Business acquisition: a case study with various accounting frauds.
Fraud can be divided into a number of categories and sub-categories. For example, fraud may be related to specific misstatements within financial statements (Galletta, 2015). Fraud can be further categorized as: employee embezzlement, Ponzi schemes, vendor fraud, pump-and-dump schemes, consumer fraud, management fraud, and many others. The fraud-related episode considered in the current case research occurred in the early 2000s. The incidents described were related to the acquisition of an interstate truck-stop by a large fuel-oil distribution company. As the authors explain, the business acquisition process can provide an opportunity for fraudsters. Depending upon the industry and the complexity of the acquisition, a variety of potential frauds are possible (Giovino, 2015).
The process of acquiring a business should include the identification of any fraudulent activity so that immediate corrective measures can be taken. The primary reason that the large fuel distribution oil company initially needed someone to serve as an accountant, controller, and systems project manager was to facilitate the automation of all business processes. Every aspect of operations with the exception of payroll--sales, payables, government reporting and regulatory compliance--were manually processed. The first meeting with the primary owner of the five affiliated fuel distribution corporations revealed that the owner's ultimate desire was to automate processes in order to expand the business through acquisitions.
After an intensive 18-month information technology systems overhaul, the organization was ready to begin realization of that goal. It was during the process of the particular acquisition described herein that a fraud-revelation occurred.
Relevant Economic Crime Information
Asset manipulation is the most significant economic crime in business in general. And specifically, asset manipulation is present as an incentive/pressure in the "fraud triangle" relevant to business acquisition (Adkins, 2016).
After a decision has been made to undertake an acquisition, managers may develop strategies to alter financial information to gain additional advantage during negotiations. Concealment of actual asset valuation may benefit the existing management. Incentives to select an asset with a valuation easily manipulated may make it difficult for to accurately analyze the target's assets and operations during a due-diligence effort (Booth, Heitzman, & Zhang, 2012)
This study focused on the acquisition of a business unit and an investigation during the due diligence process to discover potential for fraudulent activity. The case study design was appropriate for this study because it investigated a specific phenomenon (fraudulent activity) in a real-world context (acquisition of a business unit by a specific organization) (Yin, 2014). The study spanned an eighteen-month period during which the primary investigator gathered information from multiple sources including financial records and employees. The researcher used in-depth interviews in conjunction with researcher observations to gather data for the case study. The data was analyzed using content analysis in relation to information gathered through examination of financial statements and in-depth interviews. The information was coded and linked in the investigation which ultimately resulted in the discovery of fraudulent activity.
The acquisition involved the purchase of a large truck stop. Fuel distribution is very similar throughout the world; fueling stations are positioned along highways across the globe. The truck stop in this case was large in terms of business volume and physical presence--about 100 acres. During the due diligence portion of this acquisition, various frauds were discovered. This case provided a unique opportunity to investigate fraudulent activity and to present recommendations for identification and avoidance of fraud through appropriate analysis.
Industry Expertise Required--Studying the New Operation to gain Industry Knowledge
Although the five corporations included wholesale and retail fuel distribution, the truck stop business was entirely new to everyone in existing management. Existing operations covered a three-state region including: Texas, Louisiana and Arkansas. Generally Accepted Auditing Standards require audits to be performed by professionals who are experienced within a particular industry (AICPA, 2001). Understanding all aspects of a business operation is critical for audit purposes and is crucial for due diligence, and just as important for fraud investigation (Lokanan, 2014). Because truck stop management was new to the acquiring organization and the primary investigator, educating personnel about truck stop operations was critical.
The education process involved a number of very important steps. These steps were not chronological; rather they took place somewhat simultaneously. One of the first steps in the education process was to read several trade journals dedicated specifically to truck stops; this enabled the acquiring organization's personnel to become familiar with standard truck stop terminology. It is often said that "accounting is the language of business (Do You Speak the language of Business? Paragraph 1, 2013). If that is true, then truck stop accounting is one of the sub-dialects of that language.
Another important step in the education process was to become acquainted with peers in the industry. Networking is always a valuable method for understanding critical information. In some cases, controllers, chief financial officers and executives of some of the large national truck stop operators were contacted as sources of information and education about the internal workings of all aspects of truck-stop operations.
