Part 8 of 10, Fraud Inoculation

Part 8 of 10, Fraud Inoculation

Fraud Inoculation

May I put approximate time requirements on the necessary monitoring activities? First of all, to start such a comprehensive program requires a 100% physical inventory, perhaps involving every employee for one day. Setting up this forward-going scenario would require a one-time investment of time of 10 to 40 hours, depending on the complexity, the size and the numbers of items involved, plus perhaps a day in the life of all the employees. And of course the tickets used to count the inventory has to be audited by an outside auditor.

Taking a look at each and every check face as checks are cut and payrolls paid, might require ½ hour per week, while carefully reviewing all bank reconciliations monthly, might add another hour per month.

Scanning/watching all receipts of weekly inventory in (including drop shipments) might require another ½ hour per week. (Spreadsheet macros could be written to catch the salient information, but walking around is needed too.) Each vendor must be known, though most small business owners already know all of the vendors. This re-acquaintance might require a one-time 2 to 4 hour time allotment. Likewise, each customer who is granted credit, becoming an A/R, needs to be known before being added.

Then, as vendor checks are written and receivable checks are received and posted, both the AP and AR aging reports can be carefully scanned every week to match the increase or decrease of check amounts in or out to each account. Again, spreadsheet macros can be written to track and somewhat explain any non-matching issues.

Before too long, the scanning of aging AP and AR reports does not take much time, while scrutinizing the spreadsheet information becomes the focal point, because those spreadsheet macros track and match all cash flows in and out to AP and AR every week.

Ditto with every employee, as every check written to an employee matches only employees known to be on the payroll paid a known periodic amount. Again, spreadsheet macros can be written to track and explain any non-matching issues.

Finally, every checking account, credit card account, (as well as Petty Cash) needs to be independently monitored. This might take 2 to 4 hours per month. Again, spreadsheet macros can be written to track and explain any non-matching or unusual issues each month.

The meaningful issue here is to know the actual cash flow in and out, perhaps within $500 at any point in time. This knowledge requires a weekly cash flow forecast which clearly reflects the cash cycle for this specific business with changing cash expectations built into every weekly forecast. Then the spreadsheet macro reports on all the flows in and out are reconciled both on paper and in the owner’s head with what the cash balance is now and what the cash balance is expected to be in the near-future.


Part 7 of 10, Fraud Inoculation

Part 7 of 10, Fraud Inoculation

Fraud Risk Reduction

Because material fraud rears its ugly head mostly over cash issues, we need to identify cash activities, thereby identifying the fraud risk candidates.

The main areas of cash flow out, in small businesses are:

Payroll checks

Vendor checks

Cash register refund transactions – checks/cash/credit cards

Loan repayment plan checks

Auto pays in checking account

Pension/401k payments uploads

Unusual checks

Inventory product checks

Asset purchases, asset payment plans

Credit card charges

Petty cash out

Unusual/manual checks out

Postage machine/shipping charges

The main areas of cash flow in, in small businesses are:

Account receivable checks

Cash register transactions – checks/cash/credit cards

Employee COBRA checks

Loan/equity proceeds

Auto deposits in checking account

Asset sales

Credit card credits

Petty cash in

Unusual checks/cash in

If all the above avenues of cash flow in and cash flow out are monitored tightly, assuming such a scenario is possible, then only the cash-flow monitor has opportunity to commit material fraud. And if the owner, the monitor and the largest stockholder are all the same person, and he or she reports to the board of directors on a monthly basis, then his or her fraudulent opportunity could decrease to near zero.

Part 6 of 10, Fraud Inoculation

Part 6 of 10, Fraud Inoculation

Cash Flow Forecast

Of course one large contributor to survival was reducing the workforce. From the date of the fraud discovery to three and ½ years later, sales have decreased by almost half, yet payroll expenses have been reduced by more than 50%.

With the small monthly repayment plans in place, the firm now operates slightly above break-even, eking out a small operating profit during the majority of the months.

One large reason for being able to operate profitably, most months, is that every week we revise and create the new Bible – in the form of a Daily Cash Flow Forecast six weeks into the future.

This cash flow forecast includes AR in, AP out, occupancy expense, sales tax expense, checking account balances, 1099 expense, cash in through the retail stores, cash out to fund 401k agreements, auto-pays in the checking account, vendor and creditor agreement payments, shipping expenses, etc., whatever is needed, all on a daily basis. And we fit all that information into a one-page report.

Then we balance the checking account, materially, every day. Both the accounting clerk and the owner know every day what the checking account cash balance is as well as the net balance, assuming all outstanding checks had cleared, including which checks are outstanding and likely how long before they clear.


Part 5 of 10, Fraud Inoculation

Part 5 of 10, Fraud Inoculation

Working Capital

Inventory replenishment became an intricate chess game as on-the-shelf inventory value in the warehouse quickly dropped from well over $1 million to less than $500,000, causing the purchasing manager major headaches. Many stretched vendors began to do business with this firm on a cash-on-delivery or paid-in-advance basis.

The purchasing manager and the owner made new deals with different publishers to intentionally raise costs by sharing part of the rich margin of regular new publishing with them, entreating them to make units for us in bulk, then holding on to our inventory, doling out product to us as they were paid in cash.

This inventory process is a kind of ‘just-in-time’ inventory, available whenever cash is fronted, yet we begged and pleaded for these terms instead of dictating them. All the risk for inventory overruns is ours as well, at these new publishing houses. The only real risk faced by these two long-time, friendly suppliers is our bankruptcy, which the regular publishing of new inventory renders increasingly unlikely.

Payroll expenses were trimmed again and again in to reduce the bi-weekly consumption of cash in order to maintain sufficient cash for new inventory acquisition. Occupancy expenses followed payroll expenses as the second largest expense line item, so three locations were consolidated into two. Payments to landlords and leaseholders were renegotiated to smaller amounts as the credible threat of filing for bankruptcy (though decreasing over time) became a weapon to extract concessions.


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.