed, “The End is Near” – So we ask, the end of what? And the answer is: the end of a incredible stock market rise of almost 10,000 points (as measured by the DJI) or more than 35% in the last two years, since it became obvious that a President was coming into office who would stabilize the investment environment.

Wealth Creation

Here is the bottom line. If entrepreneurs (not regular folks like us) feel comfortable taking risks, then the 1) capital stock (or Investment, which is the PRIMARY cause of GDP growth) will soon grow. When the capital stock grows, then both 2) consumer income and 3) consumer spending will grow. If consumer spending grows, then the GDP will grow and wealth is created. There is NO OTHER WAY!

Part 2 of 10, Fraud Inoculation

Part 2 of 10

Background and History

The former CFO of a multi-location publishing house in the Greater Phoenix area is now serving time in prison (as of December 2011) for committing fraud and embezzlement. A detailed analysis of the before and after situations at the defrauded firm might prove instructive to any small business wanting to prevent material fraud.

The former CFO was in his thirties, married with four children. He attended church every Sunday, had a regular job with the Boy Scouts, was a college graduate, hard-working and trusted by all. In other words, he was the typical accidental fraudster.

My firm was hired to help out to determine if there was something inappropriate happening as cash was tight, even though business was good and the accounts receivable were healthy. But why were the financial statements were 7 months behind? (Red Flag!)

I requested bank statements from the former CFO (we will call him Ted, not his real name) several times, but I always received the excuse they could not be shared. Then Ted went on a second honeymoon to Italy, and finally the owner requested six months’ worth of bank statement copies sent to him from the bank.

One day later, as those statement copies included copies of all the check faces, I found fraud!

What is fraud and why does it happen?

What is fraud and why does it happen?

Simply stated, fraud happens when there is an accumulation of money, or at least a steady flow of cash or the equivalent, and a (formerly trustworthy) trusted party, managing that money, who decides to appropriate some cash for his or her own use. We call that type of theft, embezzlement. Most fraud is some form of “asset misappropriation”, the term used in the fraud examiner’s world.

Fraud is not a simple robbery, where force or a weapon is used to coerce someone to turn over valuable property of which the possessor rightfully controls. Instead of being trustworthy, the embezzler tricks the rightful owner of the property into thinking that the cash flow or the accumulated amount is still unimpeded and/or is not being diverted. That trickery is used to hide growing stolen goods, accumulating in value over time.

Who is guilty of this dastardly deed? According to the worldwide Association of Certified Fraud Examiners (ACFE), around 85% of fraudsters are what is called in the parlance, an “accidental” fraudster. Those who defraud, intentionally participated in and perpetrated the fraud. That is part of the trickery. But “accidental”, is used as a modifier meaning that although the fraudster intentionally took the money, they did not begin the job intending to become an embezzler. It just worked out that way.

How does an accidental fraudster come to be? Well, in 1973 a sociologist named Donald R. Cressey, in a book called “Other People’s Money”, put forth a theory that explains about 85% of fraudulent behavior on the part of an accidental fraudster. Cressey’s theory is known as the Fraud Triangle. The three sides of this triangle are 1) Perceived unshareable financial pressure, 2) Perceived opportunity, and 3) Rationalization. Through a combination of financial pressure like an unknown expensive surgery for a loved one or a drug habit, or gambling debts, etc., ad infinitum, plus rationalization, then if given the right opportunity, most of us could become an accidental fraudster.

We generally do not know our employees well enough to know exactly what unshareable financial pressure they are facing. And unfortunately, we humans tend to rationalize on a regular basis. Therefore, the only real way to prevent fraudulent activity taking place is to prevent the opportunity from occurring. How might this be accomplished? Stay tuned for my next blurb


Is Fraud Inoculation Possible for a Small Business Firm?

Part 1 of 10

Definitions and Challenges

If by inoculation, one means 100% fraud prevention in the future, then the short answer is no. Webster’s dictionary definition of fraud includes the following two sentences, “No definitive and invariable rule can be laid down as a general rule in defining fraud, as it includes surprise, trickery, cunning, and unfair ways in which another is cheated. The only boundaries defining it are those which limit human knavery.”

This means that new ways to commit fraud are yet to be invented, and no serious person would ever claim to be able to prevent all future instances of fraud in a multiple-person small business. The more interesting question might be, “can essentially all material fraud be prevented, and if so, how?” Response to this question will be considered, analyzed, discussed and explained in detail.

For example, if the word ‘material’ is defined to be plus or minus one-half of 1%, then in a small business with annual revenues of $2 million, ‘material fraud’ equals $10,000. Therefore, perhaps the important question to consider is, “Is it possible to prevent material fraud (of $10,000 or more, annually) in a small business, and if so, how?”

In effect, the best way to minimize the likelihood and the size of future fraud is to come as close as possible to balancing cash daily. In this ten-part series, we will show how to do this, assuming that the owner keeps that cash balance in his or her head every day. Though the task may sound daunting, it is not, if one has the proper motivation.

End Part 1 of 10