Although online information was not as robust then as it is today, there was a tremendous amount of financial and operational data available in various databases found there. Understanding the metrics used to evaluate the performance of any industry is vital to any due diligence process (Jackson, 2014). But it became particularly vital to a proper fraud investigation. Though many sources of information were available, perhaps the most valuable tactic used to build a foundation for understanding the truck stop business was to conduct informal interviews with staff and personnel in different truck stops operating in the region.
It was discovered that wearing a suit and tie and carrying a clipboard to take notes presented an image that erected perceptional barriers to effective communication with personnel working for the truck stop. No one really wanted to talk to someone perceived as a threat or answer the types of questions being directly asked. So, to overcome some innate suspicions held by the staff in the business being acquired, "camouflage" was appropriate attire. Wearing clothing that resembled a truck driver's into a truck stop seemed to offer more opportunity for conversation than wearing the type of clothing that people might associate with the internal revenue statements (IRS).
Another important strategy was to allow information to flow freely without making it obvious that a due diligence inquiry was being conducted. An informal demeanor facilitated the gathering of information that might otherwise have been unobtainable.
Within the truck stop environment a number of different, readily distinguishable operational compartments were discovered. Of course, there was the diesel fuel sales department. But within this particular department there are a number of sub categories. For example, there are cash sales, credit card sales, national clearing accounts, in-house accounts receivable and several other types.
Other departments would typically include the convenience store and grocery operations. The repair shop is a significant revenue producing component. The restaurant operation was a major operational and accounting division. Another significant component was the truck washing department located on site but separated from the main building by about 300-yards. And finally, because certain land-based gaming operations are legal in Louisiana, the casino contributed significantly to the overall operation complexity.
During the months preceding the acquisition event, many hours of personal contact in the various departments were devoted to engaging staff in informal conversations. During these discussions, appropriate attire for that location and occasion was worn. Because of the nature of the information needed, the interviewee needed to be completely comfortable, relaxed and conversational. So, notes were not taken during a conversation. Rather, after each conversation, notes were made from memory immediately so they were as complete, comprehensive and accurate as possible.
Understanding the metrics of each component of each truck stop operation was an essential first step. Financial analysis of industry standards applies to due diligence. Several specific accounting situations will be discussed, but the most important illustration will be presented last. Not only was it the most important, it was the first discovery in what became a lengthier investigation.
In isolation, that one fraud would have been financially damaging. But more importantly, it motivated more detailed analysis of the entire operation. Had this initial revelation event not occurred, the acquisition could have been a financial disaster for the acquiring company, and the principal investigator might have never become a Certified Fraud Examiner (CFE).
ELEMENTS OF THE FRAUD
The Truck Stop Restaurant
Key metrics for analyzing a restaurant include labor, administrative, and food costs as a percentage of sales. Of course, there are others, but discussion is limited to food cost because it is most relevant to the current case research illustration.
Depending upon the type of restaurant, the metrics can be significantly different (Campbell, 2012). For example, the food cost at a 4-star restaurant is significantly higher than it is for a truck stop. Alternatively, food cost at a neighborhood pizza restaurant is somewhat less than the food cost percentage at a truck stop. Similarly, the relationship between the type of restaurant and labor and administrative costs will vary significantly. But the key analytical tool to understand when investigating a specific business operation, especially restaurants, is to remain within that specific restaurant category.
Knowledge of the appropriate ratios from comparable industry operations enabled study of the restaurant's operating results. An alarming trend was discovered based on that analysis.
Based on knowledge of expected food cost percentage, the primary investigator was motivated to consider the cause for the sudden increase during the months leading up to the acquisition. Based on this financial analysis ratio, a number of restaurant supplier invoices were selected. The line items on several of the invoices were significantly larger than previous periods. Thousands of dollars in high end meat products had been purchased by the restaurant. Based on informal conversations with a waitress who had worked at that truck-stop for over 30years, it was discovered that the truck stop menu had not changed in over ten years. Subsequent discussions with the head-cook yielded the discovery that none of the high-end products were used in any of the recipes for any menu item served by the acquisition target's restaurant.
Additional informal conversations with maintenance staff revealed that the vendor's truck driver would only offload a portion of the shipment. Based on this knowledge, the primary investigator waited until the normal delivery day for that vendor. Because the truck stop was so large and very busy, he was able to unobtrusively observe the delivery. When the truck driver left, the investigator followed him until he made his next stop--at a restaurant that it was later discovered, in another informal conversation, to also be owned by the seller in the acquisition. It appeared that there was a comingling of business affairs and that the cost of one business was allocated to another business in the furtherance of this fraud. At that point, further documentation was unnecessary; it was sufficient to understanding what was taking place.
Because this was not a formal fraud investigation, a note for future reference was sufficient. It was later determined through additional investigation that the other restaurant was also for sale by the same owner as the truck stop. By using the truck stop to avoid paying some food costs in the second restaurant, the income at the other restaurant could be overstated, thereby increasing the potential selling price of that second restaurant. This would have been a successful fraud strategy by the owner of the truck stop because the sales price of the second restaurant was to be based on the net income of that business. Alternatively, the sales price of the truck stop was fixed based on the net value of total assets. Therefore, the dynamic of each business sale was different (Business Valuation Methods, 2016).
The critical element to this particular circumstance is to understand how financial ratios relate to restaurant operation. Because of the discovery that food costs had risen dramatically over a short period of time, a corresponding dramatic increase in the account payable for several vendors was also discovered. Based on the financial metrics, an appropriate value for food inventory, and the appropriate amount that should be calculated for each vendor's accounts payable was calculable. Had this particular anomaly remained concealed, those liabilities would have been transferred to the new owners, but the associated inventory would not have been available for revenue production.
Cash and Receivables
One of the most significant components of the diesel fuel sales operation involves accounts receivable. Not only were there in-house accounts receivable, there was a significant variety of different fuel card and national credit card clearing-house operations. "The Automated Clearing House, or ACH, is a network of financial institutions that processes many types of consumer payments, including debit and credit card transactions" (Credit Cards, 2015, para. 1).
Additionally, there were many intricate relationships between sales, discounts, payments schedules, banking relationships, and multiple complex organizational relationships. The schedule of each layer was developed over a long period of time, decades, and many agreements were unique to a specific customer. The complexity of the various cash cycles was difficult to unravel. However, by analyzing the cash cycle for previous periods as compared to the cash cycle for the period leading up to the acquisition, the investigation uncovered another anomaly. To unravel this anomaly, about a week of intensive billing statement and remittance analysis was completed.
By analyzing each statement--of which there were dozens--the primary investigator was eventually able to establish a point of precise reconciliation for the previous year end. Then, by advancing the reconciliation forward through all periods for the current year leading up to the date of acquisition, a $53,000 discrepancy was pinpointed. As further investigation eventually revealed, this $53,000 had been debited to the cash accounts but had not been credited to the individual customer receivable accounts.
This inflated the assets of the operation because the same $53,000 was reflected twice in current assets. The next step to unravel this was to take the amounts that individually comprised the sum total of the $53,000 discrepancy and search the general journal and receivables subsidiary accounts for those exact amounts. It was discovered that those amounts had been credited to cash sales. Detailed analysis and research identified those specific transactions in which amounts had been improperly credited to cash sales. This particular finding corresponded to an unexplained increase in the operating profit margin for the same period.
This particular aspect of the fraud investigation indicated the purposeful misrepresentation of financial statements. Because the basic nature of the accounting transaction entry required, the failure to properly enter the cash receipts for accounts receivable provided the predication for subsequent analysis of the financial statements.
One of the important operational and marketing activities for this particular truck stop's image was the uniquely attractive uniforms worn by all of the staff. They were slightly different based on the department, but the color scheme was consistent. A long-term relationship between the truck stop and the uniform company helped to retain the brand image for the truck stop (Uniform Services, 2016).
Based on informal conversations with several different departments, the accounts payable balance for that uniform vendor came under suspicion. The standard operating procedure for this vendor was to supply and clean the uniforms. Ownership of the uniforms was retained by the uniform company. Because this was an industry standard practice, and based on conversations with other truck stop professionals, some specific questions presented themselves as appropriate. The department most likely to suffer more uniform wear and tear would be in the repair shop.
An interview strategy was devised that required dressing in similar work clothes to the repair shop. An early morning visit was scheduled, so coffee and doughnuts were used as an offering to help with introductions. The visit yielded the discovery that when a uniform became unwearable due to deterioration, staff would simply alert the vendor representative; a new uniform was supplied in the next scheduled delivery. But, instead of surrendering the old uniforms as required under the contract, the old uniform would be retired to the rag bin for cleanup and oil spills. Eventually those uniforms would be discarded entirely.
One interesting discovery made during the exploratory journeys to other truck stop operations was that they were not as concerned about the employee dress code. This was particularly true in other repair shops. During one excursion, the investigator interviewed a repairman in the shop of another truck stop in the same city wearing the same uniform of the truck stop being acquired. This mechanic, who no longer worked at that acquisition, revealed that no one had monitored or controlled the issuance or recovery of the old uniforms. Based on these observations, the account payable balance was reviewed very carefully for this uniform vendor.
When asked, the controller for the operation to be acquired was very pleased to report that the current balance due as recorded in the existing accounts ledger matched precisely to that vendor's statement. However, that statement also had a cryptic note segregated on the statement away from the current billing information. That note suggested that a separate inquiry was necessary to determine the current "uniform allocation" balance.
The vendor's statement looked very similar to other vendor statements and properly listed the current delivery and cleaning costs. But direct telephone conversation with that vendor revealed an additional $26,000 due for un-surrendered, old, retired uniforms. That $26,000 did not appear anywhere in the accounts payable subsidiary ledger. When confronted, the controller could not satisfactorily explain the absence of that amount from the accounts payable ledger.
A follow up call to the vendor provided adequate explanation. That $26,000 represented the cumulative amount of all the uniforms that had not been returned in exchange for the issuance of new uniforms. Therefore, the cost for all of those uniforms that were sent to the rag bin or had been kept by former employees represented a liability that was not reflected in the accounts payable.
The Last Stop--Getting Tired
In addition to the illustrations above, there were additional discoveries. None of those discoveries would have been possible or explored had one significant event within the broader case described in the current paper not occurred. This was that moment when an intellectual concept transformed into reality; the primary investigator better understood Fraud Examination.
Based on the investigator's research of truck stop operations, he became very comfortable with his understanding of industry-wide metrics. One of the most significant components of truck stop operations is the repair division. Within the repair division, one of the most important revenue producing transactions can be tractor and trailer tire sales. Based on financial analysis, the ratio of each revenue stream within the repair shop was consistent with industry-wide standards. However, a tire sale has a unique component that is not typical in many other retail operations. For example, when a person goes to buy a new pair of shoes, he or she does not typically leave the old pair of shoes behind. For truck tires, the new tires will leave with the truck but the old tires stay behind. One category related to tire sales is particularly unusual. This atypical transaction is not related to revenue; it is an expense.
Unusable tires removed from a truck that are not eligible for retreading must be disposed of in a manner that is approved under Environmental Protection Agency (EPA) guidelines. Used tires are considered to be hazardous waste. Their disposal is regulated by the EPA. Therefore, the cost associated with the disposal of used tires is significant (EPA, 2010).
To illustrate the issue of historical costs: a 1991 study revealed that in the state of Texas alone, more than 150-million tires were illegally dumped (Tire Recycling and Disposal, n.d.) and proper disposal of a tire can cost $20 per tire (Christensen, 2009). The cost of this particular fraud will usually be passed along to residents in the form of higher municipal fees or property taxes.
The primary investigator's curiosity was piqued during an informal interview with repair shop staff. Even though the appearance was designed to be seem to be engaged in a casual conversation, the investigator was keenly aware of everything happening within the repair shop. The primary investigator observed tires being removed from trucks to be replaced by new tires. The repair shop manager would designate where the old tires were to be stored. There were several storage bins, each with a different purpose. The better-quality tires would be accumulated for recovery by a retread operator.
But some tires were placed into an open top 40-foot container. One of the mechanics was asked the name of the company that would retrieve those unusable tires. The mechanic said that he did not know but that the manager would. The repair shop manager was asked and he also said that he did not know either but that the owner should know. At that point, troubling predicative evidence began to coalesce based on seemingly unassociated information, as presented in the next section of the research and case analysis.
Assembling the Puzzle
One of the assets carried on the truck stop balance sheet was a bulldozer. Other interesting, but seemingly unrelated information was the presence of a very large dirt-mound located near the back entrance to the truck stop. There was a sign posted in the ground next to the pile of dirt that simply read, "free fill dirt". The dirt-mound's volume changed periodically.
Another seemingly unrelated bit of information was the size of the property associated with the truck stop. Of the 100 or so acres, only about half of it was developed. Forty or more acres were undeveloped and overgrown with brush. All of these different threads of information began to come together to present a very alarming possibility.
Based on the financial analysis, the primary investigator knew that a Tire Disposal expense should be in the General Ledger, but it was omitted. Based on Tire Sales revenue, the investigator could obtain general estimates of the amount that should have been in the Tire Disposal expense account. Because the expense was not included in the income statement, the net profit was potentially significantly overstated.
The seemingly irrelevant dirt-mound had no relationship to existing operations. The reluctance of the staff to answer an innocuous question, a bulldozer that seemingly has no relationship with a truck stop operation, and forty to 50 acres of undeveloped and underutilized property all became additional predication for further examination of the relationship between the apparently disparate facts.
To investigate, overalls, mud boots and work gloves were required. A search of the brush, carrying an 8-foot length of quarter inch rebar, was conducted in a grid-search pattern. Overalls, boots, gloves, coffee, donuts and construction quality rebar would not be considered standard equipment for an accountant. But they were invaluable in this particular fraud investigation.
Using the tracks made by the heavy bulldozer treads lead to a recent excavation. Standing in the soft dirt of a recently excavated 20 by 40-foot area, the rebar was plunged as deeply into the ground as it would go. Repeated plunges yielded the same results--the rebar bounced; this provided definitive indication that something resilient and flexible was buried just beneath the surface of the ground. Further investigation revealed about 20 acres of tires, buried in layers between two and eight feet deep, had been improperly concealed.
Some events create indelible impressions. One such moment can be caused by rebar bouncing off of the rubber in a buried truck tire. But before the story could evolve to that point, many important steps, methodologies and techniques had to come together in a way that assembled the facts to present a clear, unequivocal and indisputable body of evidence to establish the facts.
The ultimate task of any accountant attempting to conduct due diligence or a fraud examiner is to simply assemble the facts. Financial statement and ratio analysis were certainly critical components of the process. Equally important would be the understanding of a particular industry segment. Interview skills were invaluable.
Another essential fraud fighting tool would be the ability to decipher many variations of complex business documents. In the current case research example, the ability to synthesize information from dozens of credit card clearing companies and to reconcile cash accounts was of monumental importance. But perhaps the most important tool for due diligence and fraud investigator is good old fashioned common sense.
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University of New Orleans
Stanley Self is a Certified Fraud Examiner (CFE) and Professor of Accounting at Kaplan University (KU). Dr. Self earned graduate certificates in Not-for-Profit Organizations from Louisiana State University at Shreveport and finance from Cornell University. His undergraduate studies include an earned BS and an MBA from the University of South Alabama. He earned a DBA with concentration in accounting from Argosy University of Sarasota in 2008, and a doctorate in biblical studies from Master's International Graduate School of Divinity in 2005.
Gene Sullivan is a Professor of Accounting at Liberty University where he serves as the DBA program director. Dr. Sullivan is a Certified Public Accountant. His undergraduate studies include a BS in Accounting from Virginia Commonwealth University. He earned an MS in Accounting from Virginia Commonwealth University in 1977, an MRE from Liberty Baptist Theological Seminary in 1988, and a Ph.D. in organizational leadership from Regent University in 2004.
Tamara Fudge is a Professor in the MSIT program at Kaplan University. She earned music degrees from Indiana University and a DMus from Florida State University; for twenty+ years, she taught music at the university level, sang professionally, and heard her compositions on Public Radio. Dr. Fudge was also a weekend correspondent for the Quad-City Times (Davenport, IA) and has served as an agent and registered representative for major insurance/investment companies. She holds a recent MSIT degree from Kaplan and has won fellowships and awards for innovation and teaching.
Tom Harrington is a Criminal Justice Practitioner with 25-years of field experience. He is an adjunct professor with 4 different universities, and professional lecturer for the FBI. He earned his MA at Southern University of New Orleans, and a BA from Concordia University--Wisconsin. He is currently the Assistant Vice-Chancellor and Police Chief for the University of New Orleans system and is ABD in his pursuit of a PhD in Criminal Justice.
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|Author:||Self, Stanley; Fudge, Tamara; Sullivan, Gene; Harrington, Tom|
|Publication:||International Journal of Business, Accounting and Finance (IJBAF)|
|Article Type:||Case study|
|Date:||Dec 22, 2016|
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